NPR reports that the island nation of Kiribati recently implemented a fishing subsidy that created unintended consequences. Kiribati has two major industries: fishing and coconut harvesting. Concerned about overfishing, the local government decided to subsidize coconut harvesting. They argued that by raising the incomes of coconut farmers, that some fisherman would give up fishing to start farming. In economic terms, the government increased the opportunity cost of fishing — the money a fisherman could have made by farming.

Unfortunately for the government, a subsidy affects the quantity of coconut harvesting in two ways. The government meant for the substitution effect, the increase in the cost of fishing, to discourage the island’s residents from fishing. Instead, the substitution effect was dominated by the income effect; coconut farmers could obtain the same level of utility with less work, allowing more time for leisure. And in their leisure time, the farmers went fishing. Rather than decreasing, the level of fishing increased 33%.

Whether the substitution effect or the income effect dominates depends on the preferences of the island’s residents. Since the farmers prefer leisure to work, they will consume more leisure with a subsidy. If they had preferred the extra income from work over additional leisure time, then the substitution effect would have dominated.

Congress should consider both effects when deciding whether or not to continue subsidizing unemployment, now two years after the start of the recession. If Congress wants people to get back to work, it might be better to stop writing checks for unemployment benefits.

(h/t Freakonomics)

Adam Kirsch, in an a recent review of Anne Heller’s Ayn Rand and the World She Made, calls out Rand for failing to live up to the capitalist ideas she advocated in Atlas Shrugged. Rand wrote a lengthy speech at the end of the novel, in which the main character, John Galt, lists the virtues of capitalism. Bennett Cerf, the publisher at Random House, asked Rand to cut the speech, which she refused to do. According to Kirsh,

Cerf offered Rand an alternative: if she gave up 7 cents per copy in royalties, she could have the extra paper needed to print Galt’s oration. That she agreed is a sign of the great contradiction that haunts her writing and especially her life. Politically, Rand was committed to the idea that capitalism is the best form of social organization invented or conceivable. … Giving up her royalties to preserve her vision is something that no genuine capitalist, and few popular novelists, would have done. It is the act of an intellectual, of someone who believes that ideas matter more than lucre.

In fact, I see this transaction as the ultimate expression of capitalism at work. Capitalism isn’t about maximizing profits; it’s about maximizing utility or, more colloquially, happiness. Rand decided that she wanted to express her ideas completely more than she wanted seven cents per copy in royalties. She bought the ability to express her ideas with her foregone royalties, thus making her better off than she would have been otherwise.

The Federal Reserve Board plans to scrutinze the comensation of employees at over 5,000 U.S. banks, particuarly those of executives.  The Fed would not directly set compensation, but could intervene in cases where it thinks that compensation encourages too much risk.

On one level, I think this is a good idea.  Compensation policies for bank employees should reward activity that increases the long-term profitability and soundness of a bank.  They should not encourage employees to pursue profits in the short-term at the expense of the long-run.  For instance, paying employees on the amount of loans they write encourages them to make loans without regard to the credit-worthiness of the borrower.  If an employee turns down riskier loans, he may have helped the long-run stability of his company, but at the expense of a portion of his annual salary.  Why would he do such a thing, especially if he only plans to stay at the firm for a few years?

But in order for this government policy to be helpful, or even necessary, we first must assume that bank shareholders are incapable of setting up contracts that secure long-term growth in the value of their stock.  If it’s easy to set up such a contract, I see no reason why bank shareholders would not do so themselves.  If it’s not easy to write such a contract, what makes Federal Reserve more capable to write those contracts than the shareholders themselves (or rather, than any consultants with expertise in agency theory, which invites yet another agency problem, but that’s another story).

In the previous paragraph, I assumed that bank shareholders rationally choose the maximize long-run profits instead of short-run profits.  Might bank boards act rationally by pursuit of short-term profits at the expense of the bank’s long-term stability?  It certainly makes sense when they have an implicit guarantee of their liabilities from the government.  Then, if the bank makes big profits, they go to the shareholders, but if it makes big losses, they get foisted off to the government.  Such a guarantee encourages bank owners to play a game of “heads I win, tails you lose.”

It makes more sense to me to remove the implicit government protection from failure rather than simultaneously operate two policies that both encourage and discourage risky behavior.  However, operating both policies give the Fed a measure of control over the growth of the economy that it would not have otherwise.  Unless it is managed perfectly, such control will reduce the variability in the cyclical fluctuations of the economy at the expense of a lower long-term growth rate.  If regulations push bank executive compensation below their fair market values, then the financial sector will struggle to get the resources it needs to provide the amount of credit it would have without regulation, which will hamper the growth of small businesses.  The Fed’s move to examine pay structures indicates that it thinks the cumulative economic loss from a lower growth rate is less than the potential loss that could occur during a collapse.  That, or it overestimates its own ability to correctly determine compensation for bank employees.

Ultimately, the success of this new policy depends on how heavily the Fed applies.  If used sparingly, with an eye to the health of the overall financial system, the pay policy will help the Fed nudge the financial sector into a region of stability.  If used often, then it will restrict the proper functioning of the credit markets, interfere with the freedom of individuals to agree to contracts, and do little to protect the health of the financial system.

Recent data from the Bureau of Economic Analysis on personal income and outlays show that, despite the recession, personal income grew by $167.1 billion, or 1.4%, in May 2009. Disposable personal income, or personal income less taxes, increased by $178.1 billion, or 1.6%, over the same month. The BEA news release attributes the rise in income in April and May to “the pattern of increased government social benefit payments associated with the American Recovery and Reinvestment Act of 2009,” commonly referred to as the stimulus.

However, personal consumption expenditures grew only by $25.1 billion, or 0.3%. The larger rise in income compared to the change in consumption means that personal savings must rise. Sure enough, personal savings increased $160.3 billion, from $608.5 billion to $768.3 billion, or 26.3%.

Therefore, as the government spreads around money in an effort to get consumers to spend again, consumers respond by placing that extra money in the bank. The stimulus to date has been about as effective as President Bush’s 2008 tax rebate – 80-90% of those dollars were saved. With tough times likely down the road, who could blame consumers for wanting to keep some cash on hand, just in case?

Milton Friedman’s permanent income hypothesis suggests that consumers only increase consumption in response to permanent changes in income. Accordingly, the government should institute a permanent tax cut. Paul Krugman recently turned Friedman’s logic on its head and argued that the government should instead permanently raise taxes and institute a new permanent spending program to spread the wealth around. However, such a program would increase income for some people in precisely the amount that it decreased it for others (actually, it would be just a little less in order to cover the administrative costs), leaving the economy as a whole, at best, with the same level income. Moreover, such a program assumes that its administrators can allocate resources more efficiently than consumers in a market.

We cannot spend our way out of this recession; eventually the government’s borrowed money will run out. Instead, the federal government should cut taxes, especially capital gains taxes, and let the economy build a recovery on a solid, permanent foundation.

I was recently forwarded this email:

“In a small town in the United States , the place looks almost totally deserted. It is tough times, everybody is in debt, and everybody lives on credit.

Suddenly, a rich tourist comes to town.

He enters the towns only hotel, lays a 100 Dollar Bill on the reception counter as a deposit, and goes to inspect the rooms upstairs in order to pick one.

The hotel proprietor takes the 100 Dollar Bill and runs to pay his debt to the butcher.

The Butcher takes the 100 Dollar Bill, and runs to pay his debt to the pig farmer.

The pig farmer runs to pay his debt to the supplier of his feed and fuel.

The supplier of feed and fuel takes the 100 Dollar Bill and runs to pay his debt to the town’s prostitute that in these hard times, gave her “services” on credit.

The hooker runs to the hotel, and pays off her debt with the 100 Dollar Bill to the hotel proprietor to pay for the rooms that she rented when she brought her clients there.

The hotel proprietor then lays the 100 Dollar Bill back on the counter so that the rich tourist will not suspect anything.

At that moment, the tourist comes down after inspecting the rooms, and takes back his 100 Dollar Bill, saying that he did not like any of the rooms, and leaves town.

No one earned anything………. However, the whole town is now without debt, and looks to the future with a lot of optimism.

“And that, ladies and gentlemen, is how the United States Government is doing business today.”

Nice, right? However, the anonymous author of this story neglects two important facts. First, he assumes a 0% savings rate and a 0% interest rate. In reality, the $100 loan would allow the hotelier to pay something like $80 to the butcher, the butcher to pay $64 to the farmer, the farmer to pay $51 to the feed supplier, the feed supplier to pay $41 to the hooker, and the hooker to pay back $33 to the hotelier. Meanwhile, the rich tourist would expect $105 in return for his loan.

Second, and more importantly, the story works so neatly because the hotelier both begins and ends the circle of debt. That means at the outset of the story, the hotelier owes $100 to the butcher, but also holds $100 of the hooker’s debt, for a net liability of $0. The hotelier does not need the rich tourist’s $100 to pay off the butcher; he could just sell the hooker’s debt to the butcher (again assuming an interest rate of 0% and that the butcher prefers to hold the hooker’s debt equally as well as the hotelier’s), so that the butcher has a net liability of $0. The town’s citizens can continue to buy and sell each others’ debt until the feed supplier pays off his debt to the hooker with $100 of her own debt. Both before and after the rich tourist comes, each citizen of the town has a net liability of $0; his presence does nothing to alter that fact.

However, that circular debt structure is extremely unlikely. It’s more likely that some citizens will hold others’ debt without issuing any debts of their own. Thus, I offer a more plausible story: In a respectable society, social opinion would frown upon illicit activities. The hotelier, as a pillar of the community, would not provide any services to the hooker. In that case, the hooker would just keep the rich tourist’s $100 as payment for services she provided in an earlier period. Meanwhile, the hotelier, who was in debt $100 to the butcher, would then owe $100 to the rich tourist and have no way to pay him back.

I suppose the original author meant for his story to show how the government “helps” the economy by borrowing money and then spending it. In this case, the hotelier represent the U.S. government and the rich foreigner giving money to the government represents the Chinese. The more plausible version of the story illustrates that government’s deficit spending doesn’t reduce the total amount of debt in the economy; it just shifts who actually holds the debt. Eventually the government has to repay that debt and it has to get the money from somewhere.

In this recent opinion piece in the Financial Times, Crispin Odey argues that excess debt holds down the economy and a healthy dose of inflation would reduce the value of current, outstanding debt, thus fixing the economy.  While he is right that excess debt endangers businesses’ and households’ financial soundness, and that inflation reduces the real value of outstanding debt, either a temporary or a permanently higher rate of inflation would solve this crisis at the expense of future economic growth.

When a business takes on debt, it uses other people’s money to purchase assets.  The amount a business uses other people’s money is called leverage, because debt multiples profits (and losses) like a lever multiplies the force exerted at one end in order to exert a greater force at the other.  Financial analysts commonly use the debt-to-equity ratio to measure a firm’s leverage.  For example, a business with $1,000,000 in assets but only $100,000 in equity has $900,000 in debt — a debt-to-equity ration of 9.  A business with $100,000 in equity and $50,000 in debt has a debt-to-equity ratio of 0.5.  

Furthermore, suppose the business can make a 10% return on assets.  The highly-leveraged business generates $100,000 of revenue using only $100,000 of equity — a 100% return.  The lowly-leveraged business generates $15,000 of revenue using $100,000 of equity — a 15% return.  When the economy is good, leverage can help increase profits.  But when the economy is bad, that 10% return on assets could just as easily be a 10% loss.  In that case, the lowly-leveraged firm suffers only a 15% loss, whereas the highly-leveraged firm is bankrupt.

Inflation, or rising prices, diminishes the real value of debt because the amount of money initially borrowed can buy less goods when it is repaid.  A higher rate of inflation would stabilize highly-leveraged firms, but at the expense of creditors, the people who made highly leveraged firms’ profits in the first place.

Think about how creditors would respond if the official government response to financial crises were a deliberate inflation.  In that case, the firms taking on the debt make great profits when the economy is good, but the government, through a deliberate inflation, transfers the great losses to the creditors.  A deliberate inflation is a deliberate transfer of wealth from the responsible to the irresponsible. Given the options of modest profits or huge losses, creditors will either ask for higher interest rates or stop making loans altogether.  Neither option helps the economy as a whole.

Constantly changing prices make it hard for businesses to plan long-term projects.  Inflation increases uncertainty.  And just look at what the uncertainty regarding the value of mortgage backed securities, the ad hoc application of the TARP, and the continued threat of further government intervention has done to the economy.  In the face of uncertain decisions, people just stop trading.  They wait to make a decision until they have a better idea of what might happen.  Higher inflation might help in the short run, but it does not help sustainable economic growth.

The U.S. economy has been in recession for at least a year.  The Federal Reserve has lowered the federal funds rate to just a hair above 0%, which leaves monetary policy essentially powerless to help the economy out of recession.  So now the nation expects Congress and the incoming Obama administration to provide a massive fiscal stimulus to jump start the economy.  Congress should not spend $800 billion lightly.  To help in the deliberation, I’ve provided a list of some dos and don’ts Congress should consider in order to get the best bang for the stimulus buck.

DO: Spend the money on investment.  GDP consists of four items: consumption (consumer and business spending on goods and services), investment (business spending on plant and equipment), government spending, and net exports. The government, just like households and businesses, can choose to spend money on public consumption or public investment. Investment spending purchases tools that workers can use to produce more goods and services. It’s like a two-for-one deal; buy investment and get consumption for free.  

DON’T: Spend the money on consumption. Some economists use the idea of a Keynesian consumption multiplier to justify an increase in consumption spending. An increase in spending from a government stimulus should increase total spending on consumption by a multiple (the inverse of the savings rate) of the initial amount. For example, suppose the savings rate is 20%. If the government spends $100,000 on new fighter planes, then Boeing has $80,000 to spend on guidance systems, and Intel has $64,000 to spend on silicon for new chips, and so on. Add up the total amount of new spending that follows from that initial increase and you will find that $100,000 of government spending stimulated $500,000 in total spending in the economy. However, this strategy depends on consumers and business spending all of their money instead of saving it.   Unfortunately, with most Americans heavily indebted already, the government should encourage saving (more on that later).

DON’T: Give a lump sum payment, such as a tax rebate. The first round of tax rebates in early 2008 were a dismal failure. Consumers, worried about difficult times to come, smartly saved the rebate for a rainy day. This is about the worst thing the government can do; it transfers money from some people to others with no real economic benefit.

DO: Cut income tax rates. Consumers will only start spending again once they feel their income stream is secure.  Cutting income taxes increases consumers’ current take-home pay, just like a rebate program, but it also increases their future take-home pay.

DO: Cut capital gains tax rates.  Just as the government should look to purchase capital, it should encourage saving by cutting the capital gains tax rate.  Increased savings will lower the interest rate and encourage business to finance more capital investment. 

DO: Invest in public transportation.  Population trends show more Americans moving to metropolitan areas.  The cities are the natural location for the information jobs of the new economy.  Most middle class workers who can afford to do so choose to live in the suburbs and exurbs and commute to work.  Unfortunately, there is a physical limit to how many people and cars can fit into a crowded downtown business district.  The congestion from a traffic jam at rush hour imposes a cost on everyone stuck in a car wasting time.  Expanding the current light rail and rapid transit in America’s most congested cities would provide commuters with a viable alternative to driving that would take cars off the road and decrease traffic delays.

DON’T: Invest in new roads and bridges.  If we want to build roads, improving the roads around metropolitan areas to reduce traffic gives us the best value per stimulus dollar.  But mass transit systems in these areas will produce an even greater return.  We don’t need to improve the highway system, as most open roads in between cities are still free of congestion.  Let’s try other stimulating other transportation possibilities first, like railways for freight shipping, and leave building roads to the New Deal.  

DO: Invest in broadband Internet access.  If information technology is the future of the American economy, we need to create the modern-day equivalent of the Interstate Highway System.  Currently, the United States rank 16th in broadband Internet access per capita.  Increasing access to the Internet will open up new online business opportunities.  The fact that certain people can make an honest living playing online games such as Second Life shows that online access can create new jobs and even new industries.  To compound the benefits, spending should go to help cities create large wi-fi networks, eliminating the costly need to lay cables and providing access to anyone, anywhere.

DO: Resupply and refurbish the military.  After two wars in Iraq and Afghanistan, the American military is worn out.  Maintaining our defense capability should be a no-brainer.

DO: Invest in research and development for energy-efficient technologies.  R&D provides another two-for-one benefit: the initial spending creates jobs while those jobs create technologies that reduce the cost of business across the economy.  Energy is still a major factor of production.  Sharp increases in the price of oil or other forms of energy can still raise the operating costs of every business, and therefore the prices of every consumer good.  Increasing energy efficiency will not only insulate businesses and households from fluctuations in the supply of and demand for energy, it will also lower the fixed costs of production and increase real GDP.

DON’T: Forget to trim spending once the economy recovers.  Politicians usually forget the second half of the Keynesian prescription: the government should run a surplus during the good economic times.  This means cutting back the emergency spending programs once the emergency has passed, not incorporating them into the baseline CBO projection for spending.  In this post, I’ve advocated spending money on public capital, which has a lasting benefit long after the stimulus spending has stopped.  Social welfare programs and direct job creation by the government require continued spending in order to maintain their effects.  With a projected budget deficit of $1.1 trillion for FY 2009 and an additional $3.1 trillion over the following ten years, we can’t continue to spend money indefinitely.

DON’T: Rush to push a stimulus through Congress. A quickly passed bill or series of bills will ensure that stimulus money goes to the groups with the best political connections instead of the groups with the most productive projects. If future generations are ever to pay off the massive debt generated by this stimulus, they need to have the ability to make money above and beyond the interest payments on the debt. Yes the economy is in a rough spot now, but a little patience will ensure that the stimulus money is not wasted and this recession will not continue indefinitely.  

And last but not least, DO: Remember we don’t have to spend the money.  It’s better to do nothing than to waste $800 billion.

Every transaction involves two parties — a buyer and a seller.  Both the buyer and the seller agree to exchange a good because the exchange provides both of them a net benefit, otherwise there would be no trade.  With some transactions, however, costs of the exchange are imposed on others not party to the transaction.  Economists refer to these costs as negative externalities. No exchange in today’s economy involves more negative externalities than that of gasoline.  An increase in the gas tax charged at the pump would shift those borne by society onto those who are producing and consuming gas.

A Pigouvian gas tax is an unpopular policy, which makes any politician reluctant to endorse it.  In general, I (and I’m sure I’m not the only one) prefer lower taxes.  That’s why I endorse a gas tax with a twist – a increase in taxes on gasoline offset by a reduction in payroll taxes.  Since the average driver buys 14 gallons of gas per week, an increase in taxes at the pump by $1 (or more) should be offset by a $14 (or more) payroll tax cut.  If driving habits don’t change, then the net tax effect is a wash.  But if the tax has its intended effect, drivers will reduce their consumption of oil and pocket the difference between the payroll tax cut and the gas tax hike.  Such a change does not raise the overall tax burden in the middle of tough economic times (it will likely reduce the burden) and it has the added benefit of removing a number of negative externalities currently borne by the public:

1. Oil as political power  –  The list of the world’s top oil producers features several anti-American states — Russia, Iran, and Venezuela most prominently.  The worldwide spike in oil prices has provided dictators in these countries with an easy means of financing their aggressive foreign policy and given them little incentive to invest in a productive economy.  As oil prices have fallen from about $140 a barrel to only $40, Russia’s government has switched from invading neighboring countries to scrambling to prop up its domestic economy, and Venezuela’s dictator has cut back on buying anti-American support across Latin America.  OPEC colludes to reduce supply and keep crude oil prices high; the United States should lead a group of nations to collectively raise gas taxes in order to suppress demand and keep crude prices low.  

2. An imbalance of payments – The current account deficit has grown from $215 billion to $731 billion over the past decade, an increase that corresponds to the rise in crude oil prices from $14 to $85 per barrel.  We’ve been sending dollars abroad at a faster rate than we’ve been producing new things for foreigners to buy in order to send their dollars back to the U.S.  Correspondingly, the dollar has fallen in value against a trade-weighted basket of currencies.  Countries like China and Japan with large current account surpluses used their savings to purchase the safest investment possible: United States Treasury debt.  The corresponding high demand for American debt helped the government to finance projects like subsidies for home loans to low-income borrowers.

Long story short, a continued imbalance of payments is not good for the world economy.

3. Pollution  –  I’m not sold yet on the idea that humans are responsible for changes in the planet’s weather, but I can’t argue with getting rid of the pollution that comes from our nation’s fleet of automobiles.  I enjoy breathing clean air, especially when I exercise outdoors.  I think it’s only fair that someone who makes a mess pay for the costs of cleaning it up.  We tax cigarettes because secondhand smoke has adverse health benefits; the same logic should apply to car exhaust.  

And for those who want a reduction in emissions to prevent global climate change, a Pigouvian tax on gas utilizes market forces far more powerful than any congressional decree, such as CAFE standards. 

4. Cars nobody wants – Speaking of CAFE standards, the switch to more fuel-efficient cars precipitated by a tax on gasoline would eliminate distortions in the automobile market caused by federal regulations.  Under CAFE, the average fuel economy of an auto manufacturer’s fleet must be under a certain amount.  So car companies make the fuel-guzzling trucks and SUVs, for which there is a high demand, and meet their average requirements by creating small, fuel-efficient cars that no one in the United States cares much for and the car companies must sell at a loss.  The Vice Chairman for Global Product Development at General Motors has likened CAFE standards to trying to reduce obesity by requiring tailors to only make clothes for skinny people.  In order to get rid of this inefficiency in the car market, we should either get rid of CAFE or implement a gas tax that gives car buyers an incentive to prefer fuel-efficient cars.  Such a change would not entirely make the big three car companies profitable again, but it would certainly help.  

Now is the perfect time to implement a gas tax that, on the surface, will be very unpopular.  The incoming Obama administration has approval ratings of nearly 70%; if anyone in Washington has the political capital to pull his off, it’s the President-elect.  Additionally, the memory of $4 per gallon gas is still fresh in consumers’ minds.  Consumers had just started to adjust to the idea of permanently more expensive gas by the end of the summer and are still unsure that gas prices will remain low.  The tax should be implemented now before consumers can readjust their expectations.

So to recap, this is a win-win-win-win-win for everyone involved.  The Obama administration gets to provide a net tax cut when it needs to provide economic stimulus for everything under the sun.  Consumers get the extra money that comes with the tax cut, provided they can adjust their driving habits.  Our foreign policy gets a boost by enlisting fiscal policy in the war on terror.  The economy will pick up again as the recovering dollar attracts capital to the United States.  Greens get reduced emissions to slow down global warming.  Car companies can stop begging the government for money and start making it on their own again.  I’ll bet the only people who won’t be smiling will be these guys:

Let's wipe that grin off their faces.

 Further reading: Hot, Flat, and Crowded: Why We Need a Green Revolution — and How It Can Renew America by Thomas Friedman

In order to support the banking system, the Federal Reserve has creatively expanded its balance sheet, the list of its assets and liabilities.  Generally, the Fed holds two types of assets — government securities and discount loans, the loans that it makes overnight to other banks — and two types of liabilities — currency in circulation, the green pieces of paper in you wallet that say “Federal Reserve Note”, and reserves, both the amount that banks are required to keep in reserve with the Fed and any excess amount of reserves.  The liabilities of the Fed are referred to as the monetary base.  The monetary base is the primary, though not the sole, determinant of the supply of money.  When the Fed’s liabilities increase, the monetary base and therefore the money supply increases.  In the past few months, the Fed has expanded its holdings of securities, purchased or accepted as collateral new types of assests, and created new lending facilities to facilitate the flow of credit without expanding the supply of money.

How the Balance Sheet Works

The Fed controls the supply of money by buying and selling securities, a process known as open market operations.  When the Fed buys a security from a bank, it lists the security as an asset on its balance sheet, and credits the bank’s account with the corresponding dollar amount, increasing its liabilities because the bank can withdraw currency from its account at any time. When the Fed sells a security, the process works in reverse; it takes an asset off of its balance sheet and receives a payment from the bank, which reduces its liabilities.  In short, when the Fed buys securities it increases the money supply and when it sells securities is decreases the money supply.

The same logic applies to the Fed’s other main type of asset, loans to the banking system.  The loans are an asset for the Fed because it expects banks to repay the loan funds.  Correspondingly, the loaned funds are either placed in reserves or exchanged for currency, so they incease the Fed’s liabilities and the monetary base.

Expanding the Balance Sheet

The chart below shows data from Federal Reserve Statistical Release H.4.1 — Factors Affecting Reserve Balances.  I’ve selected dates from August 2007, right before the initial liquidity crisis; July 2008, the first appearance of loans to Maiden Lane, LLC, the corporation set up to dispose of assets from Bear Stearns; September 2008, after the collapse of Fannie Mae, Freddie Mac, and Lehman Brothers; November 2008, after the Fed announced and implemented many of the new lending programs; and the most recent release on December 18, 2008.

Over the time of the crisis, the Fed has created new lending programs — the Term Auction Facility, the Commercial Paper Funding Facility, the Money Market Investor Funding Facility, the Maiden Lane LLCs, the Primary dealer credit facility, and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility — with $840 billion in loans, worth about as much the the Fed’s holings of securities before the crisis.  The Fed’s primary credit facility has grown from $2 million in August to $88 billion in December, a 4,240,150% increase.  The Fed’s total assets have grown from $909 billion to $2.3 trillion, a 153% increase.  Ordinarily, an increase in assets like this on the Fed’s balance sheet would lead to a correspondingly large increase in currency in circulation or new loans from banks.  Any increase in the monetary base leads to roughly a 10% expansion in the money supply.  Yet currency in circulation is only up 7% from August 2007 to December 2008 and the price level, as measured by the Personal Consumption Expenditures (PCE) index, is only up 3% from August 2007 to October 2008.

The Fed Giveth, and the Fed Taketh Away

That’s because Fed has been just as creative in finding ways to pull money out of the banking system at the same time it has pumped extra funds in with new loans.  Part of the Emergency Economic Stabilization Act of 2008 included accelerating the implementation of a rule that lets the Fed pay interest on the excess reserves that banks hold.  Notice how reserves have grown from $12 billion in August 2007 to $800 billion in December 2008, a 6,471% increase.  The new rule lets the Fed minimize both the inflationary effect and the increased risk associated with the new loans.

The Fed has also used its standard method for pulling money out of the banking system, selling securities, to prevent a rapid increase in the money supply. It has sold 38% of its securities holdings over the length of the crisis.  But the $790 billion portfolio the Fed had at the start of the crisis wasn’t nearly enough.  To make sure the Fed held enough in securities, the Treasury created a Supplementary Financing Program in which it issues new debt and deposits the proceeds in an account with the Fed.  As of December 2008, the balance in the account stood at $364 billion.  The general account has also expanded from $4 billion to $79 billion.

The Hidden Bailout

The good news is that credit is flowing again.  The new actions by the Fed and the Treasury take excess funds from the public, route them through the Treasury and then to the Fed, who provides them to the financial institutions who need them.  Funds move from those who have an excess to those who need them, just like they should in any properly functioning financial market.  In fact, since Treasury debt is in high demand now because of its safety, the Treasury can borrow at a low interest rate and deposit that money in the Federal Reserve, who is loaning money to banks at a high interest rate.  Since the Fed remits most of its profits to the Treasury, the taxpayers stand to make a good profit on the spread between the two interest rates.

The bad news is what might happen if some of the borrowers default on their loans and the money doesn’t flow back in the proper way, from the borrowers, to the Fed, to the Treasury, and back to the original lenders.  The United States government is not going to default on its debt, so that means that any losses that occur from these new loans go to the taxpayers.  The government will recover losses will either through increased direct taxation in the form of higher tax rates or indirect taxation though printing new money and deprecating the value of the dollar.

“A billion here, a billion there, and pretty soon we’re talking about real money.”
-Sen. Everett Dirksen

In The Know: Should The Government Stop Dumping Money Into A Giant Hole?

In case you fell asleep in Econ 101…

Greg Mankiw’s Ten Principles of Economics, Translated

A recent interview with Anna Schwartz in the Wall Street Journal raised some interesting questions on how the Federal Reserve should respond not only to the current financial crisis, but to monetary policy in general. She blames the Fed both for its accommodative stance toward failing banks and losses in the market, but also for a reluctance to let the stock market fall that created the current crisis in the first place.

In part, the Fed pursues an easy money policy because it’s supposed to. Under the Humphrey-Hawkins Act, the Federal Reserve has a dual mandate — to pursue both “price stability” and “maximum employment.” The problem is that the Fed can’t do both at the same time. In the NFL, they say if a coach thinks he has two starting quarterbacks, he really has none. In the same way that a football coach has to decide on one starting quarterback, a central bank has to decide on one of maximum employment or price stability to pursue a consistent monetary policy.

Schwartz notes here that crashes are caused by asset bubbles, which are a symptom of the Fed’s inability of to decide on one objective for its monetary policy. In the most recent easing cycle before the current one, the Fed cut rates to cushion the fallout from the dot-com bubble burst. Cheap credit helped fuel another asset bubble in housing, which caused the Fed to raise rates. Now, the housing bubble has burst and the Fed is easing again to keep the economy from collapsing. And once again, at least before the failure of Fannie and Freddie raised risk spreads, the loose policy was fueling a commodities bubble. A dual mandate encourages this type of ping-pong monetary policy, where the solution to one problem is the cause of another.

There are two common alternatives to the discretionary policy scheme currently in place at the Fed. One is inflation targeting, where the central bank sets a range for the inflation rate and conducts policy to keep the rate of rise in prices within its comfort range. The Bank of England and the European Central Bank both have published inflation targets. The Reserve Bank of New Zealand’s governor can even be dismissed if the bank fails to meet its inflation target.

An inflation target anchors inflation expectation by clearly communicating to households and firms what inflation rate the central bank intends to allow. It allows for some flexibility by having the target as a range rather than a specific number.

The other policy regime, which Milton Friedman advocated, is an explicit, pre-determined growth rate in the supply of money, for instance 3% per year. Instead of holding regular meetings to gauge the state of the economy, central bank officials would simply administer the pre-determined increases in the money supply.

The drawback to this is that any external shocks, say an oil embargo devastating hurricane or terrorist, get passed through to employment. Current policy allows the Federal Reserve to respond to these shocks to cushion their affects on the economy. But then again that’s Friedman and Schwartz’ point: in trying to be the monetary superhero, the Fed ends up causing more problems than it solves.

Further Reading:
The Structure and Function of the Federal Reserve System — Congressional Research Service
The Goals of U.S. Monetary Policy — The Federal Reserve Bank of San Francisco
The Fed’s Monetary Policy Rule — William Poole, Federal Reserve Bank of St. Louis
Monetary Policy and the Legacy of Milton Friedman — Anna Schwartz

Recently, the national debt topped $10 trillion, which caused the Durst Organization, a group who tracks the national debt, to have to order a new sign for the national debt clock in New York City. While that sounds like a lot, the figure also has to be put in perspective. Just like a business’ or a household’s debt financing, what matters for the national debt is the ability of the government to pay it back in the future. So long as the country keeps making more than it borrows, and so long as we spend the money on investments that increase our productivity as a country, we can keep the debt to a reasonable percentage of GDP. Since a picture is worth a thousand words, check out the GOOD Sheet comparing the national debt and GDP since 1920.

Today a friend of mine sent me an article by Jeffrey Miron on some issues with the rescue plan for the financial industry. She also included a list of questions she had after reading the article:

1. The point was to inject capital, not inject liquidity right?
2. Is it really not easy to tell who is illiquid and who is insolvent?
3. Do you think this will spur bank lending? I know that increasing or maintaining lending isn’t a requirement of the money, so will they lend?
4. Do you think bank ownership will continue for a long time? It isn’t very clear when the government will get out.

Since I’m sure she’s not the only one with these questions, I thought I’d include below my response to her questions:

I can understand the author’s confusion about the goals of the bailout; since the bill was passed, some influential commentary has shifted the focus from injections of liquidity to injections of capital. The original plan was to buy the securities and assets that were in trouble; now the plan is to take an equity stake in the banks. The equity position addresses the problem of solvency, whereas the direct purchase of assets does not.

It is difficult to tell who is illiquid and insolvent because no one wants to trade these assets. That means there is no market that sets a price and determines what these assets are worth. Remember, these assets are tied to bundles of mortgages. It takes time and research to track down the original information on the physical houses and borrowers whose mortgages back the securities, especially since the bank that originated the loan is usually no longer associated with the security.

This should spur bank lending by removing the banks’ fear that they will make a loan to another bank and not get their money back because the other bank goes out of business. I haven’t looked at the details of this new plan yet, so I don’t know how many banks are getting this support. The more widespread the support is, the more it should help restart normal lending.

The author is right that there is no explicit guarantee that the government has to sell its equity positions at some point in the future. In the meantime, taxpayers will be exposed to potential losses should these banks lose more money on these assets. But it also exposes the taxpayers to any potential gains if the Treasury has negotiated well and bought into these companies at a low price. Again, I’m not sure of the details, but I (perhaps stupidly) trust that the Treasury got us a good deal.

The sooner we can separate government and business the better. I don’t think that this rescue plan will encourage other industries to be reckless and expect a bailout. Banks get this preferential treatment because they serve a public function; they aid in the creation of money, which facilitates commerce. Because the banking system serves this public function, it cannot be allowed to fail. In return for the industry’s insurance policy from the taxpayers, they are subjected to strict (well, in theory) regulation to prevent excessive risk taking and ensure, to the greatest extent possible solvency. Other industries, like automobile manufacturers, do not serve a public function, are not subject to regulation, and therefore are free to earn higher rates of return in the good times, but also must accept bigger losses in the bad times. I’d like to see this reasoning made more clear both to the financial industry, other industries, and the American public. If investors want to earn a higher return, they should invest in start-companies but accept the higher risk of failure. If investors want a safer, bur more modest, return they should invest in banks. Hopefully, some of the new regulation will encourage capital to shift from the bloated financial sector to entrepreneurs who can create some badly needed jobs. We should also be careful of over-regulating the financial industry to the point where it is not profitable; after all we do need to keep it functioning because it provides a public service. Regulation should be focused on increasing trust, transparency, and solvency — nothing more.

It’s understandable for most people to see that Congress is proposing giving (actually it’s trading money for assets, which is generally described as buying, but I’ll use the verb most that most people hear when its explained to them) Wall Street $700 billion and think, “Why can’t I get some of that money?”  A <a href=”http://www.snopes.com/politics/taxes/dividend.asp”>recent email</a> has circulated around the Internet, suggesting that instead of giving (there’s that word again) AIG $85 billion, we give that out to every American taxpayer over the age of 18 as a “We Deserve It Dividend.”

That’s a nice idea, but here’s the problem with it.  How do we pay for it?  We have two options:

1. Borrow the money.  The government can issue $85 billion in new Treasury bonds to raise the money.  The good news about that is that with the uncertainty about the soundness of any asset besides gold or U.S. Treasury bonds, demand for T-bills is high, which means that prices are high and therefore interest rates are low.  And since inflation is at its highest point since 1991 (5.37% in August), the money that the government would pay back, plus interest, would be worth less when it is due than it is now.  But that really just refinancing private goods with public money; yes, everyone could pay off their mortgages, but we would all still owe the same amount of money, just to a different creditor.  And I can assure you that once people shifted their debt from private mortgages to public Treasury bills they will just double down on their loans.

2. Just print new money.  The upside: no new borrowing and no addition to the deficit.  But be careful when someone promises you something for nothing.  Everyone would know that the new $85 billion has no additional value.  It has done nothing to redistribute real assets; it has just increased the total pool of dollars that everyone has to bid for assets.  Expect prices, especially gas and food prices to rise accordingly.  Additionally, each individual dollar will be worth less, so expect prices on imported goods, like crude oil, to rise even further.  Once inflation expectations set in, they can be very hard to break.  If that were to happen, you can expect interest rates to rise and a recession to follow, like what happened in the early eighties when Paul Volker let the Federal Funds rate rise to 20% to stop the inflation of the seventies.

The $85 billion “bailout” of AIG is actually a credit line that has been extended to them by the Federal Reserve.  It is up to AIG whether or not they take out any money from this credit line.  The catch is that the interest rate on any loans from the credit facility is 8.5 point over LIBOR, which is about 4% right now.  So the toal interest rate is about 12.5%, which is about the same rate I’m paying on my credit card.  Additionally, the loans that AIG would take out would be secured by a preferred equity stake of up to 80% for the Federal Reserve, which would cause the shareholders of AIG to take a loss.  This whole idea was so unpleasant to AIG shareholders that shortly after the bailout was announced they scrambled to find enough equity to avoid having to use the Fed’s credit line.

I take a lot of calls from constituents who don’t understand what caused the problem and certainly don’t understand what is being proposed to fix it.  All they know is that they don’t want to pay to save the rich guys on Wall Street who caused this problem.  They repeat what they hear from Rush Limbaugh and Sean Hannity that we should let these banks fail and let the free market work itself out.  Any bailout is the first step to socialism.  What they don’t understand is that the Great Depression happened because the government sat on its hands during a panic and let a quarter of the existing banks fail.  GDP dropped to almost half of what it was before the stock market crash during the Depression’s worst year and didn’t recover until ten years after the crash.  The free market cannot work itself out because the participants are in a panic and hoarding cash until the storm passes.  By the time anyone has the courage to step in the market, everything will be gone.  I talked to a guy today who saw his 401(k) fall from $50 a share to $1.

Goldman Sachs has been so successful as an investment bank (at least it used to be an investment bank), because it was “long-term greedy” — it passed up short-term gains when it might risk losing business over the long-term.  Here, the proper solution is one that is “long-term free-market.”  People who advocate a free market solution to this have no idea that free markets cannot provide the solution unless investors are acting rationally.  They have no idea how long, painful, and costly it will be to fix this if it is allowed to play itself out.  And they have no idea how much the fundamentals of the economy will change towards socialism if the complete failure does occur, the Representatives who supported this thing get voted out of office, and a Democratic administration gets to revamp the economy in order to bring it out of a Depression.  In order to protect the long-term health of our economy, we must do something to backstop the slide in the financial markets.