A view of CRA from 2004

Laurence Meyer provides an insightful look at the functioning of the Federal Reserve from 1996 until 2002 in his book, A Term at the Fed: An Insider's View. He was nominated by the President Clinton to the Board of Governors of the Fed, and in recounting his nomination, tells about the call he received from Joe Stiglitz (pp 14-15):

Joe ended our conversation by telling me that he didn't want to pressure me on any issues on behalf of the Clinton administration, but he did want me to know that the administration was strongly in favor of CRA.

Meyer did not know what CRA was, but Stiglitz handled the situation with diplomacy and sent him the information he needed. Meyer then tells the reader about it:

CRA stands for Community Reinvestment Act. It was passed by Congress in 1977 to remind banks that they are obligated to meet the needs of their communities, with special emphasis on meeting the needs of people in low- and moderate-income neighborhoods. Democrats love CRA because it demonstrates how the government can provide better opportunities for lower-income families. Republicans hate CRA because it represents interference by government in the operation of businesses (in this case banks.)

Meyer says that he became the Board expert on CRA and its chief cheerleader.

His book was written published in 2004, several years before the bursting of the housing bubble. One wonders how he would have written about the CRA episode if he were writing the book today.

Another viral youtube video

It is not too often that an economics video goes viral, but another one has.



It is rather funny, which probably explains its success.

Meltzer on the recession

Allan Meltzer argues in The Wall Street Journal that the current recession is not like the Great Depression. I thought this paragraph was interesting.

The Federal Reserve also shared this Keynesian viewpoint. It provided unprecedented monetary stimulus, increasing the monetary base by more than $1 trillion. Much of this increase corrected for its major mistake: allowing Lehman Brothers to fail. After 30 years of bailing out almost all large financial firms, the Fed made the horrendous mistake of changing its policy in the midst of a recession. That set off a scramble for liquidity and heightened the public's distrust in the market.

The Fed's fourth tool

President William Dudley of The New York Fed dismissed fears of future inflation due to the massive increase in excess reserves by noting that the Fed had a new monetary tool.

Even aside from this major factor, Dudley argued that the Fed's large and growing balance sheet is nothing that prevents the Fed from controlling inflation once the economy corrects. 'It is not the case that our expanded balance sheet will inevitably prove inflationary,' he said.

Specifically, Dudley said the Fed's new ability to pay interest on excess reserves is a critical tool it uses to keep banks from lending these reserves and thereby creating new credit and boosting inflation. 'Thus, through the IOER rate (interest on excess reserves), the Federal Reserve can effectively retain control of monetary policy,' he said, noting that the Fed can increase the IOER rate if banks begin to find it more profitable to lend these reserves.

He complete speech is here. I need to revise my material on the Fed as the result of what it has done in the last year, and writing that the Fed now has four tools to control monetary policy--open market operations, the discount rate, reserve requirements, and the interest on excess reserves--is a first step. I wonder, though, if this does not make their job harder rather than easier.

Here is more from the Fed on what new Fed powers, found on Donald Marron.

The battle over CRA

Over at businessinsider.com, John Carney writes:

The CRA led directly to lending practices that included extremely low to nonexistent down payments, outrageous loan to value ratios and other "innovations" that later became some of the best predictors of defaults and foreclosures.

The comments are interesting, as a variety of people either misrepresent his position (CRA was the source of all problems) or deny that it had anything to do with the meltdown. The reasonable position, it seems to me, is that it was one stream of many that combined to produce the river of disaster we experienced.

(A number of years ago at a financially-struggling college that I know something about, the president kept telling the faculty that retention was all important and that they needed to keep that in mind. When asked if that meant lowering standards, he would vigorously deny that he wanted standards lowered, but never provided any meaningful guidance as to what it was the faculty should be doing. Pretty much all the faculty accepted that what he really wanted was lower standards but he could not say that. The Fed's denial that CRA was intended to lower lending standards seems to be pretty similar to the college-retention situation.)

Laffer, Blinder, and Perry on the danger of inflation

Laffers says yes, Perry and Blinder no in the continuing series of excellent posts at Carpe Diem.

Meltzer on the Fed

Alan Meltzer, who having written the longest and most detailed history of the Federal Reserve is an authority on the Fed, was on the editorial page of the New York Times Sunday worrying about inflation in our future. He notes that it is possible that the Fed will withdraw the huge amount of liquidity it has created in the past several months, but he worries the political pressures will stop it.

I do not doubt their knowledge or technical ability. What I doubt is the commitment of the administration and the autonomy of the Federal Reserve. Mr. Volcker was a very independent chairman. But under Mr. Bernanke, the Fed has sacrificed its independence and become the monetary arm of the Treasury: bailing out A.I.G., taking on illiquid securities from Bear Stearns and promising to provide as much as $700 billion of reserves to buy mortgages.

Besides, no country facing enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation as we are has ever experienced deflation. These factors are harbingers of inflation.

When will it come? Surely not right away. But sooner or later, we will see the Fed, under pressure from Congress, the administration and business, try to prevent interest rates from increasing.

Meltzer is always worth reading. Read the whole thing.

Update: Krugman responds, and Meltzer replies.

Another update: Melter again.

A third update: Melter on the Enterpriseblog:

Can the Fed control inflation? Absolutely. Will the Fed control inflation? Unlikely. The Fed will face political pressures. It has sacrificed much of its independence and will have a hard time getting it back.

Where no Fed has gone before

The Fed has decided to change policy, no longer setting the federal funds rate and letting banks determine how many bank reserves they want, but directly targeting bank reserves, and in a massive fashion.

But to the surprise of investors and analysts, the committee said it had decided to purchase an additional $750 billion worth of government-guaranteed mortgage-backed securities on top of the $500 billion that the Fed is already in the process of buying.

In addition, the Fed said it would buy up to $300 billion worth of longer-term Treasury securities over the next six months. That would tend to push down longer-term interest rates on all types of loans.

Here is the statement from the FOMC:

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

In these circumstances, the Federal Reserve will employ all available tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period. To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months. The Federal Reserve has launched the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses and anticipates that the range of eligible collateral for this facility is likely to be expanded to include other financial assets. The Committee will continue to carefully monitor the size and composition of the Federal Reserve's balance sheet in light of evolving financial and economic developments.

Here is a take by Scott Sumner, an economist who is actively following monetary policy (as opposed to someone like me, who currently finds a number of other topics more interesting, though not necessarily more important.)

This graph shows the M1-data until March 2

Here is a chart of excess reserves. Banks now earn interest on excess reserves, and cannot get more by trading them for T-bills, so they do not have the normal urge to get rid of them.

The Fed is not worried about inflation--it does not see that as a threat given the large amount of idle resources. However, because the Fed is increasing reserves even more, there will be a major inflation when the economy starts rebounding (because then those excess reserves will be traded for more profitable assets, spurring monetary growth) unless the Fed can take these reserves out of the banking system quickly enough and at the right time. How much faith do you have in the Fed? If you do not have a lot, then soon you should start betting on inflation in the future.
Update: China is worried about the future value of the dollar. It apparently is moving out of longer-term U.S. securities in favor of short-term.

Fractional reserve banking bits the dust

A note on marginalrevolution.com a few days ago noted that we now have 100 percent reserve banking--bank reserves now totally cover demand deposits.

Reserve balances at the Federal Reserve

Reserve balances with the Federal Reserve, which I thought astonishing almost two months ago, have continued to rise, as this graph from the Federal Reserve Bank of St. Louis indicates. The reserve balances with the Federal Reserve are now almost as large as currency holdings. In the week ended Jan 7, currency in circulation was $887,700 million and Reserve balances with Federal Reserve Banks were $878,178 million. The latter number has increased by $873,986 million in the last year.

I keep hearing that credit markets are improving, so maybe there is light at the end of the tunnel.

Comment: As financial conditions return to normal, the Fed will have the difficult task of removing these bank reserves in a manner that does not abort a recovery but also that does not allow them to spur excessive monetary growth. The reserves that are in the banking system today are enough to give us hyperinflation. The Fed has never been in the situation that it is in today--it is totally new territory. Most people are focused on the dangers of recession, but there is also a real danger of inflation down the road. How much do you trust the Fed's competence?

The Minneapolis Fed

Under strange and unexpected circumstances I met a VP from the Federal Reserve Bank of Minneapolis two days after Christmas, and I asked him why the Fed Bank of Minneapolis had abandoned the building it had built in the 1970s. The building had received praise for its unique architecture. The feature that attracted the most attention was its use of the principle of a suspension bridge to support the structure. Despite its striking architecture, the Fed occupied the building for less than thirty years before moving to a new facility.

He said that although the building looked great, it was not people friendly. For example, the corridors were on the outside along the windows, so there were no offices with windows except for those of the top officials. Further, the building was long and narrow (like a bridge), which did not give it a good flow for people.

There were also some serious design problems with the building. It had used asbestos as insulation for the steel beams, but the windows were not watertight. (I think the suspension bridge architecture had something to do with this.) Asbestos insulation is not supposed to get wet, but this did. So after twenty years, the Fed was faced with a choice, to build a new building or to renovate the old one. The estimated cost of each was roughly the same, but the risk of the renovation option was larger because of the possibility of serious cost overruns.

The Fed sold the building and the entire city lot for a mere $500,000. However, the appraised value of the property was negative $15 million, so the Fed did pretty well in disposing of the property.

The buyer totally renovated the building, gutting the interior down to the I-beams. The process may have bankrupted the original buyer--my source was not sure. Then the developer widened the tower so that the suspension bridge construction is no longer visible from the front of the building.

The 1970 building was designed with the assumption that checks would soon be obsolete, but they continued. The newer building was designed with the assumption that people would continue to write checks, and checks are now a rapidly declining way of making payments.

I checked the Internet to see how much of this account I could verify. I found that what Wikipedia has is consistent with it.

Lucas on the Fed

Robert Lucas approves the Fed's monetary policy in The Wall Street Journal.

The Beige Book reminds me of the spiritual

The Federal Reserve released its eighth and final Beige Book for 2008, and it paints a gloomy picture of the national economy. The Beige Book is one of three briefing documents that the Federal Open Market Committee (FOMC) uses in its meetings for background information. (The other two are the Green Book and the Blue Book, which are prepared by the professional staff of the Federal Reserve and are not, as far as I know, available to the public.) The Beige Book (the copies that are distributed to the FOMC members have beige covers) is a summary of economic and financial conditions in the twelve Federal Reserve districts.

The December 3rd edition was bleak. I read only a bit, but credit is tight, retail sales are weak, manufacturing activity and construction are falling, and unemployment is rising. "Almost all Districts noted reductions in exports." There were few bright spots. Demand for some skilled workers remained strong, and "Minneapolis and Dallas reported growing demand for bankruptcy services." Another is that there is no upward pressure on prices. And the farmers in the Chicago district had done well on the futures markets: "Much of this year's corn and soybean harvest had already been sold ahead at profitable prices, with most of the rest going into storage instead of being sold at today's lower prices."

I was struck by the repeated references to the tight credit. Credit is not tight because of a low amount of reserves--the Fed has poured reserves into the system. The source of this tightness seems to be something new--a problem with capitalization and trust. There are plenty of reserves, but apparently because the interbank markets are not working properly (a lack of trust), banks need a lot more reserves than they need when the system is functioning properly.

Which reminds me: the Marxists were wrong when they said that economics was about materialism. Economics is in fact a spiritual study because most of what is important is not material. Trust and confidence are not material, and neither are expectations, preferences, value, liability, and ownership. They are the foundations of economics and they are as spiritual as faith, hope, and good intentions.

Fed Balance Sheet V

It has been a while since I wrote about the Fed's balance sheet. On Nov 6 I noted that reserve balances with the Fed were an astonishing $493,633 million. Somewhat earlier, on Oct 21, I noted that the three-month T-bill rate had risen above 1%.

I expected a month ago that the situation would improve, but there is little evidence in the numbers that it has. Today, Nov 19, short-term interest rates were again extremely low. The three-month rate was a mere .07 percent, which was actually lower than the one-month rate of .09%. Still, that beats the .03% of Sept 17, 2008. People are interested only in safety and do not care about return.

Reserve balances with the Fed have increased further, to $592,144 million for the week ended Nov 13, 2008. How high will they go? I have no idea.

Meanwhile the stock market continued to sink, with the S&P 500 Index ending at 806.58, its lowest level since March 12, 2003. How low will it go? Again, I have no idea. It is an interesting time to be an economist, but not an enjoyable time to be approaching retirement.

A letter to the Teaching Economics Group

I just replied to a thread on the teaching economics mail group (tch-econ@elon.edu).

I do not think a shortage of bank reserves is a problem right now. Check

http://www.federalreserve.gov/releases/h41/Current/

Reserve balances with the Federal Reserve are $493,633 million. That is up somewhat from a year ago. Well, a bit more than somewhat. It is up by $484,992 million.

The Fed has started to pay interest on reserve balances. I have not followed this very closely, but it seems the Fed wants the banks to hold excess reserves because it allows them to control the Fed funds rate better.

http://www.federalreserve.gov/newsevents/press/monetary/20081006a.htm
and
http://www.newyorkfed.org/markets/ior_faq.html

R Schenk

I need to update my Fed Balance Sheet series. Maybe I will get to it this weekend.

The stock market has had two days of large losses. I sure hope that is not because the market is worried about the economic policies of the president elect.

The Fed Balance Sheet IV

I have not written about the Fed's balance sheet for a few weeks. It still shows that we are in extraordinary times.

The total assets for the week ending October 15 were $1,740 billion, an increase of $882,065 from the previous year. (Wow!) Holdings of U.S. government securities, which for decades have been the primary asset on the Fed's balance sheet, were only $491 billion, down $289 from a year ago. So the Fed has shifted out of U.S. government debt into non-governmental debt.

I like watching reserve balances that commercial banks hold at the Federal Reserve banks. For the week ending October 15, 2008, they were $281 billion, which is $274 billion higher than they were a year earlier. That tells me that we have a considerable way to go before conditions in the credit markets are anywhere near normal.

I would expect that with the enormous infusion of reserves into the banking system there would be growth in money-stock measures. Both M-1 and M-2 are slightly more than 6% higher from their levels a year ago (September to September), which is tiny given what has happened to bank reserves. The banks must be holding massive amounts of excess reserves. When the history of this period is written, it will be interesting to find out what has really been happening, something I cannot see from where I sit.

One sign that the extreme panic may be over is that the three-month Treasury bill rate finally rose above 1% yesterday, October 20. The data are currently here, but will eventually move.

Meyer, the Fed, and CRA

Laurence Meyer's A Term at the Fed does a better job of explaining what the making of monetary policy entails than any other book I know of. It certainly is far superior to Alan Greenspan's Age of Turbulance, which says almost nothing about monetary policy and maybe says a bit too much about Greenspan's fascination with celebrity and power.

At the beginning of his book, Meyer describes his appointment to the Fed. One his first hurdles was an interview with Joseph Stiglitz, then chairman of Clinton's Council of Economic advisors:

"Joe ended our conversation by telling me that he didn't want to pressure me on any issues on behalf of the Clinton administration, but he did want me to know that the administration was strongly in favor of CRA.

"I suspect we've all had moments when our responses to a particular situation could change our lives and careers. This seemed like one of those moments to me. I could have said: Joe I have heard of the NBA, the PTA, and CPAs, but CRA--I don't have a clue. But then, I figured I would still be a professor of economics at Washington University and an economic forecaster. ...

"Or I could have said: Joe, I am with you 100%--and figure out later what I had committed myself to. ... So I gave Joe the silent treatment. After a brief pause, Joe said good-bye, and I patted myself on the back for apparently dodging that bullet successfully. ...

"The second lesson is about Joe Stiglitz. He handled my ignorance of CRA in a very gentle and indeed constructive way....

"Democrats love CRA because it demonstrates how the government can provide better opportunities for lower-income families. Republicans hate CRA because it represents interference by government in the operation of businesses.... I became the member of the Board to testify before Congress on issues related to CRA. I went around the country supporting the superb work that community groups and banks were doing in providing affordable housing for low- and moderate-income groups. "

There is no further mention of CRA, the Community Reinvestment Act, in the book. I wonder if Meyer would have given it a lot more space if he were writing today. CRA was not the immediate source of the current financial panic, and I do not think it was either a necessary or sufficient cause. Rather it served either as a few early steps on a long path to, or perhaps one of a number of tributaries to the river that flowed to the current panic. A full understanding of what led to the current panic would be incomplete without some discussion of CRA and the desire to expand home ownership.

The Fed's Balance Sheet III

The Fed's balance sheet continues to show the results of the financial panic. Reserve balances with Federal Reserve Banks have risen from $104.5 billion to $167 billion in the week ending October 1, 2008. The source of this increase is primarily borrowing, which increased by $180 billion over the previous week.

These numbers are amazing and I am wondering how much higher it will go.There is fear and panic at the large institutions, and they no longer trust each other, so are no longer willing to lend to one another. The commercial-paper market (short-term debt issued by private companies, much as T-bills are issued by the government) is in trouble. One example of the problem spilling over to affect people not on Wall Street is the suspension of the Common Fund, a place many colleges had been using to park cash. It will be liquidated and shut up over the next few months. The colleges should not lose anything, but they now cannot get quick access to funds that they need to pay bills.

The Fed's Balance Sheet II

I noted a few days ago that the bank's deposits at the Federal Reserve had exploded. In the latest report (Sept 25, 2008) these deposits have more than doubled from the high levels of last week, to $104,506 billion. When that number gets back down to levels that it was at prior to September, we will know that the financial panic is over.

Certainly the Fed has been aggressive in trying to meet the demands for liquidity. There were also some notes on the report announcing several new ways that the Fed is trying to deal with the crisis.

The Federal Reserve Balance Sheet

When I wrote my Ph.D. dissertation, I spent a lot of time looking at the Federal Reserve balance sheet. Since then my interests in economics have expanded, but I still maintain a bit of interest in monetary policy and monetary history. Because I have not seen anyone write about it, I decided to take a look at what the Fed has been up to, as revealed by its balance sheet, as a result of the current financial panic.

The balance sheet certainly shows some very strange things happening. The reserve balances with Federal Reserve Banks have exploded in past week. They were a mere $5.561 billion in the week ending Sept 19, 2007 but were a huge $46.996 in the week ending Sept 17, 2008. This increase is almost entirely the result of the financial panic because data for the week earlier show reserve balances of only $7.978 billion.

Banks normally do not hold much in their accounts at the Fed. They mostly meet reserve requirements with the cash they have in the ATM machines. (I once had a student who worked for a bank, and I asked her how much was in an ATM because she said she knew. She replied that if she told me the answer, she would have to kill me, so I still do not know how much cash is in an average ATM.) It may be that banks are holding these large amounts because in times of panic, cash is king. It may be that they do not want to loan excess reserves to other banks because trust has broken down. But that is a guess. I really do not know what banks are doing with such large reserve balances.

Another oddity is the huge decline in U.S. securities held outright by the Federal Reserve, which fell from $780 billion for the week ending Sept 17, 2007 to $480 billion for the week ending Sept 17, 2008. The big increases over the year were in repurchase agreements (in which the Fed buys U.S. government securities with the agreement to resell them in a few days, a way to temporarily inject funds into the financial markets), and in an item called Term Auction Credit. This last time is the account showing how much of nontraditional debt the Fed is holding as it attempts to help financial institutions. It is a new thing that has appeared as the Fed has tried to help the financial institutions recover from their huge holdings of rotten mortgage-backed securities.

Another interesting table shows the breakdown of reserves. For the two weeks ending September 10th banks held $47.112 billion in total reserves, of which $169.480 billion was borrowed. (Total Reserves minus non-borrowed reserves, or 47112-(-122368).) The banks are borrowing more than they have in reserves, which happens because the Fed sells securities to offset some of the borrowing. I have to say that I do not understand some of these numbers. Too much has changed at the Fed since the time I was paying attention to what they were doing.

Update: Megan McArdle has a post on how close we came to a financial meltdown.