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Geithner & Bernanke Amid the Global Financial Crisis

Using the University of Virginia (UVA) Case Study,

Geithner & Bernanke, Amid the Global Financial Crisis

, answer the following questions by creating and submitting a Word document. Your answers should be a maximum of 1 page per question (and very possibly less).

1. From the breadth and depth of the economic downturn, it was clear that no one single policy action would address the problem. Briefly discuss how the various actions taken by the Treasury and the Fed served to work together or possibly against one another to address the problems.

2. How did the backgrounds of both Geithner and Bernanke serve to assist or hinder them in understanding and acting to solve the problems?

3. “The biggest problem we now face is how the Treasury and Fed can withdraw from the heavy level of financial support that they’ve provided without plunging the economy back into a recession.” Please comment on this proposition.

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November 10, 2009
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
Valentine’s Day 2009 had just passed, and the financial crisis that had gripped the
country for the past year and a half was threatening to put a quick end to the American public’s
honeymoon with President Obama. The crisis, and the Obama administration’s response to it,
had the potential to determine whether the Obama presidency would be a success.
When it came to the course of U.S. economic policy, two of the top decision-makers were
Tim Geithner and Ben Bernanke. Treasury Secretary Geithner and Federal Reserve (Fed)
Chairman Bernanke had the eyes of the world on them as they sought policies to help get the
United States—and the world—through the mess that began as a financial crisis and had
morphed into a full-fledged recession and, potentially, a severe depression.
In this time of crisis, at least one thing was certain: Geithner and Bernanke would not
require time to get to know one another. Indeed, they had been working closely together since
November 2003, when Geithner became president of the Federal Reserve Bank of New York
(FRBNY), the branch that is the Fed’s primary connection to financial and credit markets (and
the large banks that reside in the New York district). Since then, except for a brief period in late
2005 when Bernanke served as head of the Council of Economic Advisors, Bernanke and
Geithner had served together on the Federal Open Market Committee (FOMC), the committee
that sets U.S. monetary policy. Throughout this crisis, they had been in continuous contact;
Bernanke (at times almost daily, it seemed) was implementing new, nonstandard policies, and
Geithner, from his previous post as head of the FRBNY, was gauging the impact on credit
markets.
On this day in mid-February 2009, the news was grim. The U.S. economy had been in
recession since December 2007. If the downturn lasted into early spring, as seemed likely, it
would become America’s longest post-war recession. The economy had shed 3.5 million jobs
over the previous 12 months, the worst 12-month period on record (employment data went back
to 1939). Bank lending was plummeting; the few banks with funds available were holding onto
them. With this massive shift into liquid assets (cash and cash equivalents) and away from
lending of any sort (even for productive uses or, in many cases, the working capital firms needed
to survive), Geithner and Bernanke knew the economy would grind to a halt. While they tried not
This case was prepared by Associate Professor Frank Warnock. It was written as a basis for class discussion rather
than to illustrate effective or ineffective handling of an administrative situation. Copyright 2009 by the University
of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying,
recording, or otherwise—without the permission of the Darden School Foundation.
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to focus on the stock market, its spectacular drops were hard not to notice. In October, the stock
market fell 20%, its worst monthly loss since a 23% loss in April 1932 (when the Great
Depression was just getting started), and November was hardly any better (a 9% loss). The
market had stabilized a bit from mid-December to mid-January, but the slide continued with the
S&P 500 down more than 10% the previous few weeks. (For basic economic and financial
indicators, see Exhibits 1 and 2.)
The U.S. economy was in danger of imploding. In the previous year, three of the five big
investment banks had gone under; the other two converted themselves into bank holding
companies. The Fed had essentially taken over the insurance behemoth AIG. Citibank, at one
time the largest bank in the world, was teetering close to bankruptcy. And millions of ordinary
Americans were in danger of losing their jobs, their homes, or both.
The United States was not alone in this crisis. As Figure 1 indicates, global production
and trade was plummeting.1
Figure 1. Global production and merchandise trade
(annualized three-month percentage change).
15
50
40
10
IP (left scale)
30
20
5
10
0
1997M1
0
1999M1
2001M1
2003M1
2005M1
2007M1
-10
-5
Trade (right scale)
-20
-30
-10
-40
-15
-50
Data sources: Haver Analytics and IMF staff estimates.
1
Figure 1 is an adaptation of Figure 2 from the January 2009 International Monetary Fund World Economic
Outlook update, available at http://www.imf.org/external/pubs/ft/weo/2009/update/01/index.htm (accessed October
25, 2009).
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The virulence of the global downturn was alarming. World economic output grew at
5.2% in 2007 and 3.4% in 2008. As late as November 2008, the International Monetary Fund
(IMF) was predicting 2009 global growth to be 2.2%. Soon after, in the January 2009 update of
its World Economic Outlook (WEO), the IMF marked that forecast down to 0.5%. The global
extent of the downturn, as well as the severity with which growth projections were being marked
down, was fully evident in the WEO update. No area escaped the downward ratcheting of growth
expectations. Advanced economies, expected to shrink in 2009 by 0.3% as of November, were
now predicted to shrink by 2%. Emerging markets, thought to be able to “decouple” from
advanced economies and grow at 5.1% in 2009, were now expected to grow at only 3.3%. It was
as if the world’s countries could be viewed on a continuum: On one end were those who were
overextended, having borrowed excessively from others; on the other end were those who saved
and then lent and exported to the profligate ones. Few were immune from this global downturn.
Beyond the numbers, the headlines had been brutal. Iceland essentially declared
bankruptcy in October. The currencies of many emerging market countries plummeted against
the dollar in late 2008, as investors everywhere rushed back to the “safe” haven of U.S. bonds.
Europe was teetering; the euro area was falling into its first-ever recession and its worst slump in
50 years. Worries persisted that Austrian and Scandinavian banks had exposure to wobbly
Eastern European markets that might lead to insurmountable losses. There were rumors that the
United Kingdom, which had bailed out a number of its banks, would have a currency crisis of its
own. Japan was in recession yet again, with growth falling an “unimaginable” 14% in 2008Q4
and its finance minister resigning under pressure. Chinese exports recorded their biggest decline
in more than a decade in January, falling 17.5% compared to a year earlier. The International
Labor Organization (ILO) estimated that 23 million people in Asia would be unemployed in
2009, three times higher than its estimate just one month earlier. The list could go on and on, and
the bad news within the United States and from the rest of the world just kept coming.
On this brisk mid-February day in Washington, Geithner and Bernanke rolled up their
sleeves and re-evaluated their plans to address the nearly impossible task of righting the ship. In
terms of monetary and fiscal policy, were they doing all they could to halt this epic slide? Were
they doing too much?
How Did We Get Here?2
How did the biggest economy in the world come to the brink of a depression? Geithner
and Bernanke knew that would be debated for a long time to come, but one could argue that the
predicament stemmed from the interaction of financial market innovation, lax internal
governance and external oversight, and easy global monetary conditions.
2
The
discussion
in
this
section
is
based
on
http://www.bis.org/publ/arpdf/ar2008e.htm (accessed October 25, 2009).
the
BIS
2008
annual
report,
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Financial market innovations
Geithner and Bernanke knew that most financial market innovations are welfareenhancing. As a reminder that financial market innovation is, in general, a good thing, one need
only to picture how life would be different were there no access to credit. That said, financial
market innovation often comes with substantial opacity, as innovators, to keep competition at
bay, have incentives to mask the true nature of a new product. They also tend to stay at least one
step ahead of regulators. As financial products develop, those that survive the test of time
become more standardized and more transparent, but during periods of rapid financial
innovation, new products tend to be quite opaque.
The recent financial innovation that had caused much grief was the originate-to-distribute
model. Loans of questionable quality had been made and then sold, as the Bank for International
Settlements (BIS, the central banks’ bank) put it, to “the gullible and the greedy.” The underlying
dynamics of this source of financial stress were not new: Time and time again throughout
history, financial institutions and investors would get sloppy in assessing risk.
In the end, as part of the learning process, some “tuition” was paid: those who made
egregiously wrong decisions tended to suffer losses. While financial turmoil often leads to
collateral damage—people and firms depend on financial institutions—learning will only take
place if the tuition is steep enough. Tuition had indeed been extracted during this crisis, with
Lehman Brothers (founded in 1850) and others being allowed to go bankrupt. But how does a
government decide whom to bail out and whom to cut loose? Geithner and Bernanke knew they
would never know the true answer. The debris from the crisis was so widely scattered that
Geithner and Bernanke could not possibly know with certainty who was “too interconnected to
fail” (i.e., whose failure would put the entire country at risk). And the desire to save important
firms from bankruptcy was always tempered by the knowledge that the basic dynamics of a
financial crisis—innovation, greed, gullibility, and the need for tuition payments—had not
changed in hundreds of years.
Lax internal governance and external oversight
One needed only to look at the huge losses, write-downs, and bankruptcies in the
financial sector to recognize that there had to have been colossal lapses in firms’ internal
governance mechanisms. It was reasonable to expect that these deficiencies would be addressed
and that surviving firms and industries would learn important lessons, but that within another
decade or two, decision-makers would again get sloppy and cause the next round of financial
crises. Human behavior is extremely persistent.
Regulators also had to shoulder some of the blame. In particular, it was difficult to
fathom how an entire shadow banking sector—the off-balance-sheet special vehicles that were
set up by traditional banks and investment banks, the enormous markets in selling “credit
protection” that ostensibly insured against your counterparties’ default, but only until the insurer
itself went bankrupt—could blossom without prompting substantial regulatory activity. Crises
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inevitably beget regulatory change, and this one would be no different: the regulatory
environment would likely take a turn toward stricter regulations and oversight.
Easy global monetary conditions
Global interest rates had been at a historic low, partly attributable to an improved
credibility of central banks and a focus on inflation targeting, both of which lowered the premia
demanded for inflation risk, and partly to beneficial supply shocks (technological progress,
globalization), which helped to shift out long-run aggregate supply curves and made the jobs of
central bankers seem deceptively easy. Global imbalances also kept rates low. When, for
example, U.S. monetary policy was finally tightened—recall that the Fed continually raised the
policy rate from mid-2004 through 2006 (Exhibit 2)—emerging markets’ policy of managing
their exchange rates by purchasing long-term U.S. bonds kept long-term borrowing costs low
(and stoked inflation locally and globally). Whatever the cause, global real interest rates had
been abnormally low, and history shows that periods of low real interest rates often end in
speculative frenzies.
2008: An Ugly Year
Geithner and Bernanke could see that the situation was desperate.
Slumping demand was tearing the U.S. auto industry apart. As reported in the New York
Times, November sales (compared with a year earlier) fell 47% at Chrysler, 42% at
Nissan, and 41% at General Motors (GM). Even the big foreign car companies suffered,
with sales dropping 32% at Honda, 27% at BMW, and 34% at Toyota, which would book
its first annual operating loss since its launch year in 1937–38. “It feels like we’re back in
1982 right now,” Bob Carter, general manager of the Toyota Division of Toyota Motor
Sales, said on a conference call. “Consumers are simply not shopping today.” Michael C.
DiGiovanni, GM’s executive director for global market analysis, added: “Our industry is
in a much more severe situation than the rest of the economy. It’s in an unsustainable
position for all manufacturers. We cannot continue to operate at these levels or else the
entire industry’s going to go down.”3 In the fall of 2008, the “Big Three” U.S.
automakers went to Washington, caps in hand, seeking about $50 billion to see them
through a difficult time that, according to them, was not of their own doing. GM received
a $13.4 billion emergency bridge loan from the U.S. Treasury in December and was
fighting to avoid bankruptcy protection. Chrysler, which received $4 billion in federal
funding, was considering an equity carve-up that would help avoid bankruptcy but leave
the existing equity owners (Cerberus and Daimler) with less than 10% of the company.
Consumption spending, not just on cars, but on just about everything, had been falling
sharply. (See Exhibit 3a on growth in economic activity and employment; Exhibit 3b for
3
Nick Bunkley, “Another Month of Miserable Auto Sales,” New York Times, December 2, 2008.
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the contribution of quarterly growth by the components C, I, G, and NX; and Exhibit 3c
for confidence measures.)
The housing sector was hemorrhaging (Exhibit 4). For the first time in decades, home
prices were falling sharply. Permits for new home construction—a leading indicator of
economic activity, in part because new homes typically generate much additional
spending—were always cyclical, but these days, they were plummeting as they had in the
mid-1970s.
The federal budget was under strain (Exhibit 1). In mid-October, it was announced that
the budget deficit for the fiscal year 2008 was a record $455 billion. With all of the
bailouts considered by the Treasury in late 2008—and with the increased expenses (in
terms of unemployment benefits, for example) and decreased tax revenues associated
with a slowdown—the FY 2009 budget deficit was expected to be in the $750 billion to
$1 trillion range.
Credit markets essentially seized up. One traditional measure to summarize the strain in
financial markets was the TED spread, calculated as the gap between three-month
LIBOR (offshore interest rates for three-month dollar-denominated loans) and the threemonth U.S. Treasury bill rate. The size of this gap was thought to reflect a risk or
liquidity premium. As Exhibit 5 shows, it had reached extremely high levels. Another
measure, the Baa–Aaa spread, represented the difficulty most firms would have in getting
loans compared with those firms who had the best credit quality (i.e., who had Aaa credit
ratings). It had reached levels not seen since the Great Depression. With credits markets
not functioning, investment was falling sharply, as firms could not borrow to fund new
projects.
The risk aversion that pushed the TED and Baa–Aaa spreads to high levels also played
out internationally, with money from all over the world flowing into short-term U.S. debt
instruments, such as money markets and Treasury bills. (For one analyst’s description of
these capital flows, see Exhibit 6).
The Fed’s attempts to offset the massive increase in money demand associated with the
flight from risky assets by increasing the size of its balance sheet (Exhibit 7) had been
thwarted by a plummeting of the money multiplier.
Going Forward: What’s in Store for 2009?
Geithner and Bernanke did not know the best way forward. No one did. Each potential
path was fraught with pitfalls, moral hazard, and the potential wasting of the public’s money. But
neither considered doing nothing to be a viable option, and new policies were almost
continuously being proposed and implemented.
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Fiscal policy: the American Recovery and Reinvestment Act of 2009
Geithner, and the entire Obama administration, was committed to a fiscal stimulus
package but did not know what form it should take, only that it ought to be “substantial.” Much
debate over tax cuts versus new spending took place. The Economist reported various estimates
of spending multipliers.4 Direct federal spending and federal funding of state and local
infrastructure had the highest (estimated) multiplier effects at anywhere from 1.0 to 2.5.
Individual tax cuts had lower estimated effects (0.5 to 1.7). The range of estimates for each type
of stimulus indicated that, really, no one could predict with any certainty the likely impact of
various proposed new spending or tax cuts.
Eventually, on February 17, 2009, Obama signed a stimulus package that totaled $787
billion: about one-third tax cuts and one-third aid (for states, the unemployed, and for access to
health care). Of the rest, labor, health, and education got 8%, infrastructure about 7%, and some
was earmarked for energy and water. For line-by-line details with amounts—including items
such as a $3.2 billion tax credit for GM, $1.3 billion to “invest in air transportation,” and $2.3
billion to improve Department of Defense facilities related to the quality of life—see Exhibit 8.
As renowned conservative economist Robert Barro of Harvard argued, the Obama
administration hoped that the multiplier associated with this package would be greater than one,
perhaps as high as 1.5; he noted that a multiplier of one would imply that when increasing
spending, the government was not crowding out private investment but was only using slack
resources—unemployed labor and capital. Barro instead anticipated that the multiplier was more
likely to be far less than one and that any increase in government spending would be at least
partially offset by some reduction in private spending.5 The U.S. public could only hope the
administration was correct on this one, but people worried that Barro might be right. Whichever
side was correct, the stimulus would do nothing to lessen the U.S. debt burden (Figure 2).
4
“Can the Centrists Hold?” Economist, February 5, 2009 (print edition).
In 1974, Barro popularized the term Ricardian equivalence, named for the British economist David
Ricardo. See any intermediate macroeconomics textbook for details. Briefly, according to the Ricardian
view, consumers are forward-looking and spend based on current and expected future income. If, for example,
consumers expect the new stimulus plan to increase their future tax liability, they might save now in anticipation of
a higher future tax bill. See also Barro’s “Voodoo Multipliers,” Economists’ Voice 6, no. 2 (February 2009),
http://www.bepress.com/ev/vol6/iss2/art5.
5
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-8Figure 2. U.S. debt by type of borrower (as a percentage of GDP).
400
350
300
250
200
150
100
50
19
77
19
78
19
79
19
80
19
81
19
82
19
83
19
84
19
85
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
20
08
0
Households
Business
Govt
Financial
Data source: Author calculations based on data from Federal Reserve’s Flow of Funds Accounts.
Of course, the current crisis was global, and sizable fiscal deficits were emerging all over
the world, as Figure 3 from the IMF’s January 2009 update of the WEO indicates.6
Figure 3. General government fiscal balances (as a percentage of GDP).
2
Emerging and developing economies
0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
-2
Advanced economies
-4
World
-6
-8
Data source: IMF staff estimates.
6
Figure 3 is adapted from Figure 6 in http://www.imf.org/external/pubs/ft/weo/2009/update/01/index.htm.
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Treasury policy: TARP
The first incarnation of the Treasury’s Troubled Asset Relief Program (TARP), signed by
Congress in early October 2008, was a $700 billion “bazooka” to bail out the U.S. financial
sector. The original idea behind TARP—to free banks and other financial firms of the most toxic
loans and securities on their books by purchasing them in auctions—never got off the ground.
The hope was that a big buyer (the government) would end up paying more than the prevailing
fire-sale prices but less than the intrinsic value if held to maturity (so that these would actually be
good investments for the U.S. taxpayer). Instead, with the crisis deepening, on November 12, the
Treasury buried the original idea and moved toward deploying TARP funds to recapitalize banks
and nonbank financial institutions (such as the financing arms of the big car companies). By the
end of 2008, the government had committed $244 billion of public money not to troubled assets,
but to troubled financial institutions. This included $40 billion to buy shares in AIG, the single
largest injection of capital ever by a government, and $125 billion to banks such as Citigroup,
Wells Fargo, and JPMorgan Chase.
On February 10, 2009, Geithner announced the revamped TARP. As the Economist
reported, the response was less than positive:7
Most disappointment was directed at the sketchy plan to tackle banks’ toxic
assets, such as mortgage-backed securities and leveraged loans. At a late stage
Mr. Geithner rejected the idea of a government-run bad bank (as well as blanket
guarantees for noxious assets), put off by the high upfront cost and the problems it
would have valuing the debt. He now hopes to amass $1 trillion of buying power
by drawing in investors, such as private-equity groups, whose inclusion would
stretch the government’s money further and bring more discipline to pricing.
[B]ut Mr. Geithner still has a yawning gap to bridge between banks, which do not
want to sell at depressed prices because of losses they would have to recognize,
and potential buyers, who need to be sure of healthy returns. It was this that put
paid to both the original TARP and Mr. Paulson’s efforts to rescue structuredinvestment vehicles. Distressed-debt investors, such as Blackstone and
BlackRock, are interested but want more information. To be sure of attracting
them, the government might need to provide a combination of cheap loans and a
guaranteed floor on losses. But even then, the mooted public-private partnership
may not be big enough. Barclays Capital counts $2 trillion–3 trillion of troubled
assets in America, excluding prime mortgages, which are souring fast.
Goldman Sachs appeared to agree with Barclays on this. Goldman reportedly estimated
that the United States had troubled assets that amounted to about 40% of GDP. In the depth of
Japan’s lost decade, troubled assets (in the form of nonperforming loans) totaled 35% of GDP.
Moreover, the Japanese experience was a lesson in the cost of delaying dealing with troubled
banks; the fiscal cost of Japan’s bailout of its financial sector totaled almost one-quarter of GDP.
7
See “Dashed Expectations,” Economist (February 12, 2009),
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In contrast, the U.S. savings and loans bailout of the late 1980s—in which a government entity
(Resolution Trust Corporation) forced the closure of troubled banks, took on their bad assets, and
in bankruptcy proceedings recouped much money on behalf of depositors—cost 3.7% of GDP
(Table 1).
Table 1. Fiscal cost of financial sector bailouts.
Country
United States
Finland
Sweden
Mexico
Japan
South Korea
United States
Start of Crisis
1988
1991
1991
1994
1997
1997
2007
Fiscal Cost
(% of GDP)
3.7
12.8
3.6
19.3
24.0
31.2
5.8*
* As of September 2008.
Data sources: Luc Laeven and the Economist.
Federal Reserve policy
Fed policy during this crisis had been nonstandard, uncommon, aggressive, scary—pick
your favorite descriptor. In the old days, prior to the onset of this crisis, there were three tools
available for monetary policy:
Open market operations. The Fed’s principal tool for implementing monetary policy was
the use of open market operations (OMOs)—purchases and sales of U.S. Treasury and
federal agency securities. With OMOs, the FOMC specifies the short-term objective,
which can be a desired quantity of reserves (as was common prior to the 1980s) or a
desired price (the federal funds rate, the interest rate at which depository institutions lend
balances at the Fed to other depository institutions overnight). In the early 1980s, Paul
Volcker’s Fed moved the focus from a quantity objective (reserves) toward a price
objective (attaining a specified level of the federal funds rate).8
8
Another change is increased transparency. Market participants had to divine Fed policy until 1994, when the
FOMC began announcing changes in its policy stance; in 1995, the FOMC began to explicitly state its target level
for the federal funds rate. Transparency increased even more in February 2000, when the statement issued by the
FOMC shortly after each of its meetings began to include the committee’s assessment of the risks to the attainment
of its long-run goals of price stability and sustainable economic growth.
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Discount rate. The Fed could also adjust the discount rate, the interest rate charged to
commercial banks and other depository institutions on loans they receive from their
regional Federal Reserve bank’s lending facility (the discount window).9
Reserve requirements. The third traditional policy tool was the level of reserve
requirements, the amount of funds that a depository institution must hold in reserve (in
the form of vault cash or deposits with Federal Reserve banks) against specified deposit
liabilities.10
On these traditional tools of monetary policy, the Fed had gone about as far as it could
go. In December, the Fed set a range of 0 to 25 basis points for the target federal funds rate
(Exhibit 2). On that dimension, monetary policy was as loose as it could be. But Bernanke—
derisively called Helicopter Ben for suggesting during the deflation scare of 2002–03 that to stay
clear of deflation he could just drop money from a helicopter—had known full well that there
were other, nonstandard tools that were permissible by the Federal Reserve Act’s Section 13(3).11
In addition to the traditional tools, the Fed had employed three other types of tools to improve
the functioning of credit markets. The first of these three new tools was in the spirit of the Fed’s
traditional role of providing short-term liquidity to financial institutions:
Short-term liquidity facilities for U.S. banks and currency swap facilities for foreign
central banks. During the course of the crisis, the Fed had created a number of new
facilities for auctioning short-term credit. Ensuring that financial institutions had
adequate access to liquidity was thought likely to increase their willingness to extend
credit and to help ease conditions in interbank lending markets, thereby reducing the
overall cost of capital to banks. To ease conditions in dollar-funding global interbank
markets, the Fed also approved bilateral currency liquidity agreements with 14 foreign
9
The Federal Reserve banks offered to depository institutions three discount window credit programs—the
primary, secondary, and seasonal—each with its own interest rate and each fully secured. The primary credit
program is for banks that are in sound financial condition; the loans in this program are very short term (usually
overnight), and the rate is set above the usual level of short-term market interest rates. (Because primary credit is the
Fed’s main discount window program, the Fed at times uses the term discount rate to mean the primary credit rate.)
Banks not eligible for primary credit may apply for secondary credit, the (unwritten) assumption being that they
must meet temporary liquidity needs or resolve severe financial difficulties; the rate is above that of primary credit.
The third type, seasonal credit, is for small banks with seasonal fluctuations in funding needs, such as banks in
agricultural or seasonal resort communities; the rate is an average of selected market rates.
10
Note that in October 2008, the Federal Reserve banks began to pay interest on required reserve balances
(balances held at Reserve banks to satisfy reserve requirements) and on excess balances (balances held in excess of
required reserve balances and contractual clearing balances). There are two implications of this new policy tool:
first, the interest rate paid on required reserve balances should eliminate the implicit tax that reserve requirements
used to impose on depository institutions; second, the interest rate paid on excess balances gives the Fed an
additional tool for the conduct of monetary policy, because it should help to establish a lower bound on the federal
funds rate by lessening the incentive for institutions to trade balances in the market at rates much below the rate paid
on excess balances.
11
Section 13(3) of the Federal Reserve Act permits the board, in unusual and exigent circumstances, to
authorize Federal Reserve banks to extend credit to individuals, partnerships, and corporations that are unable to
obtain adequate credit accommodations.
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central banks. With these currency swap facilities, foreign central banks could acquire
dollars from the Fed that could then be lent to financial institutions in their jurisdictions.
Liquidity facilities provided financial intermediaries with ample access to central bank
liquidity but did not alleviate their concerns about capital, asset quality, and credit risk, concerns
that may limit their willingness to extend credit. Moreover, providing liquidity to financial
institutions did not directly address instability or declining credit availability in critical nonbank
markets, such as the commercial paper market or the market for asset-backed securities. To
address these issues, the Fed developed a second set of policy tools that involved the provision of
liquidity directly to borrowers and investors in key credit markets.
Facilities for commercial paper market, money market mutual funds, and ABS market.
Facilities were introduced to purchase highly rated commercial paper at a term of three
months and to provide backup liquidity for money market mutual funds. In addition, the
Fed and the Treasury jointly announced a facility—expected to be operational shortly—
that would lend against AAA-rated asset-backed securities (ABS) collateralized by
recently originated student loans, auto loans, credit card loans, and loans guaranteed by
the Small Business Administration. Unlike other Fed lending programs, this facility
combined Federal Reserve liquidity with capital provided by the Treasury. If the program
worked as planned, it would help to restart activity in these key securitization markets
and lead to lower borrowing rates and improved access in the markets for consumer and
small business credit. The basic framework could also be expanded to accommodate
higher volumes as well as additional classes of securities, as circumstances warranted.
The Fed’s third set of policy tools for supporting the functioning of credit markets
involved the purchase of longer-term securities for the Fed’s portfolio.
Purchases of longer-term securities. The Fed had plans to purchase by midyear up to
$100 billion of the debt of government-sponsored enterprises (GSEs), including Fannie
Mae, Freddie Mac, and the Federal Home Loan banks, and up to $500 billion in agencyguaranteed mortgage-backed securities (MBS). The objective of these purchases is to
lower mortgage rates, thereby supporting housing activity and the broader economy.
In Bernanke’s view, most of the new policy tools exposed the Fed to only minimal credit
risk.12 The loans made to financial institutions were generally short-term, overcollateralized, and
made with recourse to the borrowing firm. With the currency swaps, it was the foreign central
banks, not the financial institutions, that ultimately received the funds and were responsible for
12
Information on Bernanke’s view on the likely credit risk of the various facilities, as well as what he
considered evidence of a relaxation of credit strains, were in two speeches: his February 10, 2009,
testimony before the Committee on Financial Services, U.S. House of Representatives, “Federal Reserve
Programs
to
Strengthen
Credit
Markets
and
the
Economy”
(Washington,
D.C.),
http://www.federalreserve.gov/newsevents/testimony/bernanke20090210a.htm, and his January 13, 2009, speech at
the London School of Economics, “The Crisis and the Policy Response at the Stamp Lecture” (London, England),
http://www.federalreserve.gov/newsevents/speech/bernanke20090113a.htm.
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repaying the Federal Reserve (and at the time of the swap the Fed received an equivalent amount
of foreign currency in exchange for the dollars it provided foreign central banks). Also, the
special lending programs to support the commercial paper market, money market mutual funds,
and ABS markets had been set up to minimize credit risk to the Fed. The largest program, the
commercial paper funding facility, accepted only the most highly rated paper and charged
borrowers a premium that was set aside against possible losses. And the facility that would lend
against securities backed by consumer and small-business loans was a joint Federal ReserveTreasury program; capital provided by the Treasury from the TARP would help insulate the Fed
from credit losses (and the Treasury would receive most of the upside from these loans). The
third new tool—purchasing debt issued by or guaranteed by GSEs—was risky only to the extent
that the U.S. Treasury was a credit risk.
One result of the implementation of this new arsenal was a massive and unprecedented
expansion of the Fed’s balance sheet. The monetary base (i.e., the amount of Fed assets) used to
grow slowly and steadily at about 5% to 10% per year (Exhibit 7); the blips stemming from Fed
activities surrounding Y2K and 9/11 were the only noticeable departures from this slow, steady,
exceedingly boring expansion of the Fed’s balance sheet. But those days were long gone; the
Fed’s balance sheet increased by 100% over the previous year.13
Bernanke knew that the Fed would have to carefully and continuously assess the
effectiveness of its credit-related tools. He and Geithner hoped the new tools would relax the
severe liquidity strains experienced by many firms and improve interbank lending markets. For
evidence, he would look to movements in LIBOR; liquidity pressures; stabilization of the
commercial paper market (a lowering of rates and lengthening of maturities so that firms can
access financing at terms longer than a few days); stabilization of the money market mutual fund
industry, with a cessation of the sharp withdrawals and maybe even modest inflows; and a
lowering of conforming mortgage rates.
Ongoing Fed evaluation of existing and prospective programs would center on three
questions. First, had normal functioning in the credit market in question been severely disrupted
by the crisis? Second, did the Fed have tools that were likely to lead to significant improvement
in function and credit availability in that market, and were the Fed’s tools the most effective
methods, either alone or in combination with those of other agencies, to address the disruption?
And third, did improved conditions in a particular market have the potential to make a significant
difference for the overall economy? For example, in Bernanke’s opinion, the purchases of
agency debt and MBS met all three criteria: The mortgage market was significantly impaired, the
Fed’s authority to purchase agency securities gave it a straightforward tool to try to reduce the
extent of that impairment, and the health of the housing market bore directly and importantly on
the performance of the broader economy.
13
For details on the composition and maturity structure of the Fed’s balance sheet as of mid-February 2009, see
http://www.federalreserve.gov/releases/h41/20090219/.
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The Fed was also considering outright purchases of Treasury debt, which would in effect
(at least partially) monetize the colossal $787 billion American Recovery and Reinvestment Act
and, potentially, future stimulus packages. Almost every Latin American country knew that
monetizing government debt, if continued too long, could lead to hyperinflation, but in February
2009, Bernanke was not concerned about hyperinflation—inflation, only six months earlier a
serious concern, had been falling sharply along with plummeting oil prices (Exhibit 9).
Bernanke knew that one way to think about what had been going on in the credit markets was
that there had been a huge increase in money demand. While that might have sounded good, it
was in fact quite scary as people and firms switched out of all other assets and moved into liquid
cash. Bernanke saw it as his job to try and work against that effect. His planned response
required a new term to describe current Fed policy, credit easing, which was similar to, but
different from, Japan’s policy of quantitative easing.
The international situation
Geithner and Bernanke, while considering their options, saw the international situation as
mixed. While the U.S. current account deficit (Exhibits 10 and 11) was narrowing, it was hard
for them to imagine that external demand would contribute much to U.S. economic growth going
forward. With global economic activity plummeting, who would buy U.S. goods? Moreover, the
United States continued to receive substantial international capital flows in 2008 (Exhibit 10),
and the dollar surged late in 2008 (which, of course, would make U.S. goods more expensive
abroad). Finally, as U.S. savings rates had declined precipitously (Exhibit 11), Geithner and
Bernanke had to worry about whether foreigners would continue to lend to U.S. households,
corporations, and the government.
The decision
In mid-February 2009, Geithner, a former undersecretary at the Treasury during the
Asian Financial Crisis, and Bernanke, a leading scholar on the Great Depression, had a lot on
their plates. Their tasks could be stated in deceptively simple terms: What could they, as
shepherds of U.S. monetary and fiscal policy, do to halt this epic slide? Were they currently
doing enough? Were they doing too much?
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2,772
6.2
7.7
6.9
8.1
1.5
6.5
–3.5
18.2
21.7
63
8
24
31
17
–1
9
10
20
1975–1984
2,700
3.0
5,652
5.8
6.4
3.3
4.1
1.7
2.4
–3.9
17.9
21.8
66
8
21
37
15
–2
9
11
20
1985–1994
5,588
3.0
12,486
4.8
5.1
2.9
13,220
4.8
4.6
2.8
3.8
1.0
2.8
–1.9
18.5
20.4
70
8
20
42
17
–6
11
17
19
2006
13,178
2.8
13,930
4.8
4.6
2.6
4.1
1.4
2.7
–1.2
18.8
20.0
70
8
21
42
15
–5
12
17
19
2007
13,808
2.0
14,626
4.8
5.8
3.3
3.4
2.9
0.5
–2.7
17.9
20.7
70
7
21
42
14
–5
13
18
20
2008
14,281
1.3
Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, Congressional Budget Office, and Haver Analytics.
9,398
4.9
5.1
1.9
(% change)
4.2
4.0
2.6
1.8
1.5
2.2
1995–2004
2005
9,460 12,422
3.1
2.9
(% of GDP)
69
70
9
8
20
20
40
42
16
17
–3
–6
11
11
14
16
18
19
(% of GDP)
–0.7
–2.6
18.8
17.6
19.5
20.2
Notes: Surplus/deficit data are for fiscal years. All data are annual averages.
Potential GDP ($ billions)
Natural rate of unemployment (%)
Unemployment rate (%)
PCE inflation (%)
Nonfarm business sector
Compensation per hour
Output per hour (productivity)
Unit labor costs
Federal surplus/deficit (−)
Federal receipts
Federal outlays
Personal consumption expenditures
Durable goods
Nondurable goods
Services
Investment
Net exports
Exports
Imports
Government spending
Gross domestic product ($ billions)
Real GDP growth (%)
Economic Indicators
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
Exhibit 1
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-16Exhibit 2
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
Financial Indicators (monthly through January 2009)1
Standar d & Poor ‘s 500 Composite Stock Pr ice Index
1941-43=10
Real Br oad Tr ade-Weighted Exchange Value of the US$
Mar-73=100
1600
115
110
1400
105
1200
100
95
1000
90
85
800
98
99
00
01
02
03
04
05
06
07
Sources: Wall Street Journal, Feder al Reserve Boar d /Haver Analytics
08
The broad dollar index is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of major
U.S. trading partners. The index weights are derived from U.S. export shares and from U.S. and foreign import shares. In 2008,
the largest weights are euro area (17%), China (16), Canada (15), Mexico (10), Japan (9), and other emerging Asia (15).
Feder al Funds [effective] Rate
% p. a.
10-Year Tr easur y Note Yield at Constant Matur ity
% p. a.
8
8
6
6
4
4
2
2
0
0
98
99
00
01
02
03
04
Sour ce: Feder al Reser ve Boar d /Haver Analytics
1
05
06
07
08
Throughout exhibits, the thicker line corresponds to the variable that is listed first.
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-17Exhibit 3a
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
Growth and Employment (GDP Data through 2008 Q4; Employment through January 2009)
Real Gr oss Domestic Pr oduct
% Change – Year to Year
SAAR, Bi l . Chn. 2000$
10. 0
10. 0
7. 5
7. 5
5. 0
5. 0
2. 5
2. 5
0. 0
0. 0
-2. 5
-2. 5
-5. 0
-5. 0
70
75
80
85
90
95
00
05
Sour ce: Bur eau of Economi c Anal ysi s /Haver Anal yti cs
Change in Nonfar m Employment
SA, Thous
1200
1200
800
800
400
400
0
0
-400
-400
-800
-800
70
75
80
85
90
95
Sour ce: Bur eau of L abor Stati sti cs /Haver Anal yti cs
00
05
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-18Exhibit 3b
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
Contributions to Quarterly Real GDP Growth (data through 2008 Q4)1
Govt Spending
Net Expor ts
3
3
2
2
1
1
0
0
-1
-1
-2
-2
99
00
01
02
03
04
05
06
07
08
Sour ce: Bur eau of Economi c Anal ysi s /Haver Anal yti cs
Consumption
Gr oss Pr ivate Domestic Investment
6
6
4
4
2
2
0
0
-2
-2
-4
-4
99
00
01
02
03
04
05
Sour ce: Bur eau of Economi c Anal ysi s /Haver Anal yti cs
06
07
08
.
1
These graphs show the contribution to quarterly (at annualized rates) real GDP growth. The last data point for
each graph indicates that government spending (thick line) is contributing positively to real GDP growth, net exports
currently have roughly no effect, and consumption (thick line) and investment are drags on GDP growth.
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-19Exhibit 3c
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
Measures of Consumer and Firm Confidence (data through January 2009)1
Univer sity of Michigan: Consumer Sentiment
NSA, Q1-66=100
120
120
100
100
80
80
60
60
40
40
94
95
96
97
98
99
00
01
02
Source: University of Michigan /Haver Analytics
03
04
05
06
07
08
ISM Mfg: PMI Composite Index
SA, 50+ = Econ Expand
67.5
67.5
60.0
60.0
52.5
52.5
45.0
45.0
37.5
37.5
30.0
30.0
94
95
96
97
98
99
00
01
02
03
04
Sour ce: Institute for Supply Management /Haver Analytics
05
06
07
08
1
The manufacturing ISM Report on Business is based on data compiled from purchasing and supply executives
nationwide. An index above 50 indicates an increase in manufacturing activity; an index below 50 indicates a
decrease in manufacturing activity.
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-20Exhibit 4
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
The Housing Sector
S&P/Case-Shiller Home Pr ice Index: Composite 20
SA, Jan-00=100
220
220
200
200
180
180
160
160
140
140
120
120
100
100
99
00
01
02
03
04
05
06
Sour ce: S&P, Fi ser v, and Macr oMar kets L L C /Haver Anal yti cs
07
08
New Pvt Housing Units Author ized by Building Per mit
SAAR, Thous. Uni ts
2500
2500
2000
2000
1500
1500
1000
1000
500
500
70
75
80
85
Sour ce: Census Bur eau /Haver Anal yti cs
90
95
00
05
Data are monthly through November (prices) or December (permits) 2008.
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-21Exhibit 5
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
Measures of Financial Market Strains (through January 2009)
The TED spread
(three-month Eurodollar rate minus three-month Treasury bill rate).
5
5
4
4
3
3
2
2
1
1
0
0
94
95
96
97
98
Sour ce: Haver Anal yti cs
99
00
01
02
03
04
05
06
07
08
The Baa–Aaa spread
(corporate bond Baa rate minus corporate bond Aaa rate).
6
6
5
5
4
4
3
3
2
2
1
1
0
0
30 35 40 45 50
Sour ce: Haver Analytics
55
60
65
70
75
80
85
90
95
00
05
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Exhibit 6
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
FX COMMENT: U.S. Treasury’s TICS Report
November 18, 2008 (3:30 p.m. EST)
The US Treasury released its monthly capital-flow data this morning, indicating that net (long-term)
portfolio investment into the United States unexpectedly rose 66.2B USD in September from a
revised 21.0B USD in August, on expectations of 27.2B USD. Foreigners bought a net 15.8B USD in
U.S. Treasury bonds, bought a net 14.8B USD in U.S. agency bonds, sold a net −6.4B USD in US
corporate bonds, and bought a net 11.5B USD in US equities. At the same time, U.S. investors sold a net 37.8B USD in foreign bonds and bought a net 2.4B USD in foreign equities. When considering also
short-term flows (such as bank deposits), total (short- and long-term) net capital inflows similarly
surprised by surging to 143.4B USD in September, much greater than consensus expectations of 10.0B USD and +21.4B USD in August.
Three developments within the capital flows data led to the better than expected results. First, U.S.
investors were net sellers of foreign stock and bonds for the third consecutive month, totaling a record 35.4B USD in September, compared to −22.5B USD in August and −34.2B USD in July. This wholesale
repatriation of foreign investment was an unambiguous USD positive in September. Second, foreign
investment in U.S. bonds surged in September led by an unexpected return of interest in U.S. agency
bonds, which had seen a sharp outflow during the prior two months in the wake of the GSE crisis. Foreign
investors were net buyers of 19.3B USD in U.S. bonds (Treasury, agency and corporate) during
September from −0.6B USD in August and −10.0B USD in July. This was also a positive development
for the USD. The third notable development in today’s report was the unexpected net buying of U.S.
deposits and short-dated securities on behalf of foreigners during September. The 77.2B USD net buying
of USD deposits and short-dated securities in September compares to a revised 0.4B USD in August and
−43.5B USD in July. This also was a USD positive and suggests that foreign liquidation of USDdenominated deposits has eased substantially despite the onset of the credit freeze.
The takeaway from today’s report is that there appears to be ample foreign investment to keep the
greenback supported amid the most turbulent financial conditions ever seen. Perhaps this is the strongest
argument yet for why the USD’s role in the global monetary system should not be changed. Discussion of
a Bretton Woods II appears to be premature if not pure hyperbole with respect to a new currency
alignment. Love it or leave it, the strong dollar mantra sets the United States apart from all other major
economies. Without the backing of a hard asset like gold, the world’s primary reserve currency must be
strong, even if at times this means in name only.
Michael Woolfolk
Senior Currency Strategist
The Bank of New York Mellon
New York, NY
Note: For the data Woolfolk is referring to, see http://www.treas.gov/press/releases/hp1278.htm.
Reprinted with Michael Woolfolk’s permission.
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-23Exhibit 7
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
The Money Creation Process (through January 2009)
The Monetar y Base
SA, Mil.$
1750000
1750000
1500000
1500000
1250000
1250000
1000000
1000000
750000
750000
500000
500000
250000
250000
98
99
00
01
02
03
04
Sour ce: Feder al Reser ve Boar d /Haver Analytics
05
06
07
08
The Money Multiplier
M2 / Monetary Base
14
14
12
12
10
10
8
8
6
6
4
4
70
75
80
Sour ce: Haver Analytics
85
90
95
00
05
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Exhibit 8
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
Details on the $787 billion February 2009 stimulus package
The $787 billion stimulus package is about one-third tax cuts, one-third aid (for states, the
unemployed, and for access to health care), and one-third other stuff (labor, health, and
education—8%; infrastructure spending—about 7%; energy and water get a bit; etc.). For gorier
details,
see
the
list
below,
adapted
from
the
New
York
Times’
http://projects.nytimes.com/44th_president/stimulus, where more even more complete details are
provided.
Tax Cuts for Individuals (New tax credit for workers) $116.2 billion; Health/Aid to States (Help states with Medicaid costs)
$87.1 billion; Tax Cuts for Individuals (Extend patch for the alternative minimum tax) $69.8 billion; Education and Job
Training/Aid to States (Help states prevent cuts to essential services like education) $53.6 billion; Unemployment (Extend
and increase unemployment compensation) $35.8 billion; Transportation (Provide money for highways and bridges) $27.5
billion; Health/Unemployment (Health coverage under Cobra) $25.1 billion; Aid to Individuals (Increase food assistance)
$20.9 billion; Health (Incentives to Medicaid and Medicare providers to adopt health information technology) $17.2 billion;
Education and Job Training/Aid to Individuals (Increase the maximum Pell Grant by $500, from $4,850 to $5,350) $15.6
billion; Tax Cuts for Individuals (Expand eligibility for Child Tax Credit) $14.8 billion; Aid to Individuals (Provide cash
payment to seniors, disabled veterans and other needy individuals) $14.4 billion; Tax Cuts for Businesses/Energy (Expand
tax incentives for renewable energy facilities) $14.0 billion; Education and Job Training/Tax Cuts for Individuals (Expand
higher education tax credits) $13.9 billion; Education and Job Training (Provide additional money to schools serving lowincome children) $13.0 billion; Education and Job Training (Provide additional money for special education) $12.2 billion;
Energy (Modernize the electric grid) $11.0 billion; Aid to States/Education and Job Training (Create new bonds for
improvements in public education) $10.9 billion; Health/Science and Research (Provide additional financing to the National
Institutes of Health for research and infrastructure) $10.0 billion; Transportation (Invest in rail transportation) $9.3 billion;
Transportation (Invest in public transit) $8.4 billion; Housing/ Tax Cuts for Individuals (Incentive for first-time
homebuyers) $6.6 billion; Aid to States (Incentives for economic recovery in distressed areas) $6.5 billion; Energy (Provide
grants to cities, counties and states to increase energy efficiency) $6.3 billion; Energy (Provide additional financing for
Innovative Energy Loan Guarantee program) $6.0 billion; Environment (Clean up sites formerly used by the Defense
Department) $6.0 billion; Environment (Finance local water projects) $6.0 billion; Tax Cuts for Businesses (Extension of
bonus depreciation) $5.9 billion; Energy/Aid to Individuals (Increase financing for home weatherization program) $5.0
billion; Unemployment (Exempt unemployment compensation) $4.7 billion; Tax Cuts for Individuals (Increase Earned
Income Tax Credit) $4.7 billion; Infrastructure (Provide additional money to the Army Corps of Engineers) $4.6 billion;
Energy (Increase energy efficiency in federal buildings) $4.5 billion; Infrastructure (Create new program to expand
broadband access) $4.5 billion; Aid to States (Create a tax credit bond option for state and local governments) $4.3 billion;
Aid to States/Unemployment (Give states aid to properly administer unemployment compensation) $4.2 billion;
Infrastructure (Make military facilities more energy efficient) $4.2 billion; Aid to States (Provide additional financing for
state and local law enforcement) $4.0 billion; Energy/Infrastructure/Housing (Repair and modernize public housing units)
$4.0 billion; Education and Job Training (Finance job training programs) $4.0 billion; Energy (Invest in fossil energy) $3.4
billion; Tax Cuts for Businesses (Expand deduction limits for banks buying bonds) $3.2 billion; Tax Cuts for Businesses
(Provide tax break to General Motors) $3.2 billion; Infrastructure (Repair and improve facilities on public lands and parks)
$3.1 billion; Science and Research (Provide additional financing for the National Science Foundation) $3.0 billion;
Infrastructure (Provide additional money to the Department of Homeland Security) $2.8 billion; Aid to States (Increase
block grants for welfare program) $2.7 billion; Energy/Science and Research (Conduct energy efficiency and renewable
energy research) $2.5 billion; Infrastructure/ Rural Assistance (Provide additional financing to improve communications in
rural areas) $2.5 billion; Housing (Help states and local governments acquire and repair low-income housing) $2.4 billion;
Health/ Infrastructure (Improve Defense Department facilities related to the quality of life) $2.3 billion; Education and Job
Training (Increase financing for Head Start and Early Head Start) $2.1 billion; Energy/Tax Cuts for Individuals (Increase tax
credits for residential energy efficiency improvements) $2.0 billion; Energy/Tax Cuts for Individuals (Incentive for
alternative vehicle) $2.0 billion; Health (Provide additional financing for the Office of the National Coordinator for Health
Information Technology) $2.0 billion; Housing (Make full-year payments to owners receiving Section 8 housing vouchers)
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-25-
UV3957
$2.0 billion; Aid to Individuals (Provide additional child care) $2.0 billion; Energy (Support battery manufacturing) $2.0
billion; Housing (Redevelop abandoned and foreclosed homes) $2.0 billion; Health/ Infrastructure (Finance renovations and
technology upgrade at community health centers) $2.0 billion; Energy/Science and Research (Provide additional financing
for science and research at the Department of Energy) $2.0 billion; Tax Cuts for Individuals (Incentive for car buyers) $1.7
billion; Tax Cuts for Businesses/Energy (Incentive for advanced energy investment) $1.6 billion; Tax Cuts for Businesses
(Delay recognition of certain cancellation of debt income) $1.6 billion; Aid to States/.Unemployment (Expand Trade
Adjustment Assistance program) $1.6 billion; Housing (Reduce homelessness) $1.5 billion; Transportation (Invest in local
transportation projects) $1.5 billion; Aid to States/Energy (Authorize more state and local bonds for energy-related
purposes) $1.4 billion; Environment/ Rural Assistance (Finance rural water and waste facilities) $1.4 billion; Transportation
(Invest in air transportation) $1.3 billion; Health (Extend Transitional Medical Assistance program) $1.3 billion;
Environment (Finance national environmental cleanup) $1.2 billion; Health/ Infrastructure (Construct and repair veterans’
hospitals and cemeteries) $1.2 billion; Science and Research (Compare the effectiveness of medical treatments) $1.1 billion;
Health (Prevent cuts to health care providers) $1.0 billion; Environment/ Rural Assistance (Provide water to rural areas and
Western areas impacted by drought) $1.0 billion; Health/Science and Research (Make grants to help prevent disease) $1.0
billion; Science and Research (Provide additional financing for the National Aeronautics and Space Administration) $1.0
billion; Other (Modernize Social Security Administration) $1.0 billion; Aid to States (Help states collect child support) $1.0
billion; Housing (Provide additional financing for Community Development Block Grants) $1.0 billion; Other (Provide
money for 2010 census) $1.0 billion; Tax Cuts for Businesses (Expand net operating loss carry-back provision for small
businesses) $947 million; Science and Research (Provide additional financing for the National Oceanic and Atmospheric
Administration) $830 million; Tax Cuts for Businesses (Expand tax break for small business stock sales) $829 million;
Education and Job Training (Finance technology upgrades in schools) $650 million; Aid to Individuals (Provide coupon to
convert to digital televisions) $650 million; Aid to States (Help states find housing and jobs for disabled people) $640
million; Aid to States (Repeal alternative minimum tax on private activity bonds) $555 million; Aid to Individuals (Help
defense employees sell homes) $555 million; Health (Extend Qualified Individual Program) $550 million; Education and
Job Training/Aid to States (Help states and local school districts track student data and improve teacher quality) $550
million; Energy/Infrastructure/Housing (Repair and modernize about 4,200 Native American housing units) $510 million;
Education and Job Training/Aid to States/Unemployment (Help states find jobs for unemployed workers) $500 million;
Education and Job Training/Health (Train primary health care providers, including doctors and nurses) $500 million;
Education and Job Training/Energy/Unemployment (Train workers for careers in energy efficiency and renewable energy
fields) $500 million; Health (Improve health services to American Indians and Alaska natives) $500 million; Tax Cuts for
Businesses (Reduce holding period for taxation of companies that convert into S corporations) $415 million; Energy/Aid to
States (Provide grants to states for energy-efficient vehicles and infrastructure) $400 million; Energy/Aid to Individuals
(Provide consumers rebates for energy-efficient appliances) $300 million; Energy (Replace older vehicles owned by the
federal government with hybrid and electric cars) $300 million; Aid to States (Delay withholding tax on payments) $291
million; Aid to States (Modify speed requirements for use of bonds to finance high-speed rail) $288 million; Tax Cuts for
Individuals/Energy (Expand tax incentives for residential renewable energy properties) $268 million; Energy/Housing
(Improve energy efficiency in government-subsidized apartment buildings) $250 million; Infrastructure/Other (Finance
improvements to Agriculture Department infrastructure) $249 million; Health/Aid to Individuals (Other Medicaid
expansions) $239 million; Other (Provide government agencies money for oversight) $233 million; Tax Cuts for Businesses
(Provide incentive for hiring disadvantaged workers) $231 million; Tax Cuts for Businesses (Expand use of industrial
development bonds) $203 million; Housing/Aid to Individuals/Rural Assistance (Provide loans for rural homeowners) $200
million; Education and Job Training (Provide additional money for College Work-Study program) $200 million; Other
(Expand national service program) $200 million; Tax Cuts for Individuals/Transportation (Equalize mass transit and parking
benefits) $192 million; Rural Assistance (Provide loans for rural businesses) $150 million; Infrastructure/Rural
Assistance/Aid to States (Provide loans for rural developments) $150 million; Tax Cuts for Businesses (Prohibit recollection
of tariff payments) $90 million; Aid to Individuals/ Aid to States (Help states provide services to homeless children) $70
million; Aid to States (Allow state housing agencies to claim Treasury Department grants) $69 million; Energy/Tax Cuts for
Businesses (Incentive for alternative fuel pumps) $54 million; Tax Cuts for Businesses (Allow more small business
deductions) $41 million.
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UV3957
-26Exhibit 9
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
Inflation and Oil Prices
CPI Inflation
year-over -year per cent change in CPI
6
6
4
4
2
2
0
0
-2
-2
94
95
96
97
98
99
00
01
02
03
Source: Bur eau of Labor Statistics /Haver Analytics
04
05
06
07
08
Oil Pr ice: West Texas Inter mediate
Spot, $/Barr el
150
150
125
125
100
100
75
75
50
50
25
25
0
0
94
95
96
97
98
99
00
01
02
Source: Wall Str eet Jour nal /Haver Analytics
03
04
05
06
07
08
Monthly data: CPI Inflation is through December 2008. Oil price is through January 2009.
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UV3957
-27Exhibit 10
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
Balance of Payments ($ billions)
1975–84
1985–94
1995–2004
2005
2006
2007
2008/e
Current Account Balance
Trade balance
Income balance
Current transfers
Capital Account Balance
−14
−30
27
−10
0
−98
−94
21
−25
−1
−331
−301
27
−56
−2
−729
−712
72
−90
−4
−788
−753
57
−92
−4
−731
−700
82
−113
−2
−705
−710
123
−118
−2
Financial Account Balance
U.S. direct investment abroad
U.S. flows into foreign securities
U.S. government assets abroad
Foreign direct investment in the U.S.
Foreign official flows into the U.S.
Private flows into U.S. securities
Net banking flows
Statistical Discrepancy
−3
−14
−6
−7
12
11
11
−12
17
97
−43
−38
−1
43
33
61
32
2
319
−158
−123
−1
150
114
309
12
14
701
−36
−251
20
113
259
583
5
32
809
−241
−365
8
242
488
625
51
−47
768
−333
−289
−22
238
411
731
44
−41
594
−287
105
−492
318
554
126
259
124
2,700
5,588
9,460
12,422
13,178
13,808
14,281
Memo: nominal GDP
Note: All data, except memo items, are in balance of payments terms. All data are annual averages. 2008 data are
estimates that make the (surely incorrect) assumption that Q4 data will the same as Q3 data.
Sources: Bureau of Economic Analysis and Haver Analytics.
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UV3957
-28Exhibit 11
GEITHNER AND BERNANKE AMID THE GLOBAL FINANCIAL CRISIS
U.S. Savings and External Balance (through 2008)
Per sonal Saving Rate
per sonal saving as a % of disposable per sonal income
Fiscal Savings
fiscal balance as % of GDP
16
16
12
12
8
8
4
4
0
0
-4
-4
-8
-8
80
85
90
95
00
05
Sour ces: BEA, OMB /Haver
Cur r ent Account Balance
SAAR, % of GDP
2
2
0
0
-2
-2
-4
-4
-6
-6
-8
-8
80
85
90
95
00
05
Sour ce: Bur eau of Economic Analysis/Haver Analytics
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Harvard Business School
9-797-094
Rev. March 18, 1997
Note on Money and Monetary Policy
Fiscal and monetary policy represent two fundamental tools of macroeconomics. In the
1930s, John Maynard Keynes focused attention on the power of countercyclical fiscal policy, an
emphasis that dominated policy circles in the United States and elsewhere at least into the 1960s.
Since then, however, policymakers in many countries have relied more heavily on monetary policy to
manage the business cycle.
Changes in intellectual fashion and political calculation have driven this shift. Policymakers
have learned that the legislative process is often too slow to allow for fiscal fine tuning, since the
budget cannot always be adjusted fast enough in the face of rapidly changing economic
circumstances. They have also discovered that fiscal policy suffers a systematic bias in favor of
stimulus because national legislatures generally find it politically easier to run deficits than surpluses.
Monetary policy, by contrast, may be less prone to such problems. Central banks can change policy
relatively quickly in response to new conditions. Moreover, central banks are often insulated from
domestic political pressures and so better able to impose economic restraint.
The Money Identity
In theory, monetary policy rests on a simple identity: economic output, measured in current
dollars, equals the amount of money in circulation multiplied by how often that money changes
hands. Economists will recognize this as
MxV=PxQ
in which M equals the money supply, V the velocity or turnover of money, P the price level, and Q
the quantity of output. Each side of the identity equals nominal GDP; and Q, by itself, represents real
GDP.
Like most identities, this one clarifies important relationships but also conceals difficult
questions that require answers if it is to be used effectively: What is money? What determines its
volume? How can we best measure it? And on what basis should we formulate monetary policy?
This note was prepared by Newcomen Fellow Wyatt Wells and Professor David A. Moss as the basis for class discussion
rather than to illustrate either effective or ineffective handling of an administrative situation.
Copyright © 1997 by the President and Fellows of Harvard College. To order copies or request permission to
reproduce materials, call 1-800-545-7685 or write Harvard Business School Publishing, Boston, MA 02163. No
part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in
any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the
permission of Harvard Business School.
1
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797-094
Note on Money and Monetary Policy
Money Creation
Money is any medium of exchange used in transactions. At different times it has consisted of
sea shells, wampum, bullion, and gold or silver coins. But today most economists define money as
the sum of currency and bank liabilities, such as checking and savings deposits. Under one
conventional definition used in the United States, known as M1, the money supply equals currency in
circulation plus demand deposits (i.e., checking accounts). Only the central bank has the power to
create currency, the bills that we carry around in our pockets. Banks, however, can create demand
deposits.
Suppose that an individual deposits $100 of currency into a checking account at his or her
local bank. Although the bank is obligated to pay the depositor (or a designated third party) $100 on
demand, the bank will probably turn around and lend out most of the $100—perhaps $80—to
someone else. In this way, new money is created. The original depositor has a demand deposit
worth $100 and the new borrower has currency worth $80. To put it another way, the bank has
increased the supply of money to $180 on a monetary base of $100.
Money creation is an iterative process. The typical borrower will either turn around and
deposit his or her loan in a bank or pay the money to someone else who in turn deposits it in a bank.
Either way, a new demand deposit is created and the process begins again. If we assume that all
money is redeposited and that banks lend 80 percent of what they take in as demand deposits, then
the money supply will ultimately grow to $500 on a base of $100. The first bank takes in a deposit of
$100 and loans out $80, which is then deposited in a second bank. The second bank then creates a
demand deposit of $80 and loans out 80 percent of that, or $64, which is again redeposited. Of course
this process has infinite iterations, but the first ten ($100 + $80 + $64 + $51.20 + $40.96 + $32.77 +
$26.21 + $20.97 + $16.78 + $13.42) add up to almost $450.
We may calculate the money supply by multiplying the monetary base by the inverse of the
leakage—that is, the proportion of money that is not recycled in the banking system. In the example
above, the leakage is 20 percent, so the final money supply equals
$100 x 1/(0.20) = $100 x 5 = $500.
The inverse of the leakage—in this case 5—is called the money multiplier.1
The size of the monetary base and the level of leakage, which determines the money
multiplier, constitute the key variables in setting the money supply. The central bank can control the
former and strongly influences the latter. Banks must, by American law, retain a certain proportion
of their deposits on reserve, not loaning this money but keeping it either in cash or on deposit with
the central bank. In the U.S. as in most other countries, the central bank sets the reserve requirement,
placing an upper limit on the ability of banks to create credit. Although banks almost always hold
more reserves than legally required, the sum of this excess is generally quite small.
In the example above, the monetary base equaled the total amount of currency in the system
($100). More formally, however, the monetary base equals the financial liabilities of the central bank.
Currency generally represents the largest liability on its balance sheet, but the deposits of private
banks, which tend to hold their reserves at the central bank, also constitute a major liability. The
following is a simplified version of a central bank’s balance sheet:
1 The money multiplier is not the same as the income multiplier, which is important to fiscal policy.
2
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Note on Money and Monetary Policy
797-094
ASSETS
LIABILITIES
$10 gold
$80 currency (outside the central bank)
$10 foreign exchange
$20 private bank deposits
$80 government bonds
or $100.
In this example, the monetary base (i.e., the liabilities of the central bank) equals $80 plus $20,
Central Bank Tools
Most central banks have three tools to affect the money supply. First, the central bank
generally determines reserve requirements. By decreasing the reserve requirement it increases the
money multiplier and thus expands the money supply. Conversely, by increasing the reserve
requirement it decreases the money multiplier and thus contracts the money supply. Because
changes in reserve requirements can produce dramatic shifts in the availability of credit, however, the
Fed rarely uses this power.
A second tool is the so-called discount rate. Private banks may borrow funds directly from
the central bank at the “discount window.” Such loans add directly to the existing monetary base by
increasing private bank reserves, laying the foundation for an expansion of the money supply. The
term “discount window” originated with the practice of private banks selling short-term notes to the
central bank at a discount. The central bank determines the size of the discount— that is, the discount
rate. By lowering this rate, the central bank makes borrowing more attractive to private banks, and
by raising it, it discourages such borrowing.
The third, and in many cases most important, tool of the central bank is open market
operations, which involve the buying and selling of government securities. When the central bank
purchases government obligations from private parties, it injects liquidity into the economy and
increases the monetary base. When the central bank sells securities, it pulls liquidity out of the
economy and thus reduces the monetary base. Open market operations represent the primary policy
instrument of the U.S. Federal Reserve System.
Velocity of Money
Although we have thus far described money as the sum of currency in circulation and
demand deposits, which is commonly known as M1, other definitions exist as well. In the United
States, for example, M2 consists of M1 plus time deposits under $100,000. The point is that not all
money is equal, at least from the perspective of monetary policy. Whereas people tend to spend
currency and funds in their checking accounts fairly rapidly, funds in savings accounts or certificates
of deposit often remain undisturbed for some time. As economists put it, the velocity or turnover (V)
of these different types of money varies. Thus, the impact upon the economy of creating $1 billion in
checking accounts and $1 billion in savings accounts is quite different. Central banks, however,
cannot control exactly where money goes in the financial system. Further complicating the picture,
financial innovations can render traditional measures like M1 and M2 less relevant. For instance,
money market accounts and credit cards finance many of the transactions within the economy, but
they do not figure into conventional definitions of money.
The question of the velocity, or turnover, of money constitutes one of the most important
divisions among economists on monetary policy. Many economists believe that the propensity of
3
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797-094
Note on Money and Monetary Policy
consumers to hold money is inherently unstable. For instance, when the future is uncertain people
are likely to store money in savings, whereas bright prospects encourage consumers to dip into their
savings to buy things. Proponents of the monetarist school of economics, however, contend that
velocity is stable or at least predictable. This belief allows them to assert that the central bank can
control the size of the economy in current dollars (i.e., nominal GDP) by manipulating the supply of
money according to some formula.
Monetary Policy and the Real Economy
Although monetary policy has substantial influence over the size of the economy in current
dollars, its control over how that figure breaks down into prices (P) and real output (Q) is quite
limited. These factors generally depend on conditions in the real economy which central bankers
must take into account when setting policy—the flexibility of prices, the confidence of consumers and
business, the labor market, and so on. These matters have immense practical implications. During a
recession, for instance, an expansive monetary policy might well spark a sharp jump in output (Q)
without having much effect on prices (P), whereas in a boom the exact same policy might well push
inflation sharply higher without having much impact on real production.
The money supply, of course, has considerable impact on interest rates. Interest rates are, in a
sense, the price of money, and an increase in the supply of money tends to reduce interest rates.
Likewise, a reduction in the money supply tends to force rates higher. Many economists conceive of
interest rates as the primary mechanism through which changes in the money supply affect the real
economy.
As a practical matter, central bank policy concentrates at least as much on interest rates as on
the money supply itself. The total stock of money is nearly impossible to determine quickly whereas
interest rates are widely advertised within the financial sector. Central banks often use open market
operations to stabilize short-term interest rates around a desired point, buying government bonds if
rates go too high and selling them if they drop too low. The central bank selects targets for interest
rates because it believes they will yield desirable outcomes in the realms of monetary growth,
economic output, and prices. This is usually true even when the central bank has explicit targets for
monetary aggregates like M1. It manipulates interest rates on a day-to-day basis to achieve its
medium-term monetary objectives.
Not surprisingly, most officials intimately involved with monetary policy consider it as much
an art as a science.
4
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