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Brad Setser: Follow the Money

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Too much, or too little

by Brad Setser
May 27, 2009

Free exchange is worried that the Obama Administration wants to change too much:

WHEN asked my assessment of the government’s handling of the financial crisis, I usually say it is too soon to tell. But I am very concerned it is doing too much, too soon and too fast. Their current agenda (not even an exhaustive list): fix financial markets, boost aggregate demand, set up a new regulatory framework, decide how much bankers should be paid, create a market for green technology, repair infrastructure, repair schools, and fix entitlements. That would be ambitious for God to achieve, even given eight days, let alone mere mortals.

Simon Johnson is worried that the US is doing too little, and thus won’t make the kind of fundamental reforms that the United States needs:

“The financial crisis is abating – although the economic costs continue to mount and new problems may still appear (ask California or Ukraine). At least among the people I talk with on Capitol Hill, there is a very real sense that business is returning to usual; certainly, the lobbyists are out in force, they want what they always want, and it’s hard to see many of them as seriously weakened. How much progress have we made on any of [Rahm] Emanuel’s priority areas or, for that matter, along any other public policy dimension that was previously stuck? The charitable answer would be: this is still a work in progress and you cannot expect miracles overnight. True, but Rahm’s Doctrine .. says that you should implement irreversible change while you still have the chance. Tell me if I missed something, but has there been any breakthrough of any kind?”

A lot of current economic policy debates seem to have a similar character.

The debate over US monetary and fiscal policy, for example.

Is the US macroeconomic response to the crisis too modest (in part because nominal rates cannot go below zero), putting the US at risk of sustained deflation and a prolonged period of subpar growth? Or is it too aggressive, and thus creating a major risk of inflation?

The debate over bank recapitalization too.

Too much stress-testing (i.e. forcing healthy banks to raise expensive capital they don’t need to cover losses that may not materialize) or too little stress testing (i.e. tests that weren’t stressful enough)?

The debate over global rebalancing. Has too much has already happened, too fast (the US trade deficit was under 3% of US GDP in q1), reducing the priority on policies to reduce imbalances further? Or has too little fundamentally changed, leading to a real risk that the US fiscal deficit will substitute for the US household deficit, keeping the trade deficit up as Asia returns to exchange rate management?

And of course, the debate over China’s ongoing willingness to finance US deficits. Has so much changed that China will no longer buy US bonds as it seeks to diversify its reserves, forcing the US to adjust? Or or has nothing really changed, as China still pegs tightly to the dollar?

30 Comments

  • Posted by FollowTheMoney

    1. Most likely a prolonged period of subpar growth, at least in the traditional west. SLOW and PROTRACTED. Most likely 5 years of not much. Greenshoots are far too early…

    2. The world needs to reach a global green deal, especially one agreed upon by China and the U.S. (the EU is already in line…). This may happen by year end if talks in September are agreed upon. QUICKER ACTION NEEDED!

    3. Stress tests? Someone at the MoMA Garden party last night said it best “U.S. unemployment will hit the teens in this crisis”. In that case, i think that the Stress Tests are USELESS.

    4. Interest Rates? U.S. government will have little choice but to raise interest rates in the next 12 months.

    I wonder, Calm Before the Storm? It’s Summer, and don’t Black Clouds gather in the Fall?

  • Posted by David Pearson

    Something has really changed. There is a volume effect of Chinese Treasury purchases, and there is a PRICE effect. China was a non-economic buyer of long-term Treasuries. It was price insensitive. Much more so, arguably, than the rest of the market.

    Now China is 1) less important to the long-dated Treasury market as a % of issuance; and 2) more focused on the shorter end of the curve.

    When a price insensitive buyer steps back from a market, what is the likely impact on the demand curve? At what price (yield) do private savers want to finance $3tr in Treasury issuance?

    Its easy to argue that the recent run-up in Treasury bond yields is a result of this price effect. Why didn’t it occur sooner — say, in 4q08? First, it took time for the Fed, through its QE commitment, to eliminate deflation tail risk. Second, Treasury issuance really started to ramp in earnest over the past two months or so.

  • Posted by Twofish

    Free exchange: But I am very concerned it is doing too much, too soon and too fast.

    Most of the things that Obama is trying to do with respect to the financial system are things that they have to do. Once the US government owns 70% of GM and 35% of Citigroup then you have to make certain decisions, even if the decision is to do nothing.

    Politics is messy. You have interest groups and lobbyists that are doing what they have always done. What’s changed are the issues they are lobbying about and the political context in which they are lobbying about.

    The type of change that Simon Johnson seems to want basically involves leveling a society and starting from scratch, and that usually causes more problems than it solves. I read his article in the Atlantic, and I was thinking “so *that’s* how the IMF managed to destroy so many countries.” There is this bizarre sadness that things weren’t worse, so that you can destroy a country and rebuild it. Destroying a country to save it, except that you don’t end up saving it.

    The attitude seems to be that economics and politics would be so much simpler if we didn’t have all these people getting in the way, so lets get rid of all of the people, which reminds me of what Mao and Stalin tried.

  • Posted by ReformerRay

    Too much money has already been spent to try to protect and preserve the large financial firms that helped create the crisis.

    I have always believed that the Lehman shock to the banking system should have been followed by the collapse of AIG within one month of Lehman. The uncertainity as to which financial firm is trustworthy would have been resolved as firm after firm failed. If that course had been followed, new banking relationships would have been developed by the private sector. The refusal to allow the chips to fall shows that the leadership of the U.S. does not believe in the ability of the private sector to re-invent itself.

  • Posted by Twofish

    FollowTheMoney responds: Most likely a prolonged period of subpar growth, at least in the traditional west.

    Subpar compared to what? Suppose the US grows 2% over the next five years. Is that good or bad?

    FollowTheMoney: The world needs to reach a global green deal, especially one agreed upon by China and the U.S. (the EU is already in line…). This may happen by year end if talks in September are agreed upon. QUICKER ACTION NEEDED!

    The world won’t agree on a global green deal by the end of the year. You might get agreements on part of a green deal by the end of the year, but even that is iffy. I’m also not sure what the rush is. Suppose there isn’t a deal by the end of this year, but you get one in June 2010, it’s not the end of the world.

    Also the thing about “QUICKER ACTION NEEDED!!!” The fact is that political and economic institutions take time to operate.

  • Posted by Cedric Regula

    So far today the 10 year treasury got a swift kick in the coupon. The Fed responded to the 911 call and took some treasuries back to the emergency care unit in Washington with the intention of re-flating the poor little guys back to health.

    But for some reason this left the rest of the treasuries howling in sympathy. Net effect was still an uptick in rates today.

  • Posted by Biofuel

    Maybe it’s not too much or too little, but whether it’s right.

    I wonder what it would take for US companies to begin considering US to be a good place to invest, instead of looking to invest abroad for cheap labor or growth potential. When would engineers get the same “respect” as bankers? Can a post industrial economy return to its industrial beginnings?

  • Posted by guest

    Brad
    Quiet hasty moves (Banks, GM, AIG,C)and the willingness to establish a reassuring morality and transparency.
    Not a time to be a choosy heir.

  • Posted by bsetser

    David Pearson — I think you have correctly described the dynamics of the treasury market. longer-term supply only started to really ramp up in the last 4-5ms (until then most of the supply was bills) and the ramp up in supply has come even as financial sector fear waned. and unlike in 05-mid-08, there isn’t a big price insensitive buyer, as china (and other cbs) are hugging the short end of the curve.

    the question then though is when does the run up in yields at the long end itself become a constraint on economic growth (esp if mortgage rates head up, removing one source of support for housing)/ when do CBs start to see value in the long-end of the curve (or at least find the yield attractive relative to the short-end)? I am not sure it is right to forecast that the current dynamics won’t encourage some natural limits, i am just not sure where those limits are …

  • Posted by Cedric Regula

    Yesterday the Treasury sold $40B in 2 year notes and today they sold $35B in 5 year notes. Auctions went swimmingly with CB participation estimated at 55%-60% in both auctions. Bucket load of 7 yearlings coming to market tomorrow.

    So we know what the CBs like, at least for now.

    I’ve thrown away my crystal ball, because I’m convinced it would only lie to me.

  • Posted by David Pearson

    the 10yr at 3.6% will likely get the Fed’s attention. Or rather, if that rate drives the RMBS rate above 5%, then the Fed will probably be compelled to act. The problem with saying, “we don’t have a target rate” to the market is that the market will push until they find one. A target rate, that is. And then the Fed has to defend that target, which will make speculators attack it, and so on. This is the same dynamic that plays out around FX interventions, so its no surprise we are seeing it now.

    The real question is, when the Fed increase its QE commitment, what will be the unintended consequences?

    For one thing, they are likely to drive CB buyers further towards the short end of the curve. For another, private savers will require more of an inflation premium. Both will mean that a QE commitment has a natural tendency to be raised.

    Where does all this leave the dollar? Maybe it won’t be long before we find out…

  • Posted by FollowTheMoney

    Twofish,

    thanks for your pointers. once again giving the rookie some critique!

    Now let’s focus on Mr. (or perhaps Madame) BioFuel.

    The poster brings up an interesting topic that is of interest to me. The way i look at the current situation is that there needs to be some structural change. The United States is home of the most bright and innovative people in the world, and we should not lose that.

    What concerns me is that the majority of the Goldman Sachs, JPMorgan, Blackstone, etc hire a bunch of the Ivy League talent. Talent that majored in Arts, History, English, and in some cases Music.

    In some cases, (speaking of my close friends) that went to these Ivy Leagues have absolutely no care to be working in finance whatsoever but just do it because it “presents them in the correct light”. Attend TRINITY, go to YALE, and work at GOLDMAN. The problem with this is the financial sector and the innovation of America is being hurt by this approach.

    The financial industry in America has become too large, and too many people are only doing it because of the “GET RICH QUICK” image. That needs to change.

    What i’m saying is that there are some absolutely talented, innovative, and creative people graduating from the most prestigious universities in America. Individuals that could jumpstart, and innovate, be leaders and entrepenuers but instead of taking risk and innovating they go into finance. not at will, but because of whats “right”.

    The system, the U.S. government needs to do more to promote and encourage innovation. They should encourage “go-getters”. To me, when i look around I see so many talented minds, with so many bright visions, but they’re sitting in a cubicle, looking at a spreadsheet, hating what they’re they doing, but are just there to be there. It’s an unfortunate situation we have, but it’s been promoted by the media, the parents, and to some extent even the current administration.

    What would be great for this country is if the big banks went to the University of Idahols or the university of Nebraska and seeked out the passionate set with finance skills?? Instead, currently the system is set up so that you go to Ivy League, major in Music, and end up as an analyst at JPMorgan (through “the brotherhood”). You have no interest, but you’ll get by for a couple years because of the EASY MONEY. At the same time this music major could have been starting his own online music platform, managing a group, or building a record label.

    Maybe it’s just me, but i see alot of wasted talent. I see a country with lots of potential. A country with lots of innovation but it’s overshadowed by finance.

    I think we need to focus on structural change. We need to focus on more BALANCE in our economy, and i think we need to focus on encouraging college graduates to be leaders who start and build companies.

    Look at Dr. Setser. Take the author of this blog for example. I mean having read Dr. Setsers posts his work is remarkable. He could easily be working at a major financial firm making XYZ $, but he’s focused on sharing his input by building an insightful blog. Sure he may not be making all the $$$ that guys make at Morgan, but he’s been creative and made a name valued to the industry.

    More of this needs to happen. We need to restructure our economy. Obama may have tried to lower bonuses, but a few months later all the banks just increase the salaries….Our country needs a plan to focus on the future. And now is a good time to for us to start! Let’s reshape and rebuild!

  • Posted by Cedric Regula

    Bond market update

    The long end just got beaten to within an inch of its life.

    It’s like Ali, Foreman, Frazier and Tyson all ganged up and womped on Tyson’s girlfriend.

    This has got to be a record for a two hour re-pricing change in the usually boring bond market.

    Looks like another handbag and a half for today.

  • Posted by Dennis Redmond

    The too much/not enough debate needs to be broadened to include the EU, East Asia, and the BRICs. The case for catastrophe only makes sense if you think the rest of the world is dragging its feet like the US, which it isn’t, thank goodness.

    EU: not enough fiscal push and not enough cash for Eastern Europe, but rates are finally close to zero, the banking bailouts are on track, and auto-stabilizers are kicking in. Hurray for the welfare state!

    East Asia: not enough fiscal push from Japan, but S Korea and China are spending. Their banks are fine.

    BRICs: put a floor under energy and commodities, did an amazing job avoiding a massive currency crisis/meltdown, used their reserves wisely, are beginning to spend on themselves and their respective regions (LatAm, S Asia, Eurasia, SE Asia).

    Don’t believe me? Then explain why the Ted spread is finally returning to something like normality:

    http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP%3AIND

    Basically, the rest of the world has idiot-proofed itself against the follies of US neoliberalism. So no catastrophe — just a long, grinding slump in the G7, and some major political changes ahead.

  • Posted by Cedric Regula

    Bond market footnote

    Mortgage bonds are getting clobbered even worse than long treauries.

    Here the Fed is buying $1.25 Trillion.

    We could be witnessing the fall of communism in the US!

  • Posted by joe hill

    @ Mr. Setser,

    I know that this comment is off topic for this post, but I remember reading a post on here regarding your thoughts on why housing bubbles seemed to pop up all over the world and not just the U.S. I am pretty sure that I read that article here, but maybe it was on another blog. If it was on here, do you mind posting the link to it on this thread? Thanks in advance! (and another great post!)

  • Posted by apachecadillac

    Why does everyone always assume the brightest and most innovative people in the world live in the United States?

    This is a serious question.

    I can accept without any examination that the heaviest, best-coifed and most credentialed people in the world live in the United States. But to seriously argue that world’s brightest and most innovative people live in any particular country requires some support. I can believe that such people tend to congregate in urban centers. I can believe that some social systems and economies are more stable, and others more conducive to transformative change. But to blandly assert that the Americans are the brightest and most innovative people around suggests an unexamined (and perhaps unjustified) sense of innate superiority. Sic transit gloria . . .

  • Posted by bsetser

    tis true that there was a big sell off in the ten year today …

    and CBs are still staying at the front of the curve. as presumably are others …

    i am not 100% sure though that CBs shorten their treasuries if the fed commits to buy more. i can see them saying — the fed isn’t gonna let the 10 year rise above 4. we can either get a 4% yield there or get 0% on bills. we need a bit of income.

    in any case, at some point, higher mortgage rates and higher oil start to weigh on the consumer; they mean less spending on other things, and weak demand and weak growth and no great shoots and no reflation and no need to sell longer-term treasuries …

    what do you all think of the argument that more QE (treasury purchases) means higher inflationary expectations, and thus it won’t succeed. fed has to buy more and more to keep nominal yields down …

  • Posted by lars

    bsetser wrote:
    “fed has to buy more and more to keep nominal yields down”

    And therein is the problem with QE. It is destined to fail; and given that fact, the FED is/was better to have never embarked on the path.

    The “recession” is too deep for QE to buy sufficient time for demand to recover. This mess will take years to right itself and the FED cannot maintain QE that long without destuction of the $.

    And this is the problem with an academic like Bernanke calling the shots.

  • Posted by Cedric Regula

    I actually buy into the argument that what the USG is doing so far may not lead to future inflation. For all the economic reasons like weak demand due to a very slowly deleveraging consumer, global overcapacity, and also monetary reasons like we blew away a ton of greenbacks, so there’s lots of empty space in bank vaults to put fresh new ones. (tho in fairness I wish I could ever be the recipient of that generosity).

    As far as what CBs do, we are back to the long running discussion here of what they believe their choices are. But the buck is high right now compared to a year ago and that was due largely to the credit crunch and also repatriation of US private investment. Once that is behind us I don’t see why the buck wouldn’t go down 15% to where it was and US exporters need that to happen as well. So a 2.5% return on a 5 year note doesn’t look that great with a 15% currency loss. But I have no idea what CBs will do.

    But there is a school of thought that this will be inflationary eventually. Paradoxically, I believe that too (I’m in an agreeable mood today) and the reasons could be how the Fed decides to handle a recovery if an when it ever gets here. We may have a Greenspanesque jobless recovery and the Fed keeps the pedal to the metal creating old or new kinds of bubbles and other misallocation of capital. Actually I think all the banks’ new found money will probably be loaned offshore. Commodity price increases are likely leading to some inflation, and a falling dollar would lead to import inflation.

    So we spent a couple decades lowering inflation expectations and we may be undoing that now.

    But the new problem is credit risk and massive supply. If the Fed and/or Treasury keep printing and borrowing, this has to create some concern among even the most price insensitive central bankers. And the private sector may not stand still for the game and decide almost anything is better. Lately corporate bonds have been hot, but who knows maybe soon it will be tulips, copper, art, baseball cards, EM stocks and even houses!

    I still don’t believe CBs and the Fed can own all the money and credit/debt in the world. There must be room for capitalists somewhere?

  • Posted by locococo

    As to the Pimco receiving all the newly printed currency units question me thinks that Ben and Tim and Larry as well as all those agencies and offices did not too much nor too little but all they could for exactly nothing.

  • Posted by Twofish

    FollowTheMoney: The United States is home of the most bright and innovative people in the world, and we should not lose that.

    And there is no reason I can think that the US is in any real danger of losing that.

    FollowTheMoney: What concerns me is that the majority of the Goldman Sachs, JPMorgan, Blackstone, etc hire a bunch of the Ivy League talent. Talent that majored in Arts, History, English, and in some cases Music.

    They also hire lots of electrical engineers, physicists, and mathematicians. If you go into any trading floor, what do you see, computers. Lots and lots of computers. JP Morgan has more programmers than Microsoft.

    You get an interesting mix of people in banking. Also Goldman-Sachs and JPMorgan tend also to hire a lot from state schools (i.e. University of Michigan, University of Virginia and the like.)

    FollowTheMoney: In some cases, (speaking of my close friends) that went to these Ivy Leagues have absolutely no care to be working in finance whatsoever but just do it because it “presents them in the correct light”. Attend TRINITY, go to YALE, and work at GOLDMAN.

    Which explains why Goldman-Sachs has such a notoriously, rigorous, and painful hiring process. They put people through many, many rounds of interviews precisely to get rid of these people.

    FollowTheMoney: What would be great for this country is if the big banks went to the University of Idaho’s or the university of Nebraska and seek out the passionate set with finance skills??

    They do. The problem is that in order to work for a large corporation (any large corporation), you can’t be too passionate. You have to work with people, at that means you have to take orders and take out the trash. The key is to be around people that you think you are not going to give you orders that you would have problems following.

    FollowTheMoney: At the same time this music major could have been starting his own online music platform, managing a group, or building a record label.

    Which turns out to be total hell because you are competing against the million other people that want to do the same thing, and you quickly learn that it’s all about money, anyway. Once you try to do something “artistic” you very quickly learn that it’s people that either have money or know how to get it that call the shots, and that gets you back into banking and finance.

    FollowTheMoney: Our country needs a plan to focus on the future. And now is a good time to for us to start! Let’s reshape and rebuild!

    But all of this comes back to money and respect. If you want me to work at a community college or high school, you aren’t going to do it if you pay me dirt and worse yet treat me like dirt. Even the “do this because it’s good for the world” doesn’t work, I think I’ve done more good in playing a tiny role in stopping the next great depression anything I could have done teaching bored students that just need a credit to graduate.

    If Obama can create a new system in which people that go into academia can be paid as much as and have as much influence as people that go into banking, they I’m all for that.

    I have my doubts that he is going to be able to do that.

    It’s easy to talk about changing things, but you quickly figure out when you do, is that it comes back to money.

  • Posted by locococo

    Cedric, there is another school of thought that thinks you have a huge klepto problem not an economic/monetary one – the latter just covers the former over. Then there is this other school that says this crisis is of an IQ – stressed in a test a bit too much – origin… who d know tho…

    anyway, nice post .

  • Posted by Twofish

    apachecadillac responds: Why does everyone always assume the brightest and most innovative people in the world live in the United States?

    They don’t, but the United States has a system of government and economics so that bright, innovative and passionate people find it easier to make something of themselves in the US than in most other places.

  • Posted by jonathan

    The long-term aspect of QE has always struck me as self-contradicting because the more you do it, the more you both indicate and create long-term weakness that requires you to do more which indicates and creates more weakness, la di da. I understand there was a desire to buy long to break the credit log jam but QE to maintain rates strikes me as an example of the apocryphal story of King Cnut the Great: Cnut put his throne on the beach and commanded the tide to stop and when the tide refused to listen, Cnut said this showed the limit of man’s powers versus God’s.

    If we continue with QE for the long end – QEII? – then that might be the story of the deaf spider. You see, there was a scientist who decided to test a spider’s ability to respond to commands. He removed one of the spider’s legs and said, “Walk, spider, walk.” The spider walked and the scientist recorded in his lab book, “Spider with 7 legs walks.” As he removed more legs, the spider still tried to walk. Even with only one leg, the spider still moved and the scientist wrote, “Spider with 1 leg tries to walk.” The scientist removed the last leg and commanded, “Walk, spider, walk!” The spider didn’t move. He repeated, “Walk, spider, walk!” The spider still did not move. The scientist then squashed the spider and wrote in his lab book, “Spider with no legs is deaf!”

  • Posted by don

    “what do you all think of the argument that more QE (treasury purchases) means higher inflationary expectations, and thus it won’t succeed. fed has to buy more and more to keep nominal yields down …”
    I would say the total amount of the debt is the main inflation concern, more so than how it is distributed. As PK explained, fighting deflation is something of a balancing act, as it involves setting future expectations, which can shift suddenly. The question is, if expectations shift, will the Fed be able (or even want to) soak up the reserves they have created. I think Ben will favor more inflation than I would. Ultimately, the amount of debt, and the extent of the debt burden, will determine if it is to be honored in full or partly reduced through inflation.
    To me, the biggest danger is that the Fed and Treasury will keep stubbornly to their wealth maintenance strategy (bailouts of banks and legacy lenders), denying the possibility that the Treasury won’t be able to afford it. The Fed is entering dangerous grounds in taking on questionnable loans that the taxpayer may (and probably will) end up paying for. Such budget considerations are properly undertaken by Congress, not the Fed.
    For those who trust the Fed more than Congress, consider the legacy of AG, recall that Ben was with Hank in arguing that the housing crisis would probably not spread to the overall economy, and consider the bank stress tests, which were more a political than an economic exercise. I don’t think Ben is unprincipled, but he is surrounded by those with a vested interest in denying the extent of the bad loan problem.

  • Posted by locococo

    …Just an example: Banking trade groups are lobbying the Federal Deposit Insurance Corp. for permission to bid on the same assets that the banks would put up for sale as part of the government’s Public Private Investment Program. The FDIC insures deposits at 8,246 institutions with $13.5 trillion in assets. The insurance fund, generated by fees paid by banks, fell to $13 billion from $17.3 billion in the previous quarter, and failures in the quarter cost the fund $2.2 billion, the FDIC said and insured some more bonds to be released with a FDIC stamp to all those hungry investors out there as the long end does the thing that sits Ben firmly in the chair. Again…

  • Posted by Twofish

    ReformerRay: The refusal to allow the chips to fall shows that the leadership of the U.S. does not believe in the ability of the private sector to re-invent itself.

    That’s largely because very few private sector people in banking and finance think that the US financial system would have survived the sorts things we were looking at last year.

  • Posted by Twofish

    The increase in US Treasuries at the long end of the yield curve may have something to do with people moving money out of Treasuries and into corporate bonds, in which case the net result is likely to be more or less dollar neutral.

  • Posted by DOR

    I’d like a major risk of inflation, please.
    Deflation is much more difficult to break than inflation. We have solid experience about how to break inflation, but deflation is mostly just theory.

    Having experienced both, I’ll take inflation.

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