[A-List] Minneapolis vs. Boston
charlesb at cncl.ci.detroit.mi.us
Mon Jan 5 13:43:38 MST 2009
Julio Huato’s Blog
Minneapolis vs. Boston
In Economics on January 3, 2009 at 2:05 pm
In an October 2008 paper, V.V. Chari, Lawrence Christiano, and Patrick
J. Kehoe (Fed Minneapolis, CCK) found no evidence of a crunch affecting
interbank credit or borrowing by Main Street. They argue that Main
Street’s cost of borrowing is not as high as a quick look at spreads
would suggest; that we should look at the levels instead.
In a November 2008 paper, Ethan Cohen-Cole, Burcu Duygan-Bump, Jose
Fillat, and Judit Montoriol-Garriga (Fed Boston, CDFM) replied in detail
to the arguments in the CCK paper and concluded that Main Street is
indeed being hit by a credit crunch. I am just starting to read the
latter, but I didn’t find the CCK view convincing to begin with.
I’ll say why below.
My sixth sense tells me that the political implications of what CCK are
arguing are relevant. What they are really suggesting with their paper
is that large public efforts to get the economy moving are not called
for, especially those directed to support employment. It’s the old
>From my standpoint, the main issue is the net (dynamic) distributional
effect of the measures taken and to be taken (by the new administration)
with the alleged aim of shoring up the financial and non-financial
sectors of the economy. Among the different possible ways in which the
financial sector can be rescued, I believe that, on equity as well as on
efficiency grounds, it can be argued that the best approach is the
direct relief to working- and middle-class borrowers via methods that
put the public interest first at the expense of the captains of finance
that drove us into the ditch.
I’ll just say, to be more specific, that I favor the outright
nationalization of, at least, the weakest banks, followed by the
re-negotiation and direction extension of new loans to lower income
individuals and small businesses by the nationalized banks. With Fannie
and Freedie re-nationalized, the mortgage market can be fixed and
revived provided the political will is there.
Following Michael Moore, I also favor a similar type of nationalization
of troubled industries, like car making, and the realignment of
priorities of those companies to serve the public interest,
particularly in the areas of environmental sustainability and workers’
Having said that about the politics of the issue, I now return to the
empirical debate mentioned above.
In the CCK paper, I find one argument utterly unconvincing, namely that
spreads (the difference between the interest rates at which banks,
business, or people borrow and the baseline interest rates, those of
assets deemed relatively risk-free by the markets, like the federal
funds rate or LIBOR) are not informative of the existence of a credit
It seems to me that the exact opposite is true. I expect all rate
levels to be dragged down to some extent by the monetary policy
reactions to the crisis: lower federal funds rate and discount (the
latter being the rate at which U.S. banks can borrow from the Fed). The
issue is how the risk, term, liquidity, and information structures of
the interest rate react to monetary policy moves. And, at that, the
spreads tell the story. And spreads for the credit instruments
available on Main Street have gone through the roof. The flight to
quality (i.e. the flight to Treasuries) is the credit crunch!
A credit crunch doesn’t mean that liquid wealth (money) won’t find
any parking spot at all. It simply means that all regular parking spots
are suddenly deemed unbearable by lenders and that the hurdle rates at
those spots vis-a-vis the seemingly riskless rate increase accordingly.
Parked in Treasuries, wealth will earn the baseline interest as small as
it may be now. So, it’ll be like cash (not entirely, because it’s
not fully liquid, but almost), except that it will earn some token
On the other hand, loaning wealth to yours truly would be an act of
unbelievable foolishness. Evidence of the credit crunch is not that the
overall rate at which I’d be borrowing now is relatively low (assuming
that the market where I can borrow exists, a rather heroic assumption
nowadays), but the difference between what I’d have to pay in interest
and what the federal government does pay in interest.
In any case, if the tons of base money (the additional reserves the Fed
loans to banks via discount window or that end up in the banks whenever
the Fed buys Treasuries in the open market) that the Fed has been
injecting into the banking system as of late had already translated into
streams of credit to average Joes like me, then we’d be observing them
in the data on deposits or measures of the money stock (M1 or M2).
Here, I only see a minuscule jump in deposits, M1 and M2 in September
On the other hand, take a look at what happened to bank reserves:
In words, in September and October 2008, bank reserves went straight
up. More specifically, they more than doubled and more than tripled,
respectively. On the other hand, total deposits and M measures in the
same periods only experienced a tiny increase. Up to the latest data
point available, reserves have been building up much faster than total
deposits or Ms have gone up. That does it for me.
I understand that businesses have other ways to raise cash than issuing
commercial paper or knocking on a banks’ door. But these aggregate
data show clearly, to my lights, that banks have not been lending at
anything near the pace at which they have expanded their reserves. Have
other forms of cash raising picked up the slack left by debt? The state
of the stock markets in the last few months doesn’t suggest that. So,
chances are, Main Street businesses are under strife while banks have
frozen lots of new credit lines, and recalled old ones, as fast as they
have been able to, and now sit on a bunch of idle base money.
How can this be? Don’t banks lose the “risk-free” federal funds
rate by holding reserves beyond what they are required to hold, since
reserves are just electronic credits recorded on the Fed banks? Well, a
zero interest rate still beats the negative returns that banks fear if
they were to loosen their purse.
To translate into new deposits (money in the economy), the base money
injected by the Fed needs to be loaned, thus expanding total deposits
and the Ms via the multiplier mechanism. It didn’t happen. It’s not
happening. The money multiplier has dropped. And since credit is the
lifeblood of the “real” economy nowadays, this situation must be
having “real” effects as documented by the press on real time.
Conclusion: There was, back in the fall of 2008, and - although it’s
eased a bit since the fall - there continues to be a credit crunch.
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