0:36 Intro. [Feb. 11, 2009] History of the Federal Reserve, vol. II forthcoming. Mysteries: What is going on? Monetary policy appears to be expansionary by some measures. True? What measures should we look at. True, never been a period like this. Fed buying illiquid assets. Has to do things about current crisis; doesn't have to neglect the future. What is the Fed doing? Added 1.5 times to its balance sheet; reserves growing in the 1000s of percent annual rate; money M2 growth at 20% annual rate for the last 6 months. It's buying assets, such as Treasury Bills, commercial paper, mortgages, including $29 billion of unsaleable Bear Sterns assets. Paid for those assets by issuing reserves--printing money. Who is holding those reserves? Banks. People are very fearful, worried there will be a collapse. Fed encouraged that fear because it never in its 95 year history had a policy of lender of last resort, so it went in the spring it helped Bear Sterns; people thought it would behave as it always has behaved, which is to bail out large banks. Then it let Lehman fail, complete reversal of its policy for the last 40 years. Policy change not necessarily objectionable, but it came unannounced, which created fear. Portfolio managers didn't know what would happen next, so held cash, to wait and see. What are the banks doing with the reserves? Holding the assets. Fed pays interest on the reserves at a very low rate. Within a bank, there is a reserve requirement--a minimum amount of capital to have on hand. Corporations holding large cash balances. People don't know what the government is going to do; the Paulson treasury changed its mind, the Fed has done things it's never done before; want to protect yourself. Fed it also holding Treasury Bills. It's buying up mortgages. Traditionally if the Fed wanted to increase the money supply--lower interest rates--it would intervene in the Treasury market, federal funds rate, rate that banks charge each other overnight, buying up Treasuries. If it wanted to do decrease the money supply, it would do the reverse, selling Treasuries, raising the federal funds rate. Recently it's gone beyond Treasuries, buying up other assets, injecting cash into the system. Banks and people all over the world are buying Treasuries with the cash the Fed is supplying. It is also supplying a lot of cash--reserves--to foreign Central Banks so foreigners can buy Treasury bills and support the dollar.

8:43 What does it mean to say the policy is expansionary if the money is coming right back out to buy up Treasuries? Some of it is showing up as growth in money, M2. Most of the reserves are being held, potential for expansion. If it's held in the form of Treasuries it is expansive? Yes, because they are liquid. Member banks have a much more liquid balance sheet than 6 months ago. Measure of their fear. Traditionally if the Fed injected cash much would be lent out. Now there is so much caution that banks are holding onto that money, and investing in Treasuries which are relatively safe. Holding both cash and Treasury Bills. Both will be available and will be exchanged for productive assets when the fear lessens. Foreign Central Banks coordinating with the Fed. Fed has the swap line, lending reserves to foreign Central Banks in exchange for claims on those banks. Foreign banks operate in this country and need U.S. dollars. What about foreign Central Banks? They are expanding their money supply, but not as much as the U.S., trying to stimulate their economies.

12:30 Federal Government is spending more than it takes in in taxes. When we talk about people turning to Treasuries, there are two things going on. They are bidding on the existing stock of Treasuries, driving down the existing return, which is why Treasury rates are very low. But at same time, Federal government is issuing new Treasuries, borrowing; running a $1.2 trillion deficit for the year, before we begin to fund the new stimulus plan. Federal Government is flooding the world (though small relative to world's capital stock, large relative to amount that will be available from those sources) and also printing money to help fund those purchases. Bottom line is money supply has grown dramatically and will grow even faster as confidence is restored. Ironically, the biggest worry right now seems to be deflation. That's changing. There is a difference of opinion about what is meant by "inflation." Milton Friedman: sustained rate of increase in a broad-based price index. Other economists, especially Keynesian economists, have defined it as any increase, even a one-time short-term increase. Falling oil and food prices cause consumer price index moving negatively, but they are one-time changes in the price level, not persistent or likely to go on. Monetarist approach: persistent and sustained. Distinguish between relative price changes and general price changes. Oil price decline is a relative price change that will make the price level go down as a one-shot matter but only temporarily. If money supply is growing that dramatically, why is that not showing up as sustained higher prices that continue to grow? First principle: government controls rate of growth of the money stock and the public decides how much they want to hold. Will change when public's confidence is restored; then pressure on Federal Reserve at that time will be to mop up the enormous increase of reserves. Normally, as inflation starts to be realized, the response of the Fed will be to try to get the reserves out of the system. But this time, they will be under pressure by Congress, Wall Street, business community saying the recovery is just starting, prices aren't rising all that much. In the 1970s the Fed knew it had an inflationary policy and vowed it wouldn't do that. But when the unemployment rate got to 7%, about where it is now, they would say they have to do something about the unemployment rate. That's how we got the Great Inflation, not ended until Paul Volker decided to follow what he called practical monetarism, not paying most attention to the unemployment rate but focusing on the inflation rate. Earlier podcast. Story in WSJ today, dispute within in the Fed about whether and how much they should buy long-term securities. Those concerned about inflation vs. those concerned about political pressures. Long-term securities: Central Banks consider their principle responsibility to not create inflation; doesn't mean they are not concerned about unemployment, but always have their eye out to see that they are not creating inflation. One way they do that is to keep their balance sheet so that they can buy and sell the securities that they own. Long-term securities are not easy to sell because they fluctuate in price so much. By buying long-term securities it is buying things it will be unlikely to sell. In the 1940s, period before the war and post-war, Fed bought long-term securities and made sure the interest rate did not go above 2.5%; produced a big inflation.

21:30 The coming inflation is going to make the 1970s look like a picnic--a picnic on a rainy day. Who would disagree with you? There are people on Wall Street, most of the people at the Fed, particularly at the Board of Governors, have their sights set on the shorter term. Meeting at the Board in 1967: group called the Consultants, Friedman and Meltzer at same meeting; Friedman turned to McChesney Martin, Chairman at the time, and said: You've done a good job of handling the most recent mini-recession, but now making big mistake, putting the money back in. McChesney Martin didn't think much of economists but nice man, nodded his head. After meeting, Friedman said to Meltzer, "I think he heard me." Meltzer: "No, I think he understood you." Then inflation for 14 years. Why are interest rates currently so low? Shouldn't they be higher, reflecting expected inflation? Because people all over the world are fearful. But they've moved up quite a bit in the last month. What measures should we be looking at? Money supply and spread between real and nominal interest rates. Where will that show up first? Spread between real and nominal interest rates; moved quite a bit, no longer anticipating deflation. Which interest rate? Ten year bonds, five year bonds. Any arrows left in the monetary quiver? People argue that the Fed's main instrument is the Federal funds rate, but the Federal funds rate is now close to zero, so it's like pushing on a string. Nothing it can do. Not true. Quantitative easing: they're going to buy longer term securities and they're not going to pay attention to the Federal funds rate because it's so low and they can't make it lower; so they'll put out reserves against other assets. But all easing is the same--they are buying assets. Totally false that they have no weapons left. But as long as there is an atmosphere of fear, pushing money out is not going to have any effect in the short run. But sooner or later, probably later rather than sooner, people will begin to buy other assets or consumer goods; that is, they will start to accumulate more cash balances and they will want to spend them. Traditional textbook story: Fed as helicopter drop, people wake up one morning and have more money than they want to hold, spend it. But the Fed is sprinkling it on financial institutions. When the banks are less fearful they will lend it out to consumers. We don't allow large banks to fail. Uncertainty in the markets about the policy environment. Yesterday's first speech by Treasury Secretary Timothy Geithner unveiled his plan but it didn't have many details; markets went down by 5%.

28:35 Japan: Meltzer honorary adviser to Japanese Central Bank for 16 years, including all the 1990s. Governor of Bank of Japan (the Central Bank), Masaru Hayami . In Diet (parliament) they spent trillions of dollars for infrastructure, fast railroads, tracks laid down in small villages, paved every square foot. Result was nothing. Hayami believed that as long as banks aren't lending there is no point to increasing money growth, so he wouldn't do it. Successor adopted policy: buy long-term bonds. Efficient way to get money into circulation, doesn't need the banks. Fiscal stimulus failed. Monetary policy wasn't tried: Hayami didn't believe it would work. One meeting: Central bankers believed there were too many reserves in the system, something like the U.S. now. Thinking about raising interest rates; ¼ point not enough to do any harm, but it was signal that they were not going to continue a policy of providing additional money growth. Recession deepened. Mistake. Don Kohn was at the meeting also and told them in a mild way that they shouldn't do that. Can understand Hayami's unease because of lack of response of banks. What should they be doing right now? Trying to clear up the mess in the financial system.

32:21 Going back to the Bear Sterns bailout/merger/marriage, Fed's and Treasury's match-making with J.P. Morgan guaranteeing $32 billion in toxic assets which at the time we were told we might break even on but now know are not worth much, March 2008: Fed and Treasury have been trying to get the banking system into health. Not very successful, prevented it from getting worse; some interest rate spreads have come down. What have they done wrong? Continued what they have been doing for 40 years: Too big to fail. That's a policy that invites people to take excessive risks. One of the main reasons we got into this mess: no bank believed they were going to fail. Greenspan put: That is, if things got bad, Greenspan would take the bad assets off their hands. Terrible policy. There are three things they can do as lender of last resort in crises like this: 1. can save the bank; 2. can merge the bank; 3. can let the bank fail. They never allowed the third option for a large bank. They need to announce that their policy is to give part of what they need at a concessional rate to any bank that needs capital, but the bank has to first raise half the capital in the marketplace. If they can't raise it in the market then the market has valued them as insolvent. We have a law on the books called the Federal Deposit Insurance Corporation Improvement Act (FDICIA), passed in 1991. While the bank still has some remaining capital, close it down, get rid of the stockholders, sell the remaining capital. What if every bank is in that situation? But they're not. Wells Fargo is not. Pittsburgh National, JP Morgan Chase doesn't have that problem. We are not going to eliminate the banks. We are going to eliminate the management and stockholders. Let the bank continue to run and sell it off, in pieces if necessary. Is that a logistical nightmare? No. People argued last March that if we let Bear Sterns go bankrupt, bankruptcy laws are so convoluted, the whole banking system would freeze up. We would just have new management. Did that for Continental Illinois back in the 1980s and sold it to Bank of America. Where will the new managers come from? They don't have to be bankers. For Continental Illinois, not a banker. Won't that be a political decision? All these decisions are political. Geithner is running into the same problem Paulson had: comes up with a program that will value the bad assets, but you can't value those bad assets at the present time. They sell every day, but their value is based on the very uncertain value of those houses and the uncertainty of the ability of anybody to put together the mortgages that have been broken apart and sold in pieces. Selling recently at $45 per $100--meaning that for a face value of $100, expect to get $45--less than half, but more than zero. But if they tried to buy all those assets at that price, they would bankrupt the banks that have to sell them. We value those banks every day; stock is sold on the market; take value for whole bank; if they can't raise the capital, they are bankrupt. Suppose a bank is holding a security on its balance sheet, mortgages or pieces of them. If none defaulted, certain cash flow. But because the default rate is uncertain--and high, house prices expected to go down 11%--discount when sold to 45 cents on the dollar. Because of mark-to-market accounting the bank is listing those assets on its books at 45 cents. Some do and some don't. The ones that do have taken their hit. But a lot say some of these mortgages we'll hold to maturity, on the hope that none of them will default, in which case they don't have to mark them to market. While the banks may do that with their accounting, the market every day values the bank, and that price values all the assets held by the bank. Big discount because of the uncertainty. If the price isn't zero, then the bank isn't insolvent by that definition. Right, but if it can't raise capital enough to comply with its reserve requirements, it's insolvent under the FDICIA law. Let the regulators take over before the entire capital is eroded so that the taxpayers wouldn't take such a big hit.

42:15 What about proposals to get rid of mark-to-market accounting? Mixed mind: agree that many of these assets, the market values aren't very good; but don't like changing rules when it's convenient for you because then you don't have rules. Judges changing the value of mortgages: we have a bankruptcy law and it doesn't permit that. Bankruptcy law is valuable to have because it tells you what will happen. Not a good idea to change it. Cochrane podcast: let the system work out its problems. Paulson Treasury's answer: we asked the banks if they would do that and they said No. No surprise! Would you rather have low-cost subsidized capital or would you rather go out to the market? Of course they said they can't go out to the market, it's too hard. But there is capital out there. California bank, IndyMac, just got sold. Greenspan put: Piece in Sunday NY Times by Joe Nocera, provocative piece: investment bankers, Bear Sterns, Lehman, etc. were misperceiving the risk they were taking. Used value at risk, statistical technique for evaluating how bad things can get and risk of catastrophe. His claim: Value-at-risk tool is misleading because although it tells you the odds of a bad event, it doesn't weight the amount of the bad event. A bad event that is 1 out of 10,000 is one thing, but a bad event that destroys your company is catastrophic. Similarly, some say these banks were leveraged even 35-1, and in that situation a 4% downturn doesn't just lose you 4%, but puts you out of business. Hard to believe that managers of these firms put their companies on the line knowingly thinking that if it happens they'll be bailed out. Book: Many of these bankers had very sophisticated models of risk, using things like the normal distribution, but don't allow for large persistent one-time changes that occur. For example, the Russian default, failure of long-term capital. Instead of normal distributions, you have fat tails. Taleb's Black Swan argument, in Nocera article. But if you get a bad event every few years you'd be looking for that. You get that more frequently in recent years because no one is allowed to fail, so you get people taking big risks. SEC told investment banks they could let their leverage go up to about 30%, so they did. Managers made oodles of boodle; had risk models that didn't tell them about this event. Conversation with Myron Scholes, a principal at Long Term Capital Management (LTCM): you worked out what happens with fat tails; why didn't you tell Merriweather about that? Scholes: We did; he didn't want to hear it. One other thing: Fed did not allow them to fail. Continued to take the risks.

50:02 Alternative explanation, where history comes in, explanation being pushed by some economists: Doesn't have anything to do with that, just irrational exuberance, got to dance when the music is playing. Is that plausible? Counter-evidence: JP Morgan Chase didn't do that it, Pittsburgh National didn't do it, Wells Fargo didn't do it. Bank of America didn't do it until after the crisis started it bought out Countrywide and Merrill Lynch. Did the ones that did not count on being bailed out? Yes. How would you prove that? Can't prove it. No doubt that it induces risk taking; but hard to understand how it induced so much risk taking. That goes along with the fat tails--they ignored the fat tails. Was that stupidity and myopia, or overconfidence about being bailed out? How bailed out are they? Acemoglu podcast. They've lost a lot, so ex post it was not a good strategy to count on it. But in the past they got bailed out. Look at LTCM--should have been allowed to fail. Fed just put together a consortium of private money. Leaned on private money to bail it out. Not a purely voluntary decision.

53:33 How did we get into this mess--one part of it. Six reasons: will stick to two. One is: there is nothing more sacred among the sacred cows of Congress than housing. They couldn't do enough to help people buy houses, and they did what they never should have done, encouraging Fannie Mae and Freddie Mac to buy up these bad securities. Why? Fannie and Freddie subsidized interest rates. They could have subsidized them on the budget, to be transparent, what a democracy is supposed to do. But not in the interest of the Congressmen. The number of dollars they were putting out in the market went from $400 billion to $2.5 trillion since 1980, over 25 years. Question: What role did monetary policy play in this problem? Too big to fail. Second big item. John Taylor: blame Greenspan 2001-2005? Incentives. Greenspan gave them the wherewithal to buy these bad assets; but he didn't make them buy them. Claim is: in the aftermath of 9-11 attacks and Internet bubble, worry about recession, so Greenspan responds by lowering the federal funds rate to 1%, historically low level and holds it there. Did that induce liquidity in the system? Money growth wasn't all that high; we got a little inflation and Fed reacted. What he did do was encourage the subsidy: could buy a mortgage that was yielding 5-6% and finance it with short term borrowing at 1-2%. Gap between fixed and adjustable rate mortgages grew. Meltzer was visiting scholar at the Fed in 2003; Greenspan believed there was a risk of deflation and continued that policy. Tough job, make mistakes. Fifteen years good policy, made a mistake. Long term rates were falling as well. Why? They are an average of expected future short rates and they expected the Fed to continue to keep short rates low.