Lehman Revisted

An old draft I forgot to publish a while back:

My students and I have been reading Gary Gorton’s Misunderstanding Financial Crises in the last couple weeks of my Money and Banking class.  Some students raised questions as to whether Lehman should have been saved or even could have been saved?   In hindsight, I get the impression that most economists would agree that Lehman should have been bailed out, been provided more assistance in finding a buyer, etc if those measures were possible.  However, there is probably more debate on whether or not  the measures were possible at all. The “could” and “should” questions lead to more questions. First, concerning “could”, the question center around what was at the heart of Lehman’s problems in Sept of 2008?  Assets write downs and negative equity or a liquidity crunch? Second, concerning “should” were there signs of a systemic run, and what were the policy measures that were being promoted publicly between the buyout of Bear Stearns and the failure of Lehman Brothers?

During a crisis there is a lot more that you can do given the costs of inaction.  The crisis state of the world is different state of the world with different rules.  In Gorton’s work this is highlighted with debt not being historically enforced during crises.   The problem is then crisis identification, so you correctly know when all options are on the table.   The central question becomes, was there a crisis before the failure of Lehman, and if so, could you see it.  I believe the answer to both of these questions are yes (see figure 4), so that Lehman “should” have been “saved” or received more assistance in finding a buyer.   Whether or not enough information was actually seen by any one person that could have done something  is another story, so I am not attempting to claim individual culpability.

 

The Fed and Long Run Price Stability

There has been talk about 5 by 5 rates a number of different places recently.  I had a conversation in the comments of a  TheMoneyIllusion post a couple of weeks back about 5 by 5 rates.  A few days ago Tim Duy had a post about them as well.

First, what is this all about?  Essentially, you can get a quick and easy estimate of what market participates think inflation will average for five years starting 5 years from now, using conventional 10 year and 5 year Treasury data and 10 year and 5 year TIPS data.  The TIPS is a Treasury security that compensates for inflation, so that its yield is essentially a measure of the real interest rate.  Differencing the two types of Treasuries gets you a measure of the average inflation implied up until the maturity of the security by the Fisher Equation.  So the difference between the yields of the two 5 year Treasuries is average inflation over the next five years, and the difference between the yield of the two 10 year Treasuries is the average inflation for 10 years.  Note that there is a number of different ways inflation could play out that could give rise to the average.  It could be relatively constant over all the years, or might be low and then become higher.  Also, these are expectations conditional on market participants current knowledge.

The useful point about looking at both the 5 year and 10 year average inflation expectations is that you can back out what the implied inflation is for years 6 through 10.  There is more about how this is done in the comments linked to above, but using the magic of natural logs, you can get a very good approximation by the 10 year average inflation being the weighted average of the two five year averages. (James Hamilton had a very good post on the usefulness of logs in economics).  The picture below is the implied average inflation for five years starting in five years using daily data from FRED starting with the earliest available date.

The first thing that is easily noticed is that there is increase in volatility in the expectations in the latter half of the series. The variance up the end of 2006 is around 0.027, while the variance after June 2009 is 0.053.

A plausible reason for this is Fed policy.  I borrowed the idea from Joao Marcus Marinho Nunes to plot expansionary or contraction changes in Fed policy on the 5 by 5 rates.  Marcus at the link looks at other data.  However, when looking at the 5 by 5 rates below, the Fed generally turns off  QE after a period of future inflation exceptions rising.   How likely is it that the FOMC (Federal Open Market Committee)  would look at the 5 by 5 in its decision making process?  Recent Fed transcripts reveal that they went into the decision making process in Sept 2008.  Obviously, the FOMC is going to be looking at a number of other things as well.  However, this serves as some indication that the FOMC is still very much concerned with long run price stability, possibility at the expense of the slowly improving job market.   With all this in mind it is not surprising that Bernanke recently stated that “Although we have been very aggressive, I think on the monetary policy front we could have been even more aggressive.”