Annette Vissing-Jørgensen and I wrote the short policy brief below. This afternoon, it was discussed in the Real Time Economics blog of the Wall Street Journal.

Why an MBS-Treasury swap is better policy than the Treasury twist

Arvind Krishnamurthy and Annette Vissing-Jørgensen

July 24, 2012

Policy note in PDF version

This note compares the effect of an MBS-Treasury swap (a strategy of purchasing long-maturity agency MBS and selling long-maturity Treasury bonds) versus the Treasury twist (purchasing long-maturity Treasury bonds and selling short-maturity ones).

We make two main points:

  1. Purchasing long MBS brings down long MBS yields by more than would an equal sized purchase of long Treasury bonds and thus is likely to create a larger stimulus to economic activity via a larger reduction in homeowner borrowing costs
  2. Purchasing Treasury bonds brings down Treasury yields, but part of this decrease indicates a welfare cost rather than a benefit to the economy. Thus it would be better to sell rather than purchase long-term Treasury bonds.

These points lead us to conclude that a superior large-scale asset purchase policy for the Fed is an MBS-Treasury swap where the Fed purchases long-maturity MBS, financed by a sale of long-maturity Treasury bonds. Continue Reading »

Here is the first annual report of the Office of Financial Research.  Among other things, the report details what the OFR don’t know and would like to. Interesting reading for those interested in questions like what should be monitored? Why? Are there clever ways to measure it? And if not, how could one structure surveys or regulation to measure it?

Extreme times sometimes lead to extremely unusual sights.  At the moment, nominal interest rates in Denmark are negative.  The zero lower bound on interest rates has been smashed: the return to holding cash is higher than the return to depositing it in a bank or investing it in government debt (with anything less than a five year maturity).  Wow.  Before asking how we can even get negative rates, how did the economy get here?


Fearing some combination of the breakup of the Euro area, a European banking crisis, and a Europe-wide fiscal crisis, European investors are getting out of risky Euro-denominated assets, such as deposits in European banks or short-term European government debt, and into safer claims denominated in safer currencies, like claims on banks and governments that are denominated in Swiss Francs or Danish Krone.  Thus, capital is flowing into Switzerland and Denmark and pushing interest rates down in these countries.


Following the increase in demand for these currencies, the Swiss Franc has appreciated significantly against the Euro, but the Danish Krone is pegged to the Euro.  For Switzerland, the appreciation hurts exports and increases imports.  For Denmark, there is little immediate effect on exports and imports, but the pressure for the currency to appreciate is the same.  To stop the appreciation, the Danish central bank – Nationalbank — has to buy Euros and sell Krone.  This is what the peg means and how the value of the Krone is maintained against the Euro.  As it turns out, the central bank doesn’t actually sell Krone.  Instead, the central bank buys Euros from banks and pays for them by crediting their Krone accounts with the central bank, account balances which are called “reserves.”  Reserves are a lot like commercial bank’s bank accounts with the central bank.  These reserves can be withdrawn from the central bank as Krone, and some are as the bank’s customers make withdraws to buy safe assets like Danish government debt and the bank withdraws from the central bank to meet the withdrawals.  One upshot of all this is that the Danish central bank has roughly doubled its foreign reserve account balances and is becoming a long-short currency fund: long Euros and short Krone deposits (and Krone themselves – cash in circulation is a central bank liability).  But that is almost an aside, the interesting point is that the demand for Krone-denominated Danish assets has driven interest rates on short term government debt negative.  And Nationalbank has now reduced the interest rate it pays on reserves to negative 0.2 percent!  Yes, it is more expensive to hold reserves with the central bank than to hold cash in the vault.


And this is how we actually get negative nominal rates: the convenience and safety of deposits or short-term government debt relative to cash.  Holding a large amount of cash is inconvenient and risky.  As an individual, it is much easier to buy a house with a check than with cash (imagine how you would feel walking with the suitcase of money from the bank to the closing agent).  As a business, it is much easier to meet payroll with deposits than cash.  And even as a bank, vaults are only so big and so safe. So short term nominal rates in Denmark are solidly in the negative range.  The Zero Lower Bound is broken.  Expect an increase in vault construction and possibly an increase in bank robberies.  And a reconsideration of the Zero Lower Bound as an economic law.


Here and here are links to two very interesting readings about bank runs occurring in Greece and Spain. Why is the bank “jog” happening? In a couple of sentences, concerns about the safety of deposits. If you have deposits in a Greek/Spanish bank and the bank goes under, will you get your money back? What about if the country leaves the Euro — will you be paid in Euros or in the new, less valuable currency? Given the fears that either might happen, depositors are taking their Euros out of these countries to the banks of other countries.

What I think this bank jog is forcing, is a quiet but massive increase in the financial commitments of the ECB (Germany) to Spain and Greece.  The ECB is being forced to either lend to these banks or let them collapse; if they collapse, then Germany must decide to either lend to these countries or let them collapse/leave the Euro.  The loans are supposedly collateralized.  But the sheer size of the bank jog and the problems in these counties suggests that the collateral probably contains lots of bad collateral, like debt of sovereigns of questionable solvency and packaged highly-rated debt that should never have been highly rates.  That is, while we can call the current support loans, I suspect that many of them will be transfers (big transfers) in the case that these countries/banks do not grow and solve their fiscal imbalances.  How does it end?  It has to end when the banks run out of collateral that even the ECB in its most desperate hour cannot in good conscience lend against, and the banks start to collapse.  But it may end sooner, when some politicians have the good sense to finally pull the plug and default and devalue.

Coverage in the press of the Facebook IPO has been sensational, with headlines about Facebook’s “stumble” at the IPO. In this post I’ll suggest a way to think about what happened, who won, who lost, and whether we should care about the decline in Facebook’s share price at the IPO. My answer: No, we shouldn’t care.

During an IPO, a firm and its shareholders wish to sell shares. Generally they want the highest possible price for these shares. Investors, on the other hand, want to pay a low price. The underwriter’s job is to strike a balance. To understand what happened with Facebook, you need to appreciate the difficulty in striking this balance.

The investors who buy in an IPO offer to buy up to a particular number of shares. Suppose Joe Average subscribes to the IPO, offering to buy 1000 shares for the offering price ($38 in the case of Facebook). If demand for Facebook is weak, that is, if there are not many subscribers, then Joe will get the full 1000 shares. However, if demand is strong, there will not be enough shares to go around and Joe will get fewer than 1000 shares. This asymmetry is the key to understanding IPO pricing. Joe thinks: When I get the full 1000 shares, the price will go down, but when I get fewer shares the price will go up. In order for Joe to willingly participate, he must expect that on average, the price will go up at the offering. This positive average return compensates him for getting fewer than 1000 shares in good times. Although the price goes up on average, sometimes it will go down. You can understand why this occurs by thinking about the strategy of those investors who actually have information. They will bid for many shares when the offering is valuable, and for few shares when it is not. This is the flip side of Joe getting all his shares in bad times and fewer in good times.

So  investors lost money in the Facebook offering and we understand that sometimes this is going to happen. Did Facebook do anything obviously wrong? Surely Facebook management should have pushed for a high price and that’s apparently what they did. Does the IPO bode ill for Facebook? Why should it? Facebook is one of the most recognized names in the world. In the future, investors will judge Facebook by its financial success or lack thereof. Do you think that Facebook users will switch to Google+ because the stock fell at the IPO? If the offering price had been $32, Zuckerberg would have earned almost $200 million less in the offering. He looks to me like a smart guy.

The party on the hot seat is Morgan Stanley, the lead underwriter. Their institutional investors will want to know why Morgan Stanley agreed to a $38 price. These things happen: Morgan Stanley will make its mea culpas and be back the next time around.

Finally, what about the retail investors who participated? Were they treated fairly? Press reports made it sound like it should have been a sure thing: buy Facebook at $38 and flip the shares a few hours later at a higher price. Of course it could have happened that way. But anyone sure it was going to happen was expecting Mark Zuckerberg and Morgan Stanley to hand them free money. Here’s an Insider Tip: Zuckerberg and Morgan Stanley are not in business to give money to you. They make money from you.

Brokers and banks love to deal with investors who think otherwise.

Suppose that a systemically important financial institution (the official designation, now in true DC style the acronym SIFI) actually fails.  Do we get a financial crisis?  Are owners/creditors punished for endangering the economic system or partly/largely bailed out by loans/transfers from taxpayers?  A few days ago here in Chicago, the acting chair of the FDIC, Martin Gruenberg, spoke to the Chicago Fed about how the FDIC would “systemic resolve” a failing SIFI without endangering the financial system while actually placing losses on those who own and are owned by the institution.  Speech here.


I am glad the work is proceeding.  If, . . oops I mean . . . when we end up in the next financial crisis, we will at least have a plan.  And an ex ante plan may help reduce the frequency of crises.  As  Gruenberg said, “developing a credible capacity to place a systemically important financial institution into an orderly resolution process is essential to subjecting these companies to meaningful market discipline. “

For an article in the Daily Northwestern, I was asked to comment on some pension proposals by State Rep. Daniel Biss of Illinois, one of which would involve the creation of a cash balance pension plan for future state workers. A cash balance plan is a type of hybrid retirement plan in which the sponsor (e.g. the state) promises to grow employer and employee contributions by a certain specified rate, and then pay an annuity based on that balance at retirement.  Here were my comments, which I made via email:

A cash balance system that promises asset growth at a low rate, such as that of long-term Treasury bonds, and converts the balance to an annuity at prevailing rates in insurance markets, could be managed so that it generates no unfunded liabilities for the state. However, the very common temptation is to promise a higher rate of accrual on the plans, and just as with traditional DB plans in the public sector, to hope that those higher returns are achieved by setting aside risky assets.

The extent to which the state can avoid that temptation (to promise safe benefits and attempt to deliver them with risky assets) will determine how successful the plan would be in avoiding new unfunded liabilities.

The author of the article paraphrased the above passage as my indicating that a cash balance plan could eliminate the existing unfunded liability, which of course neither I nor Daniel Biss believe (see his own direct quote in the article).


Ben Bernanke gave a speech in New York, transcript here, on the pre-crisis vulnerabilities in the financial sector, on the triggers for the crisis, and on the policy responses – what and why.  Clearly reasoned from economic models and closely related to the canonical (Bernanke the academic) understanding of the first part of the Great Depression.  The Federal Reserve’s actions where Bagehot’s rule in practice and are ultimately defended by saying “ . . .the responses to the failure or near failure of a number of systemically critical firms reflected the best of bad options.”


A fun research article here , covered by the Wall Street Journal here , describes Keynes’ performance as an investor.  He was nearly wiped out by the crash of 1929, but did very well thereafter.

Here is the Dallas Fed’s report that argues for breaking up the large banks in order to end “too big to fail.”  Very interesting reading.  My view (blogged about before) is that it is not enough to break up the large banks.  A sector that is critical and comprised of many small firms is not immune to the TBTF problem.  If banks all do a similar activity and are exposed to similar risks, then they all go under in response to the same losses in the same state of the world and the sector needs bailing out.  No firm is too big to fail, but if the sector just is too important to fail, then the concern is similar exposures as much as size.  That said, there is still an advantage to breakup, which is that the worst offenders can be allowed to fail, which may push the crowd back somewhat from the brink.

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