The Liquidity Tsunami

Michael Mussa argues that this is one slowdown in which nobody can claim that the Federal Reserve has been "behind the curve" as far as its response to the slowdown in the pace of real spending, demand, and production is concerned. Indeed, the liquidity tsunami the Federal Reserve and its companions have unleashed upon global credit markets is truly extraordinary:

• Dropping nominal interest rates on the Treasury assets truly free of nominal risk to levels at times only a fraction of a percent per year.
• Guaranteeing the unsecured debt of every major investment bank in America.
• Guaranteeing (or, rather, somehow inducing the Bank of America to guarantee) the unsecured debt of Countrywide.
• Unleashing Fannie Mae and Freddie Mac to borrow an extra half a trillion dollars or so, and spend it buying up and managing mortgages and so profiting from the spread between mortgages and Treasuries.

If all this isn't enough to keep the flow of funds to finance investment steady and so save America from large-scale cyclical unemployment, I will be genuinely surprised.

From Michael Mussa (2008), "Global Economic Prospects 2008/2009: Hoping for a Global Slowdown and a US Recession":

The extent of this crisis in credit markets is even more remarkable in view of the exceedingly aggressive actions taken by the Federal Reserve and the important but less aggressive actions of other leading central banks. Contrary to the nonsense spoken by many financial-market commentators, the Federal Reserve has not been "behind the curve" in its policy response. In fact, the easing of US monetary policy in the present possible recession has far outstripped the pace of easing in past actual recessions. On top of this, the Federal Reserve has recently taken truly extraordinary actions to extend specific liquidity support to a wide range of US financial institutions.

The official explanation for these extraordinary actions is not that they are motivated primarily by the desire to protect financial institutions from losses but rather to head off the risk of major damage to the general economy spreading from difficulties in the financial sector. So far, however, there is little indication that the general economy is suffering much damage from the credit market turmoil—beyond some deepening of the downturn in US residential investment. In particular, the present slowdown in the US economy and around the world is not much more than what we would normally have expected in view of falling home values, higher food and energy prices, and other developments aside from the turmoil in credit markets.

Does this imply that the Federal Reserve, in its efforts to protect the financial sector, has overreacted to the credit market turmoil? Has it eased too aggressively, unduly raising the risk of inflation down the road? Has its rescue of the financial sector by cutting massively the cost of funds and the provision of specific liquidity support generated far too much moral hazard relative to the value of the protective effect of these actions against real hazards faced by the general economy?

At this point, the answers to these questions are not entirely clear, but two conclusions can be reached with high confidence. First, given the massive easing already undertaken by the Federal Reserve and the likelihood of some modest further easing, the US economy now needs to undergo at least a near recession if the Federal Reserve's easing is not to be excessive. Second, if the Federal Reserve's highly aggressive actions have really been warranted to protect the economy from substantial harm, then deep reforms of the financial system, including the Federal Reserve's policies and practices, are clearly needed to reduce the likelihood of such problems in the future. The Federal Reserve cannot pose only as the hero riding to the rescue of the economy and the financial system. Its role as one of the villains whose earlier actions and inactions contributed to the present crisis needs to be fully and carefully assessed.

Comments

[sivere]

We really need to TakeBackTheFed.com

[kowalski]

"[The Federal Reserve's] role as one of the villains whose earlier actions and inactions contributed to the present crisis needs to be fully and carefully assessed."

*

--- assessed by whom? And to do what?

[stacked up]

Second guessing the Fed is not only superfluous, it's very boring.
" It is what it is". Now, we try to react accordingly.
Besides, if all these boring pundits are so smart, why aren't they on the Fed's Board ? ? This is especially true of Steve Leisman of the wretched CNBC crew. So obnoxious, so pompous, so egotistical. How did the country ever get along without him ? (We would love to try however).

[ponchovilla]

I would say this would make an excellent example of the trickle down theory. If liquidity was measured as 1000 gallons of water which was to be distributed by Investment Banks to the drought victims how many gallons would reach those in need? If you consider fees, reserve for future droughts, transaction costs and Investment Bank consumption and maybe a little bit of hoarding and flow rate calculations it might mean we need a better understanding of the metric system which measures volume in ml (milliliters).
Good news for Investment Banks is not necessarily good news for consumers.

[Tom Lindmark]

Interesting, but don't you have to draw a distinction among the various efforts of the Fed. Some of the guarantees merely averted the collapse of specific firms, they didn't add reserves to the system and thus didn't add liquidity. At most a lot of the Fed's actions have just restored the liquidity that became frozen.

To be sure they have added a lot of liquidity and let's cross our fingers on that one. Remember excess liquidity is what got us into this fix in the first place. There's no reason the law of unintended cosequences won't pop up and bite us in the butt again. I for one hope the Fed is just as quick to mop up liquidity as things improve.

[monday1929]

Does anyone remember the quaint theory that if the Fed were to have to take drastic actions, like the sampling offered at the start of this article, that the public would sense their panic and become "Bearish"?
See dictionary for a definition of this archiac term, last used in the previous century.

[Russ Abbott]

It sounds to me that if you look at what DeLong and Mussa are really saying it is that the Fed has done a good job.

Delong:

<blockquote>If all this isn't enough to keep the flow of funds to finance investment steady and so save America from large-scale cyclical unemployment, I will be genuinely surprised.</blockqu...

So DeLong believes that the Fed has probably saved the country from large-scale cyclical unemployment. That's good, right?

Mussa:

<blockquote>the US economy now needs to undergo at least a near recession if the Federal Reserve's easing is not to be excessive.</blockqu...

Well, we are undergoing at least a near recession. So the Fed's easing is not excessive.

Mussa's primary complaint is that

<blockquote>if the Federal Reserve's highly aggressive actions have really been warranted to protect the economy from substantial harm, then deep reforms of the financial system, including the Federal Reserve's policies and practices, are clearly needed to reduce the likelihood of such problems in the future. </blockquote>

Reforms are certainly needed. But this comment suggests a bit of sour grapes. If the only thing Mussa can find to criticize is that the Fed hasn't yet reformed the system, he must be saying that for now it has done the right thing.

[special1person]

"the US economy now needs to undergo at least a near recession if the Federal Reserve's easing is not to be excessive".

Done. 0.6% growth is near "recession" levels.

"Second, if the Federal Reserve's highly aggressive actions have really been warranted to protect the economy from substantial harm, then deep reforms of the financial system, including the Federal Reserve's policies and practices, are clearly needed to reduce the likelihood of such problems in the future."

This will only happen after the Great Republican Depression II really, really kicks in.

The Fed already has the tools to stop mortgages being issued for fraudulent reasons.

Greenspan ignored this.

Bernake is continuing the Republican tradition of looking after the Already Rich.

And the beat goes on...

[WAKEUP]

"J. Bradford DeLong is a professor of economics at the University of California at Berkeley, chair of its political economy major, a research associate of the National Bureau of Economic Research, a visiting scholar at the FEDERAL RESERVE BANK of San Francisco, and was in the Clinton administration a deputy assistant secretary of the U.S. Treasury." . . . O.K., so the author has some very strong academic credentials, and some good political connections, as well. However, as with almost all scholarly tidbits, this article is heavily hedged to protect its venerable author with some cover, if it's wrong. One example, "...the US economy now needs to undergo at least a near recession if the Federal Reserve's easing is not to be excessive."
Uh - huh. Yeah. Well, what if that doesn't happen, Bubba? What if it's a no-kidding, honest-to-God recession (which it is going to be, no matter what anyone does.) Oh, I see. Then the author will say, "Well, at least we put the brakes on the recession, to some extent.' No. It's coming, and it's outside the ability of anything other than time and market forces to mitigate it. These articles are simply an attempt to pretend that the scholarly set is never caught with its pants down.

[kotika98]

I think whats needed is to subject the investment banks, well...hmm... - to good old fashioned banking regulations, starting with reserve requirements. Just because they dont have the word "bank" in their names, doesnt mean we call them that for a reason.

[sivere]

May I repeat at this juncture,


TakeBackTheFed.com