resilience, not stability

Archive for September, 2011

Operation Twist and the Limits of Monetary Policy in a Credit Economy

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The conventional cure for insufficient aggregate demand and the one that has been preferred throughout the Great Moderation is monetary easing. The argument goes that lower real rates, higher inflation and higher asset prices will increase investment via Tobin’s Q and increase consumption via the wealth effect and reduction in rewards to savings, all bound together in the virtuous cycle of the multiplier. As I discussed in a previous post, QE2 and now Operation Twist are not as unconventional as they seem. They simply apply the logic of interest rate cuts to the entire yield curve rather than restricting central bank interventions to the short-end of the curve as was the norm during the Great Moderation.

But despite asset prices and corporate profits having rebounded significantly from their crisis lows and real rates now negative till the 10y tenor in the United States, a rebound in investment or consumption has not been forthcoming in the current recovery. This lack of responsiveness of aggregate demand to monetary policy is not as surprising as it first seems:

  • The responsiveness of consumption to monetary policy is diminished when the consumer is as over-levered as he currently is. The “success” of monetary policy during the Great Moderation was primarily due to consumers’ ability to lever up to maintain consumption growth in the absence of any tangible real wage growth.
  • The empirical support for the impact of real rates and asset prices on investment is inconclusive. Drawing on Keynes’ emphasis on the uncertain nature of investment decisions, Shackle was skeptical about the impact of lower interest rates in stimulating business investment. He noted that businessmen when asked rarely noted at the level of interest rates as a critical determinant. In an uncertain environment, estimated profits “must greatly exceed the cost of borrowing if the investment in question is to be made”.

If the problem with reduced real rates was simply that they were likely to be ineffective, there could still be a case for pursuing monetary policy initiatives aimed at reducing real rates. One could argue that even a small positive effect is better than not trying anything. But this unfortunately is not the case. There is ample reason to believe that reduced real rates across the curve have perverse and counterproductive effects, especially when real rates are pushed to negative levels:

  • Prolonged periods of negative real rates may trigger increased savings and reduced consumption in an attempt to reach fixed real savings goals in the future, a tendency that may be exacerbated in an ageing population saving for retirement in an era where defined-benefit pensions have disappeared. An investor in a defined-contribution pension plan is unlikely to react to the absence of a truly risk-free investment alternative by taking on more risk or consuming more.
  • One of the arguments for how a program such as Operation Twist can provide economic stimulus is summarised here by Brad DeLong: “such policies work, to the extent that they work, by taking duration and other forms of risk onto the government’s balance sheet, leaving the private sector with extra risk-bearing capacity that it can then use to extend loans to risky private borrowers.” But duration is not a risk to a pension fund or life insurer, it is a hedge – one that it cannot shift out of in any meaningful manner without taking on other risks (equity,credit) in the process.
  • The ability of incumbent firms to hold their powder dry and hold cash as a defence against disruptively innovative threats is in fact enhanced by policies like ‘Operation Twist’ that flatten the yield curve. Firms find it worthwhile to issue bonds and hold cash due to the low negative carry of doing so when the yield curve is flat, a phenomenon that is responsible for the paradox of high corporate cash balances combined with simultaneous debt issuance.

There is an obvious monetarist objection to this post and to my previous post. Despite the fact that the Fed also views its actions as providing stimulus via “downward pressure on longer-term interest rates”, monetarists view this interest-rate view of monetary policy as fundamentally flawed. So why this interest rate approach rather than the monetarist money supply approach? In my opinion, the modern economy resembles a Wicksellian pure credit economy, a point that Claudio Borio and Piti Disyatat have made in a recent paper who point out that

The amount of cash holdings by the public, one form of outside money, is purely demand-determined; as such, it provides no external anchor. And banks’ reserves with the central bank – the other component of outside money – cannot provide an anchor either: Contrary to what is often believed, they do not constrain the amount of inside credit creation. Indeed, in a number of banking systems under normal conditions they are effectively zero, regardless of the level of the interest rate. Critically, the existence of a demand for banks’ reserves, arising from the need to settle transactions, is essential for the central bank to be able to set interest rates, by exploiting its monopoly over their supply. But that is where their role ends. The ultimate constraint on credit creation is the short-term rate set by the central bank and the reaction function that describes how this institution decides to set policy rates in response to economic developments.

In a typically perceptive note written more than a decade ago, Axel Leijonhufvud mapped out and anticipated the evolution of the US monetary system into a pure credit economy during the 20th century:

The situation that Wicksell saw himself as confronting, therefore, was the following. The Quantity Theory was the only monetary theory with any claim to scientific status. But it left out the influence on the price level of credit-financed demand. This omission had become a steadily more serious deficiency with time as the evolution of both “simple” (trade) and “organized” (bank-intermediated) credit practices reduced the role of metallic money in the economy. The issue of small denomination notes had displaced gold coin from circulation and almost all business transactions were settled by check or by giro; the resulting transfers on the books of banks did not involve “money” at all. The famous model of the pure credit economy, which everyone remembers as the original theoretical contribution of Geldzins und Giiterpreise, dealt with the hypothetical limiting case to this historical-evolutionary process……Wicksell’s “Day of Judgment” (if we may call it that) when the real demand for the reserve medium would shrink to epsilon was greatly postponed by regime changes already introduced before or shortly after his death. In particular, governments moved to monopolize the note issue and to impose reserve requirements on banks. The control over the banking system’s total liabilities that the monetary authorities gained in this way greatly reduced the potential for the kind of instability that preoccupied Wicksell. It also gave the Quantity Theory a new lease of life, particularly in the United States.
But although Judgment Day was postponed it was not cancelled….The monetary anchors on which 20th century central bank operating doctrines have relied are giving way. Technical developments are driving the process on two fronts. First, “smart cards” are circumventing the governmental note monopoly; the private sector is reentering the business of supplying currency. Second, banks are under increasing competitive pressure from nonbank financial institutions providing innovative payment or liquidity services; reserve requirements have become a discriminatory tax on banks that handicap them in this competition. The pressure to eliminate reserve requirements is consequently mounting.

Leijonhufvud’s account touches on a topic that is almost always left out in debates on the matter – the assertion that we are in a credit economy is not theoretical, it is empirical. In the environment immediately after WW2, reserves were most certainly a limitation on bank credit. But banks gradually “innovated” their way out of almost all restrictions that central banks and regulators could throw at them. The dominance of shadow-money in our current economic system is a culmination of a long series of bank “innovations” such as the Fed Funds market and the Eurodollar bond market.

As Borio and Disyatat note, in such a credit economy, “through the creation of deposits associated with credit expansion, banks can grant nominal purchasing power without reducing it for other agents in the economy. The banking system can both expand total nominal purchasing power and allocate it at terms different from those associated with full-employment saving-investment equilibrium. In the process, the system is able to stabilise interest rates at an arbitrary level. The quantity of credit adjusts to accommodate the demand at the prevailing interest rate.” In such a economy, the conventional savings-investment framework has very little to say about either market interest rates or the abrupt breakdown in financing that characterises the Minsky Moment. The notion that our economic malaise can be cured by solving the problem of “excess savings” is therefore invalid. In Borio and Disyatat’s words, “Investment, and expenditures more generally, require financing, not saving.” A flatter yield curve therefore encourages incumbent firms to monopolise the limited financing/risk-taking capacity of the system (limited typically by bank capital) simply to increase cash holdings and in effect crowding out small firms and new entrants.

The problem in a credit economy is not so much excess savings but as Borio and Disyatat put it, excess elasticity. Elasticity is defined as

the degree to which the monetary and financial regimes constrain the credit creation process, and the availability of external funding more generally. Weak constraints imply a high elasticity. A high elasticity can facilitate expenditures and production, much like a rubber band that stretches easily. But by the same token it can also accommodate the build-up of financial imbalances, whenever economic agents are not perfectly informed and their incentives are not aligned with the public good (“externalities”). The band stretches too far, and at some point inevitably snaps….In other words, to reduce the likelihood and severity of financial crises, the main policy issue is how to address the “excess elasticity” of the overall system, not “excess saving” in some jurisdictions.

If our financial system is a rubber band, the long arc of monetary system evolution from a metallic standard to a credit economy via the Bretton Woods regime has been largely a process of increasing the elasticity of this rubber band (excepting the period of financial repression post-WW2 when the trend reversed temporarily). Snap-backs are inevitable – the question is simply whether the snap-backs are “normal” or catastrophic. What is commonly referred to as the ‘Minsky Moment’ is the almost instantaneous process of the elastic snapping back. As Minsky has documented, the history of macroeconomic interventions post-WW2 has been the history of prevention of even the smallest snap-backs that are inherent to the process of creative destruction. The result is our current financial system which is as taut as it can be, in a state of fragility where any snap-back will be catastrophic.

The natural fix for the system as I have outlined is to allow small pull-backs and disturbances to play themselves out. But we have evolved far past the point where the system can be allowed to fail without any compensating actions. Just like in a forest where fire has been suppressed for too long or a river where floods have been avoided, it is not an option to let nature take its course.

So is there no way out that does not involve a deflationary collapse of the economy? I argue that there is but that this requires a radical change in focus. The deflationary collapse of the current shadow money and credit superstructure and correspondingly much of the incumbent corporate structure adapted to this “taut rubber-band” is inevitable and if anything needs to be encouraged and accelerated. But this does not imply that the macroeconomy should suffer from a deflationary contraction. The effects of this snap-back can be mitigated in a simple and effective manner with a system of direct transfers to individuals as Steve Waldman has outlined. In fact, it is the deflationary collapse of the incumbent system that provides the leeway for significant fiscal intervention to be undertaken without sacrificing the central bank’s inflation targets. This solution also has the benefit of reversing the flow of rents that have exacerbated inequality over the past few decades, as well as tackling the cronyism and demosclerosis that is crippling our system today. Of course, the collapse of incumbent crony interests inherent to this policy approach means that it will not be implemented anytime soon.

Note: hat tip to Yves Smith and Andrew Dittmer for directing me to the Borio-Disyatat paper.

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Written by Ashwin Parameswaran

September 22nd, 2011 at 5:24 pm

Bagehot’s Rule, Central Bank Incentives and Macroeconomic Resilience

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It is widely accepted that in times of financial crisis, central banks should follow Bagehot’s rule which can be summarised as: “Lend without limit, to solvent firms, against good collateral, at ‘high rates’.” However, as I noted a few months ago, the Fed and the ECB seem to be following quite a different rule which is best summarised as: “Lend freely even on junk collateral at ‘low rates’.”

The Fed’s response to allegations that they went beyond their mandate for liquidity provision is instructive. In the Fed’s eyes, the absence of credit losses signifies that the collateral was sound and the fact that nearly all the programs have now closed illustrates that the rate charged was clearly at a premium to ‘normal rates’. This argument gives the Fed a significant amount of flexibility as a rate that is at a premium to ‘normal rates’ can still quite easily be a bargain when offered in times of crisis. Nevertheless, the Fed can point to the absence of losses and claim that it only provided liquidity support. The absence of losses is also used to refute the claim that these programs create moral hazard. However, both these arguments ignore the fact that the creditworthiness of assets and the solvency of the banking system cannot be separated from the central banks’ actions during a crisis. As the Fed’s Brian Madigan notes: “In a crisis, the solvency of firms may be uncertain and even dependent on central bank actions.”

However, the Fed’s response does highlight just how important it is to any central bank that it avoid losses on its liquidity programs – not so much to avoid moral hazard but out of simple self-interest. If a central bank exposes itself to significant losses, it runs a significant reputational and political risk. Given the criticism that central banks receive even for programs which do not lose any money, it is quite conceivable that significant losses may even lead to a reduction in their independent powers. Whether or not these losses have any ‘real’ relevance in a fiat-currency economic system, they are undoubtedly relevant in a political context. The interaction of the central bank’s desire to avoid losses and its ability to influence asset prices and bank solvency has some important implications for its liquidity policy choices – In a nutshell, the central bank strongly prefers to backstop assets whose valuation is largely dependent on “macro” systemic risks. Also, when it embarks upon a program of liquidity provision it will either limit itself to extremely high-quality assets or it will backstop the entire spectrum of risky assets from high-grade to junk. It will not choose an intermediate threshold for its intervention.

The first point is easily explained – by choosing to backstop ‘macro’ assets whose prices and performance are strongly reflexive with respect to credit availability, the program minimises the probability of loss. For example, a decision to backstop housing loans has a significant impact on loan-flow and the ‘real’ housing market. A decision to backstop small-business loans on the other hand can only have a limited impact on the realised business outcomes experienced by small businesses given the idiosyncratic risk inherent in them. The negatively skewed payoff profile of such loans combined with their largely ‘macro’ risk profile makes them the ideal candidates for such programs – such assets are exposed to a tail risk of significant losses in the event of macroeconomic distress, which is the exact scenario that central banks are mandated to mitigate against. The coincidence of such distress with deflationary forces enables central banks to eliminate losses on these assets without risking any overshooting of its inflation mandate. This also explains why central banks are reluctant to explicitly backstop equities even at the index level – the less skewed risk profile of equities means that the risk of losses is impossible to reduce to an acceptable level.

The second point is less obvious – If the central bank can restrict itself to backstopping just extremely low-risk bonds and loans, it will do so. But in most crises, this is rarely enough. At the very least, the central bank is required to backstop average-quality assets which is where the impact of uncertainty is greatest and the line between solvency and liquidity risk is blurriest. But this is not the strategy that minimises the risk of losses to the central bank. The impact on the system from the contagious ripple effects of the losses incurred on the junk assets can cause moderate losses on higher-quality assets. This incentivises the Fed to go far beyond the level of commitment that may be optimal for the economy and backstop almost the entire sphere of “macro” assets even if many of them are junk. In other words, it is precisely the desire of the Fed to avoid any losses that incentivised it to expand the scope of its liquidity programs to as large a scale and scope as it did during the crisis.

These preferences of the central bank have implications for the portfolios that banks will choose to hold – banks will prefer ‘macro’ assets without excessive micro risk as these assets are more likely to be backstopped by the central bank during the crisis. This biases bank portfolios and lending towards large corporations, housing etc. and against small business loans and other idiosyncratic risks. The system also becomes less diverse and more highly correlated. The problem of homogeneity and inordinately high correlation is baked into the structural logic of a stabilised financial system. Such a system also carries a higher risk of asset price bubbles – it may be more ‘rational’ for a bank to hold an overpriced ‘macro’ asset and follow the herd than to invest in an underpriced ‘micro’ asset. Douglas Diamond and Raghuram Rajan identified the damaging effects of the implicit commitment by central banks to reduce rates when liquidity is at a premium: “If the authorities are expected to reduce interest rates when liquidity is at a premium, borrowers will take on more short-term leverage or invest in more illiquid projects, thus bringing about the very states where intervention is needed, even if they would not do so in the absence of intervention.” Similarly, the incentives of the central bank to avoid losses at all costs perversely end up making the financial system less diverse and fragile.

When viewed under this logic, the ECB’s actions also start to make sense and criticisms of its lack of courage seem misguided. In terms of liquidity support extended, the ECB has been at least as aggressive as the Fed. in fact, in terms of the risk of losses that it has chosen to bear, the ECB has been far more aggressive. Despite the losses it faces on its Greek debt holdings,it has nearly doubled its peripheral government bond holdings in recent times. This is despite the fact that the ECB runs a significant risk of losses on its government bond holdings in the absence of massive fiscal transfers from the core to the periphery, a policy for which there is little public or political appetite.

The ECB’s desire for the EFSF to take over the task of backstopping the periphery simply highlights the reality that the task is more fiscal than monetary in nature. Relying on the ECB to pick up the slack rather than constructing the fiscal solution also exacerbates the democratic deficit that is crippling the Eurozone. The ECB is not the first central bank that has pleaded to be relieved of duties that belong to the fiscal domain. Various Fed officials have made the same point regarding the Fed’s credit policies – drawing on Marvin Goodfriend’s research, Charles Plosser summarises this view as follows: “the Fed and the Treasury should agree that the Treasury will take the non-Treasury assets and non-discount window loans from the Fed’s balance sheet in exchange for Treasury securities. Such a new ”accord“ would transfer funding for these special credit programs to the Treasury — which would issue Treasury securities to fund the transfer — thus ensuring that these extraordinary credit policies are under the oversight of the fiscal authority, where such policies rightfully belong.” Of course, the incentives of the government are to preserve the status quo – what better than to let the central bank do the dirty work as well as reserving the right to criticise it for doing so!

This highlights a point that often gets lost in the monetary vs fiscal policy debate. Much of what has been implemented as monetary policy in recent times is not only not ‘neutral’ but is regressive in its distributional effects. In the current paradigm of central bank policy during crises, systemic fragility and inequality is an inescapable structural problem. On the other hand, it is perfectly possible to construct a fiscal policy that is close to neutral e.g. Steve Waldman’s excellent idea of simple direct transfers to individuals.

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Written by Ashwin Parameswaran

September 12th, 2011 at 4:41 pm