An Inquiry into the Nature and Effects of the Paper Credit of Great Britain

The Origins of Federal Deposit Insurance

Over the past three decades five striking features of aggregates in the unsecured credit market have been documented: (1) rising availability of credit along both the intensive and extensive margins, (2) rising debt accumulation, (3) rising bankruptcy rates and discharge in bankruptcy, (4) rising dispersion in interest rates across households, and (5) the emergence of a discount for borrowers with good credit ratings. We show that all five outcomes are quantitatively consistent with improvements in the ability of lenders to observe borrower characteristics. Part of our contribution is the development of an algorithm for computing equilibria with asymmetric information and individualized pricing. From a welfare perspective, our main finding is that more information is better ex ante, even though better information can rule out pooling outcomes that some groups might find beneficial ex-post.

/pdf/a-quantitative-theory-of-information-and-unsecured-credit-1654qdqncd.pdf

A Quantitative Theory of Information and Unsecured Credit, Working Paper 08-06R

https://link.springer.com/content/pdf/10.1057%2Feej.2009.42.pdf

The Monetary Policy of the Federal Reserve: A History

It has become commonplace in the current crisis to refer to the Federal Reserve as the economy's lender of last resort (LLR) Typical is the observation of Glenn Hubbard, Hal Scott, and John Thornton (2009) that "Over many decades and especially in this financial crisis, the Fed has used its balance sheet to be a classical lender of last resort" With all due respect to these authors and numerous others holding the same view, their statement is wrong, For while there exists such an entity as the classical lender of last resort--the traditional, standard LLR model, to be exact--the Fed has rarely adhered to it And in the current crisis, the Fed has deviated from the classical model in so many ways as to make a mockery of the notion that it is an LLR In short, the Fed may be many things, crisis manager included But it is not an LLR in the traditional sense of that term True, Fed spokesmen pay lip service to the classical prescription, all the while thinking that they can outperform it with additional intervention They believe that while the classical theory of LLR policy is valid as far as it goes, it doesn't go far enough to solve current financial and credit market problems To this end, the Fed has ambitiously extended the role of the LLR so far beyond what classical writers would have recognized and approved as to disqualify itself as an authentic classical LLR The question is whether this expansion has been necessary or correct Could it be that the Fed's recent deviations from the classical doctrine have been more harmful than helpful? Could it be that they are based upon fallacious or unproved conjectures and assumptions about how credit markets work that have led the Fed astray? Might the Fed contribute more to macroeconomic stability by abandoning its ambitious new initiatives and instead returning to the classical model? This article addresses these issues by describing, analyzing, and appraising both classical theory and the Fed's departures from it Architects of the Classical Theory Classical lender-of-last-resort theory is the notion that the LLR should protect the bank-created money stock from contraction (and expand it to offset falls in velocity) in the lace of bank runs and panics, a duty it performs through pre-announced lending, at a penalty interest rate so as to minimize moral hazard, to creditworthy borrowers offering good collateral This theory was essentially the product of two Englishmen The first was Henry Thornton (1760-1815), banker, Member of Parliament, evangelical reformer, and all-time great monetary theorist, who developed his doctrine at the beginning of the 19th century when the British government had temporarily suspended gold convertibility of the Bank of England's currency during the Napoleonic Wars Freedom from the obligation to make cash payments gave the Bank some discretionary control over the money stock and room to maneuver as an LLR When the Bank proved reluctant to use these powers, Thornton sought to convince it to do otherwise The theory's second architect was Walter Bagehot (1826-77), economic historian, financial writer, and longtime editor of The Economist, who wrote in the 1850s, '60s, and '70s when the Bank of England had resumed convertibility and as an LLR was forced to operate within the constraints of the gold standard Bagehot's genius was to show precisely how and why it should do so Although others contributed to the classical theory, the Thornton-Bagehot (T-B) version was the one bequeathed to central bankers Even though no gold standard now functions as a basic monetary institution, the T-B model is today the benchmark policy for the Federal Reserve or any other central bank Henry Thornton's Contribution The term "lender of last resort" originates with Sir Francis Baring, who in his Observations on the Establishment of the Bank of England (1797) referred to the Bank as "the dernier resort" from which all banks could obtain liquidity in times of crisis …

Lender of Last Resort: What It Is, Whence It Came, and Why the Fed Isn't It

The financial crisis of 2007 and 2008 was a watershed event for the Federal Reserve and other central banks. The extraordinary actions they took have been described, alternatively, as a natural extension of monetary policy to extreme circumstances or as a problematic exercise in credit allocation. I have expressed my view elsewhere that much of the Fed’s response to the crisis falls in the latter category rather than the former (Lacker 2010). Rather than reargue that case, I want to take this opportunity to reflect on some of the institutional reasons behind the prevailing propensity of many modern central banks to intervene in credit markets.

Understanding the Interventionist Impulse of the Modern Central Bank

The financial crisis of 2007 and 2008 was a watershed event for the Federal Reserve and other central banks The extraordinary actions they took have been described, alternatively, as a natural extension of monetary policy to extreme circumstances or as a problematic exercise in credit allocation I have expressed my view elsewhere that much of the Fed’s response to the crisis falls in the latter category rather than the former (Lacker 2010) Rather than reargue that case, I want to take this opportunity to reflect on some of the institutional reasons behind the prevailing propensity of many modern central banks to intervene in credit markets

https://papers.ssrn.com/sol3/Delivery.cfm?abstractid=2241025

Thank you very much for inviting me to join you this evening. It is a great honor to be a part of this lecture series commemorating H. Parker Willis, who, in addition to helping create the Federal Reserve System, also served as the first secretary to the Federal Reserve Board and later as the first research director. As most of you probably know, early in his career, Dr. Willis was a professor of economics here at Washington & Lee. What you might not know is that, according to some accounts, the president of the university at the time thought Dr. Willis spent too much time in Washington, D.C., consulting with Congress and forced his resignation. The students protested—evidence of the abiding wisdom of your student body. Tonight, I would like to discuss Dr. Willis’s wisdom and his original vision for the Federal Reserve. I will also talk about how the Fed’s role has evolved and the ways in which the founders’ intentions continue to be relevant to policy discussions today. The Fed was founded to

From Real Bills to Too Big to Fail: H. Parker Willis and the Fed's First Century

The current financial crisis undoubtedly will inspire a great deal of research in the years ahead, and it may take some time before anything like a professional consensus emerges on causes and consequences After all, it took several decades to document the causes of the Great Depression, and recent research continues to provide new perspectives (1) Nonetheless, I believe the central questions that are likely to occupy researchers are plainly in view, and some tentative lessons have emerged already And in any event, legislators are not likely to await the fruits of future scholarship I will divide my discussion into two parts, reflecting two distinct time periods--the boom in housing and housing finance and the subsequent turmoil in financial markets--and then conclude with some thoughts about what lies ahead The Boom in Housing Finance The expansion in mortgage lending that preceded the recent turmoil in financial markets is best viewed as a component of the long boom in housing activity that began in the mid-1990s and peaked in late 2005 and early 2006 Hard work will be required to estimate the quantitative contribution of various causal factors to the rise in subprime mortgage lending and the increase in subprime losses In the meantime, the list of plausible suspects is reasonably clear First, real per capita income grew more rapidly in the decade after 1995 than in the decade before Second, real interest rates were relatively low over this period, especially after the recession earlier this decade Low real interest rates in part reflected large capital inflows, but the Federal Open Market Committee kept the federal funds target rate low in 2003, and raised rates only gradually starting in mid-2004 Some economists have argued that tighter monetary policy during that period would have led to better outcomes by preventing core inflation from rising While I find this view plausible, I believe further research will be required to substantiate this hypothesis The third contributing factor was the technologically driven wave of innovation in retail credit delivery that allowed lenders to make finer distinctions between borrowers This lowered borrowing costs for many borrowers and expanded the availability of credit to borrowers formerly viewed as unworthy of credit (2) As in any industry undergoing significant innovation--credit cards in the 1990s are a good example--natural evolution can involve overshooting and retrenchment Fourth, the regulatory and supervisory regime surrounding US housing finance probably contributed to the boom in housing and housing finance Here, several factors deserve mention Supervisory agencies, like borrowers, lenders, and investors, assigned a low probability to the possibility of an adverse housing demand shift of the magnitude and geographic extent that we have seen Private sector incentives to foresee and protect against such shocks were to some extent dampened by the presence of the federal financial safety net, including the inferred prospect of support for Fannie Mae and Freddie Mac The safety net probably also played a role in banks' involvement in the securitization process Banks' use of off-balance sheet arrangements and provision of backup lines of credit created state-contingent exposures for the banking system that by design were most likely to be realized in generally bad states of the world, when the safety-net protection of the formal banking sector would be most valuable Official policies aimed at increasing home ownership also provided at least some positive inducement to risk-taking in housing finance In addition, the unscrupulous and fraudulent practices of some mortgage brokers outside of the banking sector may have contributed to the problem Although the housing boom will, as I said, inspire a great deal of research in the years ahead, some lessons have emerged already and have motivated corrective action, both by market participants and policymakers …

What Lessons Can We Learn from the Boom and Turmoil

Thank you for the opportunity to participate in this discussion on monetary policy and what it can and can't do. In thinking about this topic, it occurred to me that one side of the question--what it can't do--generates a very long list. So for today's discussion, I intend to focus on the positive and discuss the one thing that I think we should be pretty certain monetary policy can indeed do, and that is to determine the long-run path of the price level. Recent experience has caused some to question whether monetary policy's ability to achieve even this modest goal has diminished or been lost in the years since the Great Recession. I will argue that a central bank's ability to influence inflation and how it does so is essentially unchanged. I also believe that monetary policy's ability to affect inflation is essentially independent of its effects on real economic activity, which I view as limited and temporary. My view of what monetary policy can do is based on the (perhaps old-fashioned) idea that money creation is at the heart of price level determination. A Basic Framework I take as my starting point that monetary policy is uniquely capable of affecting the price level over the longer term. Indeed, in the benchmark classical (or neoclassical) economic model without some form of friction--in which money is neutral--the price level is all that monetary policy will affect. The price level, after all, is simply the rate of exchange between money and goods. So the quantity of money must be related to how much of the latter each unit can buy. How to match the quantity of money in a theoretical model to a particular empirical measure of money is not always straightforward. But the ability of monetary policy to affect the price level, or the rate of inflation, over time is a natural starting point and one that is embedded in the Federal Open Market Committee's statement concerning its long-term goals (Board of Governors 2012/2015). In contrast, monetary policy's ability to affect real economic activity--when monetary policy is being reasonably well-executed--can be quite limited and is almost always short lived (Friedman 1968). Real activity is driven predominantly by factors beyond the control of monetary policy--productivity and population growth, for example. In the standard models used in policy analysis, monetary policy's real effects generally derive from frictions that impede the rapid adjustment of the overall level of the price. Such frictions are, almost always, short-run phenomena that generate transitory deviations in real activity, and their empirical significance is a matter of ongoing research and debate. It is true that egregious monetary policy errors can seriously damage the economy--for instance, by adding extraneous volatility and reducing the informativeness of relative price signals. But in typical circumstances, monetary policy that successfully stabilizes inflation and inflation expectations will have only modest, temporary effects on real activity. The mechanism through which monetary policy has its ultimate effect on the price level is through the process of money creation--that is, the process by which central bank actions affect the distinct forms of money, such as bank deposits, that people use in transactions for goods and services. It is more common these days to think of monetary policy as setting an interest rate target, rather than a money supply, in part because money demand seems to fluctuate significantly (Goodfriend 1991). Nonetheless, prior to 2008, the Fed achieved its target for the federal funds rate--the price of overnight loan of reserves--by manipulating the supply of bank reserves. Reductions in the Fed's interest rate target necessitated increases in the supply of bank reserves. The resulting money creation--by the central bank and the private banking system--in turn drives price-level determination. If frictions in goods or financial markets impede price adjustment, then monetary policy may temporarily affect real economic activity along with the price level. …

Jeffrey M. Lacker

Papers

Understanding the Interventionist Impulse of the Modern Central Bank

Understanding the Interventionist Impulse of the Modern Central Bank

From Real Bills to Too Big to Fail: H. Parker Willis and the Fed's First Century

What Lessons Can We Learn from the Boom and Turmoil

What Monetary Policy Can Do