A Black Swan

John Taylor and John Williams have recently written an interesting paper on the “black swan” of the money market and the effectiveness of the new term auction facility. Here is the abstract:

At the center of the financial market crisis of 2007-2008 was a highly unusual jump in spreads between the overnight inter-bank lending rate and term London inter-bank offer rates (Libor). Because many private loans are linked to Libor rates, the sharp increase in these spreads raised the cost of borrowing and interfered with monetary policy. The widening spreads became a major focus of the Federal Reserve, which took several actions—including the introduction of a new term auction facility (TAF)—to reduce them. This paper documents these developments and, using a no-arbitrage model of the term structure, tests various explanations, including increased risk and greater liquidity
demands, while controlling for expectations of future interest rates. We show that increased counterparty risk between banks contributed to the rise in spreads and find no empirical evidence that the TAF has reduced spreads. The results have implications for monetary policy and financial economics.

…and a non-gated link.

Religiosity and the Business Cycle

Our friend David Beckworth is doing some interesting work on religiosity and the business cycle. Here is an excerpt:

The first thing economic theory says is that the cost of being religious can change over the business cycle. During an economic boom individuals may find increased opportunities for higher earnings. The potential for higher earnings, in turn, make time-intensive religious activities like church attendance costly for these individuals. Consider, for example, a Southern Baptist from a low-income family being offered the opportunity of getting overtime pay to work at a retail store on Sunday morning. For this Southern Baptist, going to church suddenly becomes a lot more costly and thus, increases the likelihood of him opting for work instead of church. On the other hand, during an economic downturn, time-intensive religious activities become less costly as opportunities for earnings decline. Here, the overtime opportunity for the Southern Baptist disappears and church attendance suddenly becomes more affordable. This idea that higher earnings lead individuals to substitute out of leisure activities, like going to church, into more work and vice versa is called the substitution effect. It implies there should be a countercyclical component to religiosity.

Here is a non-gated version of the paper.

On a side note, I recommend reading David’s blog for a unique and insightful perspective on macroeconomics.

Keynes on Inflation

J.M. Keynes on inflation in The Economic Consequences of the Peace (p. 235-6):

“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers,’ who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.”

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

HT: Robert Higgs

Preventing Deflation

In response to a question regarding the current credit crisis with the Great Depression, Ben Bernanke offered this:

“I believe the difference today is that, you know, that we will address financial issues and try to maintain the integrity and stability of our financial system. We will not let prices fall at 10% a year. We will act as needed to keep the economy growing and stable.”

Of course, the Fed actually caused the decline in prices during the depression.

The Paulson Plan

The Paulson Plan is quite puzzling. First, the idea of competing regulators is somewhat strange. I understand the presumption that competition is good and creates incentives, but I fail to understand how this applies to bureaucracies. Second, and most importantly is the role of the Federal Reserve in the regulation process. Again, I understand that those at the Fed likely understand the industry more than any other government agency, but as Tyler Cowen notes, this is essentially like trading Fed independence (if there is any left) for better regulation. In my mind, the former is much more important than the latter.