Part 6 (2/2)

Here's hoorks Let's say that the Fed is worried about inflation and wants to keep the econooes out and sells 10 billion worth of short-ter so, it effectively re system Why? Because the purchasers of the debt have to write checks drawn on their respective banks, which the Fed then cashes and keeps The banking systeer economy are now out 10 billion Moreover, because banks use every dollar on deposit to createsyste 25 billion or 30 billion

In this way, the Fed has tightened the money supply and made credit harder to obtain: it has effectively raised the cost of borrowing Money, like any other commodity, responds to the laws of supply and de o up because lenders can now coher rate Whenever the media report that the Federal Reserve has ”raised” interest rates, it hasn't literally done so; rather, it has ”targeted” a higher interest rate-the Federal funds rate-via these open ine that the Fed is no longer worried about inflation; in fact, it's worried about the fact that the econo, is headed toward a recession The Fed therefore sets a lower target for the Federal funds rate and floods the econoovernet the money? It creates it out of thin air The Federal Reserve effectively writes a check for 10 billion and gives it to the sellers of government debt These sellers deposit the money they've received from the Fed in various banks Now those banks can use it to make loans worth several times that amount Money is suddenly more available, and as a consequence, credit is easier to obtain More to the point, it's cheaper: the net effect of adding money to the economy is that the Federal funds rate will fall, as will interest rates generally

This is what takes place during normal times A liquidity trap, by contrast, is not normal It's what happens when the Fed has exhausted the power of open market operations That dreaded moment arrives when the Federal Reserve has driven the Federal funds rate down to zero In nor that rate would pump plenty of easy rowth But in the wake of a financial crisis, cutting interest rates to zero h to restore confidence and compel banks to lend money to one another The banks are so worried about their liquidity needs-and so mutually distrustful-that they will hoard any liquid cash rather than lend it out In this climate of fear, the policy rate may be zero, but the actualto lend will beexpensive Because it's almost impossible to drive policy rates below zero-you can'tso-policy makers find themselves in a serious quandary They're in the dreaded liquidity trap

During the recent crisis, central banks around the world found themselves in precisely this position As the crisis worsened, they slashed interest rates, and by late 2008 and 2009 the Federal Reserve, the Bank of England, the Bank of japan, the Swiss National Bank, the Bank of Israel, the Bank of Canada, and even the European Central Bank had pushed interest rates close to zero Compared to previous financial crises, this exercise of monetary policy was remarkably swift and partially coordinated But the collective cuts did little to stimulate loans, much less consumption, investment, or capital expenditures, as iven the fear and uncertainty that gripped banks, households, and firms Nor did these cuts arrest the slide toward deflation Conventional monetary policy ceased to have sway over the” It was useless

The reason was simple: the cuts in the Federal funds rate (or its equivalent in other countries) did not percolate throughout the wider financial system Banks had money, but they didn't want to lend it: uncertainty bred by the crisis, and concerns thatloans and investments would eventually sour, made them risk averse This failure of conventional e: you can lead a horse to water, but you can't make it drink The Fed could pump plenty of water or liquidity into the banks, but it could notwith their excess reserves, they sank theovernap or ”spread” between interest rates paid on supersafe or otherwise solid investments and those paid on riskier invest this spread For example, the ”TED spread” is the difference between the interest rate on the short-terovernment debt of the United States and the three-month LIBOR (see chapter 1), the interest rate that banks charge one another for three- normal ti the fact that the htly riskier than loans to the governht of the crisis, the TED spread hit 465 basis points, because banks no longer trusted one another enough to lend money on a three-month horizon, except at exorbitant rates At the same time, risk-averse investors fled to the haven of the safest asset of all: the debt of the US government These forces conspired to si for banks and drive down the cost of borrowing for the US govern spread was a reflection of this dynareater the stress in theto lend money at low rates, the actual market rates at which banks lent to one another-the LIBOR-reh Worse, because the rates of many other kinds of short-tered in part to the LIBOR, borrowing reh for private firms and households

Measurements like the TED spread are a bit like blood pressure readings: they reflect the underlying health of the economy's circulatory systeh the econoiven moment When conditions are normal, markets are relatively liquid and trust rules; people lendcosts remain at normal levels In a time of crisis, when the patient (the financial system) is very sick indeed, the lifeblood of the syste, despite the usualopen market operations to achieve lower interest rates Deflation becomes a very real possibility

How does one deal with this sort of problem? Back in 2002, when Bernanke spoke about the perils of deflation, he alluded to a nunized at that tiiven ”our relative lack of experience with such policies,” as he rightly characterized it The japanese had experimented with sohly controversial

When the crisis hit, Bernanke instituted a series of suchthe spreads between the short-ter-term-rates set by the market and the short-term rates set by policy makers To accomplish this feat, the Fed set up a series of new ”liquidity” facilities that made low-cost loans available to anyone who needed theovern far beyond the usual ht Federal funds rate-andfinancial institutions It beca loans and liquidity available to an ever-widening cross section of the financial system

Initially, the Fed aimed these maneuvers at institutions-depository institutions or banks-that already had soht funds directly from the Federal Reserve, from the ”discount ” (the term refers to an earlier era, when cash-strapped banks would literally go to a tellerat the Fed) Few banks exercised this right, simply because in normal times the Fed imposed a penalty rate on anyone who approached the discountThe as designed to ned for a crisis As conditions worsened, however, the Fed cut the borrowing penalty and allowed banks to obtain loans for longer periods of time By March 2008, banks could borrow for up to ninety days from the discount ith almost no penalty

Yet the crisis worsened, whereupon the Fed then introduced new liquidity facilities The Teriving theer than overnight But it did little to stop the liquidity crunch or the ugly cycle of fire sales, forced liquidations, and declining asset prices that Fisher had predicted The Fed had to adopt other tools ai access to its resources

Accordingly, the Federal Reserve established the Priht loans to ”primary dealers,” the banks and broker dealers hom the Fed trades when it conducts open market operations Another facility, the Ter Facility (TSLF), roup, in exchange for illiquid securities held by such institutions Thus, for the first tiency powers to lend to nondepository institutions From there the facilitiesthe New Deal: the Co Facility (CPFF), the Money Market Investor Funding Facility (MMIFF), and most unpronounceable of all, the asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Fund (ABCPMMMFLF), better known si facilities operated in a variety of different ways and had different objectives or targets Sometimes the facilities permitted financial institutions to borrow directly from the Fed In other cases, they enabled financial institutions to swap illiquid assets-higher-quality asset-backed securities, corporate bonds, coovernment debt In still other cases, the facilities directly or indirectly financed the purchase of illiquid short-term debt Whatever the mechanism, the objective was the sans of trouble and stress This unprecedented intervention was not as indiscriht seem The Federal Reserve did not accept junk bonds or other low-grade debt as collateral; it accepted only as, in theory, higher-quality debt

These efforts eventually bore some fruit: at the end of 2008, in the aftermath of the Lehman collapse, the Fed and other central banks flooded the financial markets with hundreds of billions of dollars' worth of liquidity, and the spreads between short-terovernment assets started to decline As cumbersome and radical as these measures were, they successfully injected a measure of liquidity into the short-teruably a Pyrrhic victory The Federal Reserve and other central banks that instituted co lenders of last resort to lenders of first, last, and only resort In the process, they crossed the proverbial Rubicon not once or twice but many times

In normal times, the lender of last resort helps individual banks with liquidity problems But in this particular crisis, central banks ended up providing support to virtually every bank And they did so not siht loans, as is usually the case; this time the liquidity crunch was so severe that the Fed lent money for weeks or even months In addition, it lent to institutions that had never before been recipients of such aid: the primary dealers, which included many firms that weren't banks in any sense of the word, and the money market funds The Fed even effectively lent money to corporations via the CPFF It also provided ”liquidity support”-special low-cost lines of credit-to a host of institutions considered too big to fail: AIG, Fannie Mae and Freddie Mac, and Citigroup Central bankers in Europe adopted similar measures

These interventions had little or no precedent in the history of central banking They aovernment support of the financial syste

Last Lender Standing

As a typical crisis gathers steaainst a nation's banks and other financial institutions take place Depositors in Mexico demand their pesos back; investors in japan demand the return of the yen they've lent out It's an unpleasant scene, but the central bank in each of those nations can save the day because it can print money to meet the demands The domestic currency is in demand, and to quell the panic, the central banks can provide it

But when the liabilities of financial institutions, corporations, households, or even the governn currency, the situation can unravel Efrom banks and other financial institutions in other countries The foreign currency in question is most often the dollar, but it could also be the euro or any number of different currencies

If for so-market economy decide not to roll over its debt when it comes due, then anyone es dollars has to pay off the debt That puts debtors in a tight spot: they don't have the dollars They can go to the central bank, but it is unlikely to have stockpiled n currency reserves, and it can't help out Nor can it print dollars: that would be counterfeiting So these debtors are extraordinarily vulnerable Their predica-market crises: Mexico in 1994, East Asia in 1997 and 1998, Russia and Brazil in 1998, and Turkey and Argentina in 2001

Enter the International Monetary Fund The IMF was born at the end of World War II; one of its principal responsibilities has been to act as an international lender of last resort to governments and central banks who find themselves in the position so many countries did in the 1990s The IMF was busy that decade, but in the 2000s the world's eency-room doctor had little to do-until the crisis hit Then the IMF once again beca-ave this support in two forms It extended the eary, Ukraine, and Pakistan aiven to en-currency loans only if the recipients adopted econoround in the future Other er track record of instituting financial reforms-Mexico, Poland, and Colombia-tapped unconditional lines of liquidity known as Flexible Credit Lines (FCLs) Unlike SBAs, FCLs served as precautionary or prophylactic lines of credit: the IMF effectively pledged to help out but did not immediately disburse anywas remarkable By the summer of 2009, the IMF had authorized over 50 billion in SBAs and 78 billion in FCLs Many of these lifelines overshadowed the rescue packages put together a decade earlier In 1997, for example, South Korea received a loan of under 10 billion to tide it through the crisis that was then sweeping Asia By contrast, Ukraine, a country with an economy a fraction of the size of South Korea's, received a whopping 164 billion in 2008

The IMF was not the only lender of last resort In addition to its myriad domestic interventions, the Federal Reserve played this i ”swap lines” Under these agreements, the Fed ”swaps” dollars for some other central bank's currency It thereby enables the central banks to lend out dollars to anyone needing them in their home countries For example, in April 2009, Mexico activated a 30 billion swap line with the Fed This infusion of money injected liquidity into the market for dollars and helped anyone ed dollars to pay off or roll over his debt

These actions alone were ree and unprecedented features of the recent crisis, even the most stable, advanced economies faced liquidity crises co markets Many financial institutions in Europe had borrowed enormous quantities of dollars in short-term loans to underwrite various speculations When the interbank market froze up at the peak of the crisis, they were unable to roll over their dollar-denominated debts Everyone needed dollars, and as a consequence, the value of the dollar went through the roof This fact was terribly ironic: the country that was the ground zero of the financial crisis-the United States-saw its currency appreciate sharply in 2008

Bernanke's solution was yet another bit of lender-of-last-resort legerdemain The Federal Reserve can't lend directly to financial institutions outside the United States, but it can lend dollars to foreign central banks, who can in turn lend them to the financial institutions that need theets an equivalent sum of whatever currency is the stock in trade of the central bank receiving the dollars In this way, vast quantities of dollars traveled from the Federal Reserve to the European Central Bank, the Swiss National Bank, and the Bank of England, as well as the central banks of Sweden, Denmark, and Norway In return, the Fed took custody of an equivalent amount of euros, pounds, francs, and other currencies By late 2008 these swap lines totaled half a trillion dollars, and they started to decline only in the spring of 2009

The crisis subsided because of these andliquidity and stability back to thethewas one thing; getting banks to stop the larger drift toward deflation and depression was quite another

Nuclear Options

One of the more reht to bear on the crisis was ”quantitative easing,” though Ben Bernanke advocates calling it ”credit easing”; econoues that it should be called ”qualitative easing” Whatever its nay had been tested in japan in the 1990s The basic idea is to have the central bank intervene in -term debt in the same way that it does in o down the path of credit easing? The ic Thanks to cuts in the overnight Federal funds rate, banks had access to plenty of cash; and thanks to the host of new liquidity facilities, financial institutions of all stripes had access to cash as well, eventually driving down the cost of short-ter, as esse, banks continued to refuse to er-term loans to the many firms and businesses that needed credit to stay alive Banks were getting no-interest loans froh Financial institutions continued to hoard cash in anticipation of future losses, or they sank it into the safest investations of Fannie Mae and Freddie Mac

Banks' propensity to park -terzero, then plowing it into a ten-year or thirty-year Treasury bond paying 3 to 4 percent, they could make a reliable profit and steer clear of all the risky borroere cla to ease the credit crunch, it made eminent sense fro quantitative easing, the Federal Reserve would attack this problem on multiple fronts It would wade into the financial systeovernment debt: ten-year and thirty-year Treasury bonds That would immediately inject massive amounts of liquidity into themoney out of thin air As it purchased hundreds of billions of dollars' worth of bonds, cash would flow to the banks that sold them Now the banks would have even more cash, and presumably, they would be tened to have the additional positive consequence of reducing the attractiveness of those bonds as a future investment Why? Because bond prices and bond yields oes down When the govern them up, their price went up, and their yield went down That meant they became less attractive as a place for banks to park money In theory, banks would therefore look for other places to sink theirloans to those starving for credit

This policy, announced in March 2009, went hand in hand with massive purchases of other assets On the same day the Fed announced that it would purchase upwards of 300 billion in long-term Treasury bonds, it also announced that it would buy a trillion dollars' worth of ency debt As was the case with the proposed purchase of government bonds, the Federal Reserve had already made forays into these markets the previous fall Still, the scale and scope of these interventions-particularly in the MBSSo too was the announcement that the Fed would commit a trillion dollars to the Term asset-Backed Securities Loan Facility (TALF), to support with Fed loans the private securitization of credit card debt and auto loans

By broadening the range of assets it held, the Fed sought to prop up -teram was a relatively modest atte into the housing e-backed securities effectively gave Fannie Mae and Freddie Mac breathing rooes That strategy went hand in hand with the Fed's caovern-term interest rates tend to move in tandem with one another, this intervention would have the effect of lowering efor corporations

The Federal Reserve was not alone in its use of quantitative easing In Britain, the Bank of England was caught in a liquidity trap as well It had cut its benchmark rates close to zero, the lowest since it was founded in 1694, and it had created liquidity facilities similar to those devised in the United States But these moves failed to halt the prospect of debt deflation, and so in March 2009, in a bit of quantitative easing of its own, the Bank of England pledged to buy soovernment debt and corporate bonds The European Central Bank followed suit two60 billion to purchase ”covered bonds,” a fore debt

All these interventions constituted a dramatic shi+ft in the role of central banks In previous crises, central banks restricted their efforts to acting as lenders of last resort This time, however, in a series of incremental steps, central banks around the world adopted a new role: as investor of last resort They began by creating liquidity facilities that enabled financial institutions to swap toxic assets for supersafe government debt; they thereby effectively created an artificial market for unwanted assets At the saht loans, they accepted a re from corporate bonds to commercial real estate loans to coe of assets

The policy of quantitative easing, adopted by the Fed and other central banks, ht purchases of long-term debt in the open market As a consequence, the balance sheets of central banks underwent a profound transformation In 2007, for example, the Federal Reserve held approxi alovernment By the summer of 2009, the Fed's balance sheet had ballooned to approxithe crisis Some of these assets, such as the debt of Fannie Mae and Freddie Mac, were somewhat safe Others were less safe, particularly those derived froes, credit card debt, and auto loans

Most dodgy of all were the collateralized debt obligations and other potentially toxic assets acquired during the bailout of Bear Stearns and AIG These assets, Fed staffers reported in February 2009, represented ”some of the most esoteric components of the Federal Reserve's balance sheet” It was a serious understate, the Fed ”owns” these assets via its control of three limited-liability corporations known as Maiden Lane I, II, and III Each is privately adhly unusual arrangement has attracted considerable criticism-and skepticism It is also without precedent in the history of the Federal Reserve

Taken together, all these actions constituted a massive and unprecedented intervention in the financial syste conventional and unconventional monetary policy Over the course of the crisis, Bernanke (and to a lesser extent, other central bankers) sought to counter the effects of the financial crisis with three kinds of tools Most traditional was the provision of liquidity (lender-of-last-resort support) to a host of financial institutions, including banks, broker dealers, and even foreign central banks Less conventional was the creation of the special facilities that purchased (or financed the purchase of) specific kinds of short-teran to play the role of investor of last resort, which culra-terovern to contemplate, they were not as crazy as so the crisis For example, the Federal Reserve could have intervened directly in the stockup unwanted equities This tactic had been deployed during the Asian financial crisis of 1998, whenpurchased 5 percent of the shares being traded on the local stock exchange The ed to forestall a foreign exchange crisis by frustrating the attee funds to pull off a ”double play,” shorting both the currency and the stock overnment went on to make a tidy profit from its investment Likewise, the Bank of japan adopted a sih its intervention paled in co's and aimed merely to prop up the prices of certain bank stocks and, by extension, the banks themselves In 2009, it repeated these o down this road, and with good reason: it would have raised the understandable concern that the governest econoile credibility That same concern explains why the Fed set certain lirade assets as collateral for rade commercial paper when it waded into that particular o to stop the crisis

Nor did the Fed ever deploy several other extreht have used quantitative easing on a far e markets to weaken the value of the dollar, or even ey half-seriously proposed by Milton Friedovernment print money and scatter it on the population from helicopters Friedman never intended that policy makers actually distribute money like manna fro this: giving people tax cuts financed entirely by printing money, for example Bernanke e the crisis

Nevertheless, Bernanke and other central bankers did ehly unconventional measures in their efforts to put a stop to the crisis Unfortunately, a radical remedy administered in a crisis is bound to have unintended consequences For starters, the Fed has sent a clear e to the financialto prevent a financial crisis fro, but it creates rand scale The next time a crisis hits, banks and other financial fir that the Fed will rescue theain In fact, now that there's a precedent for setting up special liquidity facilities and extending lender-of-last-resort support to broad swaths of the global financial system, firhtest sign of trouble down the line