Financial Stability News

Flashing news about financial stability and central banking

Monthly Archives: October 2011

Rational irrationality

John Cassidy has a nice story of what we have learned form the crisis in the last issue of the New Yorker. It’s a follow up on a previous article on JM Kenyes which is also now available on line. Really worthwhile reading! According to Cassidy there hasn’t really been any new theories emerging after the crisis, although we certainly have learned some important lessons. These are:

1. Finance matters.

2. Credit busts are different from ordinary recessions.

3. Positive feedback and multiple equilibria have to be taken seriously.

4. Especially in financial markets, self-regarding rational behavior isn’t necessarily socially optimal.

5. Monetary policy doesn’t always work very well.

6. Fiscal stimulus programs don’t provide a panacea for deep recessions, but the alternatives—do-nothing policies or austerity—are much worse




Top Economists to Advise Sanders on Fed Reform

The pressure on governance changes at the Fed is mounting after the GAO report the other week (see earlier post). Senator Sanders, who was instrumental in getting the GAO audits into the Dodd-Frank legislation in the first place, announced last week a panel that would assist in drawing up meaningful proposals for Fed reforms.  The panel would work with him to… develop legislation to restructure the Fed and tighten rules on conflicts of interest, ensure that the Fed fulfills its full-employment mandate, increase transparency, protect consumers and reduce income inequality.

The panel includes well known economist like Nobel Price-winner Joe Stiglitz and Jeffery Sachs, and former labor secretary Robert Reich. Professor Randall Wray at Levy Institute is also a member of the new panel.

Nominal GDP targeting

… is gaining ground. This recent post by Paul Krugman makes the case – with some reservations:

My beef with market monetarism early on was that its proponents seemed to be saying that the Fed could always hit whatever nominal GDP level it wanted; this seemed to me to vastly underrate the problems caused by a liquidity trap. My view was always that the only way the Fed could be assured of getting traction was via expectations, especially expectations of higher inflation –a view that went all the way back to my early stuff on Japan. And I didn’t think the climate was ripe for that kind of inflation-creating exercise. At this point, however, we seem to have a broad convergence. As I read them, the market monetarists have largely moved to an expectations view.

For another take at the same issue, this post on The Moral Case for NGDP Targeting is also interesting.

Serious conflict of interest at the Fed

The Government Accounting Office has just released a report:  FEDERAL RESERVE BANK GOVERNANCE Opportunities Exist to Broaden Director Recruitment Efforts and Increase Transparency.  The report finds serious conflict of interest among several of the directors on the boards of the regional Federal Reserve banks, not the least in New York. The most prominent one is Goldman Sachs’ Stephen Friedman:

During the end of 2008, the New York Fed approved an application from Goldman Sachs to become a bank holding company giving it access to cheap loans from the Federal Reserve. During this time period, Stephen Friedman, the Chairman of the New York Fed, sat on the Board of Directors of Goldman Sachs, and owned shares in Goldman’s stock, something that was prohibited by the Federal Reserve’s conflict of interest regulations. Mr. Friedman received a waiver from the Fed’s conflict of interest rules in late 2008. This waiver was not publically disclosed. After Mr. Friedman received this waiver, he continued to purchase stock in Goldman from November 2008 through January of 2009. According to the GAO, the Federal Reserve did not know that Mr. Friedman continued to purchases Goldman’s stock after his waiver was granted.

For a short version of the report, see this summary on Senator Sander’s web site, where you will also find a link to the GOA report.

For more info on the Friedman case, see this article by Rolling Stone reporter Matt Taibbi.

Central bankers must update outdated analytical toolkit

Gillian Tett has a nice post in today’s FT where she refers to two recent BIS Working Papers by Claudio Borio, that deals with the need for new tools and policies by central banks, post-crisis. Borio notes that “the mainstream analytical frameworks at policymakers’ disposal are inadequate”, and echoes the earlier Brookings report on the need for a new paradigm for central banking. This will require, according to Borio, “bolder steps bolder steps to develop analytical frameworks in which monetary factors play a core role, not a peripheral one as hitherto – an intellectual rediscovery of the roots of monetary economics.” At the same time, it is advisable to lower expectations of what central banks can do, given the limited toolbox available. Promising too much with the new macro prudential tools could set the new framework up for failure. And the current crisis is also hard to mend with its huge balance sheet dislocation. — When you are at it, read also his earlier WP on the Savings Glut, and especially the short annex which gives the theoretical background for his analysis.

Chicago Evans wants a higher inflation target

In a speech yesterday President of Chicago Fed Charles Evans noted that the economic situation is bad and not getting any better. Given the dual mandate of the Fed, this calls for more accommodation. He points to the Taylor rule implying a negative interest rate of 3,75 % right now, and notes that an unemployment rate of close to 10 % cannot be tolerated. Suggesting that the Fed should have a more symmetrical approach to its dual mandate, he suggest a (temporary) increase in the (informal) inflation target from 2 to 3 %. Not much, but a clear recognition that the Fed should be more supportive of the weak recovery. Interestingly, in the same speech he also refer to Milton Friedman as an advocate of  monetary stimulus, given in the context of the Japanese crisis in 1998, see his WSJ article here.

IOR caps: a new instrument of monetary policy?

This finance blogger has an interesting discussion of the Modern Money Theory, and then goes on to recommend caps on reserve interest rates as a way of getting bank reserves to those (small) banks that would need them most. Interestingly, this policy has already been initiated by some European central banks, including Norges Bank. For details, see here.

Repo Market Reform

NY Fed just released summary of conference dealing with repo market reform. Presentations are posted on their web site. See Acharya’s presentation form the summary session; he proposes a new form of MMLR, that could handle runs in the repo market. Other participants discussed the “safe harbour privilege” for repos and derivatives, arguing that … recent extensions of the “safe harbor privilege,” which gives favorable treatment to some financial contracts in bankruptcy, may have gone too far and could have contributed to financial instability.


A Nobel for Freshwater Economics

John Cassidy at the New Yorker magazine has an interesting comment on the recent Nobel Price to Sims and Sargent. In his view, this is a price to freshwater economics at a pretty odd time. The crises showed that two of the basic premises of freshwater economics were wrong:

Unfortunately, in case it needs restating, freshwater economics turned out to be based on two ideas that aren’t true. The first (Fama) is that financial markets are efficient. The second (Lucas/Sargent/Wallace) is that the economy as a whole is a stable and self-correcting mechanism.

In Cassidy’s view, those who opposed this mainstream view and instead focused of the potential  instability of the economy, like Minsky or Kindleberger, should have gotten the price instead, or some of their followers like Leijonhufvud, Davidson or Benassy.


Too Big to Fail Not Fixed, Despite Dodd-Frank

Simon Johnson has an interesting Bloomberg article where he argues that too-big-to-fail is not fixed by Dodd-Frank. In his view, it is highly unlikely that Treasury would have used the new liquidation powers on the big banks – if they had been available in 2008. The only thing that will work is to break up (or down, depending on how you view this) the large mega banks. Quote: The financial system hasn’t become safer since September 2008. We are not in a strong position to weather the financial storms that now appear on the horizon.