The Fed as Market Maker of Last Resort
The Fed is acting as market maker of last resort (MMLR) – a good thing if the latest deepening of the financial crunch facing investment banks and other financial institutions is indeed due to illiquidity rather than rational fear of insolvency. As it is likely that at least part of the increased difficulty of finding private buyers for the kinds of asset-backed securities the investment banks want to unload, is due to pure illiquidity (current illiquidity created by fear of future illiquidity of the would-be seller and of the would-be buyer of the securities) the Fed is right to increase, by $140bn, its collateralised loan facilities (through a one-month maturity repo facility targeted mainly at the primary brokers or investment banks) and Term Auction Facility. It may well have to do more of the same. To avoid creating adverse incentives, the collateral offered in the repo facility and the TAF should , when it is illiquid, be valued aggressively and be subject to a serious haircut.
The increased fear of insolvency in the banking sector and the shadow banking sector is probably based on a correct assessment of the structural deterioration in the quality of their balance sheets. The US financial sector will have to shrink. This necessary shrinkage could come about in principle through a equal proportional reduction in the size of the balance sheets of all US banks and shadow banking institutions, without any bank failures. From a Darwinian perspective, it would, however, be more efficient if the necessary contraction of the size of the US financial sector were to come about at least in part through the failure of the least efficient banks and shadow banks. The enormous diversity in the performance of the banks, faced with very similar challenges, certainly supports this view. I therefore hope and expect that the required shrinkage of the US financial sector will come at least in part through the demise of some systemically significant institutions.
The Fed should be ready to mop up the liquidity damage if and when this occurs. It is not the party designed to orchestrate an insolvency-preventing bail out. That’s what the Sovereign Wealth Funds are for. If there is no private solution, a fiscal bailout financed, directly or indirectly, by the US Treasury, perhaps through the FDIC, is required if and only if systemic risks are deemed to be present. Personally, I don’t believe that, with effective deposit insurance in place, any US bank is too large to fail. But fortunately that is a judgment I will not be asked to act upon.
Further interest rate cuts would be inconsistent with the Fed’s mandate
The Fed should do no more than act as MMLR, however. US interest rates are already too low to maintain the credibility of the price stability objective of the Fed, and of its medium term implicit inflation target. The Fed should certainly not cut the target for the Federal Funds rate simply to prevent or delay the insolvency of US banks or other financial institutions, unless this action is also warranted by the need to meet its triple mandate: maximum employment, stable prices and moderate long-term interest rates.
A falling actual unemployment rate and a rising natural unemployment rate call for higher rates
The latest labour market figures show a large fall in employment and an even larger fall in labour supply, resulting in an actual decline in the unemployment rate to 4.8%. There is also evidence to support the view that the natural (equilibrium) rate of unemployment in the US is increasing. The combination of a declining actual unemployment rate and a rising natural unemployment rate means that there are now higher domestic inflationary pressures associated with any observed level of employment and unemployment than before.
It will be argued that the labour supply data are unreliable, as they are based on the Household Survey. And so they are. But the employment data are unreliable also. And the decline in the recorded labour supply is not a one-month wonder. It has been in the data for quite a while, so I will believe it is real until I see convincing evidence of the contrary.
It makes economic sense that the US natural rate of unemployment is increasing, if only because of compositional changes in the labour force that are reducing, on average, its quality and employability. The post-9/11 imposition of additional obstacles to the immigration of skilled labour are one factor reducing labour force flexibility. So is the long-standing decline in the numeracy and literacy standards of the high-school graduates.
At the same time, the need for greater changes in the mix of skills and in the geographical and industrial distribution of employment associated with globalisation and accelerating technological change, have raised the degree of flexibility required to maintain the same amount of effective labour market pressure at a given level of the conventionally measured unemployment rate. The US is not responding, except defensively by threatening a retreat into protectionism.
The US needs to restore external balance through an increase of (at least) six percentage point of GDP in the saving – investment balance. This should be achieved through an increase in the national saving rate rather than a reduction in domestic capital formation. The slowdown/recession the country is experiencing now is the (almost) inevitable by-product of this necessary rebalancing. It is in principle possible to have the ex-ante trade surplus rise instantaneously and by the same amount as the increase in ex-ante saving over ex-ante investment. In practice, the world is stubbornly Keynesian in the short run, and a decline in economic activity will tend to accompany an increase the the planned national saving rate. This is why the Fed, the White House and the Congress are so misguided about wanting to prevent a significant weakening of consumption at all cost.
The other side of the required rebalancing of the US external account is a large shift of resources from the non-traded sectors (e.g residential construction) into the traded sectors. At least a six percentage points of GDP increase in the production of exportable and import-competing goods and services and reduction in the production of non-traded goods and services is required, matching the increase in the saving-investment balance.
Such a significant shift in the composition of production requires a commensurate shift in labour resources, and significant retooling of the physical and human capital stocks. The US seems ill-prepared for an easy shift of resources towards exports and import competing goods and services. Most of the new tradables production will take the form of tradable services, as the US has a steadily weakening comparative advantage in manufacturing. The new tradable services require skills (e.g. foreign language skills) and understanding (e.g. an appreciation of the immense variety and diversity of foreign cultures and practices) that were not and are not core components of the US curriculum for the bulk of its labour force. This is probably an example of the curse of Empire for the last global empire around.
With mismatch unemployment and frictional unemployment rising, and with other man-made distortions on the increase (the recent increase in the minimum wage is one example) the natural rate of unemployment is likely to be rising in the US.
We can look at the evidence for a higher natural rate of unemployment also from the perspective of the path of potential output. Underlying total factor productivity growth in the US appears to be slowing down and with it the trend growth rate of potential output, raising the output gap corresponding to any level of observed output.
The reduction in labour supply we are seeing is highly unlikely to reflect the so-called discouraged worker effect. This occurs after a period of high unemployment, when workers quit active job search because of the reduced likelihood of finding an acceptable job. The recession, if there is one, is far too young to have created an increase in discouraged worker disengagement from the labour force.
So with inflation too high and the natural rate of unemployment rising, the Fed should be thinking of hiking rates, not lowering them further.
