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Thursday, February 19, 2009

Extraordinary events in financial markets

A colleague and I are working on an op-ed piece for a local paper on the economics of the financial crisis. here's where we are, so far.
In the last six months, the Federal Reserve has taken unprecedented steps to deal with a meltdown of the U.S. (and global) financial markets. Triggered by falling home prices, financial markets had to deal with collapsing values of mortgage-backed securities; this crisis almost immediately bled over into the entire collateralized debt obligations market. The balance sheets of banks, investment banking firms like Goldman, Sachs and Lehman Bros., and other financial firms saw their assets shrinking, while their liabilities remained. They were faced with at least temporary insolvency, and financial markets hit a wall of lack of liquidity—no one wanted to lend, especially not to other financial firms.

The Fed began by taking what can only be called a traditional response to a liquidity crisis—it tried to add to the liquidity of financial firms, so as to encourage them to resume lending, financing not only financial market activities, but also inventories and capital equipment purchases of firms across the breadth of the economic landscape. The Fed adds to liquidity by buying securities in the open market (these are called “Open Market Operations”), and when the Fed does this, the composition of the Fed’s balance sheet changes—it adds both to its assets (the securities it buys) and to its liabilities (the reserve accounts that banks maintain at the Federal Reserve banks).

And the Fed did a lot of this. Between the end of August, when the Fed held assets worth about $985 billion, and February 12, when the Fed’s assets totaled about $1,882 billion, it nearly doubled its asset holdings. What effect does this have? Almost directly and almost immediately, increases in the Fed’s asset holdings add to reserves held by commercial banks in the U.S.

Banks hold reserves for, essentially, three reasons. First, because the Fed requires then to hold reserves equal to (approximately) 10% of their checking account balances. Second, to be able to meet ordinary banking needs—to clear checks, to have cash available for customers who want it. And, third, to be prepared for extraordinary financial events. In the ordinary run of things, banks hold little or no reserves for the third reason. And they hold as little as possible for the other two reasons, simply because reserve holdings have historically been, for banks, idle balances on which they earn no income. To earn income, they need to use their reserves to make loans, or to buy other financial assets.

So in the ordinary course of business, banks would have responded to this influx of bank reserves by making new loans, or buying corporate or government bonds. This time, they did not. Bank reserves, which were $44 billion on August 1, 2008 soared to $861 billion on January 1, 2009—an increase of 1800%. (Between January 1, 1959 and August 1, 2008, bank reserves grew by only 133%, in total—over 49+ years.) Of the roughly $900 billion that the Fed added to its balance sheet, banks added more than 90% to their reserves—they reacted by hoarding reserves, not by making loans. Bank’s excess reserves—the amount of reserves they held in excess of those that the Fed requires them to hold—rose from $1.9 billion on August 1 to $798 billion on January 1.

In other words, banks used this extraordinary, unprecedented increase in bank reserves not to make loans, but to protect themselves against some extraordinary financial event. And, as a result, the nation’s money supply, although it grew quite rapidly between August 2007 and January 2009, did not grow at anything approaching the growth in the liquidity that the Fed was throwing at the financial system.

One measure of the money supply, M1 (consisting of currency in circulation plus checking account deposits), grew by about 13% during this period. A broader definition of money, M2 (everything in M1, plus essentially certificates of deposit and savings accounts), grew by only 7.6%.

Still, this is exceptional growth in the money supply over a five-month period. For M1, the only faster five-month growth occurred from July 2008 to December 2008, when it grew by 16%. For M2, this is the fastest five-month growth ever recorded. (Both these statements refer to the period beginning in January 1959, which is when the available data series begin.) In ordinary times, our strongest fear right now would be not a recession, not a cataclysm like the Great Depression, but out-of-control inflation.

And there is no inflation. Using the Consumer Price Index, we see a declining general level of prices for the past five months (through December 2008; the January 2009 CPI has yet to be released), with prices as of December 4% below their July level.

How can this be? Economists use a concept called the “velocity of money,” that measures, essentially, how quickly we “turn over,” or spend, the money available to us. If velocity gets larger, then people are spending money faster, and a given money supply will support more spending. If velocity slows down, then people are spending money more slowly, and a given quantity of money will support less spending.

And velocity has slowed down. Using M1 as our measure of money, velocity has slowed down by 10% in 2008, and we don’t have the data yet for the fourth quarter. Using M2, velocity has slowed by 7%. In short, the increases in the money supply have been essentially totally offset by slower spending. Just as banks are hoarding reserves, businesses and consumers are hoarding money.

With the financial system still in shock and awaiting the next crisis, and with consumers and businesses cutting back as fast as they can, what is to be done?


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