Fizzle at Jackson Hole

One silence, and one silo

So no QE3, at least not on the Fed’s own balance sheet, and not yet, but that was no surprise since expectations had been managed down by the time Bernanke gave his speech.

What Bernanke did not say, maybe could not say, is that the major worry confronting central bankers today is Europe, and contagion from whatever happens there. He didn’t say it, because he remembers all too well being dragged over the coals in Congress for the $600 billion credit line he opened for foreign central banks after Lehman, when the Fed stepped in as international lender of last resort at a time when global dollar funding markets were frozen.

But the worry is there, even if Bernanke can’t talk about it. We can talk about it here.

Gillian Tett draws attention to the reliance of Eurozone banks on short-term funding markets, and to the recent withdrawal of US money funds from those markets. Unlike 2008, the problem is not a dollar shortage, not now and not in the future either, given the Fed’s quiet reopening of the liquidity swap facility. (Someone tested that facility with $500 million just to make sure, so now everyone knows that the Fed’s backstop is for real.)

The problem is funding, and it arises from fears that the Eurozone banks may well be insolvent. In such a circumstance, private funding sources inevitably back away from unsecured lending, and from term lending, and begin to pay closer attention to the collateral being offered for secured lending.

That is one way to understand the sterilized ECB bond-buying program. The ECB is taking bad collateral out of the market and replacing it with good collateral. So far it has worked, but for how much longer?

Right now, the ECB is like the Fed before Lehman, selling off its Treasuries and lending out the proceeds. And already there is big-time pushback, objections that even this much intervention is too much intervention. But suppose it is not enough, and the ECB needs to do even more. Will the ECB be able, as the Fed was after Lehman, to double its balance sheet more or less overnight, if it is called upon to do so?

In this respect, recall how much the Fed’s efforts post-Lehman relied on coordination with the Treasury. When the money funds demanded Treasuries, the Treasury issued more and deposited the proceeds at the Fed, which used the money to meet the funding needs of the banks shut out by the money funds. But there is no European Treasury, and no one really knows how the EFSF is going to work. The ECB does not have the degrees of freedom that the Fed enjoyed after Lehman.

It’s a worry.

If the ECB cannot contain the problem, it will spill over into world funding markets, including dollar funding markets, and then it will be the Fed’s problem, just like last time. That’s the scenario that the Fed is likely, notwithstanding its understandable silence, even now to be scrambling to avoid.

That’s the silence. Now for the silo.

Not only is there no talk about the most important challenge of the moment, but also there is no language to talk about it. The line of analysis that I just explored would be impossible if I had constrained myself to talk the language of the Dynamic Stochastic General Equilibrium model, the lingua franca of academic macroeconomics before the crisis, and today as well.

I am not one who thinks the DSGE is a complete blight, but I must say that I find myself nodding in agreement with the recent words of John Kay, imagining a possible economics different from the present economics:

“Even if sharp predictions of individual economic outcomes are rarely possible, it should be possible to describe the general character of economic events, the ways in which these events are likely to develop, the broad nature of policy options and their consequences. It should be possible to call on a broad consensus on the interpretation of empirical data to support such analysis. This is very far from being the case.”

In this regard, I take hope from the recent op-ed of my colleague Mike Woodford. His headline is pure DSGE: “Mr Bernanke can and should use his speech today to explain how his policy intentions are conditional upon future developments.” (The idea is to signal a firm Fed policy rule, a conditional ZIRP, that private agents can feed into their intertemporal optimization routines.) But the prose that surrounds the headline quite nicely describes the “general character” of previous QE1 and QE2, pointing out the crucial difference between them—the first involved the frozen and illiquid mortgage-backed securities market, while the second involved the highly liquid Treasury market.

Even more, Woodford goes on to argue, the problem with seeing the world through the lens of the simple quantity theory of money, MV=PY, is that it blinds you to exactly that crucial difference between QE1 and QE2, and hence to the reason that QE3 is likely not to be very successful.

Yes indeed. Models do that.

Sometimes MV=PY helps us, and sometimes it doesn’t, and the same goes for DSGE. Not everything that we need to be talking about today can easily be shoehorned into a model that was never intended to engage the kind of problems we are experiencing today.

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