Is the Fed Pulling or Pushing?

I did a little interview with Mary Kissel of the Wall Street Journal, following up on thursday's oped. Mary is, as you can tell, a well-informed interviewer and asks some tough questions. She did a great job of pushing hard on the usual Wall Street wisdom about how the Fed, though it has not done anything but talk in years, is secretly behind every gyration of stock or housing prices.

The central point came to me hours later, as it usually does. Is the Fed in fact "holding down" interest rates? Is there some sort of natural market equilibrium that features higher rates now, but the Fed is pushing down rates? That's the conventional view, clearly expressed in Mary's questions.

Well, let's think about that. If a central bank were holding down rates, what would it do? Answer, it would lend a lot of money at low rates. Money would be flowing out the discount window (that's where the Fed lends to banks), to banks, and through banks to the rest of the economy, flooding the place with low-rate loans. The interest rate the Fed pays on reserves and banks pay to borrow from the Fed would be low compared to market rates; credit and term spreads would be large, as the Fed would be trying to drag down those market rates.

That is, of course, the exact opposite of what's happening now. Banks are lending the Fed about $3 trillion worth of reserves, reserves the banks could go out and lend elsewhere if the market were producing great opportunities. Spreads of other rates over the rates banks lend to or borrow from the Fed are very low, not very high. Deposits are flooding in to banks, not loans out of banks.

If you just look out the window, our economy looks a lot more like one in which the Fed is keeping rates high, by sucking deposits out of the economy and paying banks more than they can get elsewhere; not pushing rates down, by lending a lot to banks at rates lower than they can get elsewhere.

In reality of course, the Fed isn't doing that much of anything. Lots of deposits (saving) and a dearth of demand for investment (borrowing) drives (real) interest rates down, and there is not a whole lot the Fed can do about that.  Except to  see the parade going by, grab a flag, jump in front and pretend to be in charge.

Greece again

I read this morning's news of a deal -- we'll see how long it lasts -- with interest. Here's a video exchange with Rick Santelli on the subject on CNBC (I can't seem to get the embed to work, so you have to click the link.)

My main thought: what about the banks? The minute Greece reopens its banks, it's a fair bet that every person in Greece will immediately head to the bank and get every cent out. The banks' assets are largely Greek loans, which many aren't paying -- why pay a mortgage to a bank that's already closed and will probably be out of business soon anyway -- and Greek government debt; mostly Treasury bills that only roll over because banks hold them. They can't sell either, so the banks will instantly be out of cash.

The deal reported in today's papers really barely mentions that problem. But that is the problem of the hour.


Greece is basically off the euro now. Being in the euro does not mean that restaurants take euros. Being in the eurozone means that banks use euros, that you can take euros out and arrange international transfers using euros.

The economy is paralyzed. The main thing a deal needs is a way to reopen banks in a matter of days. Privatization and labor laws are fine, but that generates growth a year from now at best. And raising taxes? They must be kidding.

I've read with interest some proposals that the EU take over the banks. The EU takes on the bad assets, gives or sells the rest to large international banks, and these operate under EU rules -- not Greek regulators; they can't buy any Greek debt, and Greece can't tax them.  It's expensive, yes, but it's basically as shoot-the-hostage approach. A functioning economy would help Greek finances. And then the EU can let the Greek government default if it wishes.  Saving the banks might be a lot cheaper than saving the Greek government and the banks.

There are two original sins in the euro, neither having to do with fiscal union. The first is that each country has its own banks, and each government uses its banks as piggybanks to stuff with government debt. European bank regulators and Basel regulations treat sovereign debt as risk free. Then, if the government defaults, the whole banking system is dragged down with it. The second is the endlessly repeated fallacy that government default means the country must change the units of its currency. If Chicago defaults on its debts, nobody thinks it must introduce a new currency, or that Chicago's banks will fail.

A currency union needs a banking union, or at least banks that are not stuffed with government debt. A currency union needs to let sovereigns default without changing currencies or paralyzing the banking and payments system. A currency union needs a banking union.

Asset Pricing Summer School

I’m going to offer my online course “Asset Pricing” over the summer. The intent is a “summer school” for PhD students, either incoming or between the first year of foundation courses and the second year of specialized finance courses.

At least one university is going to use this more formally: Require completion of the class for their PhD students (either incoming or between first and second year,) and organize a TA and group meetings around the class. We have found that this sort of social organization helps a lot for students to get through online classes.

The course offers a free “certificate” for achieving a certain grade level in the class, which gives an incentive to actually do the problems. Faculty can tie achievement of the “certificate’ to whatever carrots and sticks they want to offer. For example, one instructor is going to treat achievement of the “certificate” as an assignment for his fall PhD class, and include it in the grade.

Since the class covers most of the basics, this structure may free a faculty member teaching next year to focus the PhD classes on more advanced material. It’s also useful as a “flipped classroom,” allowing the faculty member to spend less time on algebra and derivations, and more on intuition, extensions, and current research.

This session won’t have TAs on my part, though I will monitor the forums and attend to glitches as they crop up.

The class is free. To sign up or see the classes, follow these links

Part 1: https://www.coursera.org/course/assetpricing
Part 2: https://www.coursera.org/course/assetpricing2

The class experience consists of watching short lecture videos, doing the assigned reading, answering quzzes and fairly extensive problem sets, and taking an exam. The course has discussion forums which are quite useful.

The class starts next Monday, June 8. It is open for registration now, and will be open for students to see materials and start work by the end of the week. Part 1 (7 weeks) ends July 27, and Part 2 (7 weeks) ends Sept 14. The two parts may be taken independently. Students not wishing a grade may use these materials freely and just do whatever parts seem interesting. I've also set up the grading pretty flexibly to allow people to adjust their schedules rather than follow the week by week rigid schedule.

This is a bit late notice, but I hope blog readers will pass on notice to PhD students or prospective ones, and to faculty members who are teaching PhDs in the fall and might find this resource useful.

The syllabus:

Part I
Week 1 Stochastic Calculus Introduction and Review. dz, dt and all that.
Week 2 Introduction and Overview. Challenging Facts and Basic Consumption-Based Model
Week 3 Classic issues in Finance. Equilibrium, Contingent Claims, Risk-Neutral Probabilities.
Week 4 State-Space Representation, Risk Sharing, Aggregation, Existence of a Discount Factor.
Week 5 Mean-Variance Frontier, Beta Representations, Conditioning Information.
Week 6 Factor Pricing Models -- CAPM, ICAPM and APT.
Week 7 Econometrics of Asset Pricing and GMM.  Final Exam

Part II
Week 1 a) The Fama and French model b) Fund and performance evaluation.
Week 2 Econometrics of classic linear models.
Week 3 Time series predictability, volatility and bubbles.
Week 4 Equity premium, macroeconomics and asset pricing.
Week 5 Option Pricing.
Week 6 Term structure models and facts.
Week 7  Portfolio Theory and Final Exam

Interviews

I did two interviews that blog readers might enjoy.


This is an interview with Jeff Garten at Yale, covering financial crises and reform/regulation efforts rather broadly. Source here. It's part of a very interesting series of interviews on the "future of global finance" with lots of superstars. I give Niall Ferguson the prize for most creative  author photo.

This one is a podcast interview on the ACA and how free-market health care can work, with Don Watkins at the Ayn Rand institute's "debt dialogues" series. If you follow the link you get several formats.