The Chinese renminbi (RMB) has come under intense scrutiny in the last four years, and calls for greater flexibility of its exchange rate have found receptive audiences amongst economists, politicians and the popular press. Many have advocated that China move to a more flexible exchange rate in order to alleviate global imbalances and improve its own macroeconomic management. But the benefits of an exchange-rate regime change for China and for the world may have been over-sold in policy circles. I say so on two grounds. First, the role of a flexible exchange-rate regime in facilitating current account adjustment may be vastly exaggerated. Second, the virtue of a flexible RMB exchange-rate regime in enhancing the effectiveness of China’s macroeconomic stability may also be overrated.

Would a flexible exchange rate really speed up current account adjustment?

I ask this question not just due to the fact that a country’s current account imbalance is the difference between its national savings and national investment, that the large US current account deficit is a reflection of its large saving deficit, and that the US bilateral deficit with China is only part of its overall deficit with the rest of the world. All these are true.

Beyond these, many economists and policy wonks take it as self-evident that a flexible exchange-rate regime must deliver a faster current account adjustment. Many IMF statements also reflect this supposition. There is in fact no systematic evidence supporting it. I call this a faith-based initiative, something widely assumed to be true and actively peddled to countries as policy advice, but with little solid supportive evidence.

In a systematic analysis of this issue, Menzie Chinn and I find absolutely no support in the data for the notion that countries on a de facto flexible exchange-rate regime exhibit faster convergence of their current account to the long run equilibrium.¹ This is true when we control for trade and financial openness; and this is true when we separate large and small countries.

To be sure, the current account does have a tendency to revert to its long-run steady state. This is clearly reflected in our empirical work. However, the speed of adjustment is not systematically related to the degree of flexibility of a country’s nominal exchange-rate regime.

Should we be surprised by this finding? Perhaps not. The current account responds to the real exchange rate, not the nominal exchange rate. If the real exchange rate adjustment does not depend very much on the nominal exchange-rate regime, then the current account adjustment would not depend very much on the nominal exchange-rate regime either. Menzie Chinn and I therefore go on to check whether the nature of a country’s nominal exchange-rate regime significantly affects the adjustment process of its real exchange rate. After looking at enough regressions, we conclude that the answer is no: the real exchange-rate adjustment is not systematically related to how flexible a country’s nominal exchange-rate regime is. If anything, there is slight, but not very robust evidence that less flexible nominal exchange-rate regimes sometimes exhibit faster real exchange-rate adjustment.

Just to be clear, if one could engineer a real appreciation of the renminbi, it could have some effect on China’s trade or current account balance. Indeed, in a separate research project that I am doing with Caroline Freund and Chang Hong, using China’s bilateral trade data and separating processing from non-processing trade, we find evidence that bilateral trade volume clearly responds to changes in bilateral real exchange rate, especially for non-processing trade.² But a more flexible exchange rate does not promise a faster current account adjustment or resolution of global current account imbalances.

If China does opt for a more flexible exchange-rate regime today, its real exchange rate will most likely appreciate on impact. However, given China’s still-shaky financial sector and the credit crunch in advanced economies, it is certainly possible for the real exchange rate to go the other direction the day after tomorrow. After all, today’s expectation of an RMB undervaluation is a relatively recent phenomenon, emerging in late 2003. As clearly shown in Figure 1, taken from a paper with Jeffrey Frankel, until October 2003, the market actually expected a RMB depreciation, as measured by the non-deliverable forward rate.³ But the expectation shifted in late 2003 when US officialdom and scholars at prominent think tanks started to up the volume in the call for an RMB revaluation.

The very high speed of China’s foreign reserve accumulation really took off within the last four years, as seen in Figure 2. It may very well be responding to a shift in market expectation on the RMB movement, or at least the reserve accumulation and the exchange rate speculation feed on each other. However, if it took only four years for China’s FX reserve to triple in value, it may take only another four years for it to lose 60% of the value once the exchange rate expectation starts to reverse itself. Economic history books are full of examples of seemingly sudden shifts in market sentiment. A tight credit market in developed countries, such as the one we are seeing today, has in the past engendered a reversal of global capital flows, and a concomitant shift in the valuation of emerging market currencies.

Would a flexible regime vastly improve the effectiveness of China’s macro policies?

To appeal to China’s self-interest, advocates of a more flexible exchange-rate regime say it will greatly enhance the effectiveness of China’s domestic macroeconomic policy. A more flexible regime, as the logic goes, would free the domestic interest rate to serve as an instrument for domestic macroeconomic stability, and may benefit other policy objectives as well, such as financial reform and addressing future shocks. While I agree that a shift to a more flexible exchange-rate regime is a net positive for China, I would caution that the benefits of doing so for China should not be overrated.

First, China’s current monetary policy still has room for maneuver. Fundamentally, China’s capital controls, while leaky, are binding at the margin. The gap between lending and deposit rates can be widened further. The required reserve ratio might also be raised if desired.

Second, China’s fiscal policy still has room for maneuver. True, there are a lot of contingent liabilities that should and may show up on the country’s balance sheet. On the other hand, state-owned firms collectively are making a profit that is not currently counted in the government budget. The state may require these firms to pay up more dividends to augment existing fiscal management tools.

Third, to the extent that the de facto dollar peg constrains the conduct of China’s monetary policy, it may not be a bad thing. The most important goal of a good monetary policy is to maintain price stability. The de facto peg to the US dollar has served China well – beyond its role in promoting exports – as it has provided an anchor for its monetary policy. Once the country switches to a substantially more flexible exchange-rate regime, it will by definition lose this nominal anchor. One might prescribe an inflation targeting framework. But one could question how faithfully China will follow such a framework.

China’s recent monetary history has clear bouts of double-digit inflation, as shown in Figure 3. So resisting political pressure to deviate from maintaining price stability isn’t necessarily a strong suit for the central bank. The current leadership at the Central Bank, Governor Zhou Xiaochuan and his deputies, happens to be superb. But leadership at the central bank could change, and a look at the recent history doesn’t inspire absolute confidence that an inflation-targeting framework will be faithfully followed. So a less stable domestic price is a risk that cannot be easily ruled out if and when the country shifts to a more flexible exchange-rate regime.

Conclusion

I have stressed two points. First, the notion that a flexible exchange-rate regime would facilitate a faster current account adjustment is in fact not well supported by empirical evidence. Second, the virtue of a flexible exchange-rate regime in enhancing the effectiveness of China’s macroeconomic policy may also be overrated.

I still think that the benefits of moving to a more flexible exchange-rate regime likely outweigh the costs for China. On the other hand, China faces many challenges in its economy, including environmental degradation, rising income inequality, pervasive corruption, mining production safety, food production safety, and a constant threat of massive unemployment, to name just a few. In the grand scheme of things, when ranking all the reforms to do on the basis of benefit to cost ratio, how much priority this particular reform – the shift of the exchange-rate regime - should be given is a separate question.

References

1 Chinn, Menzie and Shang-Jin Wei, 2007, “Faith-based Initiative: Do We Really Know that a Flexible Exchange Rate Regime Facilitate Current Account Adjustment?” University of Wisconsin, Madison and Columbia University.
2 Freund, Caroline, Chang Hong, and Shang-Jin Wei, 2007, “Bilateral Exchange Rates and Bilateral Trade Balance,” International Monetary Fund and Columbia University.
3 Frankel, Jeffrey, and Shang-Jin Wei, 2007, “Assessing China’s Exchange Rate Regime,” Economic Policy. A longer version is available as NBER Working Paper 13100 (May 2007),

The two Bs in the title of this Vox column refer not to bed and breakfast, but to the rather less restful and nutritious contributions made on Friday, August 31 by President Bush in the Rose Garden of the White House and by Chairman Bernanke of the Federal Reserve Board, at the annual Jackson Hole Conference in Wyoming.

Both addressed the crisis in the US subprime mortgage market, falling US house prices, the wider turmoil in credit markets and the liquidity problems encountered by a growing number of diverse financial institutions.  Bernanke listed the weapons in the Fed’s armoury and tried to outline the Fed’s contingent reaction function to new developments.  Bush outlined a small bailout for financially distressed low and middle-income homeowners.

Bernanke’s ‘wait and you shall see’

Chairman Bernanke first.  He succeeded completely in what he set out to do: he said nothing at all new, but said it very well indeed. Ignoring the scholarly/historical bits, what is relevant to future Fed policy can be captured by the following quotes and their translations.

“…. if current conditions persist in mortgage markets, the demand for homes could weaken further, with possible implications for the broader economy. We are following these developments closely.”

Translation: Even though the Fed is in Washington DC, we are not asleep at the wheel.

“The Federal Reserve stands ready to take additional actions as needed to provide liquidity and promote the orderly functioning of markets”. 

Translation: We can inject additional liquidity through open market purchases or at the discount window; we can cut the discount rate or the Federal Funds target rate, and we can widen the range of eligible assets we will accept as collateral in repos or at the discount window.

“… the further tightening of credit conditions, if sustained, would increase the risk that the current weakness in housing could be deeper or more prolonged than previously expected, with possible adverse effects on consumer spending and the economy more generally.” 

Translation: An increase in credit risk spreads represents a tightening of monetary conditions, even if the Federal Funds target is unchanged.  The Fed is aware of this.

“… in light of recent financial developments, economic data bearing on past months or quarters may be less useful than usual for our forecasts of economic activity and inflation. Consequently, we will pay particularly close attention to the timeliest indicators, as well as information gleaned from our business and banking contacts around the country. Inevitably, the uncertainty surrounding the outlook will be greater than normal, presenting a challenge to policymakers to manage the risks to their growth and price stability objectives. The Committee continues to monitor the situation and will act as needed to limit the adverse effects on the broader economy that may arise from the disruptions in financial markets.”

Translation: Never mind what we said following the August 7 FOMC meeting.  That was then.  This is now.  HOWEVER, financial kerfuffles influence the setting of the Federal Funds target if and only if (and to the extent that) they have a material impact on our fundamental objectives, employment and price stability, going forward.

What does this mean for the future path of the Federal Funds rate?

Most of the recent real economy data are robust, including the QII GDP growth rate of 4.0% (annualised) and robust personal income and personal spending growth in July.  However, they extend no later than July 2007, and therefore do not capture any negative effect on consumer and investment demand of the August financial turmoil. 

Core PCE rose 0.1% in July 2007, keeping the 12-month rate of core PCE inflation at 1.9% for a second month.  Headline CPI also rose by 0.1% in July, and fell to 2.1% over a 12-month period, down from 2.3% in June.  While both are north of the centre of the Fed’s assumed comfort zone (which ranges from 1.0 to 2.0%), they are low enough not to be a cause for embarrassment were the Fed to decide to cut the Federal Funds target on September 6. 

Although if I were a voting member of the FOMC, I would vote to keep the Federal Funds rate constant, barring exceptional developments between now and September 6, I believe that the most likely outcome is a 25 bps ‘insurance cut’ in the Federal Funds rate.  We shall see.

Bush’s small bail-out

By revealed preference, poverty in the USA is something this Republican Administration and Democratic Congress (like past Republican and Democratic Administrations and Congresses) can live with.  The prospect of a couple of million homeowners being foreclosed upon during the year before a presidential election is, however, more that the body politic can stand – these people might well be voters.  President Bush gave us the homeowners bailout ‘lite’ in his speech.  The Congress will no doubt up the ante and turn this into a homeowners bailout ‘premium’. 

Bush first gave a concise statement of the case against bailing out mortgage lenders, speculative investors in real estate and those who unwisely took on excessive mortgages and then outlined a plan for bailing out the last-mentioned category.

“A federal bailout of lenders would only encourage a recurrence of the problem. It's not the government's job to bail out speculators, or those who made the decision to buy a home they knew they could never afford. Yet there are many American homeowners who could get through this difficult time with a little flexibility from their lenders, or a little help from their government. So I strongly urge lenders to work with homeowners to adjust their mortgages. I believe lenders have a responsibility to help these good people to renegotiate so they can stay in their home. And today I'm going to outline a variety of steps at the federal level to help American families keep their homes.”

There are a number of aspects of these proposals that are interesting from an economic point of view.

(1) It represents a cyclically appropriate, albeit small (especially in the President’s version – the only one formally on the table) fiscal stimulus. That’s what is meant by “…a little help from their government”.

(2) The fiscal stimulus proposed by the President will be implement mainly through quasi-fiscal means.  That means that they will not come in the form of on-budget tax cuts or increases in subsidies or other public spending.  Instead they will be hidden in below-market mortgage interest rates, supported by Federal Guarantees, through subsidised mortgage insurance and other off-budget measures that are functionally equivalent to tax cuts or subsidies.  The full budgetary impacts will be obscured and delayed. 

That is clear from the central role assigned to the Federal Housing Association (FHA), the cornerstone of socialised housing finance in the USA.  The FHA is a government agency that started operations in 1934 and provides mortgage insurance to borrowers through a network of private sector lenders. Bush proposes to expand a proposal he sent to the Congress 16 months ago that enables more homeowners to qualify for this insurance by lowering down-payment requirements, by increasing loan limits and providing more flexibility in pricing.  There are obvious elements of subsidy in this proposal.

Already about to come online is a new FHA program (‘FHA-Secure’) that aims to allow American homeowners who have a good credit history but cannot afford their current mortgage payments to refinance into FHA-insured mortgages.  Again, the unaffordable can only be made affordable through a Federal subsidy.

The President also proposes to change a feature of the US Federal income system that can hit homeowners who no longer can service their mortgages hard.  Debt forgiveness counts as taxable income.  Assume you have $100,000.00 worth of mortgage debt you cannot afford to service. Your house is worth $100,000.00 to the bank.  If the bank were to forgive you your mortgage debt and take your house in exchange, you would still be left with income tax liability on the $100,000.00 of forgiven debt.  That seems a bit rough.  Of course, you could instead sell the house to the bank for $100,000.00 and use the proceeds of the sale to pay off the loan.  No income tax would be due (there could, under certain conditions, be capital gains tax). 

The US Congress is likely to expand on these proposals by letting Fannie May (or Federal National Mortgage Association) and Freddie Mac (or Federal Home Loan Mortgage Corporation), two Government Sponsored Enterprises (GSEs) created by the Congress that are at the heart of the US system of socialised housing finance, expand the scale of their operations, specifically by increasing the upper limit on the size of the mortgages they can extend or guarantee from its current level of $417,000.00¹

(3) It represents a redistribution of income towards those low and middle-income Americans who had taken on excessive mortgage debt.  The bill is paid mainly by the shareholders of the mortgage lenders (that is what is meant by “… a little flexibility from their lenders,…” and by the American tax payer who will have to foot the bill of the increased subsidies attached to the loan guarantees and subsidised mortgage insurance offered by the FHA.  If the Congress manages to get Fannie May and Freddie Mac involved in the game, the cost to the tax payer could turn out to be significantly higher.

(4) By subsidising excessive and imprudent borrowing, it reinforces the moral hazard faced in the future by low and middle income Americans pondering the size of the mortgage they can enforce (if the market-friendly President Bush is willing to bail us out today, would a more market-sceptical President Barack Obama or President Hilary Clinton not do so again tomorrow?)

(5) By leaning on the lenders to show greater leniency towards delinquent mortgage borrowers than would be required by the mortgage contracts and the dictates of the competitive environment, it will discourage future subprime lending and other higher-risk mortgage lending by banks and other mortgage finance institutions.  This will further increase the role of the FHA, Fannie, Freddie, and the Federal Home Loan Banks, and will further strengthen the role of socialised housing finance in the USA.

(6) There is a reasonable prospect that Federal legislation and Federal regulation and supervision of the housing finance industry will be changed in such a way as to reduce the likelihood of the excesses, the mis-selling and the misrepresentations that became rampant especially during the past 5 years or so.  There has been a serious failure by the regulators to stop the rogue mortgage lending practices that have proliferated, and not just in the subprime market.  The Fed, both under Chairman Greenspan and under Chairman Bernanke is one of the institutions that bears responsibility for this regulatory fiasco. 

It is, unfortunately, quite likely, that the legislative and regulatory changes we will get will amount to a Sarbanes-Oxley-style regulatory overshoot, that is, regulation of the ‘if it moves, stop it’ variety. This will discourage future lending to low-income or credit-impaired would-be homeowners even when such lending is fundamentally sound.

Parochialism in US economic policy.

Both sets of remarks were amazingly parochial.  The President clearly believes that, except for oil and Chinese imports, the US is a closed economy. 

Chairman Bernanke’s text contains a few rather generic references to global matters, but rather less than the topic deserved.  Surely the fact that so much of the subprime exposure ended up in European and Asian financial institutions must have made it easier for the US lending excesses to occur.  One also has to recognise the importance of international regulatory arbitrage as a factor limiting the ability of national regulators to impose even mild disclosure restrictions (let alone more serious regulatory constraints, whether for prudential or consumer protection reasons) on internationally mobile financial institutions. 

Even in a lecture on ‘Housing, Housing Finance, and Monetary Policy’, it is surprising not to find the word ‘exchange rate’ in a section of the lecture titled ‘The Monetary Transmission Mechanism Since the Mid-1980s’.  During the past 20 years, the US economy has become increasingly open, both as regards trade in real goods and services and trade in financial instruments.  Transmission of monetary policy through the exchange rate undoubtedly has become more important, both for prices and for aggregate demand, during this period, and US real interest rates are increasingly influenced by global economic developments, as Governor Bernanke himself has pointed out in a lecture on the global saving glut 

When all is said and done, the entire construction sector in the US is 5 percent of GDP.  The bit that is hurting badly, residential construction is somewhere between 3 and 4% of GDP.  Exports are 12% of GDP and growing in volume terms at an annual rate of over 11%.  Import competing industries are also doing well.  The combination of a sharp nominal and real depreciation of the US dollar and continued rapid growth outside the US accounts for the strength of the externally exposed sectors of the US economy.  It goes a long way towards offsetting the weakness of parts of the nontraded sectors, including housing.  While increased credit risk spreads represent a tightening of monetary conditions, the weaker dollar represents a loosening of monetary conditions.  There is no indication from Chairman Bernanke’s address that the Fed pays any attention to this in its actual policy deliberations.  This is especially surprising in view of Chairman Bernanke’s recognition of these issues ‘in the abstract’, in some recent lectures.

Of course, housing troubles are not limited to the construction sector.  Housing wealth is an important component of total net household financial wealth; real estate assets can be collateralised and thus are a ready source of consumer spending power.  Another Fed Governor, Frederic Mishkin argued at the same Jackson Hole conference that a fall in housing wealth could be a serious drag on consumer spending, assuming that the marginal propensity to spend out of housing wealth was 3.75% (a very precise number indeed). 

Bottom line

A 25 bps cut in the Federal Funds rate on September 6 is unnecessary, likely, but my no means a foregone conclusion.  By the time Congress is done augmenting the Bush mini bail-out of financially stressed mortgage holders, there may be a fiscal stimulus worth about 0.5% of GDP.  With elections looming, this fiscal stimulus could be enacted rather swiftly.  The anticipation of relief on both the fiscal and monetary side is likely to be enough to normalise credit conditions (albeit at spreads closer to long-run historical levels rather than at the anomalously low levels of 2003-mid 2007) and to provide a boost to asset markets.  The US housing market is in structural trouble, with excess capacity in most categories that will take years to work off.  But that is a small enough part of the US economy not to be a serious drag on overall activity in the years to come.

The public and (especially) the press seem to have overreacted to the current turmoil in financial markets. It is often claimed that all we are witnessing is the global-liquidity‘s revenge on Bernanke. However, if it is a financial turmoil that we are facing, it is most likely to involve an “extensive/benign” scenario rather than an “intensive/malign” scenario. An extensive/benign scenario is one in which a specific and quantitatively limited type of risk (i.e., the one related to the subprime borrowers in the US) is spread out extensively across investors and countries for risk-sharing purposes (the benign phenomenon) via the instruments of financial diversification. An intensive/malign scenario, by contrast, is one associated with a large amount of risk concentrated with some investors (possibly geographically), whose deterioration usually leads to large default losses (the malign phenomenon).

In the last twenty years, financial markets have changed dramatically throughout the world, and in the US in particular. This has been synonymous with increased ability of risk diversification. Put differently, the new financial system has become increasingly atomistic. The physical link between the primary borrower (the family seeking a mortgage) and the lender, via a plethora of instruments of financial diversification (and of subsequent borrowers/lenders along this chain), has weakened considerably.¹ At the same time, technological improvements in the risk assessment process have substantially reduced monitoring costs for lenders.

In this context, the fact that lenders (loosely speaking) have been assuming an increasing amount of risk (“the subprime loans”) is a natural implication of the deepening of financial diversification. In the specifics of mortgage markets, home-ownership projects that were turned down ten years ago have now become eligible for finance. With falling monitoring costs and increased ability of diversification, financing riskier categories of borrowers can be perfectly consistent with profit maximisation by lending institutions. On the other hand, for previously constrained families, this process of financial diversification has meant a loosening of their borrowing constraints. Overall, and from the viewpoint of economic theory, it is hard to identify this as a malign phenomenon.

It is sometimes argued that, along the financial diversification chain, it may become increasingly difficult to identify where the risk exactly lies. Certainly true, yet isn’t this exactly what financial diversification is all about? Making idiosyncratic (family-specific) risk negligible relative to the aggregate pool of financed (home-ownership) projects.

From a different angle, many critics have pointed out the fallacy of this process arguing, somewhat loosely, about “excessive lending” or “excessive amount of risk” as necessary drawbacks of increased financial diversification. From the standpoint of economic theory, though, “excessive” is meaningful only if “inefficient”. In this case, one can formally identify an inefficiency if either of two phenomena arises: (i) an increased “adverse selection” and/or (ii) an increased “moral hazard” problem. Possibly, only the latter qualifies as concrete in this context.

Adverse selection and moral hazard

Isn’t it worrying that, simply allured by the rumour that “nowadays nobody is denied a mortgage”, virtually any family – including the most risky ones – decides to show up in a bank and ask for a loan? Not really, to the extent that the risk associated to this borrower is priced correctly (with this being more likely as monitoring costs fall) and is diversified through the system. After all, once again, this is what financial risk-sharing is all about.

Isn’t it true that, tempted by the increased opportunities of insurance, financial institutions have been taking up an increasing amount of risk? Prime facie, this may qualify as a deepening of a moral hazard problem. “Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the most money. A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly”.²

In the specifics of our example, the “insured” is financial institution “n-1” along the chain and the “insurer” is financial institution “n” buying a mortgage-backed security. What is crucial about moral hazard, though, is that the insured individual (better informed than the insurer about her own intentions) has the ability to affect the return distribution through her behaviour, and does that in a distorted way. Does this apply to our case? Possibly yes. Pushed by fierce competition to make it to the “funds-of-the week” top-ten list of pseudo-specialised financial reviews, with the comfortable belief that one will be handsomely compensated in the case of success and allured by the possibility of diversifying much of the risk away, many funds’ managers have probably taken up an increasingly inefficient amount of risk. A correct assessment of risk should instead consist in compensating funds managers just slightly less if the fund is listed, e.g., eleventh in the ranking (if only such an ideal ranking existed!)³. To be sure, this potential source of inefficiency does not lie in the funding of subprime loans per se, but in the excess funding of risky projects due to a perverse/distorted assessment of risk.

A correct quantitative assessment of the proportion of these inefficiently risky loans is extremely hard. However, one should make sure that such an assessment be made relative to the spectacular increase in financial investment experienced in the last ten years in both the US and global markets. In this vein, there is scope for cautious optimism.

House prices, and aggregate vs. idiosyncratic risk

In the turmoil of comments witnessed these days, many seem to have forgotten that, in the US, the initial cause of distress has been a fall in house prices. It is well-known that, via gains in home equity⁴, the house price acceleration has considerably widened the access to borrowing for the average family - through a series of instruments: secondary loans, mortgage-equity withdrawal, mortgage refinancing, etc. Here, though, we would like to focus the attention on two partly neglected aspects: (i) the previous increase in house prices may not have necessarily been a bubble; (ii) a fall in house prices is the realisation of an aggregate risk.

Are we really confident that the recent fall in house prices qualifies (as many have repeatedly suggested) as the pricking of a bubble? This is important; for it implies that the previous price inflation was somehow inefficient.⁵ However, serious models exist (the elaboration of which Governor Bernanke has eminently contributed to⁶) that can rationalise an acceleration in asset prices as the result of a so-called “credit cycle”: an initial increase in house prices (perfectly consistent with “fundamentals”) strengthens the demand for borrowing (via an equity valuation effect), which in turn validates and reinforces the initial increase in prices. Of course, one cannot rule out that part of the observed run-up in house prices may have been unjustified on the basis of “fundamentals”. Yet, once again, such an assessment should be made relative to the acceleration that can be rationalised on the basis of a coherent model of the type described above. Furthermore, the parallel strong acceleration in housing investment experienced in the US may have gradually led to a re-balancing of supply with demand in the housing market, finally leading to the recent fall in prices.

A possible source of concern behind the fall in house prices is that it constitutes the realisation of an aggregate shock. As it hits all families simultaneously, this shock is by definition not diversifiable. Hence, there is nothing to blame the modern financial architecture here. This is definitely material for monetary policy. Fortunately nobody knows better than Bernanke about the connections between the financial and the real side of the economy. Despite the allegations of “rooky mistake” for defining the subprime problem as “contained”, Bernanke is the one that has spoken recently about a possibly forthcoming “negative financial acceleration” problem for US families: falling house prices leading to a worsening of balance sheets, to a rise in families’ finance premia and tightened borrowing conditions, with possible final effects on consumption.⁷

However, this concern may once again be worth a word of caution. In today’s increasingly integrated financial markets, national (usually the prototype of aggregate) shocks assume increasingly the form of idiosyncratic shocks: country risk can in fact be shared away internationally. This entails that both the US and Europe may end up experiencing a dampening in their growth rates of consumption/output in the near future, but of possibly contained magnitude exactly because of the benefits of international risk-sharing.

The stock market and Bernanke's two sides

What to make, then, of the recent turmoil in financial markets? Here we obviously enter more risky territory. One interpretation is that the usual irrational exuberance of the market may have focused excessively on the “extensive” rather than on the “benign” part of the story. A spark originating from a somewhat limited niche of the US mortgage markets was after all spreading geographically with surprising pervasiveness. In this vein, the phenomenon was taking the form of a “new” crisis.

But couldn’t it be that we are just facing a relative benign risk being spread out extensively (and therefore not likely to generate major losses and defaults) as opposed to a malign intensive risk concentrated geographically (as the bank crises of the past, see for instance the Massachusetts credit crunch of the 1980s?).

Is the Fed hesitating too long in cutting interest rates? The malevolent interpretation is that Bernanke is hostage to his (alleged) schizophrenic identity, with the champion of inflation targeting on the one hand, and the scholar of the Great Depression on the other. More than a weakness we may see this as a strength. The Fed may well have embraced the extensive-benign interpretation. If this was the case, it is sensible to wait that the portion of “inefficient risk” (see our point above) be naturally re-absorbed by the market, thereby avoiding an ex-post validation of any moral hazard behaviour (however relevant it might have been). Different, and more important, is the issue that pertains to spillovers that may affect the real side of the economy. The Fed is definitely anticipating a cut in the funds rate if any signals of such spillover materialise. In the meantime, the international risk-sharing scenario cited above may continue to offer a comfortable buffer of inertia, both for the Fed and the ECB.

Footnotes

1 The IMF refers to this as a “more arm’s length” financial system, with an increased role for price signals and competition among lenders (see IMF WEO, September 2006).
2 Source: Wikipedia
3 I thank Nicola Pavoni for a lively discussion on this point.
4 Technically, the difference between the existing value of the mortgage and the market value of the house.
5 Some economists would, for goods reasons, also qualify bubbles as efficient outcomes, but we prefer to abstract from this point here.
6 Bernanke and Gerler (1989), Kyotaki and Moore (1997). These papers differ in many details but both contain a financial acceleration mechanism.
7 See http://www.federalreserve.gov/boardDocs/speeches/2007/20070615/default.h...

The roller-coaster swings of the financial markets that are sending shivers down the investors’ spines since February are much more than the unavoidable correction after a 5-year bull period.

The Economist wrote that this is a good time for a credit squeeze and praised the benefits of tighter conditions, following the conventional wisdom that downfalls are helpful because they lead to a more correct pricing of goods and financial assets. There is however a peculiar feature of the last crises (and particularly of this one) that makes this position less acceptable, at least from the point of view of who bears the losses and who pocketed the gains during the boom.

There are four characteristics of the present financial system that are worth remembering.

•  The dramatic rise of financial assets and derivatives all over the world. At the end of 2005 (IMF, Global Financial Stability Report, April 2007), total financial assets stood at an astonishing level of 3.7 times the world gdp. The notional amount of total derivatives was double than the volume of total financial assets, which means 11 times global gdp. Remember that financial derivatives did not exist only thirty years ago.
• The historical low level of interest rates over the last years, since the mid-90s (as an effect of the Greenspan monetary policy and his attempt to feed the growth of the stock market). As a consequence of favourable monetary conditions, the price for risk required by the market also stood at very low levels. The two following graphs give clear evidence of the abnormal situation prevailing in the last years.

• The growing weight of stocks and bonds as a percentage of total financial assets (therefore the decrease of loans by banks and other financial intermediaries). At the world level (and in the European Union), bank loans account for 50% of total financial assets, but in the US and Japan the ratio is much lower. In the US, only 1 dollar out of five is borrowed from a bank.
• The decrease of government bonds (i.e. risk-free assets) on total debt securities. While the average ratio at the world level is 50%, in Europe is 35% and in North America 26%, with a downward trend. The last two points mean that households' portfolios are more and more made of securities bearing both market and credit risk.

These are the ingredients of the magic of financial innovation of the last decades: in a nutshell, banks created an astonishing volume of debt, packaged it into various kinds of securities, with different degrees of guarantees. These securities have been purchased by a wide range of smaller banks, pension funds, insurance companies, hedge funds, other funds and even individuals, who have been encouraged to invest by the generally high ratings given to these instruments. According to an important school of thought, this “arm-length” financing is the most efficient to allocate resources. Others can recall Dickens who many years ago defined credit as a system “whereby a person who cannot pay gets another person who cannot pay to guarantee that he can pay”.

As a matter of fact, the global financial systems proved to be very resilient to real and financial shocks in the last two decades, but what mostly worries central banks is that – unlike the old bank-based times - they simply do not know where the risk is. Witness this statement in the June 2007 Report of the Bank for International Settlements (p. 145): “Assuming that the big banks have managed to distribute more widely the risks inherent in the loans they have made, who now holds these risks, and can they manage them adequately? The honest answer is that we do not know”. Honest, but frightening.

The only thing we know is that the losses will fall on the shoulders of final investors, and will not be shared with banks as it happened in more intermediated forms of finance. The point is that banks’ profits in the last 20 years stood at historical high levels. Returns on equity have been normally at two-digit levels (the first being preferably two) and probably will only be dented by the forthcoming market correction. In other words, the credit madness is over, a diet was overdue, but those that will have to follow a rigid diet are not those who put on weight in the past years. The allocative efficiency of the arm-length financing deserves at least a second judgement.

The policy implications of what is under our eyes are at least threefold.

First, once again, a rating problem has emerged. Credit risk assessments have been made on too optimistic assumptions, using data not always statistically significant and systematically ignoring tail events. When banks do not take risks on their books, but only sell them, the fragmentation of responsibilities leads to what The Economist has defined as “too much money [being] lent too cheaply and too easily to too many people”. Banks should not skip risks so easily: a portion of the risk (for instance using capital requirements) should remain on banks’ balance sheets.

Second, the securities issued were much less marketable than banks pretended. Most sophisticated bonds were infrequently traded; some were tailored by investment banks for specific clients and were never traded. Mark-to-market was therefore only a subjective valuation involving complex computer models and assumptions. Both directly made by the investment bank itself. The price discovery by the market, the very heart of a securitised world was simply an illusion. Final investors are barely protected when their securities are traded in such over-the-counter (unregulated) thin markets.

Third, there is a problem of transparency in the retail market for financial assets. As financial products are becoming more and more sophisticated, a great majority of investors are not aware of the risks that they are actually taking. There are two hypocritical reactions that are emerging: to ask for more disclosure and/or for more financial literacy. The first one should lead only to an increase of sophisticated prospectuses, which can be read only by those holding a PhD in finance (possibly of a very recent vintage). The second one is even more absurd (not surprisingly was immediately backed by President Bush) as it is simply impossible to fill the gap between the current level of financial education and the current level of rocket-science finance involved in current financial products. The only solution is to use regulation (and particularly the conduct of business rules) to make more convenient for retailers to sell simple financial products. A wide body of research (particularly in the United Kingdom, sponsored by the Treasury and the FSA, the financial supervisor) proves that the present regulatory philosophy creates a strong bias towards sophistication and opacity. Time has come to change course and to create incentives for financial intermediaries to sell easier products to the final investors. Only at that point will a higher level of financial education be effective. Time has also come for finance economists to look more closely and in a more Dickensian way at what happens at the last step of the magic of credit creation.

This article comes from our Consortium partner www.LaVoce.info. You can find an Italian-language version there.

In response to the credit and liquidity crunch that has recently spooked global financial markets the Federal Reserve reduced, on Friday 17 August 2007, its primary discount rate from 6.25 percent to 5.75 percent. The discount rate is the rate that the Fed charges eligible financial institutions for borrowing from the Fed against what the Fed deems to be eligible collateral. It is normally 100 bps above the target Federal Funds rate, which is the Fed's primary monetary policy instrument and which is currently 5.25 percent. We believe that this cut in the discount rate was an inappropriate response to the financial turmoil.

The market failure that prompted this response was not that financial institutions are unable to pay 6.25 percent at the discount window and survive (given that they have eligible collateral). The problem is that banks and other financial institutions are holding a lot of assets which are suddenly illiquid and cannot be sold at any price. That is, there is no longer a market that matches willing buyers and sellers at a price reflecting economic fundamentals. Lowering the discount rate does not solve this problem; it just provides a 50 bps subsidy to any institution able and willing to borrow at the discount window.

What the Fed should have done

Instead of lowering the price at which financial institutions can borrow, provided they have suitable collateral, the Fed should have effectively created a market by expanding the set of eligible collateral and charging an appropriate "haircut" or penalty. Specifically, it should have included financial instruments for which there is no readily available market price to act as a benchmark for the valuation of the instrument for purposes of collateral.

There is no apparent legal impediment to doing this.¹ Allowable collateral includes a wide range of government and private securities, including mortgages and mortgage-backed securities. Indeed, the Federal Reserve Act of 1913 allows the Federal Reserve to lend, in a crisis, to just about any institution, organisation or individual, and against any just about any collateral the Fed deems fit. Specifically, if the Board of Governors of the Federal Reserve System determines that there are "unusual and exigent circumstances" and at least five out of seven governors vote to authorize lending under Section 13(3) of the Federal Reserve Act, the Federal Reserve can discount for individuals, partnerships and corporations (IPCs) "notes, drafts and bills of exchange ... indorsed or otherwise secured to the satisfaction of the Federal Reserve bank...". The combination of the restriction of "unusual and exigent circumstances" and the further restriction that the Federal Reserve can discount only to IPCs "unable to secure adequate credit accommodations from other banking institutions", fits the description of a credit crunch/liquidity crisis like a glove.

How to avoid planting the seeds of the next crisis

It is of course essential that ‘moral hazard’ be minimised.² This 'bail out' of the illiquid by the Fed should be sufficiently costly that those paying the price would still remember it during the next credit boom, and act more prudently. Second, where no market price is available, the Fed should base its valuation on conservative assumptions about the creditworthiness of the counterparty and the collateral offered by the counterparty. They counterparty should not expect to get 90 cents on the dollar for securities that it could not find a willing private taker for at any price. Third, the highest 'liquidity haircut' in the Fed's arsenal should be applied to this conservative valuation. 

The Fed should also enlarge the set of eligible counterparties at the discount windows. This should not just be banks and other depository institutions, but any financial entity that is willing to accept appropriate prudential supervision and regulation. The nature of the supervision and regulation required will differ depending on the nature of the institution. Hedge funds or private equity funds need different prudential regulation from depository institutions, investment banks or pension funds. At the very minimum, however, transparency grounded in comprehensive reporting obligations should be required of any institution eligible to use the discount window.

The wisdom of leaving the monetary policy rate untouched

At least the Fed did not cut the monetary policy rate (the Federal Funds target which remains at 5.25%). A cut in the Federal Funds target is warranted only if the Fed were to believe that the recent financial market kerfuffles are likely to have a material negative effect on real activity in the US or on the rate of inflation.  There is no evidence as yet to support such a view. If and when it happens, the Fed should act promptly. But addressing the problem of illiquid financial markets using the blunt instrument of monetary policy, a cut in the monetary policy rate, would be clear confirmation that the Fed is concerned about financial markets over and above what these markets imply for the real economy. Such regulatory capture would effectively redirect the 'Greenspan put' from the equity markets in general to the profits and viability of a small number of financial institutions. It would not be a proper use of public money.

Editors’ note: This column updates the 13 August 2007 column on the same topic and includes a slightly revised version of the content of the earlier column.

Let’s start with the facts: On Thursday 9 August 2007 the Federal Reserve’s Open Market Trading Desk (the “Desk”) injected $24 billion into the U.S. banking system. This was done in two equal size operations, one at 8:25am and a second 70 minutes later at 9:35am.¹ On Friday 10 August 2007, the Desk was in the market three times (8:25am, 10:55am, and 1:50pm) putting in a total of $38 billion dollars. By early this week, things seemed to have returned to normal with injections of $2 billion on Monday and no action at all on Tuesday.

The Fed’s operations came on the heels of two even larger injections by the European Central Bank (ECB) in Frankfurt. On Thursday morning the ECB in Frankfurt Germany had put nearly €95 billion ($130 billion) into European financial institutions, followed by a somewhat smaller operation of €61 billion ($83.6 billion) on Friday. Things continued to seem unsettled in Europe after the weekend, as the ECB added €47.7 billion ($65.3 billion) on Monday (13 August), and then in two separate operations put €25 billion ($34.2 billion) into the European banking system on Tuesday.²

How is this actually done? What are the mechanics of the transactions?

In all of these cases, the funds were put into the banking system using what are called “repurchase agreements” or “repos” for short. Here’s a dictionary-style description: A repurchase agreement is a short-term collateralized loan in which a security is exchanged for cash, with the agreement that the parties will reverse the transaction on a specific future date at an agreed upon price, as soon as the next day. For example, a bank that has a U.S. Treasury bill might need cash, while a pension fund might have cash that it doesn’t need overnight. Through a repurchase agreement, the bank would give the T-bill to the pension fund in exchange for cash, agreeing to buy it back at the original price – repurchase it – with interest the next day. In short, the bank gets an overnight loan and the pension fund gets some extra interest. The details are shown in the figure below.

The easiest way to think about a repo is as an overnight mortgage. In the same way that you pledge your house to the bank in exchange for a loan, a financial institution pledges a bond to the Fed in exchange for funds. 

The Federal Reserve Bank of New York’s Open Market Desk engages in repurchase agreements every morning (the exact time varies). The quantities normally range from $2 billion to $20 billion dollars.³ Most of them are overnight; but it is standard to engage in repos that are as long as 14 days. The $35 billion on Friday 10 August 2007 was the largest since those in the aftermath of the 9/11 terrorist attacks. The record is $81.25 billion on 14 September 2001.

How does the Fed pay for the repo? Where does it get the money?

There is an important difference between what happens when two private financial institutions would engage in a repo with each other and how it works when the Fed is involved. When pension fund engages in a repo with a bank, the pension fund transfers cash to the bank. Looking at the cash accounts of the two institutions, we see the level of one went down (the pension fund) and the other one (the bank) went up, for a total of zero. When the Fed engages in a repo, it simply credits a bank’s reserve account creating money (albeit for a very short time). Put another way, when the Fed wants to engage in a repo, or buy anything else for that matter, it can simply create liabilities to do it. It’s a bit like having a credit card with no limit where the bill never comes.

What happens if the bonds used in the repo fall in value overnight?

When the Fed engages in a repo the bank (or securities dealer) on the other side – what is called the “counterparty” – agrees to repurchase the security at a fixed price regardless of what happens in the markets.⁴ It is these banks who reap the gains or suffer the losses from prices moving up or down. The only risk the Fed faces is that the counterparty in a repo goes bankrupt and can’t make good on the promise. Given that these are very large banks, and that the repos are very short term, this is an incredibly unlikely event.

Does this have any impact on the government’s budget deficit?

No. Central bank operations have nothing to do with fiscal policy – federal government tax, expenditure and debt management policies – they are all about the interest rate and the quantity of reserves in the banking system. The Federal Reserve is the Federal Government's banker – accepting and making payments, issuing debt when they want, etc. – but they are not connected in any material way. (I'm simplifying slightly here, as there is an esoteric connection that creates a quantitatively negligible impact.)

 If the Fed has $35 billion to help the financial system, why can’t they use some of their money to help the poor?

The Fed isn’t spending the money on bailing out banks, hedge funds, or helping rich people. It is making fully-collateralized loans that will be repaid the next day (or week). So, while it’s putting the funds in today, it’s taking them out almost immediately. If, instead, the Fed were to take $35 billion in $20 dollar bills and go hand them out to the needy, this would be a permanent increase in the quantity of money in circulation. More money in the long run means higher prices – and that’s inflation.

What is liquidity and why is it so important?

The publicly stated rationale for these large interventions is that liquidity dried up. Unfortunately, liquidity is one of those terms that means different things to different people. In the glossary to my Money and Banking textbook, I define liquidity as “the ease with which an asset can be turned into a means of payment such as money.” That is, when an asset is liquid it is easy to sell large quantities with out moving market prices. When something is illiquid, it is hard to sell.

People don’t want to buy things that they can’t easily sell. If they are worried that a bond they are considering buying may be difficult or expensive to sell they will lower the price they are willing to pay, assuming anyone are still willing to buy it at all. For financial markets to function well, it must be cheap and easy to both buy and sell securities. When market liquidity dries up, the financial markets stop functioning.

This form of liquidity might be better labeled “market liquidity” as distinct from what I would call “lending liquidity.” Lending liquidity is the term I attach to the concept that was in the news until recently. You may recall reading or hearing about “enormous amounts of liquidity sloshing around the system.” When people said this what they meant (I think) is that loan supply is plentiful so it is easy to borrow at favorable rates. Put differently (and using some technical jargon) it meant risk spreads were low and insensitive to a borrower’s balance sheet position. That is, the risk premium a borrower paid was small and did not increase with additional borrowing, which should be riskier.

Fall 1998 was the last time market liquidity dried up to a greater extent than we observe today. Then it was difficult to even trade U.S. Treasury securities – usually the most liquid financial market there is.⁵ So far, things are no where near that bad. In fact, with few exceptions markets still seem to be operating normally.

$35 billion seems like quite a bit of money. Is it?

To put the number into perspective we have to understand what these funds are used for. When the Fed injects “money” into the financial system what it does is create balances in something called “reserve accounts”. That’s where the money goes. Commercial banks have deposit accounts at the Fed (you and I can’t have one). Those are the bank’s checking accounts, with the exception that they don’t pay interest. Because there is no interest paid on reserve balances, banks try to economize on the quantities.

Banks hold reserves at the Fed for three primary reasons: (1)They are required to hold them. (2) They need it to do business, so that meet customer demands for withdrawals and they can make payments to other banks. And (3), it is prudent to do so; reserves act as the bank’s emergency fund – they are always ready just in case disaster strikes.

So, is $35 billion a big number or not? Here are three numbers we could use to get some sense: 

(1) Total reserves in the U.S. banking system for the two weeks ending 1 August 2007 averaged $45 billion, of which roughly $12 billion was held as deposits in reserve accounts at the Federal Reserve. The remainder is held in cash in banks’ vaults – that counts, too.

(2) Excess reserves, those above what the Fed requires banks to hold, usually total less than $2 billion.

(3) On an average day, the gross quantity of interbank transfers is $4 trillion (that’s with a “t”). This includes $1.6 trillion in funds that are transferred for the purpose of settling purchases and sales of various bonds (primarily U.S. Treasury securities).⁶

Looking at these numbers, first we see that the Fed’s action on Friday increased banking system reserves by more than 75 percent. More importantly, the addition of $35 billion increased the size of reserve accounts by a factor of 4. Second, the increase was more than 10 times the normal level of excess reserves (although for complex reasons it is hard to know today exactly how much it will add to average excess reserves). 

Finally, note the rather amazing fact that during normal times the banking system uses $12 billion to engage in $4 trillion in daily transactions. That is, on average a dollar in a reserve account is used more than 300 times PER DAY. Because reserves do not pay interest, banks have a big incentive to economize on their use – this is pretty efficient. (This is also the reason that excess reserves are so low.)   That banks do this every day suggests that they know how to do it; but the fact that they use the funds so many times means that if anyone starts hoarding reserves, there is the potential to disrupt the system.

The conclusion is that the $35 billion is a very big number – it is three times the normal level of reserves that banks hold. Why did the banks need it?

Why did the banks need this money?

It is easy to explain why the Fed used open market operations to add $81.25 billion on 14 September 2001 in the aftermath of the 9/11 terrorist attacks.  People’s inability to reach their offices in downtown New York had closed some very large banks. Though those banks could still receive payments from other banks, they couldn’t make any payments to anyone else. Funds were flowing into a few huge reserve accounts, but nothing was coming out. A few large banks were sucking up the lifeblood of the financial system.

Last week the trigger seems to have been the continued fall in the value of certain mortgage-backed securities. Mortgage‑backed securities bundle a large number of mortgages together into a pool in which shares are then sold. The owners of these securities receive a share of the payments made by the homeowners who borrowed the funds. The pools create a form of insurance. In the same way that automobile insurance companies know what fraction of the insured will have collisions (but not exactly which individuals), pools of mortgages mean investors can predict the quantity of defaults and the repayment rates.

There are numerous types of mortgage-backed securities, but the ones that have run into difficulty are in what is called the “subprime” segment of the market. Subprime borrowers are basically people with poor credit who cannot qualify for a standard mortgage. Making loans to these people is known to be risky. And when things are risky, sometimes they don’t work out. That’s what happened.

But up to now, the problems in the subprime mortgage market are relatively small. Currently, losses are estimated to be at most $35 billion – equivalent to a stock market decline of about 0.2 percent. (Last week the value of stocks traded in U.S. markets were down a not terribly unusual1.5 percent, or 7 times the total expected decline in the value of these mortgages).

What’s happened is that problems in this one relatively small part of the financial system been seeping into the rest of the market. When people see that they have underestimated the risks in one place, they start to question their ability to accurately evaluate risks everywhere else. 

Then two things happen. First, the prices of risky financial assets fall. Risk requires compensation, and the more risk there is the more compensation. Second, people flee risky stuff that they find hard to evaluate and put their money in safe assets – what’s called a “flight to quality.” The flight to quality is reflected in a increase in prices of U.S. Treasury securities and an influx of funds into the banking system.

So, the first reasons the banks need the reserves is to serve the customers that have brought money into their deposit accounts.

But individuals are not the only ones who have reduced their tolerance for risk. Bankers have, too. Bankers’ reduced risk tolerance shows up in two important ways, both of which result in higher demand for reserve balances. The first is that they simply want a bigger cushion against the possibility of losses. That’s pretty simple. 

The second reason bankers need more reserves is that they became less willing to lend their reserves to other banks. There is a huge daily interbank market for overnight loans. It’s called the “federal funds market” and the interest rate charged on those overnight loans is the “federal funds rate.” The federal funds rate is the rate targeted by the Federal Reserve.⁷ On a normal day (which Thursday and Friday of last week were not) banks are willing to make loans early in the day even if it means temporarily overdrawing their accounts. (Yes, they are allowed to do that.) Banks that are overdrawn in the morning figure that if they don’t receive payments to bring their reserve accounts back into positive territory by the end of the day, they can always go out and borrow it back. Well, it appears that last week banks were not willing to behave this way and the result was that it was very difficult to borrow late in the day.

The bottom line of this very long-winded explanation is that the banks wanted to hold substantially higher level of reserves. Keeping the federal funds rate at its target level of 5¼ percent – that’s what the Open Market Desk at the Federal Reserve Bank of New York is supposed to do every day – meant engaging in huge operations.

I’ve heard that the Fed’s operation had something to do with mortgages. Did it?

Yes it did. On Friday 10 August the Fed accepted mortgage-backed securities as collateral for the entirety of the $35 billion in repos it engaged in that day. Importantly, though, they did not accept just any mortgage-backed securities. They only allowed dealers to pledge mortgage-backed securities issued or fully guaranteed by federal agencies.

Two comments are important here. First, this is not new. The willingness to accept mortgage-backed securities as collateral in repo goes back to changes made in advance of Y2K. At the time there were concerns about being able to get funds into the financial system quickly, and this is one of the changes made to ensure the Desk could do that. Since then, the Fed has taken mortgage-backed securities as collateral in repo at nearly the same rate they have taken agency securities.

Nevertheless, the way in which the Fed chose to do this on Friday 10 August is notable. Normally, when the Fed sends out a message they tell dealers exactly what they want in collateral. Each of the three categories is treated separately. So, it is common for the Desk to send out a message that they are willing to accept only Treasury securities. Alternatively they might send out a message that they will accept all three types – Treasury, agency and mortgage-backed – in three separate operations. What the Desk did on Friday is send out a message that said they would take whatever the dealers wanted to deliver. Since mortgage-backed securities are the cheapest to deliver (they have the lowest price in the market), that’s what came in.

My speculation is that the Fed did this to demonstrate to the markets that they believe mortgage-backed securities are good as collateral. They were trying get financial market participants to value mortgage pools sensibly.

Who decides to do this?

A number of people are involved in deciding the quantity of a daily open market operation. On a normal day there isn’t much to decide. The Desk staff makes a recommendation in a conference call and the participants agree. (Having listened in on these calls, I can attest to the fact that they are normally not very interesting.) Last week was obviously not normal. While I doubt that the entire Federal Open Market Committee decided on the action, they may have been consulted through a conference call. My guess is that Chairman Bernanke and New York Fed President Geithner had a say. What I can be sure of is that the decision was made by the Federal Reserve, not by the Secretary of the Treasury or the President of the United States.

Why did this happen when it did?

It is natural to ask whether there is some specific reason for these events to occur when they did. Can we identify a specific trigger? While we can see something that has happened, as I suggested earlier there has been no fundamental deterioration in economic conditions. In fact, in the United States there was no economic data released on Thursday 9 August 2007. So, it isn’t that people suddenly changed their view of the future.

Instead, what happened was analogous to a bank run. Bank runs can be the result of either real or imagined problems. Here’s what how it works. Most people, even fairly sophisticated investors, are not in a position to assess the quality of the assets on a financial institution’s balance sheet. In fact, most people don’t even know what those assets are. So when we learn that one bank is in trouble, investors begin to worry about all financial institutions and investors start to flee. The inability to accurately value assets leads to a strong shift toward high-quality securities like Treasury bonds. 

Thinking about it this way, there are two events that may have precipitated this. The first was the announcement on 2 August that the German bank, IKB Deutsche Industriebank AG, was in trouble because of investment in U.S. subprime loans. And then, on Wednesday that one of Europe’s largest banks, BNP Paribas had three funds with similar problems. Financial market participants’ response was to reduce their exposure to risky investments under the assumption that they could not properly assess the risks. That’s exactly analogous to a bank run. It is impossible to predict the exact timing of something like that.

Does this have anything to do with discount lending?

For those of you who have seen (and heard) Jim Cramer’s diatribe on CNBC on Monday 3 August,⁸ you may be wondering about discount lending. Here’s the deal. The Fed has a standing offer to lend to banks (so long as they have collateral to pledge for the loan) at a rate that is 1 percentage point above the federal funds rate target of 5¼ percent. So, today a bank can borrow from the Fed at 6¼ percent. Banks, not the Fed, decide when to request a discount loan. The borrowed funds are deposited into the bank’s reserve account and can be loaned out to other banks.

While we do not know for sure, it seems unlikely that discount lending increased much last week. The reason is that banks always have the option of borrowing from other banks at the federal funds rate, and the Federal Reserve Bank of New York reports that the highest rate charged for an overnight interbank loan late last week was 6 percent.⁹ I seriously doubt that a bank would borrow from the Fed at 6¼ percent when they can borrow more cheaply from another bank.

I would guess that Cramer was really arguing for an interest rate cut. It’s hard to see why that’s necessary at the moment. If you can’t buy and sell the securities you own, you probably don’t care if the cost of funds is 5¼ percent or 4 percent, or whatever.

The European Central Bank’s operation was much larger than the Fed’s. Is there a reason?

The details of the European Central Bank’s (ECB) operating procedures are very different from those of the Fed, and I won’t go into the details here. Nevertheless, I can provide the simplest explanation for the size the ECB’s operation. When the ECB announced its intention to provide funds on Thursday 9 August 2007 (a day they would not normally operate at all) they said that they would accept all bids at or above the their 4 percent target.  The result was that banks asked for and received €95 billion ($130 billion) on Thursday, €61 billion ($83.6 billion) on Friday, and €47.7 billion ($65.3 billion) the following Monday.¹⁰

To explain this, we need to understand two things about how bank reserves work in Europe. As it turns out, 9 August is the first day of a 35 day reserve maintenance period in the Eurosystem. As I mentioned earlier, banks hold reserves because they are required. The amount they need to hold depends (in a complicated way) on the size of deposits the bank held in the past. Because there can be day-to-day fluctuations in accounts, the requirement is enforced as an average over a longer period, called the maintenance period. In the United States, the maintenance period is 2 weeks. In Europe it varies from 28 days to 35 days.

That’s the first thing. The second point is that in Europe banks receive interest on the reserves that they are holding. The interest rate paid on required reserves is equal to the average of the overnight lending rate over the maintenance period – a rate that is almost always slightly above the ECB’s target rate. (This is very different from what goes on in the United States where no interest is paid.)

Okay, so now imagine that you are a bank and you hear the ECB announce that they will lend you as much as you want at the 4 percent target. Maybe you know something about what’s going on, maybe you don’t. In either case, when the ECB says that they are going to give you as much as you want on a day when they normally do nothing, you have to wonder what they know that you don’t.  

You also know that since the reserve requirement is an average over the next 35 days, if you hold a high level of reserves today, you can always make up for it with a very low level before the end of the maintenance period. And, again unlike in the U.S. if you are stuck with excess reserves holdings, in you can redeposit it at the ECB at a 3 percent interest rate. All of this makes it much cheaper for European banks to take the reserves from the ECB and helps explain why they took so much.