preview.tinyurl.com/25xnwp -> krugman.blogs.nytimes.com/2008/03/08/whats-ben-doing-very-wonkish/
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Back to front page March 8, 2008, 9:51 am What's Ben doing? Panic in August, then partial recovery thanks to lots of money thrown at the system by the Fed. Renewed panic late fall, then partial recovery thanks to even more money thrown in, especially the Temporary Auction Facility. And panic has set in yet again: INSERT DESCRIPTION Panic returns So the Fed is throwing another wave of money in, via the TAF and also additional loans to banks. All this lending is backed by collateral: the banks are setting aside various stuff, but probably mainly mortgage-backed securities.
Steve Waldman -- that the old framework I learned back in grad school for thinking about sterilized intervention in the foreign exchange market applies pretty well. The basic idea (which goes back to James Tobin) involves thinking of equilibrium in the markets for assets, while putting the question of how all this interacts with the markets for goods and labor temporarily off to one side. So, in this case, imagine that there are three assets: money (really monetary base), Treasury bills, and private securities (think mortgage-backed). There are three separate market-clearing conditions, which can be represented by the lines SS, TT, and MM below; the interest rates on T-bills and private securities have to adjust so as to clear all three. But if any two markets clear, the third one does too -- Walras's Law, for the nerds. INSERT DESCRIPTION Tobinesque equilibrium Normally, the Fed engages in open-market operations: it buys T-bills with freshly printed money. This shifts the market-clearing conditions for T-bills and money, but not securities. So it looks like this: INSERT DESCRIPTION Ordinary monetary policy But now the Fed faces a new problem: the private sector is fleeing from private securities that are seen as risky/illiquid, and seeking safe haven in T-bills. Hence rising interest rates on securities even as T-bill rates fall: INSERT DESCRIPTION Flight to safety And the Fed is afraid that this will lead to a vicious spiral of financial collapse. So it's responding by doing something different from normal monetary policy: by lending to banks with securities as collateral, it is arguably in effect buying securities other than T-bills.
Jim Hamilton says, the Fed is conducting monetary policy on the asset side of its balance sheet -- shifting from T-bills to less liquid, and arguably riskier assets. The effect, looks like this: INSERT DESCRIPTION The Bernanke intervention That is, it's the reverse of the flight to safety by private investors. OK, this is just like the way you analyze sterilized intervention in currencies. And the usual problem with such intervention applies: the financial markets are so huge that even big interventions tend to look like a drop in the bucket. If foreign exchange intervention works, it's usually because of the "slap in the face" effect: the markets are getting hysterical, and intervention gives them a chance to come to their senses. have tried slapping the market in the face -- and panic keeps coming back. So maybe the markets aren't hysterical -- maybe they're just facing reality. And in that case the markets don't need a slap in the face, they need more fundamental treatment -- and maybe triage.
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Why sterilization matters Brad DeLong, commenting on my last post, misses the point, I think: Foreign exchange markets are so large that even big exchange intervention efforts look like a drop in the bucket. But domestic financial markets are even larger-so that even big open-market operations not just look like but they are a drop in the bucket.
Panic in August, then partial recovery thanks to lots of money thrown at the system by the Fed. Renewed panic late fall, then partial recovery thanks to even more money thrown in, especially the Temporary Auction Facility.
It has begun OK: payrolls down 22,000 in January, 63,000 in February. Hard to see things improving any time soon, thanks to dramatically worsening conditions in the credit markets. So it's a very good guess that we will eventually be told that the second recession of the Bush administration began in December 2007 or January 2008.
Meanwhile, on a happier note Soothing news of market panic (well, I find it more soothing than politics, anyway): "Every day is like the 1987 stock market crash,'' said Thomas Tucci, head of US government bond trading at RBC Capital Markets in New York, the investment-banking arm of Canada's biggest lender.
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