The Great Escape? Evaluating the Fed’s non-standard policies

Marco Del Negro interviewed by Romesh Vaitilingam, 28 January 2011

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<p><em>Romesh Vaitilingam interviews Marco Del Negro for Vox</em></p>
<p style="padding-top: 0px; padding-right: 0px; padding-bottom: 0.5em; padding-left: 0px; margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; "><em>January 2011</em></p>
<p style="padding-top: 0px; padding-right: 0px; padding-bottom: 0.5em; padding-left: 0px; margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; "><em>Transcription of an VoxEU audio interview []</em></p>
<p><b>Romesh Vaitilingam</b>: &nbsp;Welcome to Vox Talks, a series of audio interviews with leading economists from around the world. My name is Romesh Vaitilingam, and today's interview was recorded at the European Economic Association's annual meetings in Glasgow in August 2010. I met Marco Del Negro, from the New York Fed, who had just presented a paper on the macroeconomic impact of the nonstandard monetary policies implemented by the Fed in the wake of the financial crisis. He began by introducing himself and the study.</p>
<p><b>Marco Del Negro</b>: &nbsp;I'm Marco Del Negro. I'm an economist with the Federal Reserve Bank of New York. Let me start by saying that whatever I'm going to say represents my views only, and not necessarily those of Federal Reserve Bank of New York or the Federal Reserve System. So, I am going to discuss a paper that is jointly written with Gauti Eggertsson and Andrea Ferrero, two colleagues of mine from the New York Fed, and Nobuhiro Kiyotaki from Princeton. And the paper is called &quot;The Great Escape? A Quantitative Evaluation of the Fed's Nonstandard Policies.&quot;</p>
<p>So what the paper is about is nonstandard, or also called unconventional, monetary policy. Unconventional monetary policy in the US began in late 2007, with the inception of the facilities. So, broadly speaking, the Fed started to take in assets that had then become illiquid, and exchanged them for liquid, that is reserves, or Treasuries. At the time, there were very few, if any, models available to understand the effects of these interventions on the macroeconomy. In fact, if, in 2007, you would have asked most economists what they thought the effect of unconventional monetary policy was, they would most likely have said none.</p>
<p>And this general wisdom, I guess, was based mostly on a result, by Wallace, that's very important in paper, that shows that under certain conditions, changes in the composition of the central bank's balance sheet ‑‑ which is what unconventional monetary policy is, largely ‑‑ have no effect on equilibrium, are, as they say, irrelevant. What's important is that these conditions hold for most dynamically stochastic general equilibrium, or DSGE, models, used at central banks. So in those models, you cannot rationalize what the Fed was doing. And so, from our perspective, they were not that useful in terms of figuring out why we were doing the facilities and what they were doing to the macroeconomy.</p>
<p><b>Romesh</b>: &nbsp;Can you give us a feel, Marco, for why the Fed did make this intervention this time? Remind us. Take us back three years as to why the Fed responded to the early emergence of the crisis in this way.</p>
<p><b>Marco</b>: &nbsp;One way to look at the facilities, to rationalize the facilities, is to postulate, as Nobuhiro Kiyotaki and John Moore do in their liquidity paper, the following: That there are differences in liquidity across assets, so that there are assets, such as private‑sector liabilities like mortgage‑backed securities, for instance, that are subject to liquidation. So, for these assets, market can dry up, generally speaking. And then there are other assets, such as US government liabilities, Treasuries, reserves, that are not subject to these shocks, and these assets become a safe haven in times of turmoil. So this distinction among assets is important because this, to us, then, and even now, seems a fairly plausible description of what was happening in the US at the time. And so what the purpose of the facility was, was to again take in those private illiquid assets into the central bank's balance sheet and offer, in exchange, assets that were liquid, that the private sector could sell.</p>
<p><b>Romesh</b>: &nbsp;So, in a way, the Fed was using the kind of idea in the Kiyotaki‑Moore model, which wasn't part of the generally accepted programme for using monetary policy. This is the kind of work that you're building on in your research. Can you explain that in a little more detail?</p>
<p><b>Marco</b>: &nbsp;I guess that's the way we rationalize the intervention. But I am convinced that there's more people at the Fed who came up with the idea of the facilities, in the back of their mind, even if they hadn't read the Kiyotaki and Moore model, they had something very similar. So that doesn't quite explain what the facilities do to the macroeconomy. It may explain why it helps financial markets, but what about Main Street?</p>
<p><b>Romesh</b>: &nbsp;That's the issue you're focusing on in this paper, really.</p>
<p><b>Marco</b>: &nbsp;Yes, absolutely.</p>
<p><b>Romesh</b>: &nbsp;Why you call it &quot;The Great Escape.&quot; It's the impact of these policies on the macroeconomy.</p>
<p><b>Marco</b>: &nbsp;Yes. And so, why do they matter? Well, they matter because ‑‑ again, I'm referring to the Kiyotaki‑Moore model, just as a framework to sort of understand reality ‑‑ in that model, just like in reality, investors need liquidity to finance investment. And they get this liquidity by issuing debt or selling the assets that they have. During a liquidity crisis, they can't do either. And so, in terms of the macro economies, the liquidity crisis translates into a halt of investment. Which is, by the way, what we observed, pretty much, in the Great Recession: investment tanked. So what do the facilities do? By increasing the amount of liquid assets available to the economy, to the private sector, during the crisis, the central bank can undo some of the negative consequences of markets drying up. And that's how the intervention works in the Kiyotaki‑Moore model, and that's one of the main features of how the intervention works in reality.</p>
<p>But this was their idea. And the question, the novelty of our paper, and what we set out to do, is to do a quantitative evaluation. So, in terms of numbers, how much that matters. In practice, what would have happened in the US had the Fed not undertaken unconventional monetary policy? How worse would have the recession been?</p>
<p><b>Romesh</b>: &nbsp;So that's the counterfactual you're trying to calculate. You're trying to put a number on that.</p>
<p><b>Marco</b>: &nbsp;Absolutely. Absolutely.</p>
<p><b>Romesh</b>: &nbsp;Tell me what you find in your analysis.</p>
<p><b>Marco</b>: &nbsp;Before I delve into that, let me stress a few differences that are very important with the Kiyotaki‑Moore model. Because, you see, in that model, liquidity shock lead investment to tank, but little happens to help. And the reason is that that's a flexible‑price model, and in a flexible‑price model, output is determined by productivity, and the liquidity shock just doesn't affect productivity. They don't affect how productive firms are. So, in the end, since output is determined, demand has to adjust. And what demand adjusts, that's consumption. So, in equilibrium, real interest rates drop. That makes consumers more willing to consume, and in the model ‑‑ certainly not in reality ‑‑ consumption goes up.</p>
<p>The nominal rigidities in our model means that output is demand‑determined. And so, as investment tanks, well, so does output. Which, in equilibrium, implies that real rates go up, consumption goes down, and so you have co‑movement. You have investment, consumption, and output all declining at the same time, which is obviously a feature of recessions, and of the Great Recession in particular.</p>
<p>What's also very important in our model, differently from Kiyotaki‑Moore, is that, even with the nominal rigidities, the Fed can initially respond to the shock by cutting interest rates, which is what it did. But of course, when the nominal interest rate reaches zero, or close to zero, it has to stop, and the economy risks entering a liquidity trap. So, what motivates the title of our paper, &quot;The Great Escape,&quot; is that the unconventional monetary policy, the facilities enacted by the Fed, counteracted the drop in investment, as they provided more liquidity to the private sector, and therefore led the economy to escape the liquidity trap, whence the title, &quot;The Great Escape.&quot;</p>
<p>In terms of numbers, our main finding is that unconventional monetary policy can have a substantial effect on output. The results are still preliminary; we are still working on them. But what we find is that the decline in output could have been 50 to 75‑percent worse without an unconventional monetary policy, and that's not a small effect. It's not small, particularly if you recall that under standard models these interventions have no effects whatsoever, so finding large effects of this kind is actually somewhat surprising.</p>
<p><b>Romesh</b>: &nbsp;Are there any differences, in the work you've done, in the impact of the policies in the period, say, between end of 2007, when they introduced, and Lehman's, and then after Lehman's? Were there differences between the implementation of the policy and the outcomes?</p>
<p><b>Marco</b>: &nbsp;Well, I have to say, we really focused on the aftermath of Lehman. And when we talk about unconventional monetary policy, what we mostly have in mind is the facilities. Because, again, with the facilities, the TAF and so on, they work like they work in the model. The Fed takes in illiquid assets and gives liquidity in exchange. The policy in 2009 is somewhat different in nature. It has some similarities in that the Fed started buying mortgage‑backed securities. And one can claim that, especially at the beginning, those mortgage‑backed securities were less liquid than other assets in the economy.</p>
<p>So, to some extent, the intervention, then, was along the same line. But also, certainly, buying Treasuries. Obviously, from the perspective of our models, Treasuries are liquid, and so this kind of intervention is different in that it amounts to exchanging in the asset side of the balance sheet, or increasing the size of the balance sheet by acquiring different types of liquid assets. So our model is not really well situated to address the interventions conducted in 2009, and that's why we focus on the post‑Lehman period.</p>
<p><b>Romesh</b>: &nbsp;All in all, it sounds like it's an incredibly positive outcome in terms of the relative loss of output that would have happened if the unconventional monetary policies hadn't been in place.</p>
<p><b>Marco</b>: &nbsp;Definitely. So, when we talk of the facilities, we conclude that facilities have been extremely successful. However, the question mark after &quot;The Great Escape&quot; is due to the fact that this ex‑post success is, ex‑ante, not necessarily good, and that's an issue that we need to investigate more. Remember that what is good ex‑post, in the cleanup of the crisis, is not necessarily good ex‑ante, as it may lead to moral hazard. If the private sector knows that the Fed is very good at cleaning up, or at least better than it could otherwise be at cleaning up, then the incentives to take risks are possibly increased. Again, we don't study this question in this paper, so I don't have much to say about it, but it's certainly potentially very important and it needs to be studied more. But at the time, after the shock had occurred, my personal view is that not only the facilities were a good idea but that, we find, at least in the paper, they were quite successful.</p>
<p><b>Romesh</b>: &nbsp;You say this is a work in progress. What other issues surrounding the impact of the unconventional monetary policies do you plan to look at?</p>
<p><b>Marco</b>: &nbsp;You see in this model the original source of the shock, this liquidity shock, is not really macro‑founded. We assume that some assets become less liquid than others. Which, again, sounds realistic, but we don't explain why that happens. I think it's very important to go deeper, dig deeper into this question, to figure out what frictions led to this loss of liquidity. And there are papers now, written by John Moore, as well, an MIT graduate student, Pablo Kurlat, that are studying this micro foundation of markets drying up. I think it's quite important to see to what extent, in those microeconomic models, the results obtained in this paper will still carry through.</p>
<p><b>Romesh</b>: &nbsp;So, final question, really, about the confidence you have in the results of your paper, about the effectiveness, because these are big numbers you're showing here, and saying this really has been a very successful policy. How confident do you feel in them?</p>
<p><b>Marco</b>: &nbsp;We are macroeconomists. We write model, and within the context of the model we ask a question. For me, the bottom line is not so much that I'm 100 percent sure that the facilities really avoided a much worse recession, but rather that, building again on Kiyotaki‑Moore, we show that their framework provides an explanation as to how the facilities work. And that is, I think, food for thought for a policymaker. And the fact that, quantitatively, a model that can reproduce the Great Recession, that leads to a big drop in macro variables but also a big movement in financial variables, right, which not all models do, can broadly match the features of the crisis, and that, within the context of that model, the facilities has a big impact‑‑well, that suggests to me that maybe there is some plausibility in our results. But of course, other people can come up with different models and question our results. That can always happen in economics.</p>
<p><b>Romesh</b>: &nbsp;Marco Del Negro, thank you very much.</p>
<p><b>Marco</b>: &nbsp;Thank you.&nbsp;</p>

Topics:  Monetary policy

Tags:  monetary policy

Related reading: Del Negro, Marco Gauti Eggertsson, Andrea Ferrero and Nobuhiro Kiyotaki (2010) The Great Escape.

Vice President, Macroeconomics and Monetary Studies Function. Research and Statistics Group, New York Federal Reserve Bank


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