Belle Waring "Congratulates" Megan McArdle
xkcd: The Economic Argument

Rich Clarida Says: "We Ought to Have Knowed"

Somebody whose name I forget--was it Jim Hamilton?--sends me to a nice paper by Rich Clarida

Rich Clarida: This Jackson Hole consensus as summarized well by Bean et al. (2010) embraced the following seven pillars

  1. Discretionary fiscal policy was seen as generally an unreliable tool for macroeconomic stabilization.
  2. Monetary policy, conducted via setting a path for the expected short term interest rate, was therefore to be assigned the primary role for macroeconomic stabilization.
  3. Because the transmission mechanism for monetary policy was presumed to operate mainly through longer-term interest rates. expectations of future policy rates were central and credibility of policy was essential to anchor these expectations.
  4. Central bank instrument – if not goal - independence of the political process was important to supporting central bank credibility.
  5. Setting targets for intermediate monetary aggregates... fell out of or never gained favor.... as historical velocity relationships between these aggregates , nominal GDP >growth, and inflation appeared to break down....
  6. The efficient markets paradigm was seen as a working approximation to the functioning of real world equity and especially credit markets....
  7. Price stability and financial stability were seen as complementary....

As noted above, pre-crisis discussions of monetary policy took financial stability for granted, and workhorse models used for teaching (Clarida, Gali, Gertler 1999, 2002; Woodford 2003) and even the much larger models used for policy analysis routinely assumed financial frictions were irrelevant for policy design...

[...]

Financial history suggests “never again” eventually becomes “this time it is different” and as Rogoff and Reinhart (2009) remind us, throughout history “this time it is different” eventually sets the stage for the next financial crisis. This is especially true when, as emphasized by Minsky (1982) , the “this time it is different” wisdom supports and encourages greater and greater use of leverage.... [I]mportantly, this channel is missing in the justly celebrated and influential Bernanke – Gertler model (1999) presented at Jackson Hole in 1999. In that model, the bubble affects real activity... a wealth effect on consumption... the quality of firms’ balance sheets depends on the market values of their assets rather than the fundamental values.... B and G assume that—conditional on the cost of capital—firms make investments based on fundamental considerations.... This assumption rules out the arbitrage of building new capital and selling it at the market price cum bubble - the Ponzi finance stage of a bubble in the Minsky nomenclature

In the case of the current crisis, the this time it was supposed to be different because securitization and the expertise of the ratings agencies in assessing default risk correlations across various tranches of structured products was in theory supposed to make the financial system more stable and reduce systemic risk.... Of course it was recognized that originate and distribute business model of the ‘shadow banking system’ had its flaws.... But the cost of poor security selection would be spread, it was thought, among millions of investors around the world who bought these securities.... It was supposed to be the brave new world of ‘originate and distribute’ financial intermediation and for twenty years it was – until in July 2007 when it was no longer...

[...]

With the benefit of hindsight (excepting rare examples such Rajan (2005) and McCulley (2007) two of very few to foresee the essential contours of the growing systemic instability being created by the shadow banking system) and authoritative, post- mortem research such as that in the Pozsar et. al., it seems clear – at least to this author - that the financial crisis and the credit and securitization bubble that preceded it resulted not only from spectacular failures in securities markets - to allocate capital and price default risk - but serious failures also as well by policymakers to adequately understand, regulate, and supervise these markets. Policymakers, academics, and market participants simply didn’t know what they didn’t know...

[...]

[A] central bank can everywhere and always put a floor on any nominal asset price (or set of nominal asset prices) for as long as it wants regardless of 1) how ‘credible’ it’s commitment is 2) how expectations are formed or 3) how term or default premia are determined.... [T]he central bank simply needs to stand ready to buy government bonds with maturities at that point on the curve whose yields it wants to cap by posting a bid each day at the minimum nominal prices it stands ready to support.... The central bank can, if it so desires, robustly put a ceiling on the yield of any bond, public or private, it chooses to target...

[...]

According to monetary theory, central banks have at least two powerful – and complementary – tools to reflate a depressed economy: printing money and supporting the nominal price of public and private debt. As discussed above, a determined central bank can deploy both tools for as long as it wants regardless of 1) how ‘credible’ it’s commitment is 2) how expectations are formed or 3) how term or default premia are determined. There are two fundamental questions. First, can these tools, aggressively deployed, eventually generate sufficient expectations of inflation so that they lower real interest rates? Forward looking models generally predict that the answer is yes.... A second question relates to the monetary transmission mechanism itself. In a neoclassical world that abstracts from financial frictions, a sufficiently low , potentially negative real interest rate can trigger a large enough intertemporal shift in consumption and investment to close even a large output gap. But in a world where financial intermediation is essential, an impairment in intermediation – a credit crunch – can dilute or even negate the impact of real interest rates on aggregate demand.... Deleveraging and the collapse of the shadow banking system that intermediated so much credit before the crisis continue to represent a significant headwind that presents a challenge to policy effectiveness.

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