What’s New at the Minneapolis Fed?

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Presidents of Federal Reserve District Banks, somewhat isolated from policymaking action in Washington and but still wanting to be heard, frequently adopt a signature issue. The new Minneapolis Bank chief, Neel Kashkari, has chosen breaking up the big banks as his hobbyhorse, packaging the idea as a promising strategy to prevent future Great Recessions. It is a surprising choice for the Fed District Bank that long pioneered the Real Business Cycle paradigm. From a RBC perspective, Kashkari’s argument requires big-bank behavior in 2008-09 to have damaged the productive potential of the U.S. economy so substantially that six million people lost their jobs and total equity value fell by half.

So far at least, the new big-bank focus has not improved the Minneapolis Fed’s capacity to make sense out of the extreme insatiability experienced in 2008-09. The much anticipated conference hosted by its research department was a disappointment, as has been the entirety their nearly two-year-investigation of the causal role of the largest banks in acute instability.

John Cochrane’s conference paper illustrates the curious approach. He proposed the restructuring of the banking system by replacing short-term debt, including deposits, with equity and by taxing leverage. While he is inattentive to the huge cost of imposing such a restrictive bank structure the U.S. economy, no one can argue with his conclusion that, absent debt, banks are not vulnerable to runs: “Runs at specific individual institutions caused by identifiable problems [are] not really the danger. A specific contagion mechanism by which troubles at one institution spread to another because they cause people to worry about their own bank’s assets — it’s that systemic-run element that means banks can’t easily sell cash, issue equity or otherwise handle problems.”

In their attempt to place bank size at the center of Great Recession macrodynamics, Cochrane and the Minneapolis Fed fail to adequately model contagion. From Hal Scott’s fine new book (2016): “Connectedness occurs when financial institutions are directly over exposed to one another and the failure of one institution would therefore directly bankrupt other institutions, resulting in a chain reaction of failures. Contagion is a different phenomenon. It is an indiscriminate run by short-term creditors of financial institutions that can render otherwise solvent institutions insolvent due to the fire sale of assets that are necessary to fund withdrawals and the resulting decline in asset prices triggered by such sales.”

The GEM Project provides a plausible model of contagion rooted in rational behavior. It is a much superior basis for designing effective policies to halt and reverse contracting total spending. Recall that the Project demonstrates collapsing nominal demand to be the engine of the nonstationary disturbance that occurred in 2008-09 and, more dramatically, in the 1930s. In the build-up to the acute instability of late 2008, there were two types of investor/lender confidence that, in retrospect, required management by central banks. The first is familiar: the trust that funds held by banks can be effectively withdrawn. That belief prevents bank runs and their damaging feedback on total spending and employment/output. Beginning in middle-2007, the ECB and the Fed, joined somewhat tepidly by the Bank of England, flooded the banking system with liquidity and aggressively used swap lines to channel dollars to Europe in the successful effort to keep the failures of three French funds managed by BNP Paribas, the British bank Northern Rock, and the US investment bank Bears Stearns from inducing bank runs. Walter Bagehot would have been proud.

A second manifestation of confidence would have be less familiar to Bagehot but has been, since the spread of the Second Industrial Revolution, at least as important as bank runs. In the 2008-09 extreme-instability macrodynamics, this second class of confidence dashed the hopes of stabilization authorities that plentiful liquidity by itself would effectively contain financial disruptions rooted in gathering uncertainty about U.S. residential-mortgage CDOs that had been distributed globally. Denoted by Ƈ in the GEM Project, it measures general investor/lender perceptions of the creditability of the real-side goals of stabilization policymakers. (Chapter 6) Perceived credibility is increasing in the degree to which future macroeconomic states can be characterized by probabilities rooted in the known objectives of monetary and fiscal authorities. Ƈ turns out to be a most consequential application of Lucas’s admonition that expectations in macro modeling must take full account of observed government policies.

The bankruptcy of the investment bank Lehman Brothers in September 2008 produced immediate turmoil in the U.S., featuring disarray among stabilization policymakers (especially the ill-informed, unmindful Congress) and widespread dire assessments, most startling when coming from the respected chief of the Federal Reserve, of the significant possibility of repeating the devastating 1930s depression. Information on the macro future, most notably on the capacity of stabilization authorities to maintain sufficient aggregate demand to make good on their trend high-employment objectives, quickly deteriorated, becoming increasingly perceived as incomplete and asymmetric. Investors/lenders became uncertain. In Nancy Stokey’s insightful description of such circumstances, gathering uncertainty breeds rational inaction. Many investors/lenders moved to the sidelines, waiting to see how the market turmoil gets resolved. An early casualty of buyer inaction was equity valuations. Sidelined buyers provided an open field for short-sellers, and the S&P 500 fell by half in the six months after the Lehman debacle. It is foolish to argue that such a huge a drop resulted from a corresponding contraction in the economy’s underlying productivity rooted in human, physical, and organizational capital. We all know, at least deep down, that the stock-market collapse can only be understood as a collapse in confidence. (Chapter 6)

The GEM Project identifies the best available means of preventing future Great Recessions (or worse): strengthen Ƈ by focusing on making the Fed’s toolkit for managing aggregate nominal demand both as effective as possible and broadly understood to be as effective as possible. As a bonus, the Project also identifies Kashkari’s hobby-horse of breaking up the largest banks in order to prevent future episodes of extreme instability as a fool’s errand.

Blog Type: Wonkish Chicago, Illinois


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