The State of Monetary

Back in August 2008, Olivier Blanchard, an undisputed “czar” of macroeconomics, professor at MIT and currently Director of Research at the IMF, was asked to write a paper on the future of macro for the first volume of a new journal, the Annual Review of Economics.

“The state of macro is good”, he concluded--in a phrase that has since become a favorite source of laughter (or sarcasm) for many a theorist and practitioner in the field, given what happened only a month later (/1):

The near-death of the global economy, the discrediting of macroeconomists for failing to see it coming, and the eruption of internecine debates among them, so partisan in nature that made a mockery out of economics as a social “science.” The state of macro was… in disarray!

So a year later, Donald Kohn, vice-chairman at the Federal Reserve Board, knew better. At a speech last Friday for the launch of the third volume of the Handbook of Monetary Economics, Kohn humbly avoided any definitive statements on “the state of monetary”.

Rather, he talked about the strands of monetary theory that helped guide the Fed’s efforts to rescue the global economy; and the gaps in the literature that need to be addressed to make monetary policy more effective.

The state of monetary may be in flux, he might have concluded… but hail to our theorists who, over the years, have built a valuable body of literature to guide our decisions, even when the worst of stuff hits the fan.

Hard to disagree... But here is where I see the problem: Not with monetary theory itself, which, for all its limitations, is the best we have… but with the theory’s execution.

Basically, despite its success in resurrecting the financial system, the Fed made a number of fundamental misjudgments during (and even before) the crisis that had little to do with the failings of theory to capture *the* truth.

Instead, they were the result of institutional constraints, naïve neglect, or a sclerotic adherence to theoretical models, the limitations of which were spectacularly ignored.

Let me begin.

The first blunder was the failure to accept early on that the crisis was one of insolvency rather than illiquidity. OK, maybe, there is a blurry line between the two concepts, which can become even blurrier when a liquidity crisis transforms itself, like a self-fulfilling prophecy, into an insolvency crisis. Maybe the authorities’ understanding of systemic risks was compromised by the explosion of securitization and its ostensibly efficient distribution of risk across a wide gamut of investors. Maybe I have the benefit of hindsight here.. Maybe.. but…

…The policy debate never really went in that direction, until it was too late.. The Fed effectively turned a blind eye to sources of insolvency in the system, going about with its ample liquidity provision, thus postponing an inevitable crisis to a later date. And that movie went on even after the failure of an institution as big as Bear Stearns.

True, the Fed did not have regulatory authority over many of the financial institutions that almost went under in the Fall of 2008. True, the issue of insolvency should be addressed by the fiscal authority (aka US Treasury), not the Fed. But why was the issue ever ignored by either institution? Why did it take a ginormous crisis and one full year later for banks to be forced to raise capital?

In this sense, Kohn’s reference to Bagehot’s writings as the Fed’s guide in fighting the Panic of 2008 is all but ironic. Rather than “lend[ing] early and freely to solvent institutions, against good collateral and at high rates”, the Fed lent freely to a number of insolvent institutions at low rates and lenient collateral in what really was a bailout of gigantic proportions. (Mind you, the bailout still goes on, in the form of ultra low rates for an extended period, which is allowing financial institutions to beef up their earnings through a steeper yield curve.)

Effective? Yes, (alas!). But let’s not kid ourselves, this was not exactly the most dexterous application of monetary theory to practice!

Then you have the whole quantitative easing (QE) saga and the Fed’s back-and-forths with Treasury purchases. Not only was theory inconclusive about the effectiveness of Treasury purchases in lowering private long-term borrowing rates; not only did the measure ignore the fact that, when extreme demand for liquidity is *the* problem, Treasuries and cash are near-perfect substitutes, making QE useless...

...The Fed just failed to explain why purchasing Treasuries was a good idea in its own right, rather than an act of despair in its rush to “employ all available tools to promote economic recovery.” And in the process, it also underestimated the impact the “monetization” of government debt would have on the American psyche, which undermined, at least temporarily, the long-fought battle of anchoring inflation expectations.

Then you have the whole infatuation with inflation targeting—as in, product-price inflation targeting, as opposed to a monetary policy framework that embeds asset prices in it. Now that’s my favorite baby, and I’m glad to see that things seem to be moving on that front (even if at a glacial speed!). But..

..I cant help noting that I’m still amazed with the headlong adherence of some policymakers to the prescriptions of the available literature (like, “do nothing until it’s time to clean”). Might have to do with the fact that the Chairman is himself is the author of a seminal paper in that literature…Might have to do with the fact that the "clean-up approach" is all we have. Still, there is no excuse, given that the assumptions supporting those prescriptions are very simplistic.

Asset bubbles exogenous to monetary policy? Hello? If that were the case, why would the Fed ever assume it can revert the “negative bubble” (as in, utter collapse in asset prices) once it happened, with its extraordinary rate cuts and other policy actions?

Asset prices affecting demand only though tiny wealth effects on consumption? You’re kidding me! What about the whole lending spree in the form of home equity loans? Or the broader credit boom, facilitated by a steadily rising collateral, that led to the build-up of large systemic risks as well as external imbalances?

The Fed has no comparative advantage vs. the markets in determining the “fair value” of asset prices?! But does it need to? If risk management is (as it should be) a necessary component of policy, the containment of large asset price swings, upward or downward, may be a worthy objective in its own right.

Anyway, don’t get me started…!

Final point: The crisis brought into the fore the absolute necessity of a transparent and disciplined relationship between the Fed, the Treasury and the other regulatory bodies governing the financial sector.

As I argued above, insolvency problems should be dealt by the Treasury (if at all)—yet the Fed found itself engaged in bailout operations, while the Treasury (and Congress) were still dragging their feet! Clarification of the roles of the two institutions, and the commitment by the Treasury’ to take over ownership of the toxic assets on the Fed’s balance sheet only came in March this year.

At least it came, you might say! But in the future, a clearer definition of each institution’s mandate would help avert concerns about the Fed’s political and financial independence. Similarly, clarity about which regulator has the ultimate say on the financial sector will allow a swifter enforcement of corrective actions—to the extent that looming problems are diagnosed early on.

More generally, even the finest economic models won't "deliver" unless the institutions are in place and ready to assume swiftly their due respective roles.

I’ll close with this note--and I know I'm no Blanchard, nor Ben Bernanke for that matter!

The state of monetary (theory) is not bad; and it’s set to become much better. But while academics are looking to find the magic serum, practitioners can make huge progress by re-shaping the landscape for the theory’s effective implementation.


/1 Blanchard’s paper is actually much more nuanced about the achievements of macroeconomic theory, and more humble about its limitations, than suggested by his ill-fated punch line.