reboot the republic daily August 8, 2010

Can the Fed Successfully Exit?

Posted: 08 Aug 2010 03:51 PM PDT

From The Mises Institute

The Federal Reserve Bank of Minneapolis recently interviewed macroeconomist Robert Hall for the June issue of its quarterly magazine, The Region.Download PDF His words on the Federal Reserve’s ability to enact an exit strategy to unwind its unconventional policies were clear and sure: “There are two branches to the exit strategy: There’s paying interest on reserves, and there’s reducing reserves back to normal levels. They’re both completely safe, so it’s a nonissue.”

Before addressing the question of whether the exit strategy is really “completely safe” or a “nonissue”, we must first address the specifics of these two components.

In the wake of the credit crisis of late 2008, the Federal Reserve flooded the banking sector with liquidity. The Fed purchased troubled assets in exchange for base money. Since the banking system was not prepared to immediately loan this new base money, the system’s reserves increased dramatically. The Fed concomitantly commenced paying interest on these reserves to remove the incentive for them to be fully used. In theory, by removing the incentive to loan out reserves, price inflation would be minimized: banks would not be constrained by their troubled loans and bad assets, and the Fed would retain credibility as an “inflation fighter.”

The result was immediate and effective. As bad assets were removed from their balance sheets, banks were not forced into fire-sale situations by selling their assets to maintain regulatory capital levels. At the same time the Fed was able to save the banking sector via an increase in available credit without causing inflationary pressures to build.

While the short-term effects were seemingly beneficial and controlled, the long-term outlook is much less certain.

The Fed’s liquidity injection was made by issuing credit to banks and simultaneously buying back troubled (i.e., subprime) banking sector assets. While the banking sector’s balance sheet ballooned with cash and cash equivalents, the Fed’s own balance sheet witnessed a sharp rise in the very troubled assets it was removing from the banking system. As Philipp Bagus recently noted, the Fed had become exactly the type of “bad bank” it had tried to rescue.

The figure below outlines the growth in the Fed’s balance-sheet policies during the crisis.

Figure 1: Banking system loans initiated by the Federal Reserve System
Figure 1
Source: Federal Reserve Statistical Release H.4.1 ($bn., monthly: Jan. 2008 — Jul. 2010)

Some of the enacted programs were self-liquidating, and now pose minimal danger to the financial system (central-bank liquidity swaps spring to mind, as does the money-market mutual-fund liquidity provision). Other programs have continued growing and cannot be so easily phased out. Over $1.1 trillion of mortgage-backed securities have been purchased since March 1, 2009. These assets, typically rated subprime, are of questionable quality (with total assets of almost $2.4 trillion as of July 1, 2010, nearly half of the Fed’s total assets are subprime). More troubling is that these mortgages cannot be properly valued until they are sold to a willing buyer — buyers who are increasingly in short supply.

This “qualitative easing” — the purchasing of low-quality assets from the banking sector in exchange for high-quality assets from the central bank — persisted until central banks lacked adequate high-quality assets to continue the policy. It was only at this point that the more obvious policy of “quantitative easing” was pursued.

Philipp Bagus and I have been among a minority of economists who have signaled the occurrence of this policy (both by the FedDownload PDF and the European Central Bank), and, more importantly, its detrimental ramifications. The long-term implications of this policy are now becoming evident.

As the Fed withdrew these troubled assets from the banking system, they were offset by issuing increasing amounts of Federal Reserve liabilities — cash. By offering an interest payment on reserve holdings, banks were incentivized to hold on to this newfound liquidity, thus nullifying any inflationary effects the policy could immediately cause. And as Robert Hall correctly notes, one exit strategy the Fed now has is the continual payment of interest on these reserves. As long as banks can profitably hold the 1.1 trillion extra dollars of monetary base that the Fed has created since August 2008, no inflationary pressures will build.

The reality may be very different from what Hall’s theory suggests. As the figure below shows, the banking system now receives around $230 million each and every month for doing nothing other than holding on to the assets they passively received in exchange for their low-quality mortgage-backed securities.

Figure 2: Monthly Federal Reserve System interest paid on reserves
Figure 2
Source: Federal Reserve Board of Governors release H.3 (Aug. 2008 — Jul. 2010)

Three billion dollars a year in interest payments is a large portion of the Fed’s annual operating profits. The recipients — America’s large and not-so-large banking establishments — are now much less hindered by subprime loans than they were two years ago. How much longer the Fed can give the banking sector billions of dollars to hold on to these reserves is questionable. Politically, it seems unlikely that Americans will continue to support these payments. Economically, the Fed is losing a large portion of its operating profits to these payments.

Despite these troubling aspects, the banking system’s subprime situation is being alleviated. The Fed continues its policy of buying these mortgage-backed securities from the banking sector in order to maintain stability. This is a show of force, an attempt to demonstrate that the Fed is in full control of the situation.

Full control, however, is exactly what the Fed does not have. The alternative exit strategy, if financial stability is to be maintained without runaway inflation, is for the Fed to simply swap the “bad” assets on its own balance sheet for the “good” assets of the banking system.

Herein lies the rub. Inflationary pressures could be neutralized if the aggregate value of the assets originally purchased by the Fed is equivalent to the aggregate value of the assets now being returned. We should take comfort in knowing that at least one of these numbers is known with some degree of exactness. The cash now resting as reserves, and more importantly excess reserves, on the banking system’s balance sheet can be valued at par: more or less, there are $1.1 trillion waiting on the sidelines for the Fed to reabsorb.

The value of the mortgage-backed securities that the Fed holds is far less certain. While the reported value on its balance sheet is $1.1 trillion, we should note that the Fed is balancing its books based on the current face values of these securities. These trillion odd dollars represent the outstanding principle on this debt, which is guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. While these assets may have been purchased originally by the Fed for this recorded amount, the maintenance of this value is questionable.

At what discount are securities backed by and comprised of Las Vegas gambling parlors and Miami vacation rentals selling today? We don’t know for certain, and more troubling, we won’t know what discount a trillion dollars worth of these securities will sell at until the market finds buyers for them. Presumably, the Fed purchased the lowest-quality assets that the banking system held: removing the most “toxic” assets to aid bank capitalization levels. Knowing that the Fed now holds the most toxic of the subprime assets the banking system could create during the roaring 2000s should leave us with some concern.

What then of the Fed’s exit strategy? Ben Bernanke and Robert Hall, along with a multitude of fellow central bankers and economists, have stressed that there is no technical problem in exiting these positions. This is theoretically true — until reality sets in.

Any Fed-enacted swap of its subprime assets for the excess reserves of the banking system will result in some degree of inflation if the two values do not coincide. An upper and lower bound for future price inflation can be approximated from this differential.

At the upper bound, as several commentators such as Robert Murphy have warned, is the outcome where the Fed does nothing to reign in excess reserves. In this case, the Fed will have created $1.1 trillion worth of inflation.

More importantly, we can estimate the lower bound for the Fed-created inflation. The value differential between the excess reserves in the banking system and the subprime assets held by the Fed will remain in the banking sector indefinitely. As the Fed can only purchase back from the banking system reserves of equal value to its available assets, any drop in the value of its own assets will result in excess reserves remaining in the hands of the banking sector — waiting to manifest as price inflation when finally utilized.

Neither bound, upper nor lower, seems particularly attractive.

The silver lining in all this may be that any inflationary pressures will have to wait for another day. The Fed will not enact either exit strategy until the banking sector is back on firm footing, lest a tenuous situation worsen. With several banks entering insolvency weekly, the Fed is in no position to start unwinding any of its balance-sheet policies designed to aid the struggling sector.

Until the day comes when the Fed deems the banking sector able to stand on its own two feet — either with its subprime mortgages back, or without the interest payment on its reserve holdings — inflationary pressure on prices will remain low. But until the Fed finally decides to unwind its subprime balance-sheet positions, entrepreneurs will have to function in an era of uncertainty as to what price inflation lies ahead.


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Study: Is the FDA Safe and Effective?

Posted: 08 Aug 2010 11:45 AM PDT

Medical drugs and devices cannot be marketed in the United States unless the U. S. Food and Drug Administration (FDA) grants specific approval. We argue that FDA control over drugs and devices has large and often overlooked costs that almost certainly exceed the benefits. We believe that FDA regulation of the medical industry has suppressed and delayed new drugs and devices, and has increased costs, with a net result of more morbidity and mortality. A large body of academic research has investigated the FDA and with unusual consensus has reached the same conclusion.

Drawing on this body of research, we evaluate the costs and benefits of FDA policy. We also present a detailed history of the FDA, a review of the major plans for FDA reform, a glossary of terms, a collection of quotes from economists who have studied the FDA, and a reference section with many webbed links. A more detailed table of contents follows. We are happy to receive comments and criticisms.

Read through the study @ The Independent Institute.


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The Effect Of Speed Limits On Actual Travel Speeds

Posted: 08 Aug 2010 08:37 AM PDT

From The National Motorists Association (2008)

I have worked closely with the Michigan State Police for several years in their pursuit of correcting as many Michigan posted speed limits to the correct 85th percentile speed level as possible. Yes, we have a very enlightened state police administration that wants to see posted limits set for safety, not revenue.

I have testified before Michigan legislative committees in support of the State Police to help explain the science involved, helped to nominate the key officers for a Governor’s Traffic Safety Advisory Committee Award which they won in 2006, and helped the police find areas of state trunk line routes (numbered highways) which should be re-surveyed because the posted limits were set far below the normal speeds of traffic.

In late 2006, the state police came to Ann Arbor and did speed studies on several state routes through Ann Arbor, parts of Business Route US-23 and parts of Business I-94. The posted limits on these trunk line routes are legally under the control of the state police and MDOT, not local authorities, but the local authorities can sometimes “push back” in the court of public opinion.

After a long period of negotiations and explanations with a city that does not want posted limits raised at all, three areas were re-posted in early 2008 with corrected speed limits raised to the 85th percentile speed of free flowing traffic under good conditions.

The City Council even passed a resolution opposing these safety-oriented changes, but they do not have legal control over state routes, so they finally agreed to the three areas to be changed.

After allowing a period of adjustment while drivers got used to the newly posted higher limits, I re-surveyed these three areas to see what changes there were, if any, in actual travel speeds.

The huge study done in 1992 by Martin Parker says there would be little change in the speeds people actually drive.

This was, of course, the result.

Actual travel speeds changed by a maximum of 2 mph in some parameters, not at all in others, and some speed points were lower with the higher posted limits. The actual traffic speeds remained the same as they have been for 23 years.

One thing did change. As was expected, the vast majority of safe, sane, competent drivers who go along with the normal flow of traffic are no longer arbitrarily defined as criminals, and no longer subject to big ticket fines and even bigger insurance surcharges.

One of my key goals is to get a reluctant Ann Arbor city government to adopt the proven practices to set the safest speed limits as described in the Institute of Transportation Engineers Engineering Handbook, the Michigan Manual of Uniform Traffic Control Devices, and the revised set of Michigan traffic laws that went into effect in November of 2006.

It is an uphill battle, because of two reasons.

First, the city makes so much money from traffic tickets that safety practices take a back seat to the revenue.

Second, the flow of misinformation and deliberate disinformation that has come out of Washington since the early 1970s has convinced many citizens that lower numbers painted on the speed limit signs means lower actual traffic speeds and safer driving.

Anyone who has read the scientific literature knows this is totally false, but a lot of education is needed to repair the damage and correct the false beliefs many people have about posted limits.

Hopefully the City Council members and others who read the charts will see the proofs that actual travel speeds do NOT rise with corrected 85th percentile posted speed limits and that will remove one counter argument for posting 85th percentile speed limits to maximize safety.

Definitions included at the bottom of the page.

History Of Speeds On North Main Street (Northern Section)
Data is from the middle of the section where the posted speed limit was corrected to 45 mph in 2008, from the former 40 mph. Data is taken at Points 1 and A on the MDOT Traffic Control Order Map.

Survey Date Sep 2006 Aug 2008
Posted Speed Limit 40 MPH 45 MPH
% of Vehicles Obeying Speed Limit 33% 71%
50th Percentile Speed 43 MPH 43 MPH
85th Percentile Speed 47 MPH 47 MPH
90th Percentile Speed 49 MPH 49 MPH
% of Vehicles at 50 MPH or Higher 8.4% 8.6%
Fastest Speed Recorded 55 MPH 54 MPH
Total Range of Speeds 29 to 55 MPH 33 to 54 MPH
Maximum Difference in Speed 26 MPH 21 MPH

History Of Speeds on Washtenaw Avenue, Near the City Club
Data is from the middle of the section where the posted speed limit was corrected to 40 mph in 2008, from the former 30 mph. Data is taken at Points 5 and P on the MDOT Traffic Control Order Map.

Survey Date Sep 2006 Aug 2008
Posted Speed Limit 30 MPH 40 MPH
% of Vehicles Obeying Speed Limit 8% 86%
50th Percentile Speed 35 MPH 36 MPH
85th Percentile Speed 40 MPH 40 MPH
90th Percentile Speed 41 MPH 42 MPH
% of Vehicles at 45 MPH or Higher 0.7% 1.7%
Fastest Speed Recorded 47 MPH 49 MPH
Total Range of Speeds 28 to 47 MPH 28 to 49 MPH
Maximum Difference in Speed 19 MPH 21 MPH

History Of Speeds on Washtenaw Avenue, Ann Arbor, Michigan
Data is from the middle of the section where the posted speed limit was corrected to 45 mph in 2008, from the former 35 mph. Data is taken at Points R & S on the MDOT Traffic Control Order Map.

Survey Date Sep 2006 Aug 2008
Posted Speed Limit 35 MPH 45 MPH
% of Vehicles Obeying Speed Limit 4% 79%
50th Percentile Speed 42 MPH 43 MPH
85th Percentile Speed 47 MPH 46 MPH
90th Percentile Speed 48 MPH 47 MPH
% of Vehicles at 50 MPH or Higher 4.7% 2.6%
Fastest Speed Recorded 58 MPH 52 MPH
Total Range of Speeds 33 to 58 MPH 34 to 52 MPH
Maximum Difference in Speed 25 MPH 18 MPH


50th Percentile: Speed at which 50% of vehicles are above that speed and 50% are below.

85th Percentile: Speed at which 85% of the vehicles are below or right at that speed.

90th Percentile: Speed at which 90% of the vehicles are below or right at that speed.

Update (8/24/08) – The story was picked up by the media in Ann Arbor:


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UN panel: New Taxes Needed For a Climate Fund

Posted: 07 Aug 2010 07:58 PM PDT

From Yahoo News

BONN, Germany – Carbon taxes, add-ons to international air fares and a levy on cross-border money movements are among ways being considered by a panel of the world’s leading economists to raise a staggering $100 billion a year to fight climate change.

British economist Nicholas Stern told international climate negotiators Thursday that government regulation and public money also will be needed to create incentives for private investment in industries that emit fewer greenhouse gases.

In short, a new industrial revolution is needed to move the world away from fossil fuels to low carbon growth, he said.

“It will be extremely exciting, dynamic and productive,” said Stern, one of 18 experts in public finance on an advisory panel appointed by U.N. Secretary-General Ban Ki-moon.

A climate summit held in Copenhagen in December was determined to mobilize $100 billion a year by 2020 to help poor countries adapt to climate change and reduce emissions of carbon dioxide trapping the sun’s heat. But the 120 world leaders who met in the Danish capital offered no ideas on how to raise that sum — $1 trillion every decade — prompting Ban to appoint his high-level advisory group.

The Copenhagen summit also resolved to mobilize a three-year emergency fund of $30 billion starting this year. It was unclear how much has been raised and disbursed so far.

The advisory panel, which began working in March, will present its final report to Ban in October, a month before the next decisive climate conference convenes in Cancun, Mexico.

It will analyze a range of options, Stern said, and governments must decide which to chose, how much to raise from each source, and how to distribute the money.

Potential revenue sources include auctioning the right to pollute, taxes on carbon production, an international travel tax, and a tax on international financial transactions, as well as government grants and loans. Each could produce tens of billions of dollars a year, Stern said.

“No one single source will deliver $100 billion by itself. There is no silver bullet, no hole in one,” he said.

Private capital also will be crucial, and governments must adopt policies reducing the risk to investors, he said.

The panel’s recommendations will weigh the practicality, reliability, and political acceptability of each method, he said.

The advisory panel is chaired by the prime ministers of Norway and Ethiopia and the president of Guyana. Its members include French Finance Minister Christine Lagarde, White House economic adviser Lawrence Summers, billionaire financier George Soros and public planners from China, India, Singapore and several international banks.

The governments of 194 countries are negotiating an agreement to succeed the 1997 Kyoto Protocol, which called on industrial nations to reduce carbon emissions by an average 5 percent below 1990 levels by 2012. Unlike Kyoto, the next deal would set emission goals for developing countries, especially rapidly growing economies like China and India, in exchange for help with financing and technology.

The negotiating session in Bonn ends Friday, and delegates will meet once more in China before the Cancun ministerial conference.


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