Richard Koo was one of the commentators who got many elements of the US Recession correct. In particular, he referred to it as a "balance sheet recession" and consistently pointed to the lesson of Japan, where a property bust lead to protracted stagnation, and no inflation despite low interest rates and high deficits. Koo argued that Japanese households were trying to repair their balance sheets, and the usual mechanic of lower interest rates encouraging people to take on more loans, was not going to work.
Hard to figure out this latest position then:
But nightmare scenario awaits when private loan demand recovers. The problem is what happens when private loan demand recovers. Loan books could grow more than tenfold in the US and five fold in Japan and Europe if bank reserves remain at current levels, triggering inflation rates of 500% to over 1,000%.Unlikely. If private loan demand recovers, it means that the balance sheet repair is over and households are ready to begin re-leveraging. If horizontal money create generates too many dollars chasing too few goods, we could have inflation, but changing reserve ratios or interest pair on reserves will do nothing to deal with this problem. Banks lending is not reserve constrained, it is capital constrained, so trying to manage the size of a bank's balance sheet via reserve manipulation is climbing a tree to catch a fish.
To avoid this outcome, central banks will have to mop up excessive reserves by raising the statutory reserve ratio, raising the interest rate paid on reserves, and selling government bonds. All of these measures will serve to lift interest rates, sending bond yields sharply higher and triggering a possible crash in the bond markets.
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changing reserve ratios or interest pair on reserves will do nothing to deal with this problem.
ReplyDeleteSerious question: What made monetary policy effective prior to 2007? What mechanism allowed the Fed to reduce demand for real goods in earlier tightening episodes?
I am open to the answer that it didn't, and that the coincidence of Fed tightening, rising rates and falling real activity is just that, a coincidence. but I'm curious what you think.
Also, why can't bank lending be constrained both by capital and by liquidity? (With reserves being an important source of liqudity.)
ReplyDeleteIt can. The central bank could refuse to issue reserves. In which case interest rates will start to go skywards and will continue to go up until one of the banks goes bust. In the meantime the payment system will struggle to clear payments between banks.
ReplyDeleteGiven that the central bank won't even let insolvent banks go bust, there is no way they will let banks go bust due to a lack of liquidity.
Particularly as it would collapse the payment system.
@JM, when the CB raises rates it increases borrowing costs decreasing the private sectors ability to service debt and hence its ability to borrow money which leads to curtailed demand. But the effect is through the DEMAND for loans, not the ability of a bank to lend to creditworthy customers.
ReplyDeleteJW: I think that monetary policy can have an impact through the housing market--there's a good paper somewhere on how the business cycle is the housing market--but this doesn't work in a ZIRP environment that's gone through a real estate bubble.
ReplyDeleteNeil: Right. If the CB doesn't issue reserves, checks stop clearing even if there are sufficient funds. Not an acceptable outcome.
Y'all are soft, having grown up during the long decline of interest rates since 1981. But surely it is possible for the central bank to push rates up again. It would be a change, but it would be nothing new.
ReplyDeleteThe Kalekian analysis of using interest rates is that each cycle generates a greater load of debt and that means that interest rates cannot go up as high as the previous cycle without causing problems, and that for each bust it has to go much lower than the previous cycle to force a recovery.
ReplyDeleteThat latter is subject to a zero bound - which we've just hit or at least skirmished.
So bankers, who are the only people to benefit from the system, might be able to push one or two more cycles out of this model before it completely collapses as a mechanism.
The one thing that always surprises is how long stupid ideas continue before they are finally abandoned.
If you want to call someone stupid you should be direct about it, or i may fail to understand what you are saying.
ReplyDeleteIn my analysis also, each cycle generates a greater load of debt. And in the obvious case of reality as well. But clearly, the ability of the economy to support that debt also increases in some sort of self-defeating evolution. Up to a point.
J.W.Mason asks “What made monetary policy effective prior to 2007?” Simple: we weren’t in a ZLB scenario. I.e. prior to 2007 central banks could adjust rates and that had an effect. In contrast after 2007 and with rates at or near zero, rates cannot be adjusted.
ReplyDeleteAn alternative is QE, but that hasn’t been a resounding success, and I never expected it to be.
Neil, Why would a substantial interest rate rise cause a bank to go under? The rate rise would stem from demand for loans exceeding banks’ ability to supply. Banks would charge borrowers more. Sounds to me like extra profit for banks, not banks going bust.
Re any possible shortage of reserves for settling up purposes, we are talking here about the supply of reserves being constrained, but at a level which is way above the historical norm. I.e. shortgage of reserves for settling up purposes does not enter the picture.
But even if there is such a shortage, commercial banks are not reliant on CBs to settle up. If CBs didn’t exist, commercial banks would quickly find an alternative way of settling up between each other. In fact inter-bank loans are the beginnings of a settling up process that by-passes CBs.
Ralph,
ReplyDeleteThe inter bank loan system is the first to freeze up - as has already been demonstrated in the real world.
At which point the payment system is interrupted unless the central bank plays the role of liquidity provider.
"I.e. shortgage of reserves for settling up purposes does not enter the picture."
That's precisely what we're talking about - reserves as some kind of cash flow constraint.
Neil,
ReplyDeleteSo it's either no liquidity constraint at all, or collapse of the payment system? Doesn't this dial have any intermediate settings?
Not from the analysis I've seen. There has to be just the right amount of reserves in the system to maintain an interest rate or the central bank has to pay interest on reserves.
ReplyDeleteToo many reserves and the interest rate collapses to zero. Too few and the payment system is in trouble as reserves are bid up in price until something gives.
That's why the central bank is seen as servant rather than master under the MMT analysis. To use reserves as discipline it has to sacrifice the payment system. The consensus is that the central bank won't do that, and of course markets test resolve by design.
Monetary policy was never effective. If you look at the long term rate of interest set by the Fed, it just follows the inflation rate, not the other way around. The correlation is between low interest rates and low inflation. See this graph...
ReplyDelete