The Fed’s Swap Loans and Libor – OIS Spread

For about two years—from August 2007 to September 2009—fluctuations in the spread between dollar Libor and the overnight index swap (OIS) served as a valuable quantitative indicator of financial stress in the interbank loan market. It also served as a measure of the impact of various government interventions. The paper "A Black Swan in the Money Market" by John Williams and me focused on the unprecedented jump in that spread in August 2007 and showed that the Fed’s Term Auction Facility (TAF) was not effective in reducing the spread. As shown in the chart, the dollar Libor-OIS spread rose further during the panic in September-October 2008. It then returned to near pre-crisis levels in September 2009 and stayed there until the new crisis in Europe erupted when it started to increase again, attracting the attention of financial analysts and the financial press.

Note, however, that the recent increase—visible in the right part of the chart—is very small compared with the jumps in 2007 and 2008. Nevertheless, as part of the European rescue package, the Fed agreed to provide dollar swap loans to the ECB and other central banks so that they could provide dollar loans in the interbank market. Have these swap loans affected the spreads?

As shown in the second chart, which focuses on the Libor - OIS spread during March - May 2010, it is hard to find any effect, not even an announcement effect. On the Friday (May 7) before the announcement of the European rescue package the spread was 18 basis points. It increased on the Monday (May 10) after the announcement and then continued to increase in the two weeks since then, reaching 32 basis points on May 24. However, the size of the loans has thus far been remarkably small and has declined sharply since the start of rescue package. According to the Fed’s H.4.1 release of today, the amount of swap loans provided was $9.205 billion on Wednesday May 12, remained the same on $9.205 on Wednesday May 19, but fell to only $1.242 billion ($1.032 to the ECB and $210 to the BOJ) on Wednesday May 26. I have argued since the start of the crisis that the Fed should provide daily (not just weekly) balance sheet data so people outside the Fed can evaluate the impacts of its programs on the markets, but this is all we have. It is not clear why the loans have declined so rapidly. Perhaps criticism about participating in the European bailout led the Fed to discourage the use of the swap loans under the program at a time when the Fed is trying to prevent the Congress from reducing its independence. Or perhaps the interest rate (1.24 percent) was simply too high.

The Administration and the IMF on the Multiplier

In a soon to be published paper, several economists at the International Monetary Fund report estimates of government spending multipliers which are much smaller than those previously reported by the U.S. Administration. In order to obtain the estimates the IMF economists use a very large complex model called the Global Integrated Monetary and Fiscal (GIMF) Model developed by Douglas Laxton and his colleagues at the IMF . The paper is quite technical, but the bottom line summary is that a one percent increase in government purchases (as a share of GDP) increases GDP by a maximum of 0.7 percent and then fades out rapidly. This means that government spending crowds out other components of GDP (investment, consumption, net exports) immediately and by a large amount.

The IMF estimate is much less than the multiplier reported in a paper released last year by Christina Romer of the President’s Council of Economic Advisers and Jared Bernstein of the Vice President’s Office. The attached graph shows how huge the difference is. It shows the impact on GDP of a one percentage point permanent increase in government purchases as a share of GDP reported in the IMF paper (labeled GIMF) and in the Administration paper (labeled Romer-Bernstein).

John Cogan, Volker Wieland, Tobias Cwik and I raised questions about Romer-Bernstein paper soon after it was released last year because the estimates seemed to be much different from comparable estimates based on more modern new Keynesian models. We classified the Romer-Bernstein estimates as old Keynesian. Since then many technical papers have been written on this subject, of which a recent paper by Michael Woodford is the most comprehensive in my view. The IMF model is of the new Keynesian variety and adds more evidence of the huge policy differences between new Keynesian and old Keynesian models.

The Euro's Post-Package Slide

In a column Central Banks are Losing Credibility published in the Financial Times last Tuesday, just after the announcement of the European rescue plan, I noted that the euro’s quick set-back hours after its initial boost was a harbinger of negative consequences. The euro's continued decline throughout last week (see chart) shows that this set-back was not only a harbinger, but also the first in sequence of negative market reactions. Much commentary during the week supports this view.

Harald Uhlig, in an article "Die Trichetisierung des Euro" in Handelsblatt on Wednesday, raises more credibility concerns about the ECB as does Simon Nixon, in his Friday Wall Street Journal article "Central Banks, Politics Don't Mix" (adding criticism of the Bank of England’s endorsement of the new British government’s budget plan). Yesterday Mohamed El-Erian warns in an FT.com guest post of the possibility that governments will "do more of the same" and that the US will "press Europe to do more of the same" which is a real concern. Recall that when it was clear that the 787 billion dollar stimulus package passed in the United States in February 2009 was not helping the recovery, some argued that it was not big enough, and they may be soon arguing that the near 750 billion euro package is not big enough. Indeed, that might have been an argument heard on the G7 finance ministers conference call late last week.

But the evidence is that a larger package could easily make things worse. As we learned in the U.S. financial crisis starting in August 2007, more liquidity will not solve a basic solvency problem. As Mohamed El-Erian points out "it is not easy to change track," but last week reminds us how important it is to at least start getting back on track, the title of my article in the current issue of the St. Louis Fed Review.

More on Chapter 11F

My column published last Monday May 3 in the Wall Street Journal “How to Avoid a ‘Bailout Bill’” generated a lot of questions about the idea of a "Chapter 11F," which I argued is a needed alternative to bailouts. Chapter 11F is a proposed modification or addition to Chapter 11 of the bankruptcy code. It would allow large non-bank financial firms to go through bankruptcy in an orderly and predictable way and thereby minimize disruptions to the financial markets and the economy. Currently there are several different versions of a Chapter 11F, but they all have the common theme of relying more on the bankruptcy law rather than on a new discretionary liquidation or resolution authority or on bailouts. By relying more on the rule of law, the reorganization or liquidation process would be more predictable.

The proposals differ in four main ways: (1) in the type of financial institutions to be covered—most versions do not apply to depository institutions, which would continue to be resolved by the FDIC, (2) in whether or not a regulatory agency could file an involuntary bankruptcy petition for a financial firm, (3) in whether or not the government would be able to provide debtor-in-possession financing, and (4) in whether or not derivatives and repos continue to be exempt from the automatic stay. The last of these is the trickiest of all.

One version of Chapter 11F was put forth by Tom Jackson, the bankruptcy expert from the University of Rochester, in a chapter of the book Ending Government Bailouts As We Know Them. Another version is already in legislative language as a possible amendment to the Dodd Bill filed by Senator Sessions, ranking member of the Judiciary Committee; this version would add another chapter (Chapter 14) to the bankruptcy code, analogous to Chapter 9 for municipalities. Yet another version has been put forth by the Pew Task Force on Financial Reform; it tries to combine resolution authority and bankruptcy. The most recent version is being developed by the Resolution Project, which is part of the Working Group on Economic Policy at Stanford’s Hoover Institution, in which Tom Jackson is a key participant along with other authors (including me) of Ending Government Bailouts As We Know Them.

It is very promising that so many people are now working on these important ideas. I hope that the financial reform legislation now moving through Congress incorporates at least some of the ideas before it becomes law.

Latest Data Continue To Show Little Impact of Government Stimulus on GDP

The 3.2 percent growth rate of real GDP in the first quarter (released by BEA yesterday) confirms that the recovery is looking more U-shaped than V-shaped. But it also provides further evidence that the stimulus package of 2009 has had a small contribution to the recovery. Most of the recovery has been due to investment—including inventory investment, which was positive in the first quarter after declining for all of last year—and has little to do with discretionary stimulus packages. The two charts show the percentage contribution of investment and government purchases to real GDP growth in the first quarter and in the preceding quarters since 2007. The charts clearly indicate that the changes in real GDP growth have been mostly due to changes in investment and little to changes in government purchases. In fact, government purchases have been a drag (a negative contribution to real GDP growth) in the fourth quarter of 2009 and the first quarter of 2010. I also include similar charts for the other two components of GDP, consumption and net exports. The government purchases chart looks very similar if you exclude defense spending, as I have in previous posts on this subject.


In response to these previous posts, some have argued that government spending might have declined by a larger amount without the stimulus because the stimulus package prevented state and local government from cutting spending. More research is needed to determine what would have happened in the counterfactual of “no discretionary stimulus,” but in the meantime these data at the least suggest that the simple Keynesian model frequently taught to beginning students—in which government spending shifts up the aggregate spending line to counteract an investment-induced downward shift in that line—needs to be reworked.