Packed
elbow to rib in a cacophonous six seat
paint-can shaker implausibly airborne 800 feet above the ground, fighting for breath against senses of entitlement inflated to SUV size by a sham economy addicted to cheap debt, carrying a desperate need to out consume and out do rooted in a lifetime diet of spoon fed commercials and the easy calories of celebrity worship, mindless of nature's rigors or the rewards of patient cultivation of character or virtue, grimly wondering if their enemies below have surface-to-air or a surprise welcoming committee at the LZ - so begins the US holiday weekend for capitalism's winners according to
Bloomberg News.
Fear not for m* however. For one thing, m* took the
Rolls earlier in the week. (No shaking, forced intimacy, or cortisol floods and door to door, about the same). For another, while the clamoring masses of fake-tan attorneys, has-been movie stars, and assorted financial eel and remora are heading east, m*, ever the contrarian, will be heading back from whence they came to the wonderfully peaceful and empty late summer city.
While the holiday signals the official end to summer and the impending reality of m*'s packed fall agenda, idyllic thoughts of majestic mountain vistas, sparkling clear streams, sun drenched hikes, and yes, heated campfire discussions of monetary policy offer a temporary reprieve. m* is referring of course to the annual
Kansas City Fed Symposium and
central bankers' working holiday this weekend in Jackson Hole.
m* will not be attending of course, but in honor of the event and the final weekend of summer will be sitting down with two very recent papers from
Michael Woodford, an occasional co-author with Chairman Bernanke and the esteemed intellectual godfather of inflation targeting and rule driven central bank decision-making now very much embedded in the thinking of current CB-ista. Why? Know thine enemy. It is Woodford of course who's work shows that monetary aggregates are largely irrelevant to the conduct of modern monetary policy, a viewpoint widely accepted among leading monetary economists today, implying of course that m* is not simply elusive but nonsensical too (and well, m* would have to agree!)
Of course, an effective inflation targeting policy requires an accurate and transparent measure of inflation. Dissenters to inflation targeting in the US frequently point to the vast discrepancy between government price indices and consumers' reported "sense" of inflation. No where is this more apparent than in the spread between the reality of rapidly rising home prices over the last ten years and the stagnant behavior of the much derided statistical construction, "owner equivalent rent."
As an illustration, consider the
BOE. While the BOE follows an explicit inflations targeting mandate and thus adheres closely to many of the protocols expected in that regard, it also rather unusually includes direct asset prices (in particular home prices) into its price measures. The relevance of asset prices to measuring inflation is still open to debate in the academic world. But the BOE apparently believes that asset price levels do contain signaling information for inflation and an ability to influence the very important expectations component.
It may not be a coincidence then that Woodford believes
the BOE comes closest to his idealized inflation targeting Central Bank. It is certainly no coincidence that the BOE has had m*'s vote for the hardest bank over the last three years - witness the performance of Sterling over that period. It will be interesting to see, now that inflation targeters are in charge in the US too and confronting a home finance crisis with larger potential ramifications, whether some greater recognition of the indicator that Greenspan pointedly ignored in price measures is warranted, particularly as popular sentiment views home price declines as analogous to a depressionary deflation. The announced theme of this weekend's symposium is housing, housing finance and monetary policy so this could be interesting.
Two papers by Woodford:
"
How Important is Money in the Conduct of Monetary Policy?"
"
Globalization and Monetary Control"
Meanwhile, Greg Ip in the WSJ "
Bernanke Breaks Greenspan Mold" does a smashup job of burying former Fed Chairman Greenspan's crisis response approach of listening to the markets in relation to Chairman Bernanke's attempts to let the real economic data tell the story. Ip relates a quote from Greenspan during the deliberations on the 1998 LTCM crisis that shows dramatically how far apart the two philosophies for managing policy are.
"It would be wrong to say that the change in psychology is all ephemeral just because we have not seen it in the hard data yet," he told colleagues. "It is the change in value judgments that alters the real world."
In m*'s opinion, Greenspan saw his role as one of actively managing monetary policy, especially during times of crisis, through a forecast (using a very personal mosaic of indicators) of the animal spirits at work in the economy. Undoubtedly these forecasts were colored by his baptism in the 1987 crisis, and following this more intuitive policy, he fell back on the (appropriate) response to that crisis time and again. It is quite clear that in later crises, Greenspan gave the markets significant weight, really too much weight, in his assessments of future risk taking appetite in the economy and acted, erroneously, on those assessments.
It is the personal nature of those assessments, in the face of widespread evidence to the contrary (in particular the dramatic increases in mortgage debt and real estate values), the mistaken signals sent to the economy via inappropriate interest rate policy in response, and the long term consequences for the nation's standard of living as a result of the serial asset price bubbles, mal-investment and overconsumption, unprecedented explosion in debt, and inflation from a devalued dollar that incite Greenspan's critics, m* among them.
Bernanke, on the other hand and like Woodford, is an advocate of inflation targeting. Though he does not have that mandate at the US Central Bank, he has clearly discussed his desire to hew much more closely to the more mechanical adjustment mechanism such targeting espouses, with a healthy appreciation for expectations of course as befitting one of the foremost scholars on the Great Depression. Ironically, Greenspan's Vice Chairman,
Alan Blinder, was also a
proponent of for data-dependent incrementalist approach but he seems to have been less influential than one would have thought.
As has been widely reported during the current crisis, Bernanke has said while he will of course take whatever action necessary to preserve stability, he is attempting to hold off policy adjustments that effect the real economy as much as possible until data show a policy change is required. Not said but also clearly implied is that Bernanke supports an unwind in the degree of leverage promoted under his predecessor provided it can be done without dramatic effect on the real economy. While this may seem unresponsive to a vocal sector of the financial markets, it is a view widely shared, it seems to m*, in the central banking community globally.
The likelihood of success of that de-levering, whether success is even possible, even the actual definition of success are to m* still very much open questions. The problem is that it may be just one crisis too late to take that harder line. With a global system as leveraged as the current one, it's highly doubtful there is much less they can do than the inevitable blunt rate stimulus.
Happy Capital Day.
Ricardo Caballero and Arvind Krishnamurthy: A liquidity crisis is taking place where investors, banks, and funds are scrambling for liquidity. Several hedge funds run by prominent investment banks in the US and abroad have liquidated or have suspended convertibility.
Paradoxically, when viewed as a whole there is sufficient liquidity in the financial system. Banks are well capitalised and flush with liquidity. Just a few weeks ago stock markets were soaring, investors were optimistic, and the VIX hit 13, not far from its 9.5 all time low. Yes, the residential real estate market in the US was declining and creating a mess in the subprime market.
But it was generally understood that the scale of these subprime losses was small in relation to the US and world economy. Even if all subprime mortgages and related CDOs were to lose all value, this would amount to just 2.5 per cent of US wealth. A more realistic, yet still pessimistic scenario puts the potential losses at $400bn, less than 1 per cent of US wealth. These losses could hardly have reversed the liquidity position of the financial sector. Hence, many pundits used the word "contained" in describing the subprime losses. Yet, it is clear that there is a liquidity crisis unfolding before our eyes.
Why? The reason is a rise in uncertainty - that is, a rise in unknown and immeasurable risk rather than the measurable risk that the financial sector specialises in managing. The financial instruments and derivative structures underpinning the recent growth in credit markets are complex. Market participants cannot refer to a historical record to measure how these financial structures will behave during a time of stress. Thus, today there is considerable uncertainty about who will and will not lose money in the credit market turmoil.
To understand how uncertainty can move an economy from excess liquidity to a liquidity crunch, an analogy might be useful. In the children’s game of musical chairs, when the music stops, only one child will be left without a seat. However if the children are confused about the rules and each is convinced that they will be the one left without a seat, chaos may erupt. Kids may start grabbing on to chairs, running backwards, etc.
In the same way, in today’s market uncertainty is leading every player to make decisions based on imagined worst-case scenarios. Market players that have the liquidity stay out of markets or pull back dramatically. But the financial markets need participants and their liquidity in order to function. When much of the market disengages due to uncertainty, the effective supply of liquidity in the financial system contracts. Those that need liquidity are unable to get it and financial markets turn illiquid.
What should central banks do in this case? They must find a way to re-engage the private sector's liquidity. Understanding that uncertainty is the cause of the disengagement is the start of finding the solution. A first step in reducing agents' uncertainty is for the central bank to clarify how it will act if agents’ worst case scenarios come to pass.
The central bank’s mission is to stabilise the economy as a whole and not individual participants. When viewed as a whole, the worst case scenarios that guide the behaviour of each market participant cannot simultaneously occur. Like musical chairs, when the music stops, only one child will be left without a seat, not every child.
The subprime shock at the end of the day is a small shock; it is only the actions of panicked investors that make it appear large. A central bank that understands this point will convincingly promise large liquidity injections in the event of a meltdown. The likelihood of having to deliver on the promise is minimal, but the reduced anxiety fostered by such a commitment restarts private liquidity circulation and helps restore normalcy.
It is important to understand that this is all about information and not about real liquidity additions. We do not have a true liquidity shortage on our hands; we only have one because of the reactions of an anxious private sector. Talking and providing information and certainty can go a long way to reducing uncertainty. A rate cut may be the right tool, but it is important not for its direct liquid addition, and instead for what it conveys about the central bank's readiness to act if things do get worse.
Will the Fed and other central banks around the world act appropriately? The early reactions are positive. The ECB was first to act, injecting more than $214bn in the last two days. The Fed followed with a more modest $38bn on Friday, and the rest of the central banks of the world did their share, lending over $73bn to the market.
It may also be that some of investors’ uncertainty stems from not knowing how Fed chairman Bernanke will react in case of a meltdown. Is he too much of an inflation targeter and oblivious to the workings of financial market? Not likely. From his extensive academic work on these matters, it is apparent that he is quite aware of the importance of credit markets to the functioning of the economy and the cost of the central bank failing to identify a liquidity event in time. It may well be time to start buying put options on the VIX.
Reference: R Caballero and A Krishnamurthy, "Collective Risk Management in a Flight to Quality Episode", forthcoming in The Journal of Finance