Minneapolis vs. Boston


In an October 2008 paper, V.V. Chari, Lawrence Christiano, and Patrick J. Kehoe (Fed Minneapolis, CCK) found no evidence of a crunch affecting interbank credit or borrowing by Main Street.  They argue that Main Street’s cost of borrowing is not as high as a quick look at spreads would suggest; that we should look at the levels instead.

In a November 2008 paper, Ethan Cohen-Cole, Burcu Duygan-Bump, Jose Fillat, and Judit Montoriol-Garriga (Fed Boston, CDFM) replied in detail to the arguments in the CCK paper and concluded that Main Street is indeed being hit by a credit crunch.  I am just starting to read the latter, but I didn’t find the CCK view convincing to begin with.  I’ll say why below.

My sixth sense tells me that the political implications of what CCK are arguing are relevant.  What they are really suggesting with their paper is that large public efforts to get the economy moving are not called for, especially those directed to support employment.  It’s the old let-the-markets-sort-things-out shibboleth.

From my standpoint, the main issue is the net (dynamic) distributional effect of the measures taken and to be taken (by the new administration) with the alleged aim of shoring up the financial and non-financial sectors of the economy.   Among the different possible ways in which the financial sector can be rescued, I believe that, on equity as well as on efficiency grounds, it can be argued that the best approach is the direct relief to working- and middle-class borrowers via methods that put the public interest first at the expense of the captains of finance that drove us into the ditch.

I’ll just say, to be more specific, that I favor the outright nationalization of, at least, the weakest banks, followed by the re-negotiation and direct extension of new loans to lower income individuals and small businesses by the nationalized banks.  With Fannie and Freedie re-nationalized, the mortgage market can be fixed and revived provided the political will is there.

Following Michael Moore, I also favor a similar type of nationalization of troubled industries, like car making, and the realignment of priorities  of those companies to serve the public interest, particularly in the areas of environmental sustainability and workers’ interests.

Having said that about the politics of the issue, I now return to the empirical debate mentioned above.

In the CCK paper, I find one argument utterly unconvincing, namely that spreads (the difference between the interest rates at which banks, business, or people borrow and the baseline interest rates, those of assets deemed relatively risk-free by the markets, like the federal funds rate or LIBOR) are not informative of the existence of a credit crunch.

It seems to me that  the exact opposite is true. I expect all rate levels to be dragged down to some extent by the monetary policy reactions to the crisis: lower federal funds rate and discount (the latter being the rate at which U.S. banks can borrow from the Fed). The issue is how the risk, term, liquidity, and information structures of the interest rate react to monetary policy moves.  And, at that, the spreads tell the story.  And spreads for the credit instruments available on Main Street have gone through the roof.  The flight to quality (i.e. the flight to Treasuries) is the credit crunch!

A credit crunch doesn’t mean that liquid wealth (money) won’t find any parking spot at all.  It simply means that all regular parking spots are suddenly deemed unbearable by lenders and that the hurdle rates at those spots vis-a-vis the seemingly riskless rate increase accordingly.  Parked in Treasuries, wealth will earn the baseline interest as small as it may be now.   So, it’ll be like cash (not entirely, because it’s not fully liquid, but almost), except that it will earn some token interest.

On the other hand, loaning wealth to yours truly would be an act of unbelievable foolishness.  Evidence of the credit crunch is not that the overall rate at which I’d be borrowing now is relatively low (assuming that the market where I can borrow exists, a rather heroic assumption nowadays), but the difference between what I’d have to pay in interest and what the federal government does pay in interest.

In any case, if the tons of base money (the additional reserves the Fed loans to banks via discount window or that end up in the banks whenever the Fed buys Treasuries in the open market) that the Fed has been injecting into the banking system as of late had already translated into streams of credit to average Joes like me, then we’d be observing them in the data on deposits or measures of the money stock (M1 or M2).  Here, I only see a minuscule jump in deposits, M1 and M2 in September and October.



On the other hand,  take a look at what happened to bank reserves:


In words, in September and October 2008, bank reserves went straight up.  More specifically, they more than doubled and more than tripled, respectively.  On the other hand, total deposits and M measures in the same periods only experienced a tiny increase.  Up to the latest data point available, reserves have been building up much faster than total deposits or Ms have gone up.   That does it for me.

I understand that businesses have other ways to raise cash than issuing commercial paper or knocking on a banks’ door.  But these aggregate data show clearly, to my lights, that banks have not been lending at anything near the pace at which they have expanded their reserves.  Have other forms of cash raising picked up the slack left by debt?  The state of the stock markets in the last few months doesn’t suggest that.  So, chances are, Main Street businesses are under strife while banks have frozen lots of new credit lines, and recalled old ones, as fast as they have been able to, and now sit on a bunch of idle base money.

How can this be?  Don’t banks lose the “risk-free” federal funds rate by holding reserves beyond what they are required to hold, since reserves are just electronic credits recorded on the Fed banks?  Well, a zero interest rate still beats the negative returns that banks fear if they were to loosen their purse.

To translate into new deposits (money in the economy), the base money injected by the Fed needs to be loaned, thus expanding total deposits and the Ms via the multiplier mechanism. It didn’t happen. It’s not happening.  The money multiplier has dropped.  And since credit is the lifeblood of the “real” economy nowadays, this situation must be having “real” effects as documented by the press on real time.

Conclusion: There was, back in the fall of 2008, and — although it’s eased a bit since the fall — there continues to be a credit crunch.


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