What is the Question? Responding to Paul Krugman

by Mike Kimel

What is the Question? Responding to Paul Krugman

Paul Krugman has been kind enough to respond to my post which in turn was commenting on an earlier post he had written.

As I noted in my previous post, I’m very leery about writing this, given Prof. Krugman is usually a very perceptive individual and I’ve noticed that Prof. Krugman is usually right when he is in a disagreement with someone. My trepidation is increased quite a bit by the fact that we’re treading on ground that is so much closer to his area of expertise than the two topics I normally write about. That said, I still believe he is wrong, and I will try to make my point a bit more explicit.

Prof. Krugman’s response comes in four paragraphs. The first is merely an introduction. In the second paragraph, Prof. Krugman states:

Ordinary monetary policy involves cutting short-term rates to fight a slump; it’s not what we’re talking about here, since it’s hard up against the zero lower bound. But the large-scale conventional expansion the Fed engaged in by getting to the zero bound has, of course, widened the spread between short and long term rates, since markets expect short rates to rise above zero eventually. So looking at the raw data on the short-long spread tells you nothing.

Now note this from Krugman’s earlier piece (bolding also mine):

Furthermore, Fed efforts to do this probably tend on average to hurt, not help, bankers. Banks are largely in the business of borrowing short and lending long; anything that compresses the spread between short rates and long rates is likely to be bad for their profits. And the things the Fed is trying to do are in fact largely about compressing that spread, either by persuading investors that it will keep short rates at zero for a longer time or by going out and buying long-term assets. These are actions you would expect to make bankers angry, not happy — and that’s what has actually happened.

Notice… in Prof Krugman’s second post, the spread widened. In his first, post, the one to which I objected (and in response to which I showed a graph of the spread), the spread compressed. As I understand it, on that issue to which I objected, we are now on the same page – we both agree the spread widened. But then what Krugman wrote in his first post about banks being made worse off is not correct, all else being equal. 

What I don’t understand in Prof. Krugman’s second post is the last sentence of the paragraph shown above – why does looking at the short long spread tell us nothing? I could be wrong, but I am assuming Prof. Krugman is stating that it wasn’t the Fed’s intent to widen the spread. the widening of the spread was not the intent of the Fed. That may well be correct – Prof. Krugman knows the key players personally and I do not, so he enjoys both greater access to and greater insights into the behavior of the people involved.

In his next paragraph, Prof. Krugman writes:

QE is an attempt to get traction despite those zero short-term rates by buying long-term debt, hopefully narrowing the spread and thereby boosting the economy. I don’t think it’s had a large effect, but that’s the goal.

Again, I don’t dispute what Krugman believes the Fed was trying to do with QE. I also don’t dispute his opinion that it didn’t have much of an effect. Personally, I suspect the positive effect on the economy of QE was very close to zero and I wrote about my expectation that the effect would be very close to zero at the time.

As I recall, Prof. Krugman was also stating the same thing in real time, albeit more rigorously. In fact, I would say Prof. Krugman made the point better than anyone of whom I was aware. He also was, to my knowledge, the first person with a big platform to make the point that the “bond vigilantes” were wrong as QE would not result in inflation. All of which is to say, not only am I in agreement with him on this issue, I have been one of the small voices supporting him on the issue since 2008.

So let us move on to my other objection to Prof. Krugman’s post (the first being the non-existent compression of short and long term interest rates, and how that was negatively impacting banks). My problem, and the one that I share with many others, is with this statement from Prof. Krugman’s earlier post:

The naive (or deliberately misleading) version of Fed policy is the claim that Ben Bernanke is “giving money” to the banks. What it actually does, of course, is buy stuff, usually short-term government debt but nowadays sometimes other stuff. It’s not a gift. 

To claim that it’s effectively a gift you have to claim that the prices the Fed is paying are artificially high, or equivalently that interest rates are being pushed artificially low. And you do in fact see assertions to that effect all the time. But if you think about it for even a minute, that claim is truly bizarre.

Now let me be 100% clear. I do claim it’s a gift. And did so without mentioning interest rates at all (except in the context of checking whether interest rates compressed or not). Regular readers know I virtually never mention interest rates as I don’t think they are particularly important when it comes to the outcomes of monetary policy. (What is important? Well, it is called monetary policy and not interest rate policy for a reason.)

My claim that the Fed gave a gift to a certain very specific subset of banks and similar entities is based on the following:

1. the housing market was tanking, driving down home prices and driving up foreclosures

2. the expectation was that the situation in the housing market was becoming worse and foreclosures were going up with no end in sight

3. the perceptions described 1. and 2. was that derivatives based on mortgages would continue losing value and nobody knew where the process would end

4. as a result of 1., 2., and 3., nobody wanted derivatives based on mortgages… those who had such derivatives on their books wanted them gone, and nobody else would buy them at any price

Whether the perception of the risk associated with holding those assets was correct or not, it was what everyone believed. The Fed stepped in and paid a price that only made sense in a world where there were no such perceptions of risk. And it wasn’t willing to help everyone that had been blindsided by these perceptions of risk, but rather just one group that had made some very poor decisions.

Put another way – the Fed was willing to relieve some (but not all entities) of assets they didn’t want at a price much higher than those entities could have received from anyone else. That is a gift.

Prof Krugman closes his new piece with this:

And as for the other thing: Kimel apparently thinks the Fed is buying privately issued MBS, aka toxic waste; actually it’s only buying agency debt, which already has an implicit federal guarantee and is functionally not much different from long-term Treasuries.

This is sort of correct, but not in a helpful way. First, a quibble – leaving aside principal reinvestment the Fed no longer is buying agency debt. Now, some substance – yes, the agency debt had an implicit federal guarantee. But… let us be very precise about our definition.

Agency debt means debt issued by a US gov’t sponsored agency. A US government sponsored agency is an agency created by the Federal government to engage in particular commercial activities. Fannie Mae, for example, was created by the Federal government to securitize mortgages and thus help increase the size and scope of the secondary mortgage market, which in turn would make mortgages easier for most people to get.

But Fannie Mae became a publicly traded corporation in 1968. It was no longer owned by the Federal government, and it started acting in the best interest of its shareholders. The Federal government no longer backed the debt Fannie Mae issued, but it was in Fannie Mae’s interest to imply that its debt and its operations were, in fact, guaranteed by the Federal government as that allowed it to borrow for less. If that sounds like the same reason why some charlatan goes around pretending be an heir to the Rockefeller fortune, well, it is, and it puts precisely the same obligation on the Rockefeller family as Fannie Mae put on the Federal government.

So, Fannie Mae’s “implicit guarantee” only began to have any real world value at the point where the Federal government took the company over and that really did happen before the Fed started picking up MBS. But if the Treasury was willing to guarantee MBS debt, why had the market for the debt dried up?

The answer has to do with the size of the Treasury’s guarantee. Remember, the size of the MBS problem was, at the time un-knowable, Hank Paulson’s bazooka had $700 billion in it, was rapidly being seen as inadequate to the task, and there was a big fight over increasing the debt ceiling going on. There was no certainty over whether Congress was going to pony up money to keep the Federal government going, much less pay off some recently acquired private obligations run up by a group of companies suddenly being given the gimlet eye.

Even if you forget about the existence of that uncertainty, the mere fact that the Fed had to step in should remind you that uncertainty was there and was big. If the markets believed the Federal government was providing a full and credible guarantee, the markets for the MBSs would have unfrozen. There has been a lot of money sloshing around earning zero in the last few years – why wouldn’t investors on the sidelines take a positive return guaranteed by the Federal government… unless they didn’t believe the guarantee.

All of which is to say, the gift came not just from the Fed. The Federal government, in the form of the Treasury department, took the first crack, but what was sitting in that particular corner of the financial kitty litter box was too big for the Treasury’s scoop alone. That just goes to show how big of a gift public entities gave to a small group of miscreants.

In closing, I’d like to address a final point… something from Paul Krugman’s post that I originally responded to, namely (and I’m paraphrasing) how are these policies are supposed to hurt the rest of us?

The answer is simple… moral hazard. Most of us were pretty sure that when push came to shove, certain entities would be saved from their folly. Now, any doubts are gone. We know with absolute certainty that it’s true. We have seen the lengths to which our government has gone to save these favored few. Those entities, going forward, have the magic guarantee. So not only has competing against them gotten more costly, it has gotten more costly simply not to be them. Because those entities know they can take bigger risks with no penalty, so they will.

There were other, better ways to proceed. None of them are perfect, but I’ll mention three better options that I wrote about back in 2008.

One would be for the Treasury and the Fed to guarantee that during the crisis, a) any financial entities that couldn’t meet their obligations would be taken over the moment they failed to make a payment and b) the moment a financial entity was taken over by the Treasury + Fed, those two would guarantee that entity’s debts. There would still be moral hazard but it wouldn’t be nearly as bad. We wouldn’t be treated to quite the same spectacle of companies on taxpayer life-support giving themselves huge bonuses while mocking the hoi polloi with drivel about the importance of their place in society. More importantly, we the people would be getting a lot more bang for our collective buck.

Another option would be to allow the public to bank with the Federal Reserve. Things have changed in the past 100 years, after all. Financial intermediaries aren’t all that necessary these days, except to the intermediaries themselves. Besides, the Fed can misread someone’s FICO scores just as easily as Bank of America can, and Ben B is paid orders of magnitude less than his counterpart at B of A. If people could bank directly with the Fed, there wouldn’t be a need to save a bunch of entities whose bad decisions periodically “require” some sort of bail-out.

A third option (one I noted at the time was ludicrous, but was less ludicrous than what would eventually transpire) would be for the Fed & Treasury to have simply recognized at the time that a process that relied on banks loaning money to the public to get the economy hopping had no hope of working because there wasn’t a mechanism to get banks to loan money to the public. The Fed could simply have handed each American a menu and said: “pick $X worth of stuff from this menu.”

This gets back to my statement that from where I’m standing, interest rates aren’t something on which monetary policy should focus. Money, and where that money goes, should be the focus. To quote a comment left by a reader called Mark at Professor Krugman’s blog the other day:

If the Fed printed one trillion in cash and gave each American $3000, I have a pretty good understand what the result would be. But purchasing one trillion in long term treasuries seems to just make an already large pile of unused, uncirculated money even larger. I’m not sure how this qualifies as quantitative easing any more than Bill Gates walking into soup kitchen qualifies as quantitative easing.