Minneapolis Fed President Kocherlakota Warns Massive Debt Load Can Only Be Paid By Tax Collections Or Debt Monetization
Minneapolis Fed's recently appointed president Narayana Kocherlakota had his first public speech before the Minnesota Bankers Association. His remarks on the economy were significantly much more cautious than some of the other Bernanke sycophants. While the Fed President espouses the need for bank regulation by the Fed (to be expected, the inverse would be equivalent to mutiny), Kocherlakota is much less sanguine than his Fed colleagues about the prospects for the $1+ trillion in excess reserves and how these may lead to (hyper)inflation in the future. His remarks that the only way to fix the debt excesses: increased taxes and debt monetization (even more so than to date), should let many readers reconsider just how appropriate the Fed is to regulate a system which never changes but keeps on keeping on, changing absolutely nothing in its policy approach, and merely hoping that a rising stock market (with or without its invisible hand) is sufficient to fix everything.
The Economy and Why the Federal Reserve Needs to Supervise Banks
Narayana R. Kocherlakota - President
Federal Reserve Bank of Minneapolis
Minnesota Bankers Association
St. Paul, Minnesota
February 16, 2010
talk today is about the recent performance of the U.S. economy, about
the prospects for recovery, and about the role of the Federal Reserve
in bank supervision. Those may seem like disconnected topics. But my
main point today is that they are not. My goal is to convince you that
a healthy U.S. economy requires a Federal Reserve that is actively
engaged in bank supervision. Before I continue, I would like to remind
you that the following views are my own, and not necessarily those of
others in the Federal Reserve.
So let’s begin with the status of the economy and its future
prospects. Of course, we can’t talk about the future without a brief
review of the past. We have just experienced an unprecedented
recession, unlike anything we’ve encountered since World War II. From
the third quarter of 2008 through the second quarter of 2009, the
United States experienced four consecutive quarters of negative growth
in real gross domestic product. There is no other such sequence in the
postwar period. Not only was the length of this recession unparalleled;
it was also largely unanticipated. Most economists did not see this
coming. I mention this, in part, as a means of handicapping the
forecast you are about to hear. The Romans used to cut up birds to make
their economic forecasts. Our methods have improved—somewhat—but just
like in Roman times, it’s very much caveat emptor with economic
Having said that, even very bad recessions do come to an end. There
is a nascent recovery under way. As I will describe, I expect it to
continue. However, my own forecast is that the recovery in GDP and
especially unemployment will be slow because of uncertainties relating
to various legislative initiatives and problems in the banking sector.
I do think the news is mostly good on the inflation front, although the
need for careful policy choices is even more critical than usual.
Why do I say that a recovery is under way? Real GDP began to grow
again in the third quarter of 2009. In fact, that growth rate
accelerated to a seasonally adjusted annualized rate of 5.7 percent in
the fourth quarter. My own prediction is that the National Bureau of
Economic Research will declare this recession to have ended sometime in
the second half of last year. However, GDP is not the whole story. It
is true that, as measured by unemployment, the economy is still stuck
in a trough. I will have more to say about that in a few minutes.
Will this turnaround in GDP continue in the coming months and years?
In November, the minutes of the Federal Open Market Committee included
summary measures of the forecasts of the presidents of the 12 Federal
Reserve banks and the governors of the Federal Reserve System for real
GDP for 2010 and 2011. Their predictions are roughly around 3 percent
growth for 2010 and around 4 percent growth in 2011. These predictions
seem to be in step with many private sector forecasts.
My own forecast is closer to 3 percent per year over the next two
years, not 3.5 percent. This pessimism derives from two sources. First,
our statistical forecasting model at the Federal Reserve Bank of
Minneapolis is predicting that GDP growth over this period will be
around 2.5 percent per year. The model is a simple one in many ways,
but its forecasting track record is surprisingly good. And, unlike the
Romans, our forecasting model leaves the surrounding eagle population
However, my relative pessimism is grounded in more than the
statistical model’s forecast. I see two areas of concern. First, there
is a great deal of uncertainty related to major policy initiatives
under consideration in Washington. Congress is considering proposals
for enormous changes in health care and in the structure of financial
regulation. These proposals have generated a great deal of uncertainty,
for the capricious winds of politics seem to change them on a
near-daily basis. As bankers, you know that too much uncertainty in a
business plan makes for a risky loan. The same is true for the economy
as a whole. I see this kind of political uncertainty as problematic for
the prospects of rapid recovery.
Second, financial markets have largely healed from the traumas of
2007-09. But the banking sector faces ongoing problems. I do not need
to tell this group that banks with large amounts of commercial real
estate risk-exposure face a correspondingly elevated risk of failure.
This threat could well lead to continued declines in bank lending,
which would curtail the recovery. Even worse, as we saw in the thrift
crisis of the 1980s, in the presence of deposit insurance, banks that
are near failure have strong incentives to make poor loans. This
outcome would be even worse for the economy.
To this point in my talk, I have been discussing broad factors that
can affect GDP growth and that have influenced my economic forecast.
But as I indicated earlier and as we all well know, GDP does not tell
the full story of the impact of recessions. I’m speaking, of course,
about unemployment. Over the past 15 years, more and more
macroeconomists have begun studying household-level data on variables
like earnings and consumption. (Much of this work, by the way, was done
by researchers and consultants at the Federal Reserve Bank of
Minneapolis.) These data have given us a greater appreciation for the
unequal impacts of recessions. Over the fourth quarter of 2008 and the
first quarter of 2009, GDP fell by about 3 percent per person. If this
fall had been spread uniformly across all people in the United States,
it would have been equivalent to everyone’s losing between three and
four days worth of income. This would be difficult, but probably not a
cost that would have led Congress to contemplate the redesign of the
entire financial regulatory system.
The point, though, is that the fall is not spread uniformly across
all people. Some workers—those who lose their jobs—suffer much bigger
falls in income. For this reason, many macroeconomists now believe that
the true cost of a recession is not the fall in GDP per se, but the
associated increase in the risk of people becoming, and staying,
Unemployment is currently 9.7 percent. It has been higher in the
post-World War II period—it reached 10.8 percent in the bleak fall of
1982. However, in the 25-year span between January 1984 and January
2009, unemployment never topped 8 percent. It is safe to say that those
born after 1968 have never experienced an economic episode of this kind
in their working lives.
The outlook for unemployment is not comforting. Though unemployment
has fallen somewhat, forecasts remain uniformly troubling. Unemployment
is notoriously slow to recover, and it has been especially slow to
decline after the last two milder recessions of 1990-91 and 2000-01. I
would be highly surprised if unemployment were below 9 percent by the
end of 2010 or below 8 percent by the end of 2011.
Looking at data on job flows is even more disturbing. Much has been
made in the media about how employment losses are stabilizing, as if
this portends inevitable job growth. However, the source of this
stabilization is problematic. Beginning in the fall of 2007,
unemployment started to rise. This increase in unemployment came about
because firms started to cut back on hiring, and so workers could not
find jobs. Firm hiring rates continued to fall and hit their low point
in early 2009, where they have remained. Why then have employment
losses slowed? The reason is that the rate of layoffs and quits—what
economists call the separation rate—has slowed. But declines in the
separation rate cannot be viewed as a robust source of employment
growth. To get a true expansion in employment and in the economy, the
hiring rate has to pick up—and we have yet to see evidence that it will
do so in the immediate future.
Let me end this portion of my talk on a more positive note, with a
caveat to follow, of course. The positive news in this economy is that
inflation has been relatively tame. From the fourth quarter of 2007 to
the fourth quarter of 2009, PCE inflation has averaged slightly less
than 1.5 percent per year. Over that same period, core PCE inflation
(subtracting food and energy) averaged around 1.7 percent per year. The
Fed is keeping inflation at levels consistent with good long-run
Here’s the caveat: Deposit institutions are holding over a trillion
dollars of excess reserves (that is, over 15 times what they are
required to hold given their deposits). These excess reserves create
the potential for high inflation. Suppose that households
believe that prices will rise. They would then demand more deposits to
use for transactions. Banks can readily accommodate this extra demand,
because they are holding so many excess reserves. These extra deposits
become extra money chasing the same amount of goods and so generate
upward pressure on prices. The households’ inflationary expectations
would, in fact, become self-fulfilling.
Why might households expect an increase in inflation? The amount of
federal government debt held by the private sector has gone up by over
30 percent since the beginning of 2008. This debt can only be paid by
tax collections or by the Federal Reserve’s debt monetization (that is,
by printing dollars to pay off the obligations incurred by Congress).
If households begin to expect that the latter will be true—even if it
is not—their inflationary expectations will rise as well.
I hasten to say—and I want to stress—that I view this scenario as
unlikely. For it to transpire, we would need a combination of bad
monetary policy and poor fiscal management. I do not foresee this
combination as likely to occur. Nonetheless, good policy requires good
choices, and policymakers at the Federal Reserve and in Congress need
to keep this scenario in mind when making their decisions. I can assure
you that we in the Federal Reserve have every intention of keeping our
end of the bargain.
So, to summarize my economic forecast, I do think that the economy
is on the mend and should continue to recover over the next two
years—in terms of both GDP and unemployment—but at slower rates than we
would like. The outlook for inflation is basically promising, as long
as the Federal Reserve and Congress work together appropriately.
My discussion leaves out the main way that the economy has improved
in the past 18 months: We face much less uncertainty. Let me take you
back to September 2008. At that time, almost all believed that a
horrific economic collapse—already named Depression 2.0—was possible.
(Indeed, many believed that it was inevitable.) Real GDP did fall by
over 3.5 percent from December 2007 through June 2009. Unemployment did
double from 5 percent in December 2007 to 10 percent in December 2009.
Those numbers are shocking. But it cannot be emphasized enough how they
pale in comparison to their analogs from the Great Depression. From
1929 through 1933, real GDP in the United States fell by 27 percent.
Unemployment rose from 3.2 percent to 25 percent. Today, unlike in
September 2008, this type of catastrophic economic collapse is no
longer on the menu of likely or even plausible events.
How did this improvement in the level of economic uncertainty come
about? The answer to this question brings me to the second part of my
talk. My theme here is that this improvement in our economic situation
is attributable in large part to actions taken by the Federal Reserve.
I will emphasize that the Federal Reserve was only able to undertake
these actions because of expertise and information that it had acquired
as a supervisor of the nation’s banks. My conclusion is that stripping
the Federal Reserve of its supervisory role would needlessly put a
Great Depression on the menu of possibilities for our country.
Let’s begin by recollecting the state of the financial world in
September 2008. The problem was that the world was in the midst of a
financial panic that had started a year earlier. Financial panics are
events that blur the line between liquidity and solvency. And here I
should take a moment to define these terms. A firm is solvent if its
revenues (in a discounted present value sense) exceed its expenditures.
A firm is liquid if it is able to raise enough funds—either by
borrowing or by selling assets—to pay its current costs. In a
well-functioning financial market, solvent firms are typically liquid,
because they can borrow against their future revenues. In contrast, in
a financial panic, lenders feel unable to assess the resources or the
collateral of borrowers. Borrowing becomes highly constrained, and even
highly solvent firms may become illiquid. In severe financial panics,
like the one that took place in the Great Depression, the shortages of
liquidity can eliminate large amounts of GDP and large numbers of jobs.
It was exactly this possibility that we faced in the fall of 2008.
The actions of the Federal Reserve System were instrumental in
ensuring that this eventuality did not occur. Beginning in the fall of
2007, the Federal Reserve undertook a number of critical interventions
designed to enhance the functioning of financial markets. In the
remainder of this speech, I will go through two of them in some detail.
I will pay particular attention to the role that our experience as a
bank supervisor played in the success of these interventions.
The first intervention is a traditional one. In any economy, one of
the main jobs of the central bank is to make sure that both the
quantity and allocation of liquidity are appropriate. In terms of the
quantity of liquidity, the central bank’s tool is a targeted short-term
interest rate, like the federal funds rate. In terms of the allocation
of liquidity, the central bank’s tool is the discount window.
During the recent financial crisis, the Federal Reserve used the
discount window in a truly massive way. On July 25, 2007, the Federal
Reserve had 246 million dollars of discount window loans outstanding to depository institutions. At the end of 2008, the Federal Reserve had nearly 90 billion dollars of such loans outstanding—a 36,000 percent increase.
But even this enormous increase is really a vast underestimate. In
late 2007, the Federal Reserve became concerned that the traditional
discount window was being underutilized. It opened what was known as
the term auction facility—the TAF—which allowed depository institutions
to bid on loans from the Federal Reserve. Through this facility, at the
end of 2008, the Federal Reserve had 450 billion dollars of loans
outstanding to depository institutions. The combined total of 540
billion dollars of loans to financial institutions from the TAF and the
discount window represented a 200,000 percent increase over July 2007.
We do not know the impact of this lending on the financial sector
with certainty. However, it seems reasonable to presume that it was
essential in keeping solvent financial institutions afloat during the
height of the financial crisis. There is compelling supporting evidence
for this view in aggregate loan data. Total liabilities for
U.S.-chartered commercial banks grew by 1.2 trillion dollars from the
third quarter of 2007 to the fourth quarter of 2008. Loans from the
Federal Reserve account for nearly half of this increase.
Now, it is important to emphasize that the Federal Reserve did not
use these facilities to simply hand out money to banks. In a financial
panic, public policy has two goals. One is to make sure that illiquid
but solvent firms survive. The other is to make sure that truly
insolvent firms do in fact fail. For this reason, the Federal Reserve
only made loans to sufficiently high-quality financial institutions.
This kind of selective intervention requires the Federal Reserve to
have good information about any financial institution that is a
Under our existing regulatory system, the Federal Reserve could turn
to its own supervisors for this information and the ability to evaluate
that information. But suppose instead that, as has been proposed by
Senator Christopher Dodd and others, the Federal Reserve had no
supervisory authority. How would the discount window or TAF have
worked? Given any financial institution that wanted to borrow, the
Federal Reserve would have had to call that financial institution’s
regulator and ask for information about the financial institution’s
quality. I see two distinct problems with such an arrangement. The
first is purely logistical. During a crisis like 2007-09, this other
regulator would necessarily face huge resource demands in terms of
obtaining and sharing information about a financial institution’s
quality. Getting the phone answered in a timely fashion about a given
financial institution might well be extremely challenging.
But the bigger problem is one of incentives. Under the current
system, if the Federal Reserve makes a bad loan through the TAF or
through the discount window, that loss appears on its balance sheet. It
has every incentive to do a good job in assessing the borrower quality.
Now suppose instead that some other agency were responsible for
providing this information to the Federal Reserve. What exactly are
this other agency’s incentives to provide the Federal Reserve with the
best possible information? This other agency is not going to suffer a
loss for making a bad loan—the Federal Reserve is. Indeed, one can
readily imagine that in the politically charged circumstances of a
financial panic, this other agency’s objective might be to keep as many
banks alive as possible. In these circumstances, the Federal Reserve
would have no way to obtain reliable information from this other
regulatory body and would have no way to make appropriately targeted
loans. As it is, the Federal Reserve has not lost any money on either
TAF or discount window loans made during this period.
Let me talk next about a less traditional intervention: the
Supervisory Capital Assessment Program—that is, the bank stress test.
Through March and April of 2009, the Federal Reserve and other federal
bank supervisors conducted an assessment of the capital needs of 19
large bank holding companies under a benchmark macroeconomic scenario
and a hopefully unrealistically adverse scenario. The study released
bank-level information about risk exposure of various kinds. It was
extremely valuable in restoring market confidence in the viability of
the large American banks.
The Federal Reserve played the leading role in the implementation of
the stress test. In part, this leading role arose because, from a legal
perspective, the Federal Reserve was the primary regulator of the
various bank holding companies. But there is also a more fundamental
reason for its taking the lead. By its very nature, a good central bank
needs expertise in a wide range of areas: supervision, monetary
economics, financial markets, and macroeconomics. The stress test
required this same range of expertise. Playing the leading role in the
stress test was an intrinsic outgrowth of the Federal Reserve’s
multitasking role in the economy.
Now suppose that the Federal Reserve did not have
supervisory authority over banks. Then, no institution in the
government would have the kind of collective expertise to orchestrate a
stress test for the large banks. My guess is that the stress test would
never have taken place. Along these lines, it is worth noting that
countries with divisions between supervision and monetary policy did not undertake exercises similar to the stress test.
Indeed, one could go further. Suppose that the Federal Reserve had
had responsibilities for systemic risk regulation, as has been proposed
in the House financial regulation bill. My belief is that under this
proposed regulatory structure, the stress test would have been better
in terms of both its form and its timing. In terms of form, the May
stress test studied the 19 target institutions in a parallel but
entirely separate fashion. The test did not gauge the institutions’
interactions with each other or with other financial entities. A stress
test done by a systemic regulator would have included those critical
In terms of timing, the stress test took over two months from
inception to finish. In late 2008, the speed of events was such that
two months seemed like an eternity. If the Federal Reserve had been a
systemic regulator, the stress test would have been much less
resource-intensive, because it would have been a natural outgrowth of
the Federal Reserve’s obligations. It is not difficult to imagine that
this cheaper stress test would have taken place in October or November
of 2008. At that point in time, interbank lending markets were still
significantly dislocated. At least some of these stresses were
attributable to lenders’ lacking good information about the portfolios
of potential borrowers and their financial connections. My own view is
that a November stress test, with its associated release of
bank-specific information, would have been enormously helpful.
Discount window lending and the stress test are but two of the
interventions that the Federal Reserve undertook in response to the
financial crisis. I hope that I have convinced you that these
interventions would have been significantly more difficult, if not
actually impossible, in a world in which the Federal Reserve did not
have a supervisory role. The Federal Reserve undertook a number of
other broad-based market interventions to provide liquidity to solvent
firms. Here, I should emphasize that I am not talking about
the targeted injections of funds into Bear Stearns or AIG. These
injections were designed to achieve objectives other than the provision
of liquidity. Rather, I am talking about interventions like the Term
Asset-Backed Securities Loan Facility, under which the Federal Reserve
purchased a broad range of asset-backed securities from a large number
of sellers. I won’t go into detail about these other lending
facilities, except to note that all of these interventions were highly
complex. The Federal Reserve’s expertise in banking supervision was
essential in their design and implementation.
Would we have had Depression 2.0 without the Federal Reserve’s using
this range of policies? We will never know for sure. However, it is
clear to me that these policies worked as intended: They kept illiquid
but solvent firms alive during the course of the financial crisis,
while letting truly insolvent firms fail. In so doing, these policies
eliminated the possibility of Depression 2.0.
My remarks have focused on the Federal Reserve’s ability to stop a
financial crisis from creating a Great Depression. I’ve done so because
I believe that this ability is critical. Don’t get me wrong—we can and
should do a better job of financial regulation so that we minimize the
likelihood of a financial crisis ever taking place. In the 2000s, the
Federal Reserve made some significant mistakes along these lines—as did
the FDIC, the OCC, the OTS, and regulators in many other countries. As
the Minneapolis Federal Reserve has been urging for over 30 years,
politicians and regulators need to create incentives that will lead
financial firms to avoid risks that end up costing taxpayers.
However, no financial regulatory scheme will ever be perfect.
Whatever we do about financial regulation, at some point in the future,
investors and regulators will again confuse the unlikely and the
impossible. Their mistake will create the next financial crisis. Right
now, our regulatory system has the ability to prevent those crises from
generating 30 percent falls in output and unemployment rates of 25
percent. When changing the system, we have to make sure that it doesn’t
lose that ability. Stripping the Federal Reserve of its role in
supervision is a step in the wrong direction. Making it the systemic
risk regulator is a step in the right direction.
Thank you once again for this opportunity, and I welcome your questions.
- advertisements -