Jeffrey Rogers Hummel explains the Bernanke view of financial intermediation but raises a critical question about its policy implications.
what distinguishes banks from other financial intermediaries is not merely that deposits are used as money but also that banks, in Bernanke’s words, “specialize in making loans to small, idiosyncratic borrowers whose liabilities are too few in number to be publicly traded.” Because bank loans are especially unmarketable, a bank collapse interrupts the flow of funds more than the insolvency of other financial institutions. ..
Offsetting negative shocks to money or velocity (i.e., stabilizing M times V in the equation of exchange) with untargeted, general injections of liquidity, as consistent with Friedman’s analysis, has the added advantage of helping to clarify which banks are just illiquid and which are also insolvent, whereas direct bailouts, as implied by Bernanke’s analysis, obscures the distinction.
My main takeaway from this paper is that from an aggregate demand perspective you should never need a targeted bailout. This is obvious if you think about it. Every aggregate demand shock is either a money supply shock or a velocity shock. Any negative velocity shock can be offset by a money supply increase. Thus, if an institutional failure is going to cause a negative velocity shock, you can absorb the failure while increasing the money supply.
I think that the case for targeted bailouts has to rest on a supply-side story. That is, you think that losing Citicorp will affect the supply side of the economy in some horrible way.
I presume that Scott Sumner would endorse Hummel’s view. I am not sure how to evaluate targeted bailouts from a PSST perspective. I oppose them from a karma perspective.
READER COMMENTS
Richard Hammer
Oct 17 2010 at 10:27am
I suppose that an argument in favor of general money supply increase is that it avoids one perverse effect of targeted bailouts, that targeted bailouts give positive feedback to institutions which have made bad decisions. But am I correct in supposing that any general money supply increase must necessarily have some of the same perverse effect: If the injection is accomplished through purchase of bonds then positive feedback is given (on margin) to the specific institutions whose bonds are purchased.(?)
AJ
Oct 17 2010 at 11:07am
There is a phenomena in Washington that when when you get there, your perspective on economics and markets is that the entities like Citicorp and Goldman Sachs are the economy, not their assets, their business activities, or their employees/executives. It’s the “As goes GM, so goes the economy” perspective of the 1950’s-60’s.” And they have representatives and friends (e.g. Larry Summers) who remind you of this all the time in D.C. You eventually fall under the illusion that they are the tools by which “you” can get things done (the facist type economic model). It leads to an economy of institutions, not one of markets and new business development with weakening property rights for the entrepreneurial/middle class -> ask Mexico how that worked out for them.
Targeted bail-outs are insidious in so many ways. It’s just one manifestation (like teachers unions and so many other deals) of an economy where getting yours from the Washington trough becomes the most important determinant of economic well-being is destined for disaster — i.e. look at France and Greece.
AJ
Lee Kelly
Oct 17 2010 at 1:02pm
Hummel notes equivalence between an decrease in the money supply and increase in money demand — it just depends on how narrowly or broadly on defines “money”. Wherever one draws the line between money and non-money, there will usually be some money-like asset which is not included. A change in the supply or demand for such an asset is likely to have consequences for the supply and demand for money, and so the stance of monetary policy can change without any intention of the Fed.
With regard to the current recession, shadow banking was creating money-like assets that were not included in conventional measures of the money supply. It was a run on the shadow banks which had issued these types of assets which prompted the financial crisis. Although the official money supply did not change, the supply of these money-like assets decreased. The demand for these money-like assets then spilled over into demand for more conventional money and the rest is history.
Depending on how broadly one defines “money”, these events can be equivalently described as a decrease in the money supply or increase in money demand.
I am going to finish reading Hummel’s paper now.
Simon K
Oct 17 2010 at 5:13pm
Bailouts would be unnecessary if the Fed created enough liquidity to prevent aggregate demand from falling as the banks contracted. However:
1. How does the Fed know how much liquidity to create? If there were a price level target or NGDP target they’d know, but in 2008 there wasn’t even an official inflation target.
2. If the Fed fails to create enough liquidity, banks that are merely illiquid will fail along with the insolvent. That potentially causes aggregate demand to fall still further. Targeted injections of liquidity overcome this problem.
So there’s still an argument for pushing liquidity into banks as part of the strategy for stabilizing the financial system in a collapse. That said, obviously there is a lot to criticize in the specific mechanics of TARP.
Silas Barta
Oct 18 2010 at 2:37pm
Yes, I *guess* you can say that if people ignored their greater poverty because of the recent extreme misallocation of resources and decided to extravagantly spend anyway, employing clumsy businesses and banks to do so, despite not really wanting or needing the junk they were turning out, then it would save us from having to bail out the clumsy banks that turned out that junk.
But I’m not sure this proves what people think it does, once you put it in those exact terms…
Scott Sumner
Oct 18 2010 at 8:03pm
Your presumption is correct. There is a more difficult question of whether bailouts can be defended on the grounds that the Fed was not going to offset the effect of bank failures. I don’t have strong views on that–but I think that a more severe banking panic would have almost forced the Fed to move more aggressively. So I lean toward the view that bailouts were a mistake.
Jeff
Oct 19 2010 at 12:01am
OK now, let’s have a quick show of hands: How many of us believe that Citibank and Goldman Sachs
The fact that this quote was from Bernanke himself only increases the disgust.
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