Economics One

I’m always trying to find good ways to teach beginning economics students about monetary policy. For years I compared it to flying a fighter jet where you have to anticipate the actions of the other pilots, and if you get it wrong you crash and burn in a great depression or a great inflation. I liked to show the scene from the movie Top Gun where, in a classroom scene after a flight, instructor Kelly McGillis (Charlie) chastises fighter pilot Tom Cruise (Maverick) for a near crash and burn because of his risky behavior. I stopped showing that scene because the next scene is quite a bit more intimate, not really appropriate for an introductory economics class, and if you do not stop the DVD just in time the students get completely distracted from the subject of monetary policy. Once while I was lecturing at West Point the DVD didn’t stop and the movie rolled on past the classroom scene to the next scene to a roar of laughter from hundreds of Army cadets in the lecture hall watching the big screen behind me.

So I was pleased that Philadelphia Fed President Charles Plosser, in a speech last Tuesday in Rochester, came up with an even better analogy: hockey. He tells the story of how “Hockey great Wayne Gretzky was once asked about his success on the ice. He responded by saying, ‘I skate to where the puck is going to be, not to where it has been.’ He didn’t chase the puck. Instead, Gretzky wanted his hockey stick to be where the puck would be going next. He scored many goals with that strategy, and I believe monetary policymakers can better achieve their goals, too, if they follow the Gretzky strategy.”

A year ago I wrote Getting Off Track one of the first books on the financial crisis. I argued, based on data available at the time, that government actions caused, prolonged and worsened the crisis. After a year of debate, this early assessment is holding up well. Indeed it is being reinforced by new evidence.

Consider, for example, the government actions associated with the takeover of Fannie and Freddie in 2008. Of course, Fannie and Freddie were a big part of the reason for the explosion in mortgage debt including risky subprime mortgages, but I want to focus now on the impact of government actions relating to these institutions during the period leading up to the panic in 2008.

A good way to assess this impact on risks is to look at the spread between interest rates on subordinated debt and senior debt at Fannie or Freddie. When investor concerns about risks at the institutions increase, the interest rate spread between subordinated and senior debt rises. So what caused the movements in these spreads in 2008?

The three charts show the spread between the interest rate on Fannie Mae subordinated debt and Fannie Mae senior debt over three different periods. The yellow line with the green shading in the lower panel of each chart is the interest rate spread of sub debt over senior debt. In the top panel (harder to read) the orange line is the rate on subordinated debt and the white line is the rate on senior debt. The first chart focuses on the period from June 2004 to February 2008. The spread was fairly stable fluctuating in a rather narrow range around 20 basis points over this period.

The second chart covers the period from March 2008 through June 2008. Observe that the spread jumped to around 80 basis points after the Bear Stearns intervention. Unlike many other risk spreads it did not come back down after Bear Stearns.

The third chart focuses on the period from July 2008 through September 2008. There are two big upward jumps during this period. The first was on July 11. What was the big event that day? It was a leaked news story about a possible government action, a takeover of the two institutions. In particular the New York Times ran a front page story with the headline “U.S. Weighs Takeover of Two Mortgage Giants“

The other big jump up was on Monday August 18th. Again the reason was a news story about another government action. The previous Friday the Washington Post reported that the Treasury hired Morgan Stanley to assess the vulnerability of Fannie and Freddie, a strong indicator that the government was looking for outside justification to take over the institutions. It is important to note also that certain other events, which could have moved the spread up, did not move it up. When Freddie and Fannie released their second quarter earnings in August, there was little to no reaction in the spread.

So the major movements are clearly linked to government policy decisions and news stories about them. This timing does not prove that the government actions were responsible, but at the least it raises questions about why rumors of possible government actions were leaked to the news media.

The questions are important because some government officials have indicated that these jumps in the subortinated debt spread were part of the evidence to justify the take over the institutions at this time. But the evidence shows that the government itself was increasing the spreads.

This week was monetary policy week in Economics 1 at Stanford. It was also monetary policy week in Washington: the House Financial Services Committee surprisingly voted 43-26 for Ron Paul’s controversial bill to audit the Fed; the TARP inspector general found that the Fed’s AIG bailout was unnecessarily generous to creditors; and people continued to debate how long the Fed could hold the interest rate at zero without threatening the dollar.

To discuss the interest rate decision in my lectures, I made use of the Taylor Rule, a guideline for the Fed and other central banks to use in setting interest rates. To start I showed the students how to derive the rule from economic theory. Actually, the students derived the rule on their own–with the help of a little Socratic questioning–even choosing the signs of the coefficients and the target inflation rate (2 percent) correctly. I was happy to welcome the NewsHour’s Paul Solman and his camera crew who came to film part of this lecture. Here’s my paper on what others would later call the Taylor Rule

The Taylor Rule says the interest rate should equal one-and-a-half times the inflation rate plus one-half times the GDP gap plus 1. Rounding off to the nearest percent, inflation is running around 2 percent and the GDP gap around -8 percent, so the rule says the interest rate should be near 0, (1.5 x 2 + .5 x (-8) + 1 = 0) which is about where the Fed is now. As the economy recovers and real GDP increases, the Fed should raise rates. If inflation picks up too, it will have to do so more rapidly.

Several columnists and bloggers also used the Taylor Rule this week, including Gene Epstein of Barron’s in “Better Baking for the Bank: The Right Recipe for Rates.” The recommended interest rate setting can vary a bit because of different estimates of the inflation rate and the GDP gap (the percentage difference between real GDP and potential GDP). Epstein also finds the interest rate to be close to zero, but slightly higher at 0.6 percent.

But sometimes you read really wild things about what the interest rate should be. Paul Krugman’s Monday piece about the Taylor Rule is an example. He says he likes to use an estimate of the Taylor Rule. But the estimate is much different from the Taylor Rule, so he gets a much different interest rate setting of -7 percent! This implies that we are unlikely to see a positive interest rate for many years, which would be dangerous for the stability of dollar let alone the stability of the U.S. and world economy. I explained the problems with using such estimates in a Bloomberg oped several months ago. Estimates can perpetuate past mistkes. In the current environment they could lead to a repeat of the same mistakes that led to this deep recession. Michael McKee, in another Bloomberg opinion piece , suggested a line for me from Woody Allen’s Annie Hall, where Marshall McLuhan makes an appearance and tells an academic pontificating about McLuhan: “you know nothing of my work!”

Stories this week in the Wall Street Journal, the New York Times and the Washington Post focus on how Senator Chris Dodd’s new financial reform bill threatens the independence of the Federal Reserve. And Larry Kudlow took it up on his CNBC program. Loss of Federal Reserve independence is a serious problem, especially at this time of rapidly increasing Federal debt and a greatly expanded Federal Reserve balance sheet. But an important issue not touched on in these stories is that Fed actions during the crisis have themselves raised questions about its independence. After reviewing these actions in the new book The Road Ahead for the Fed, former Secretary of Treasury George Shultz writes:

“Observing this process, the question comes forcefully at you: Has the Accord gone down the drain? And remember how difficult it was for the Fed to disentangle itself from the Treasury in the post-World War II period.”

Secretary Shultz is referring to the 1951 Accord where the Federal Reserve regained its independence following the World War II peg of Treasury borrowing rates. So even without the Dodd bill the Fed has a lot of work to do to disentangle itself. For a broader summary see Tom Simpson’s recent review of this book which came out of a conference hosted at the Hoover Institution at Stanford Univeristy by John Ciorciari and me last March.