Financial Markets (2008)

ECON 252 (2008) - Lecture 16 - The Evolution and Perfection of Monetary Policy

Chapter 1. Introduction: Thoughts on Icahn’s Talk [00:00:00]

Professor Robert Shiller: I want to talk today about monetary policy. First though, I wanted to just review some thoughts about Carl Icahn, who spoke on Monday. I thought he was very amusing. I’m again happy that you asked questions because that’s when you bring out a speaker really well. I thought you could have given him more trouble. He is a controversial figure. What he does, as you know, is takes over a company and shakes them up and, in some cases, is accused of stripping their assets. But, it’s all legal and you could make an argument that it’s in a general good of our society that people do that. If a company — if its stock sells for less than its assets are worth, then the company maybe should be broken up and the assets taken and given somewhere else because the low stock price indicates a problem.

I don’t know how to evaluate everything Icahn has done, but some corporate raiders have been unkind to employees. Maybe it’s not always the raider; it’s that some employees had trusted in an implicit contract that they were offered by their employer. For example, the employer may have said verbally — or suggested to an employee — that if you do well, we’ll promote you up and you will have various advantages in the future. Then an outside raider comes in and just fires the employee, so naturally the employee feels wronged. There are instances of that sort of thing. Again, it’s like anyone who does important things, it’s hard to judge the whole picture and on that I am sure he has created value for the economy. Someone suggested that we should bring in corporate regulators as well. I think maybe in the next year I’ll do that to offset — I’m bringing in a lot of very successful finance practitioners and I don’t have any regulators this year.

Also, one of you asked, what literature do you read? He mentioned the Nicomachean Ethics, which I have never read — I don’t know what that is. He also mentioned a poem by Rudyard Kipling called If. I didn’t recognize what he was referring to immediately, but I looked it up and it’s a famous poem that you must have seen — written in 1910 — an inspirational poem. I put it up on the ClassesV2, not as part of the reading list, but it’s under Resources, so you can read Kipling. Maybe he thought of that because it’s really a poem — seems to be a poem of advice for young people because it ends up — the last line is — do you know the last line? Can someone recite it? What’s the last line? “If you follow these instructions, you will be a man my son.” So, that’s the mode of thought he may have been in when he talked.

Anyway, we have our second mid-term exam on Monday and it will be like the first mid-term, but it will be less mathematical. This part of the course had less technical apparatus than the first part of the course, so it will concentrate on the middle third of the course, up to this lecture. You have to read Fabozzi, et al. again carefully because I’m free to take anything from Key Terms and Key Concepts from the chapters that were assigned for this part of the course. Of course, every reading that is online — I don’t expect you to go to the library — is something I might ask about. April eleventh, we have Stephen Schwarzman coming and I’m looking forward to that. That will again be a Friday, but it will be at nine o’clock and he will be here, so I think that will be a lot of fun also.

Chapter 2. The Gold Standard and the Earliest Central Bank [00:04:49]

I want to then start today’s talk–lecture — which is about monetary policy and it’s really apropos right now. We are living in very unusual times and I am sure that Ben Bernanke and other central bank presidents are losing sleep right now because this is a time to challenge monetary policy makers. The thing that really emerged just in the last week or so is that — of course, monetary policy is about setting of interest rates. In the last week, the Treasury bill rate on the United States four-week Treasury bill, which is the standard, essentially — three-month — it fell to 0.2%. This is shocking. What is happening now? Interest rates have hit zero — 0.2%; that’s twenty basis points above zero. People have long thought that these kinds of things happen only in Japan, but that’s not true at all; it’s happening right now in the U.S.

There’s been a total crash in Treasury bill rates, so it’s not going to — one thing we know is that this crash is over. The Treasury bill — the three-month Treasury bill rate has crashed — it’s virtually zero — and the story is over because it can’t go any lower. Well, it could go twenty basis points lower, but interest rates can never be negative. So, that’s it; it’s over; we’ve just hit zero. This is the thing that worries central bankers. When interest rates hit zero, then they don’t have — it’s a little bit like your steering system on your car freezing up or hitting a — you’re hydroplaning on the highway; your steering wheel doesn’t work anymore. Once interest rates hit zero, you can’t cut them anymore and that’s what the Fed wants to do. I’m talking about four-week Treasury bills; the Federal Funds Rate is still at 2 ¼%, but at least the more prominent three-month T-bill rate is at the end.

What I want to do is talk about what the Fed in this country is doing and what other central banks are doing. I want to start by putting it in historical perspective. If you’ll allow me, I will talk first about just what is a central bank, such as the Federal Reserve, and what do they do. I want to first just go back — the story I told you in a recent lecture was the story of a goldsmith banker. This is how it started. There were people — goldsmiths were people who worked in the metal gold and made beautiful things for people — jewelry and other things. They had safes in their shop and some people would say to the goldsmith, I have some valuables. I don’t have a safe — can I put it in your safe? The goldsmith would say, okay. Then he’d write on a little note and hand it to the guy and say, just keep this note. If it was a bearer note — if the note said, I’ll pay — if it wasn’t a unique object but just gold, the note would say that this goldsmith will pay to the bearer so many ounces of gold. And that’s how banking got started.

It emerged into an institution in which banks would have notes — bank notes — that circulated widely and we began to think of them as money. If you put your gold in the care of a goldsmith, initially you don’t think — you think the money is there. But eventually, you have this bearer note that you start passing around to spend to other people and they start to think of them as money and that’s the origin of banking. If you ask someone a couple hundred years ago, what’s the essence of a bank? They would say, oh they print paper money — private banks print paper money, not just government banks. Well, there weren’t government banks; originally, they were all private.

There is an institution called the “gold standard” — now totally and completely gone everywhere in the world. What it was — it began — the first country to adopt the gold standard officially was the United Kingdom and that was in 1717. What it meant was that the government of the U.K. committed that their paper money would always and at all times be redeemable in gold. It was gradually adopted by other countries through time and the United States didn’t officially adopt it until 1900. Let me just go back to the way the thing worked. It used to be that it was–actually, the gold standard kind of came in by accident in England, originally; that was in the 1600s. The prominent coin was called the shilling and it was a silver coin. The British pound was twenty shillings, so effectively, the pound was on a silver standard. Then they started minting new coins out of gold and the government was issuing coins — they called them guineas. They started out as a — they just minted the amount in one coin, which they thought was equivalent to twenty shillings. So, they had a guinea, which they said was twenty shillings, and then there were two coins — either shillings or guineas — that was the money at the time.

Then, the problem was that the price — relative price of those two — was not really fixed by the government. So, it started to drift and people started to think, I think a guinea is worth more than twenty shillings and the market price drifted up to twenty-one shillings. So, the government was upset — of the U.K. We wanted this to be a twenty shilling coin, but now in the market it’s trading at twenty-one. Then they implemented a rule that the guinea is worth twenty-one shillings. Then, the relative price of gold versus silver shifted to the point that the gold with — at the twenty-one shilling exchange rate, the gold shilling was worth less — the gold guinea was worth less than twenty-one shilling. So, all the shillings disappeared and the only coin left was the guinea. So, England became on the gold standard.

The Bank of England was founded in 1694 and that was the world’s first central bank. It was granted a monopoly on joint stock banking by Parliament in return for giving war loans to the government. It started out just a powerful bank. It did not have a government monopoly on note issue, but over the time, it became the prime issuer of U.K. notes. Now, what actually developed in the 1700s was that the Bank of England, being the most powerful bank in England, started to demand that other banks in the U.K., who were also issuing notes, would leave their — would keep a deposit with the Bank of England.

The Bank of England — if you were a little bank somewhere in the U.K., the Bank of England would say, you’ve got to keep a deposit with us, otherwise we’ll destroy you. Because the Bank of England could then demand all the — it could start accumulating notes from some issuing bank and then demand payment in gold. The issuing bank would be driven out of business if it didn’t — They all were using fractional reserve banking, so if you have a big player that’s demanding gold from you, you’re in trouble. All the banks complied and kept deposits with the Bank of England. You see what the Bank of England emerged into was a banker’s bank. You have lots of banks; the banks are taking in gold and issuing notes, but they are forced by the Bank of England to keep a deposit at the Bank of England.

So, the Bank of England then became a kind of regulator of these banks and it would also loan to them when they were in trouble. They had a relationship, between the Bank of England. The Bank of England became the source of stability in the UK. The problem with private banks issuing notes is that there would periodically be banking crises when the banks failed to pay on their notes and they couldn’t pay out the gold that was demanded — that was required. With a fractional reserve system, you’re in an unstable equilibrium. If people start demanding payment on their notes, then they will destroy the system. If they start demanding, then we’re in trouble. So, the Bank of England effectively enforced that the banks in England kept adequate reserves and they would see some of these reserves in the deposits at the Bank of England.

Chapter 3. The Rise of the U.S. Federal Reserve System [00:15:11]

England’s money was more stable than other countries. In the United States, we did not have a central bank until 1913 when we created the Federal Reserve System. Before that, the United States went through repeated banking crises when people would start demanding the gold for their notes. When did we have — we had a severe banking crisis in the United States in 1797, in 1819, in 1837, in 1857, in 1873, in 1893, and in 1907. We just had one after another; the banking system kept collapsing. What would happen is there would be a panic; people would say, they’re not paying on the notes. So, everyone would run to the bank and demand their money. When that happened, it would destroy the economy. It was a subject of much discussion of what to do to prevent these bank runs.

In the United States, in Massachusetts, a bank called the Suffolk Bank created a little Bank of England in the State of Massachusetts. They created what was called the Suffolk System, in 1819. What the Suffolk Bank did is it just, on its own, it just declared that it was the Bank of England for the State of Massachusetts and it required that all banks in the Boston area keep deposits with them. So, the Suffolk Bank became a banker’s bank and it lasted until 1860. It then made Massachusetts the most stable state, or essentially the most stable state, in the country and it was widely-admired. The thing you have to understand is, if you could go back in a time machine to before 1860 in the United States, you would have real problems with paper money and you would be very much aware of the paper money.

If you took out your wallet and looked at the paper money in your wallet, it would be issued by lots of different banks, not any one standard bank. If you went to a store to buy something with paper money, then the person at the — would it be a cash register? What did they have? Cash box would be — would have something called — it was called, Van Court’s Bank Note Reporter and Counterfeit Detector [sic]. It was a magazine that would be — every retailer would subscribe to it. So, what the guy would do is he would say, okay you’ve got — if it was local money — if it was from this town — if it was New Haven money — there were New Haven banks — the guy would immediately know what it’s worth. But, if you were to make the mistake of trying to spend Boston money in New Haven, they would get out Van Court’s and then they would read the discount. So, Boston money was probably pretty good because of the Suffolk System, but if you tried spending New York money in New Haven, they would get out the Bank Note Reporter [sic] and put a discount on it.

Well, it was a messy system, so you’d only get like ninety cents on the dollar. That’s because nobody trusted these banks, they could go under any day and so they tended to sell at a discount. Incidentally, the U.S. did create what sounded like central banks. They were The First Bank of the United States and The Second Bank of the United States. The First Bank of the United States was created in 1791 and they had a twenty-year charter, which expired in 1811. It wasn’t immediately renewed because the United States got into a war that we call The War of 1812. It was the U.S. connection to the Napoleonic Wars. It wasn’t until after the war that we created a new Bank of the United States in 1816 and gave it a twenty-year charter as well. But those were not central banks because they — there was —

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In the United States, we created the National Banking System in 1863 after a banking crisis and that worked fairly well. Instead of having a central bank, we decided that there would be a list of banks called the National Banks. The National Banks would be required to help bail out any bank that was failing. It was something like a central bank, but it was different essentially in that the National Banks really didn’t have authority to run monetary policy. They merely were there in a time of emergency to prevent, hopefully, a banking crisis. They didn’t succeed; we still had banking crises, so the system didn’t seem to work very well.

The 1907 banking crisis then led finally to the creation of the system that we have now — the Federal Reserve System. What it was was, in many ways, an effort to bring the Bank of England to the United States. They wouldn’t have said that because it doesn’t sound — we want to think that we invented this here, but it actually was a new invention in a way because the United States has a different philosophy, which the United States has been committed, since its beginning, to federalism. That is, they don’t want — or more broadly — they don’t want centralization of power in the government. Instead of setting up a central bank in the United States, as was done commonly in other countries, the United States instead created twelve banks; they’re the twelve Federal Reserve Banks. That was an effort to disburse power away from the center. The idea was that power to the people, rather than the central government.

The Federal Reserve System that was created in 1913 was different in that it was independent, or much more independent than central banks in other countries. Other countries had set up central banks following on the Bank of England, but the U.S. didn’t set up a central bank; it set up a system of twelve banks and they were regional. The idea was that this is better, it’s more democratic; each region of the United States has its own bank. The banks were not technically government institutions — well, they’re semi-government; it’s kind of strange set-up. The Federal Reserve Banks are owned not by the government but by the banks in the region where they operate; they’re called member banks. So, banks that become a member of the Federal Reserve System get shares and they become stockholders in the Federal Reserve Bank. They get dividends — does it work now? Can I walk away? Thank you. — but they’re not traded.

There’s no price per share that you can observe and the banks can’t do anything except passively receive the dividend. But they can also participate in choosing the directors and the president of the Federal Reserve Banks. That’s a very dispersed system, but it still works because member banks keep deposits at the Federal Reserve Banks and they’re required to keep these deposits. Moreover, they can also borrow from the Federal Reserve Banks when they’re in trouble and need money and that’s supposed to help prevent banking crises. So, that’s the Federal Reserve System.

Incidentally, there are twelve banks and there are twelve districts. The districts back in 1913 represented the population distribution of the U.S. at that time. There are a lot more districts in the East Coast of the U.S. than the West Coast. There are also two Federal Reserve Banks in one — in the state of Missouri — the Federal Reserve Bank of Kansas City and the Federal Reserve Bank of St. Louis. You wonder, why would it be that the whole western half of the U.S. gets only — or the western third of the U.S. — gets only one Federal Reserve Bank — that’s San Francisco — but Missouri gets two. That’s kind of political history; it’s kind of absurd, but that’s the way it is.

Chapter 4. The Abandonment of the Gold Standard and Adoption of Central Bank Autonomy [00:25:30]

The real difference between Federal Reserve Bank System of 1913 — the most important difference — and the Federal Reserve System of today is that we are no longer on the gold standard. The Federal Reserve System was a gold standard institution like the Bank of England. It was supposed to maintain the convertibility of the currency into gold. Under the gold standard, your dollar bill represented so many ounces of gold and you were supposed to be able to always get that gold. That means you could go to a bank and demand gold and the bank then could go to the Federal Reserve and get gold for it. That was the system. The gold standard was a success in the sense that the price of gold stayed constant because that’s what the whole system was designed to do.

There’s a famous story about Irving Fisher, who was a professor here at Yale, who — remarking on how few people understand the gold standard. I don’t know if I’m repeating this, but he was at his dentist — I didn’t tell you this. He was at his dentist and they used to give gold fillings in those days. He said to the dentist, just out of curiosity, can you tell me what the price of gold has — what it’s been doing lately? The dentist said, gee I don’t know, I’ll look at my records. I have some old records and I’ll see what I’m paying for my gold for the gold fillings ten years ago. The dentist came back and said, funny thing; it hasn’t changed at all; I’m paying exactly what I did ten years ago. Irving Fisher then told that story as an illustration of how poorly the understanding was of what was going on. Of course the price of gold never changed in the gold standard because that was the whole point of the gold standard — that’s if currency was convertible into gold.

What happened in the 1930s was that one country after another abandoned the gold standard. The United Kingdom was the prominent first case, even though they had invented the gold standard hundreds of years earlier. In 1931, they dropped convertibility of the pound sterling — still called pound sterling even though it’s not silver, it was gold. They dropped the pound convertibility. The United States dropped it in 1933 and other countries did it later. The reason that countries dropped the gold standard was that, under the effort to keep the currency convertible into gold, they were worsening the depression of the 1930s. In order to keep the currency convertible, they had to keep interest rates high to prevent people from demanding the gold. Keeping interest rates high was destroying the economy. So, the gold standard ended in the 1930s and every country dropped it.

We’re left with the central banking institutions that are now functioning without convertibility to gold. Then you start to wonder, well what is the system and what is it supposed to do? The old gold standard was supposed to maintain the convertibility of gold in currency but now we’re not even backing it with currency anymore — with gold anymore — so what does it mean? Well, what it means is that starting in the 1930s, we began to think of central banks as managing the money stock to stabilize the economy. That’s what — that’s the view that’s developed — that has been with us ever since. They still hold gold and right now the Federal Reserve System has about eleven billion dollars of gold. They still have it. Remember what happened in 1933 is they abandoned convertibility with gold. That means that you no longer have the right to get it, but that doesn’t mean they don’t still own gold; it’s just sitting there in their vaults from way back.

Some people ask, what is the currency backed by? It used to be backed by gold. The question is — what it means to say something is backed by something because, well you could say it’s backed by gold because the Fed has eleven billion dollars of gold. That’s a lot less then the amount of money out there, but they always had fractional reserve of banking anyway. They never kept all the gold for all the dollars that they issued, so you could say it’s still backed by gold. The really important thing is, it’s not convertible into gold. So, since 1933, the Fed has been managing inflation. It used to be that there was zero inflation, if you define it with respect to gold, and they were really true to that — zero inflation in terms of gold. Now, there was inflation with regard to a basket of — the Consumer Price Index is not just the price of gold; it’s the price of many things, but the — there would be inflation or deflation as the relative price of gold changed.

After 1933, we had lost our moorings; there was no longer any idea that the dollar was backed by anything. The concept changed fundamentally. The concept that became the Federal Reserve or the central banks in any country is managing the economy and their management of the money supply is their way of managing how well things go. Generally, it has been inflationary after 1933; central banks have generally, gradually allowed prices to rise. The general view is that if it’s not extreme — the rise is not too extreme — it’s good for the health of the economy as long as we don’t have inflation that’s too high. So, central banks around the world began to manage — became managers of inflation rather then defenders of a gold standard.

Let me just mention a couple of other central banks. The Bank of England has been providing an example for the world for a long time. The Bank of Japan was established in imitation of the Bank of England in 1882. Many central banks in Europe, they have dates that go back to the eighteenth or nineteenth century. Some banks, however, are very new; the European Central Bank, which issues the Euro currency, was founded in 1998, so it’s only ten years old. That’s because it replaced central banks of the member countries of the European Union. The central banks still exist, so you still have the Bank of France, the Deutsche Bundesbank, etc., but they no longer have the importance that they once did because they no longer manage the currency. The currency is centralized at the European Central Bank.

One thing that’s been a trend around the world is that the — I mentioned that the U.S. Federal Reserve System was different from other central banks in that it was designed to have independence. The thought was that the central bank is guarding the money stock and governments have a tendency to sometimes want to raid the bank when they’re in trouble. Typically it happened during wars. The government gets into a war. During the war, the government needs resources; it’s in trouble; it raises taxes to try to pay for the war, but then it finds it unable to collect taxes well. People start evading taxes; there’s a lot of discord. It’s just hard to raise money by taxing. What the government would do is send someone over to the central bank and say, hey expand — give us–-just lend us the money. You’re the central bank, lend us the money.

So, the central bank would print up notes and give it to the government and the government would start spending it on the war. Then you’d have inflation because they’re printing all this money. So, war time periods were typically periods of great inflation and debasement of the currency. That’s why we need independence of the central bank; we want to have a central banker that can say no to the government. The government comes to the bank and says, it’s a war we need the money. The central bank would ideally say no. How can you get a central banker to do that? Well, they definitely have to be independent of the government and that was the idea in the U.S. There’s been a trend to making central banks more independent and there are particular things that happened. In Japan, in 1997, the government of Japan granted the Bank of Japan independence like the U.S. central bank. It also happened in the U.K. in the same year. Now, I’ve been describing the Bank of England as the model for everyone, but in fact, the Bank of England was not independent until 1997.

Chapter 5. The Federal Funds Rate and Discount Rate [00:36:30]

These people are — the people who run these banks — they may still be appointed by the government, but they have terms of office that are lengthy. The government can’t kick the central head — head of the central bank out for failing to offer them loans when they want it. In the United States, we have twelve Federal Reserve Banks, but we have a Federal Open Market Committee. The Federal Reserve Board in Washington organizes policy for all twelve banks and the members of the Federal Reserve Board have fourteen-year terms. Plus, all of the presidents of the Federal Reserve Banks come and serve on something called the Federal Open Market Committee. The Federal Open Market Committee makes monetary policy, so it’s decentralized and long terms. The board members have fourteen-year terms, which is quite a long time. And the central — and also there are the banks from the regional banks that have a roll.

The Federal Open Market Committee meets about every six weeks or so and they decide on monetary policy. In fact, they decide on how to set interest rates and borrowing requirements for member banks. One of the things that the Federal Reserve does is it sets reserve requirements for banks. Reserve requirements are like what the Bank of England did or the Suffolk Bank did long ago. It says that you have to keep deposits with us here at the central bank; either that or else keep vault cash and show that you have it as reserves for your deposits. Now, these banks no longer issue notes. We’ve centralized the note issue in the United States starting in 1913 with the Federal Reserve Board, so your notes that you see are called Federal Reserve Notes.

Banks still are vulnerable to bank runs because they still have deposits, so the system is still vulnerable and, therefore, the Federal Reserve has a set of reserve requirements. Now the reserve requirement is progressive. Small banks have lower reserve requirements but it rapidly gets up to a standard. The reserve requirement now is 10% on demand deposits, so they’re forced to keep those reserves and much of that is in the form of deposits at the Federal Reserve Banks. One form of monetary policy that the Fed does is they can change these reserve requirements. The other, but more commonly used, monetary policy is to change the rate — is to effectively alter the rate of interest on deposits. So, the interest rate — the policy tool in the United — the policy interest rate or key rate in the United States is called the Federal Funds Rate.

The Federal Funds Rate is an overnight lending rate between banks. The Federal Reserve conducts monetary policy by targeting the Federal Funds Rate and it announces — since 1994, it has been announcing after the meetings of the Federal Open Market Committee — it’s been announcing the Federal Funds Rate publicly. The Federal Funds Rate was recently cut to 2.25% and it’s expected to be cut further because of the recession that we’re now apparently in. So, that will be the monetary policy tool. What’s happening right now in the United States is that the economy is collapsing — maybe that’s overstating it. It’s contracting, so the Fed is trying to prevent a serious recession by cutting interest rates; they’ve been cutting them rapidly. The Federal Funds Rate is a rate that is targeted by the Fed and it’s their principle target. The Federal Funds Rate is the rate that banks borrow and lend to each other overnight.

There’s another interest rate that the Fed sets and that’s called the discount rate. The discount rate is the rate that the Fed charges for loans to member banks. The member banks, just as with the Bank of England — when they’re in trouble, they are supposed to be able to borrow money from the central bank. The central bank posts an interest rate that is the rate at which these member banks can borrow. There was an important change in the discount rate in January of 2003. It used to be that the Fed would grant loans to member banks in the form of discount rate lending if the bank could certify that it was in trouble. At that time they would give generous — this was before 2003. The discount rate was a policy variable set by the Fed and it was typically fifty basis points below the Federal Funds Rate. They were lending to banks that were in trouble and the — so, we’ll give them a good rate; that’s what they used to do. In 2003, they decided to change that and they decided to raise the discount rate above the Federal Funds Rate. Actually, there are two discount rates; there’s primary and secondary. The primary discount rate is typically a hundred basis points above the Funds Rate. That’s not so recently; they’ve been cutting it relative — but that was originally the idea.

What they wanted to do starting in 2003, was to eliminate the idea that the discount rate is only for banks who are in trouble. They wanted to eliminate the stigma — it used to be embarrassing to borrow at the discount window, because the discount rate would — because it would be an admission that the bank is in trouble. So, in order to try to eliminate that stigma, they made it a penalty rate. They made the discount rate higher than the Federal Funds Rate; so now, the Federal Funds Rate is at 2.25%. The discount rate is now only twenty-five basis points higher; it’s at 2.5%. They’ve been cutting the spread between the discount rate and the Federal Funds Rate — again it’s an effort to stimulate the economy. I think one reason why they may have changed it in 2003 is that interest rates were getting really close to zero in 2003. They were worried that if the discount rate is fifty basis points below the Federal Funds Rate, then it’s going to hit zero and that would be embarrassing; so they moved it. I think that might be the reason — no one knows what all their reasons were.

Chapter 6. The Fed’s Innovations against U.S. and Global Stagflation [00:45:00]

The basic idea that’s developed is that the Fed is looking at inflation and unemployment as the two major things that it looks at. Inflation is the most important thing, according to many views, because the Fed has to guarantee the soundness of the money supply and there have been so many cases in history when the central bank allowed debasement of the currency through inflation. It’s thought that that is a serious error because it destroys trust in the currency. On the other hand, the Fed is also concerned with unemployment and the possibility of a collapse in the system. Right now, the Fed is in a difficult situation. Last year, we had 4% inflation — 4% inflation is high by traditional standards. It’s above what we’d like; we’d like it to be more like 2% — 4% is high. So, that would mean that the Fed should be raising interest rates to try to tighten up the economy and bring the inflation rate down. Unfortunately, we’re in this collapse situation in the economy, so the Fed has a problem. There’s a name for this — it’s called stagflation.

Stagflation was a term that was developed in the 1970s to refer to a time when inflation is — we have both high inflation and high unemployment; and so we’re in that situation apparently again. With interest rates hitting zero — I say Alan Greenspan — Ben Bernanke must be losing sleep at night. This is exactly the worst nightmare of a central banker. You’ve got this policy tool of interest rates, but once it hits zero you’re out of business. So, he has been working on trying to find other tools of monetary policy. Ben Bernanke has been very creative in doing — maybe I ought to write some of these things down.

The Term Auction Facility — or TAF — was created by the Federal Reserve under Bernanke, on December 12^th. It’s a new form of monetary policy — a new invention, which we’ve been doing only for a matter of months now. What the term auction facility — it was also created in connection — in collaboration — with the Bank of Canada, the Bank of England, the European Central Bank, and the Swiss National Bank. So, we’re seeing an internationalization of bank monetary policy. All of these central banks — of Canada, England, Europe, and Switzerland — got together with the Federal Reserve and said — obviously they were worried about the financial crisis that was engulfing the world. So, they agreed to auction off — it’s a little bit different than a — it’s a little different from an ordinary monetary policy. It’s a way of helping troubled financial institutions.

What they did instead of just — remember, the Federal Funds Rate is a target interest rate that the Fed attempts to hit through buying and selling treasury bills in the U.S. or in other countries buying and selling government bonds to affect the market. If the Fed wants to push the Federal Funds Rate up–down — it goes and buys short-term government bonds. Buying them tends to push up the price; that tends to influence the yield down, so it encourages a lower level of interest rate. The term auction facility is different. In this facility, banks are allowed to — the Fed announces a certain amount of money that it wants to put out there in the form of collateralized loans with other banks — with member banks. What the Fed said it would do is announce an auction of so many billion dollars of loans to member banks and the banks have to supply collateral to the Federal Reserve. The collateral could be a number of things, including mortgages — securitized mortgages — that are risky and dangerous assets. In effect, the Fed is trying to solve the subprime crisis by taking on, as collateral, some of these risky things in exchange for offering loans to member banks. It’s different from Fed policy in that they set up a certain amount of money and auction that off to the highest bidder. Troubled banks then, who have this — the problem banks have now is they have these securitized mortgages that they’ve bought and the homeowners are defaulting on the mortgages now.

So, there’s a panic in the market for securitized mortgages and the price is often very low or if it’s — they’re very hard to market and hard to sell. Banks are in trouble and, as you know, they’re starting to fail because they — the value of their assets in the market is falling rapidly. The Fed is effectively just saying, we’ll take those assets as collateral for loans to you. So, they’ve given, as of today, it’s eighty billion dollars on the term. This thing — this new invention is three months old at this point. The system continues to look more precarious. This is a very interesting time because the Fed is continuing to invent. Then they came up with the Term Securities Loan Facility.” Don’t look this up in Fabozzi because the date of founding was March 11, 2008; that’s the date that they announced it. What they’re going to do is have auctions of loans of treasury securities in exchange for collateral, such as the mortgage securities. The first auction is March 27, 2008, which you may note is tomorrow.

Actually, I mentioned the Term Securities Loan Facility because it’s a new innovation but it hasn’t started yet. In their announcement on March 11^th, they said the Fed would lend up to $200 billion of securities to the market. What they’re really doing is just — we’re facing this seize up of our financial system, so we have banks that — we’ve just seen the failure of Bear Stearns, which is actually a broker-dealer. But banks and broker-dealers are in trouble because their assets are collapsing under them. They can’t sell them to get money, so the Fed is saying, fine we’ll just take those and we’ll give you Treasury bills, which are completely — everyone trusts them. So, you have some asset that nobody trusts, the U.S. Federal Reserve will take it on.

This is an effort — this is different from most monetary policy. Now, it’s different in important ways because it’s really focused at preventing the collapse of the economy that is created by a financial system failure. It’s looking at the problem that certain troubled institutions have — that their assets can’t be sold — and it’s just saying, okay we’ll replace them with assets that can be sold. The Fed is taking on a serious risk in doing this because these assets that it takes on in exchange for Treasury securities could fail. Nobody knows how bad the mortgage crisis is going to get, but Ben Bernanke thinks that it’s so important that we prevent a collapse that we should take that risk. Incidentally, both of these things — this is called a TSF and this is called a TAF — both of these are joint with the Fed in the United States, the ECB, the Bank of England, and the Swiss Bank, and Bank of Canada. These are all international efforts to forestall a financial crisis.

There’s a third one, which is even newer. It made — this one was announced — the third innovation is called the Primary Dealer Credit Facility and that was announced March 16, 2008. So, that’s how many days ago? A few days ago — ten days ago — and that’s called the PDCF. What the PDCF is, it’s really an extension of the discount window beyond member banks. You have to know what are primary dealers. Primary dealers are broker-dealers; they are not banks. The critical thing that’s happening is that at a time of financial crisis, which exceeds any that we’ve seen perhaps since The Great Depression, but certainly bigger than we’ve seen in many years, the Fed is worrying about not just member banks but also other financial institutions. For example, Bear Stearns, which is a broker-dealer failed recently. The Fed is worried about a collapsing house of cards.

What’s essential about the Primary Dealer Credit Facility is that they’re opening up the discount window of lending beyond the member bank to primary dealers. What is a primary dealer? When the Treasury in the United States sells Treasury bills, notes, and bonds, they deal almost exclusively — or we say primarily — with broker-dealers, not the general public. The Federal Reserve has a list, which you can find on their website, of dealers who are eligible to participate in Treasury security auctions. There are twenty — actually, I’m not sure there are twenty anymore. One of them was Bear Stearns, so I don’t know whether they’re still on the list — maybe they are, maybe they’re not; we might be down to nineteen. These are broker-dealers — some of them are international, like BNP Paribas is one of them — it’s French.

By opening up the Primary Dealer Credit Facility, we are — what the government is offering to do is to take bad investments that they made on as collateral for loans at 2.5%, which is the current discount rate. This is quite a remarkable change, reflecting the seriousness of the crisis. I think it’s reflecting the fact that we’re moving into possibly a situation of — protracted situation — of nearly zero interest rates. In an effort to get more — to keep the economy from collapsing at a time when — at a time of great concern about the structure of the financial system. This is different than other recessions. We’ve had other economic problems that have led to recessions, but it hasn’t seemed to be something as potentially global as it is now.

We had the Savings and Loan crisis of the 1980s. In the Savings and Loan crisis, it was a certain segment of the banking community — the S&L’s — that seemed to be in trouble, but it didn’t seem to be then a house of cards that could spread around the country and around the world. In 1998, there was the Russian default crisis and then there was some seize up of — that maybe resembles what is happening now. Long-term Capital Management was a big hedge fund that failed in 1998 and got bailed out by the Fed. I didn’t see then the proliferations of these new instruments that reflect concerns about the current economic situation.

Chapter 7. A Trace through Recent Recessions and Conclusion [01:00:47]

I think maybe the concluding lesson — the central banks were institutions that emerged out of experience with bankers. It started not really as a planned system — not planned by any government. The Bank of England was its own bank and the Suffolk Bank was its own bank, and they developed ways of doing business without government planning to help try to preserve stability of the system. There have been fundamental changes through time that make the role of the central bank evolve and change through time. I mentioned earlier that we used to be on the gold standard and central banks were gold standard institutions that were trying to stabilize the economy but subject to the constraint that they had to maintain convertibility with gold, but those central banks’ role has changed a lot. It seems like the nature of recessions is always changing. The biggest recession we’ve had since The Great Depression was actually a pair of recessions in — there was a short recession in 1980. It lasted just a few months and people — once we got out of it people thought, maybe we’re getting a brief — a respite. But then the U.S. crashed into a huge, well actually, it was as worldwide recession of 1981-2. This was the biggest recession since The Great Depression.

What caused that recession? I think there’s a simple story, which is very different from what’s causing the current — apparently current — recession. In the 1960s and 70s, central banks around the world were inflating the currency. It was getting out of proportion. We had inflation rates in the United Kingdom on the order of 20% a year and people were asking, what is going on in the UK? Bastion of enlightenment, what’s going on? They elected Margaret Thatcher and there was a resolve to do something about it, but it wasn’t just the U.K.; it was all over the world. Inflation rates had gotten very high, even in Germany, where anti-inflation sentiment was the highest. Central banks, around this time, I think it was under the leadership of Paul Volker, who was the Federal Reserve Chairman, they raised interest rates to kill inflation and they threw the world into a huge recession. What caused it? It was caused — maybe it’s oversimplifying it — it was caused by a change in our resolve to let’s get inflation under control and a willingness to accept the recession — to stop the advance of inflation. You can blame it on other things, like the oil crisis of 1979 — nothing is completely simple.

Anyway, this recession has been a model for what happens in recessions. The idea that emerged — the memory of the ‘81-82 recession is very strong in our imagination because we think that it was caused by lax monetary policy, by liberal thinking, by the soft-hearted liberals who just didn’t want to create any pain and suffering. I’m talking about the view that’s commonplace. So, we finally got tough and we got Paul Volker in there and central banks around the world all managed to get tough around that time and we killed inflation, but it created a recession.

That’s what happened in ‘81-82, but you have to remember that times are different. Subsequent recessions were not like that. We had another recession in 1990-91 and it wasn’t very big or bad. This recession was, I think, just a Gulf War recession. It was caused by, well partly by, an oil price spike caused by the Saddam — the war against Saddam Hussein. It was also caused by just a general lack of confidence. It wasn’t caused by the Fed’s sudden tightening against inflation. It was different, it was — this recession was not understood, not anticipated; the Fed came in late to cut interest rates to try to prevent it from being worse because it just didn’t seem to have any reason for happening. It just surprised everyone, so it was not a repeat of this.

Then we saw the 2001 recession; that recession again is different. I think the 2001 — if you want to have a story about it, the 2001 recession was caused by the end of the stock market boom. We had a bubble in the stock market in the ’90s and it collapsed after 2000 and with that it brought the economy down. The Fed then again cut interest rates in 2001 in response to the very definite weakness of the economy. Then that brings us to the 2008 recession. Now, it still hasn’t been identified as a recession and some people are still hoping that we won’t have a recession in 2008. I think it’s really looking like we are in a recession. Notably, there are different indicators. The one that just came out is the Consumer Confidence Index, which was a Conference Board publication. That index is now way below the lowest that it got in the 2001 recession. It’s at the level — almost down to the lowest that we got in the 1990-91 recession. So I — by that indicator, we are in a recession and we don’t know that it’s over yet; it’s been falling.

Home prices are falling at the highest rate we’ve ever seen. I have my own index, the Standard & Poor’s/Case-Shiller indexes, and we announced our indexes yesterday. We saw record price declines on a monthly basis for fourteen of our twenty cities that we reported. That means that they’ve never declined as much in one month before; our data started in 1987. We don’t have data on individual city basis, but it really looks like the housing collapse — price collapse — that we’re going through now is on a magnitude not paralleled since The Great Depression of the 1930s. I think that we are in a difficult situation, but maybe let’s not panic about it.

The optimistic thing is, I think that we have a very good Fed chairman and we have coordinated efforts by central banks around the world and we’re doing things that are attempts to prevent the collapse of the financial institutions. I think we’re still in a precarious situation, but I think we do have central bankers who are working effectively, given the tools that they have. Now incidentally, I’m writing a book, the title of the book is Subprime Solution; I just sent off the draft to the copy editor last Friday. The book — my publisher, Princeton University Press, wants to get it out before this crisis is over. We’ve got them on a rush to try to get the book out and they’re thinking that we’ll at least have copies to reviewers by June. I’ve been worrying that my book will be too late and that by June everything will be rosy — that it’ll all be over. I guess I should hope that that happens, but I have a suspicion that come June, this crisis will not be over.

Unfortunately, some of you are on the job market this year and I want to give you some consolation if you have not had a great success so far in finding a finance job. The consolation is, they’re killing people at the top too, so they’re going to — so when you do get a job in a financial institution, there will be more spaces above you on the ladder to move up. I’m saying that kind of jokingly, but I think you are facing a rather — if you’re out in the job market, you are facing a difficult economy, but I’m sure that you will emerge all right in the long run.

[end of transcript]

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