Thursday, March 20, 2008

Paul Volcker the practical monetarist

FT coverage of the Volcker interview;

He told CBS Charlie Rose show: “We have seen the Federal Reserve take more extreme measures in some respects than any that have been taken in the past to deal with a financial crisis.”

He said the decision to lend cash to Bear Stearns and make emergency fin-ance available to other primary dealers was “understandable” but raised “real questions” as to the appropriate division of labour between US authorities.

The former Fed chief said the US central bank had not been thought of as a place “where you put in bad assets, possibly bad assets” – an apparent reference to the collateral backing the $30bn credit line extended by the Fed as part of the Bear rescue takeover deal.

At some point the government, in my view, ought to be taking responsibility for that kind of action, not the Federal Reserve,” Mr Volcker said.

He added that the Fed’s latest move “stretches their authority to the limit”. The problem of what to do with bad housing loans was “basically a governmental responsibility”.

He urged the government to channel funds into the market through Fannie Mae and Freddie Mac, the government-sponsored agencies – possibly by activating a longstanding Treasury credit line to these institutions.

Echoing the message from the Fed this week, which cut interest rates by less than the market had expected and highlighted concern about inflation, Mr Volcker said “there are limits to how much you can reduce interest rates”.

He warned that the threat of resurgent inflation was “lurking not very far in the background”. That would be “the ultimate destructive result of this”, he said. “We just must not let that happen.”

The former Fed chief also said the administration’s strong dollar rhetoric had “become meaningless”.

He said a weak dollar allowed the US to increase exports and reduce its reliance on foreign savings but “begins to raise questions” as to its role as a world currency.

In addition to above Volcker raised the issue compensation packages of investment bankers that may be providing incentives to take greater risks.

Former Fed chair Volcker: financial crisis not over

The realignment of the regulatory powers
Second, the more commitments made by the Fed, the more we lose the (quasi) independence of our central bank; for a large commitment Treasury sign-off is needed. The realignment of the regulatory universe will eventually emerge as a big story from the current crisis, though it is hardly commanding much attention right now.

How to deal with banking crises;
One lesson is that trouble is all too common. Most members of the IMF have undergone at least some distress since the late 1970s. Crises in poorer countries tend to be deeper and more costly, often because they are twinned with collapsing currencies. According to a 1996 survey of insolvencies by economists at the World Bank, the bail-out of Argentina's banking system in the early 1980s cost a stunning 55% of GDP to fix.

The rich world's banking troubles have not been cheap either. The bill for bolstering Finland's banks in the early 1990s came to 8% of GDP; Sweden's bail-out was scarcely less dear. America spent more than 3% of GDP cleaning up the savings-and-loan crisis, its priciest to date. That suggests that the possible cost of today's troubles, though alarming, is not off the charts. The best, though still highly uncertain, estimate of prospective lending losses is around $1.1 billion, less than half of which would be borne in America by banks, investors and in forgone taxes: $460 billion is equivalent to about 3% of last year's GDP.

History shows wide-ranging reasons for recessions

How Paul Volcker became a practical monetarist;
It always seemed to me that there is a kind of commonsense view that inflation is too much money chasing too few goods. You could oversimplify it and say that inflation is just a monetary phenomenon. There are decades, hundreds of years, of economic thinking relating the money supply to inflation, and people to some extent have that in their bones. So I think we could explain what we had to do to stop inflation better that way than simply by saying that we've got to raise interest rates. It was also true that we had no other good benchmark for how much to raise interest rates in the midst of a volatile inflationary situation.

At least as important was the idea to discipline ourselves. People in the Federal Reserve don't like to raise interest rates. So the danger is you're always too little too late. I think that would apply to the current situation [April 2000]. So, when inflation really had the upper hand, it was, I think, very important to put something out there so you could discipline yourself. For that kind of a commitment, you've got to know what's at stake, and it does make some broad sense if you have that much inflation [pp. 178-179].

What really propelled me to make the change was when we raised the discount rate for the second time, when I was first down there. The vote was 4-3. I thought it was a reasonably strong move and we'd get a favorable reaction in the market, but we didn't. The response was, "Well, gee, the Federal Reserve is behind the curve anyway, the vote was 4-3, and that's the last increase of the discount rate we'll see." So the market reacted very badly, which surprised me. I guess I was a little naive. I remember very clearly, I didn't bend over backwards to try to twist the arms of the three people who voted the other way. I knew I had four votes. If we had to increase the discount rate again, we'd have another 4-3 vote. But that's not the way the market read it. Then I realized that we had this credibility problem worse than I thought. That got me off and really thinking operationally about the other approach [basing policy on target growth for the monetary aggregates]. But when it was sprung on them, everybody was very much in favor, even those who were voting against the increases in interest rates [pp. 178-179].

Fannie and Freddie: The End of the Punishment is Nigh

Cost of insuring bank debt falls after Bear bail-out

The cost of protecting the senior debt of the 25 European banks in the iTraxx Financials index has fallen 44bp this week, or about 28 per cent. It now costs an average of €114,000 per year to insure €10m of the banks' debt against default over five years, €44,000 less than it did on Friday.

Defending Market-Value Accounting

The Prisoner of Wall Street
So central banks, including the Fed, should stand ready to act as market maker of last resort, accepting a wide range of private securities as collateral in repos (or purchasing such securities outright) from a wide range of counterparties at a wide range of maturities. Likewise, individual systemically important financial institutions should have recourse to lender of last resort facilities, including the discount window.

The Fed has recently extended access to its discount window to the 20 (or is that now 19?) primary dealers. Other non-deposit-taking institutions will no doubt be granted the same privilige before long. The restriction of the new PDCF to overnight finance only should also be lifted. The same terms as those available to deposit-taking institutions (up to 90 days) should be available. Provided the collateral is priced appropriately (which means the prompt abandonment of the approach outlined on the Fed’s website that “…the pledged collateral will be valued by the clearing banks used by the primary dealers to access the new facility, based on a range of pricing services.” - an invitation to stuff the Fed with fools’ gold priced as bullion), this will stop the unavoidable and fundamentally warranted solvency problems of a number of households and financial institutions from triggering a system-wide liquidity crisis and a system-wide fundamentally unwarranted solvency problem, and will do so with minimal damage in terms of moral hazard.

Seeing Red at the Fed

Home Sweet Investment

Can’t Grasp Credit Crisis? Join the Club
“If anything goes awry, these dominos fall very fast,” said Charles R. Morris, a former banker who tells the story of the crisis in a new book, “The Trillion Dollar Meltdown.”

This toxic combination — the ubiquity of bad investments and their potential to mushroom — has shocked Wall Street into a state of deep conservatism. The soundness of any investment firm depends largely on other firms having confidence that it has real assets standing behind its bets. So firms are now hoarding cash instead of lending it, until they understand how bad the housing crash will become and how exposed to it they are. Any institution that seems to have a high-risk portfolio, regardless of whether it has enough assets to support the portfolio, faces the double whammy of investors demanding their money back and lenders shutting the door in their face. Goodbye, Bear Stearns.

Bear Economists Snipe at Bernanke
But in their most recent economics report released Wednesday — titled “Apart From That, Mrs. Lincoln, How Was the Play?” — Bear Stearns economists detail their sometimes sarcastic critiques of Mr. Bernanke, and lay their firm’s inescapable demise squarely on his shoulders.

Post-Bailout Punditry

No comments: