Our American Discourse, Ep. 27: Why the Federal Reserve Is More Politically Constrained Than You Think

We’ve been having a mistaken debate, or so it would seem based on the new book The Myth of Independence. The Federal Reserve, the nation’s central bank and most influential economic regulator, isn’t as independent as critics like Rand Paul and Bernie Sanders suggest. Congress created it, and Congress continues to shape it to the people’s will. This new perspective might just change your expectations about Fed policy and your appreciation for their delicate strategic work.

In this episode, Sarah Binder discusses the historical research that led to this new thesis and helps us appreciate the interplay between two of America’s most important political institutions.

Continue reading “Our American Discourse, Ep. 27: Why the Federal Reserve Is More Politically Constrained Than You Think”

The Best Monetary Policy Is Strict Financial Regulation

On Wednesday, in her first speech on monetary policy, Janet Yellen, the new Chairwoman of the Federal Reserve, pointed out a discouraging paradox: In recent years, private-sector forecasters have been surprisingly accurate at forecasting changes in the unemployment rate, but they have been equally inaccurate when forecasting changes in the federal funds rate, the baseline interest rate controlled by the Fed.

Since interest rates supposedly have a strong effect on unemployment, how can forecasters be so right about unemployment if they’re so wrong about interest rates?

Three economists at the Bank of International Settlements — Morten L. Bech, Leonardo Gambacorta, and Enisse Kharroubi — have been studying this question, and coincidentally their results were published this week in the journal International Finance.

Bech and his colleagues amassed a dataset of interest rates and economic output for 24 industrialized countries from 1960 to today. Over that time period, these countries experienced 78 recessions, of which 34 were the result of financial crises like the one we experienced a few years ago. In each recession, the BIS economists measured how much the central bank lowered interest rates to stimulate recovery — and then how long it took for the economy to recover its lost output.

Unsurprisingly, they found that “normal” recessions — the ones without a financial crisis — were much less severe. On average, they resulted in an output loss of 1.9 percent, which it took the country 3.8 years to recover. Financial crises, on the other hand, resulted in an output loss of 8.2 percent, which it took 5.1 years to recover.

Monetary Policy in Different RecessionsWhat was perhaps more surprising was the fact that “accommodative” monetary policy — i.e. lowering interest rates — had no effect on the economy after a financial crisis. This wasn’t the case with normal recessions. Typically, the more the central bank lowered the interest rate, the faster the economy recovered its lost output. But not so with financial crises.

In times like these, interest rates simply don’t matter as much as they normally do.

That doesn’t sound like good news for Janet Yellen. What’s a central banker to do?

Fortunately, the BIS economists did find one thing that accelerated recovery from financial crises: private-sector deleveraging. After a normal recession, it doesn’t seem to matter whether households and firms pay down their debt, but after a financial crisis, it significantly speeds up economic growth.

As luck would have it, the Federal Reserve has a tool at its disposal that can reduce the economy’s reliance on debt. It’s called the “capital requirement,” and it refers to the difference between what a bank owns and what it owes.

When a recession strikes, asset prices fall, and since banks own a lot of assets, their value goes down. If they go down too much, they can fall below what the bank owes to its lenders and depositors, meaning it’s basically bankrupt. It doesn’t own enough to pay what it owes.

So the Fed sets a minimum capital requirement. The more capital a bank is required to have, the more it has to own relative to what it owes. It’s a buffer. The bigger the buffer, the more room asset prices have to fall before the bank becomes bankrupt.

Unfortunately, banks don’t like high capital requirements. They want to rely on debt. Why use your own cash when you can use somebody else’s cash? Lower capital requirements are cheaper — but they’re also more dangerous because it’s easier to go bankrupt when you owe so much relative to what you own.

Banks argue that high capital requirements restrain lending because they can’t borrow as much debt to fund their loans, but another paper published in the latest issue of International Finance debunks this myth. In it, the German economists Claudia M. Buch and Esteban Prieto study the behavior of German bank lending for the past 44 years, and they find that banks with higher capital actually issue more business loans.

This doesn’t come as a surprise to those of us who understand how banks actually operate. They don’t lend based on how much debt they can borrow. They lend based on how many loans they can sell. The more, the better. The only question is, will they fund the loans with cash or debt?

Janet Yellen may have her work cut out for her in this post-financial-crisis economy, but there is a way to stimulate the economy and prevent future crises. It all starts with financial regulation.

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This op-ed was published in today’s South Florida Sun-Sentinel and Huffington Post.

Don’t Blame the Fed for Holding Back the Recovery

Rick Perry must not spend much time in banks.

How else can you interpret his accusation that Ben Bernanke, the Chairman of the Federal Reserve, “is almost treasonous” for “printing money”?

He must think that banks spend every dollar they get from the Fed. He must think that banks depend solely on the Fed for funding. Because that’s the only way that “printing money” — if that’s even what you could call what the Fed does — could result in any damage for the United States.

Rick Perry lives in the Bizarro World of Banking.

Here on Planet Earth, U.S. banks are holding $1.6 trillion in excess reserves. That’s $1.6 trillion that they’re not spending or loaning or investing. It’s just sitting there. Not doing anything for the economy.

Just to give you a little context, before this recession, excess reserves had never been higher than $20 billion.

In other words, most of the money that Perry is so angry about is just minding its own business. Nobody is spending it. Nobody is borrowing it. It’s not contributing to inflation or the depreciation of the dollar. It’s not eroding your purchasing power.   Continue reading “Don’t Blame the Fed for Holding Back the Recovery”

I Hate Being Right

No, seriously. Because it’s always about bad things.

Me, back in early December:

Hence “QE2,” shorthand for the second round of quantitative easing. By buying long-term bonds, Bernanke hopes to push down long-term interest rates. Low rates encourage borrowing, which increases spending — and prices.

The problem with QE2 isn’t that we’re printing too much money. It’s where that money will go. It should go to workers, who will spend it and stimulate the economy. But it won’t.

The New York Times, today, summarizing the economic consensus:

The Federal Reserve’s experimental effort to spur a recovery by purchasing vast quantities of federal debt has pumped up the stock market, reduced the cost of American exports and allowed companies to borrow money at lower interest rates.
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But most Americans are not feeling the difference…   Continue reading “I Hate Being Right”