Monetary Mechanisms: Then and Now 8 comments
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This is the second of a three-part collection that explores the current housing/financial market conundrum using the title of a 1958 romantic "witch-hunt" comedy, Bell, Book, and Candle.
- The first part of this series (available here), briefly reviewed the record for the prior 20 years and suggested that what is surprising is NOT the current meltdown, but the prior run-up. This should have been a signal - or bell - that our "prosperity" was a mirage.
- THIS post will identify what I believe is the most critical document - or book - authored by the most influential practicing monetarist of the 20th century, and briefly compare its focus with one of the instruments available to the Fed prior to the mid-1980s.
- The next and third post will suggest that simple and transparent solutions - a candle - will be needed if we are to crawl out of our current predicament.
Alan Greenspan became the 13th Chairman of the Board of Governors of the Federal Reserve on 11 Aug 1987. Chairman Greenspan served for 6,748 days, stepping down on 31 Jan 2006. This made Greenspan the second-longest serving Chairman; William McChesney Martin, Jr. (2 Apr 1951 - 31 Jan 1970) served 6,879 days.
When Greenspan became Chairman in ‘87, one well-used “avenue” of monetary control had just faded from the scene. When he left the office, 18 1/2 years later, he took unusual care to describe - in great detail - an alternative “avenue” that had successfully moderated the course of the post 9/11 contraction. Below is the brief story of both “avenues.”
On 13 Mar 1986, 17 months before Greenspan became Chairman, the last remaining elements of "Regulation Q" were abolished. Since that time, it has largely been forgotten. The elimination of Reg Q put an end to the use of a critical avenue or "tool" that the Fed had previously relied upon to control economic expansion.
During the 20 years prior to the abolition of Reg Q (pdf warning), ceilings for S&L deposit rates slightly exceeded those for commercial banks, and this favored the expansion of mortgage lending. As market rates for money market instruments soared in the late 1970s to mid 1980s (see chart, below; click to enlarge), it became difficult for both thrifts and banks to compete. Lending declined – and the economy slowed - as depositors withdrew their funds from banks and reinvested their cash in either treasuries or money market securities.
Source: R.A. Gilbert, Federal Reserve Bank of St. Louis - Requiem for Regulation Q: What It Did And Why It Passed Away, Chart 3 (page 8 of 16), Feb 1986.
During his 18 1/2 years as Chairman, I believe (but am not certain) that Alan Greenspan did not author any research working papers (as distinct from speeches or Congressional testimony) until September 2005.
In September 2005, Greenspan co-authored a paper providing a detailed description of the ways in which consumers extract equity from their homes. Five months before he left office, he released "Estimates of Home Mortgage Originations, Repayments, and Debt on One-to-Four-Family Residences," Federal Reserve Working Paper # 2005-41, with James E. Kennedy of the Fed.
As Greenspan & Kennedy note in their abstract of the 83 page paper, it focused upon home equity extraction:
…[W]e have developed a system that reconciles the change in regular home mortgage debt with mortgage flows… In the process, we derive the sources of equity extraction from homes financed by mortgages. [emphasis added]
Chairman Greenspan relied upon the borrowers’ extraction of home equity, along with the consumption that it supported, to limit the severity of the post 9/11/2001 recession. The 2005 Greenspan & Kennedy Working Paper, along with a 2007 G&K paper that examined home equity extraction in even greater detail, were - in my view - published to ensure that future economists would understand the power of, and benefit from, the authors’ experience with this new method of monetary control.
In the 21st century world of monetary policy that Greenspan would shortly be leaving, consumption increased – and the economy expanded - as borrowers withdrew accumulated equity from their houses and redeployed the proceeds.
[Note: Compare this “transmission channel” with that under Reg Q, above: Lending declined – and the economy slowed - as depositors withdrew their funds from banks and reinvested their cash in either treasuries or money market securities.
Under Reg Q, channel worked through consumers’ – as depositors - assets (savings/money market accounts). As described by G&K in WP 2005-41, channel worked through consumers’ – as borrowers’ - liabilities (mortgage or home equity line/loan). Very different.]
If you were looking for a way to control the economy, there truly was no place like homes.
Speaking to the American Bankers Association at the end of September 2005, Chairman Greenspan included a brief summary of the paper’s findings and its impact upon macro policy. I will quote extensively but selectively from it below, with emphasis added.
Chairman Greenspan:
… I plan … to focus on one of the key factors driving the US economy in recent years: the sharp rise in housing valuations and the associated buildup in mortgage debt…
This enormous increase in housing values and mortgage debt has been spurred by the decline in mortgage interest rates … [T]he … associated run-up in housing values has left households with a substantial pool of available home equity...
Home mortgage debt is thus the final source of funding of some consumer outlays originally financed by [banks’] extensions of credit card and other consumer debt …[W]e can have little doubt that the exceptionally low level of home mortgage interest rates has been a major driver of the recent surge of homebuilding and home turnover and the steep [home price] climb…
The apparent froth in housing … may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other, more-exotic forms of … mortgages… bear close scrutiny. To … the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is adding to the pressures in the marketplace.
Chairman Ben Bernanke is now working to moderate the impact of the current housing decline upon financial markets and the real economy. As he does, we can only hope and pray that he is as creative and successful with his toolbox as Chairman Greenspan was with his.
Disclosure: none
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This article has 8 comments:
But you don't know either. You can't take money out of the commercial banking system. If funds are transferred to the financial intermediaries (non-banks), the only thing that changes is the ownership of the deposit. The funds don't leave the CB system.
Savings held within the commercial banking system are LOST TO INVESTMENT. Why?
When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, & every person), (except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (transactions accounts) -- somewhere in the banking system. I.e., commercial bank deposits are the result of lending, not the other way around.
Thus, the growth of time/savings deposits within the CB system, shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment. That was the source of STAGFLATION and it was predicted by Dr. Leland James Pritchard, MS Statistics Syracuse, Ph.D. Economics Chicago (Milton Friedman was his classmate).
Exactly! People seem to believe that banks relend their savings balances so that unless savers first make deposits the banks will have no money to lend. But this is simply not the way our banking system functions, as I've been trying repeatedly to get across by quoting textbooks and every other way I can think of to get people to see the facts.
Have you read Warren Mosler's "Soft Money Economics"? Google him and you'll find the text on his website. He published this in 1995 so this is not new knowledge. Mosler has a clear understanding of the workings of modern money and until our policymakers also get clear about this critical issue they will make the same mistakes over and over, like raising taxes on productive corporations who employ us, sell us stuff, and whose profits pay the dividends that fund our pensions.
#1: ebreen: You are correct. In balance between content & length I confined inflation comments to first piece in series ("The Demographic and Economic Record Prior to the Housing Meltdown"), but not here, and perhaps should have.
#2: flow5+derryl: Understand point that you are making. But how, then, to interpret the claims that occurred during the 70's - 80's that "dintermediation" was occuring in banking system? If deposits can't leave, then "where did they go?", or would you say that - by definition - there is NO such thing as dintermediation?
research.stlouisfed.or... (from 1973)
Disintermediation is a term which only applies to the financial intermediaries (non-banks). REG Q was a conspiracy (literally)...not in the sense that legislators received kickbacks from lobbyists, but the bankers literally bought off - economists, both pro & con. Debates were cancelled, papers unpublished.
You have to look at the data and not rely on the pundits. Alton Gilbert's Requiem for Regulation Q: What It Did and Why It Passed Away. He circumvents the arguement and provides no statistics. This is the biggest error in economics.
The idea that required reserves are a tax is applicable to the individual commercial bank, but from the collection of banks, the CB system (from the economic point of view), excess reserves are like manna from Heaven (free/gratis), they provide a multiple expansion of money & credit and bank earning assets.
This is the HOLY GRAIL:
As many people have noted, there have been eight boom-bust cycles in the housing industry since World War II. It is widely believed that those periodic crises in the housing industry are largely attributable to “disintermediation-whi... means that money flowed out of savings accounts in banks and thrift intuitions…Their solution? Have the Federal Reserve Board and other regulators…take the immediate step of raising the interest ceilings on new consumer time deposits nationwide by 1 or 2 percent…After a period of adjustment to this initial step, they advocate raising interest ceilings on all consumer savings accounts in all institutions now subject to loan associations and mutual savings banks. In their opinion, this will give financial institutions the flexibility to meet the needs of the housing industry.
I am certain their interest-raising nostrum, far from curing the patient, would actually create crises in the housing industry that could otherwise be avoided.
Take, for example, the housing crisis of 1966. In Dec. 1964, the monetary authorities raised interest ceilings on consumer savings accounts in all insured commercial banks from 4.5 to 5.5 percent. During the next seven months-January 1966-July 1966 time deposits in CBs increased by 10.1 billion, compared with an increase of less than 500,000 dollars in the savings accounts of savings and loan associations.
Housing starts decreased by almost 50 percent and for a time it was almost impossible to obtain financing for the sale and purchase of existing houses.
A housing crisis existed, and the Federal Reserve authorities diagnosed the cause as disintermediation. But instead of raising interest ceilings, as others would suggest, the ceilings were lowered to 5 percent in July 1966.
The effect of this reduction in interest ceilings on commercial bank held savings accounts was to sharply reduce the volume of “saved” demand deposits being shifted into time deposits.
Instead these deposits were transferred through the savings and loan associations-and consequently became available for the financing of the housing industry.
During the August-December 1966 time period, time deposits in CBs increased only 2 billion, and savings accounts in S&Ls increased 3.1 billion. There was thus an immediate increase in the volume of loan-funds available to the housing industry, and the industry gradually recovered.
In the hope of forestalling similar future crises, the Federal Reserve authorities collaborate with the Federal Home Loan Bank Board to have interest ceilings imposed on S&Ls as well as the CBs. The ceilings become effective September 1966 with the proviso that the rates for S&Ls would be one-half of a percentage point higher-later reduced to one-quarter of a percentage point-than the ceiling rates imposed on CBs.
It is obvious from those data that the CBs suffered no disintermediation in the January-July 1966 period but the S&Ls did, even though they were not subject to any interest rate ceilings. Why this seeming contradiction?
Disintermediation occurred in the S&Ls because their loan inventory was mostly made up of 4 to 5 percent long-term mortgages, and they simply could not compete when most of the CBs chose to go to the 5.5 percent ceiling. (The S&Ls held large deposits with the CBs, the S&Ls were the customers of the CBs)
The CBs suffered no disintermediation before or after the ceilings were lowered for the simple reason that the CBs disintermediation is not predicated on interest rate ceilings.
Disintermediation for CBs can exist only in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction as a consequence of currency withdrawals from the banking system.
The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933 the Federal Reserve has had the capacity to take unified action, through its “open market power, to prevent any outflow of currency from the banking system by forcing the banks to contract credit.
Unlike S&Ls and other financial intermediaries, the CBs suffer no disintermediation when savers decide to shift their savings to another type of investment. Shifting from TDs in CBs to nonblank types of investments has no effect on the total assets or the volume of earning assets of the CBs. It merely involves a transfer from TDs to DDs within the banking system.
CBs do not loan out TDs, DDs or the equity of bank owners. CBs acquire earning assets through the creation of new money. When CBs make loans to, or buy securities from, the nonblank public, new money-DDs-are created in the banking system.
The aggregate lending capacity of the CB system is determined by the monetary policy of Federal Reserve authorities. It is in no way dependent on the savings practices of the public. People could cease to hold any savings in the CBs and the legal lending capacity of the CB system, given our current institutional arrangements, would be unimpaired.
Insofar as there is an interest-rate solution to the problems of the housing industry, I would recommend that interest ceilings on savings accounts held by S&Ls and other financial intermediaries be removed and that interest ceilings be placed on all types of TDs in CBs. Existing Ceilings should be lowered-gradually. This action would decrease the proportion of TDs to DDs, increase the flow of funds available to the so-called thrift institutions-and vastly reduce the costs and increase the profits of the CBs.
The point is that you can't segregate transaction accounts from savings-investment accounts (time deposits). An increasing percentage of newly created money was transferred into interest-bearing accounts and the FED ignored the growth of highly liquid interest-bearing accounts (ignored the growth of the money supply).
If the “store of purchasing power” attribute of money, when applied to a given asset, is to have significant meaning, it ought to be defined in terms which are applicable to the whole economy. That is, no asset really has a “monetary store of purchasing power” quality unless there can be a net conversion of that asset into money, ceteris peribus.
In other words it must be possible to effect this conversion without necessitating that any present money holder reduce/liquidate his holdings/assets. Any other interpretation becomes mired in a futile discussion of relative degrees of confidence and liquidity.
But much more than monetary liquidity for the individual holder is necessary if an asset can be said to have the “store of purchasing power” quality; it must be simultaneously monetarily liquid for society as a whole.