Thursday, February 24, 2011

Monetary easing and the need for macroprudential monitoring

I had previously thought QE’s main goal was to help inflate away debt. But by its very nature, it is also designed to inflate the price of assets. I had thought proponents wanted monetary easing because it helps ensure there is adequate money going around to address the needs of illiquid people/entities. But it seems proponents advocate it just as much to increase inflation expectations.

I had previously thought of monetary easing in defensive terms, and even then, I had thought it to be destructive because of the way it encouraged asset speculation as a side effect. But now I see that asset speculation is in fact a primary transmission mechanism of monetary easing. A central bank undertaking it wants real assets to appreciate because the increase in assets makes people feel they are wealthier, and therefore more open towards purchasing more. A rising monetary base increases inflation expectations among the people, such that they begin to purchase things now rather than later.

Noble though monetary easing's objective is in alleviating the economy, realizing that the ugly side effect of blowing asset bubbles is in fact front and center in its transmission mechanism does color my perspective on it. Monetary easing then is akin to waving the red cape to the bull, to induce the bull to attack you. Given this, what exactly are your defensive mechanisms against a charging bull?

If a Fed policy were to encourage the rise of various asset classes to effect an economic rebound, it should at least acknowledge and monitor the rise of unsustainable bubbles. A pricking could put the economy on worse footing then from where it started.What exactly are the monetary experts’ recommendations to ensure that such a pricking does not destroy the economy? The only surefire way I could think of preventing a meltdown is to make the easing permanent.

But making it permanent means that if the easing overshoots, the increasing inflation might be permanent and unstoppable. An unstoppable inflation eventually feeds onto a feedback loop of ever increasing inflationary expectations, which could escalate into further inflation*, asset appreciation escalating into even more asset appreciation.

The transmission channel is not limited just to the regular banking system, and QE could make the parallel shadow banking system become powerful once more, and we know that the shadow banks are not constrained by regulation or strict capital requirements. A parallel banking system actually accumulates its capital from chasing a market as it rises to the top, and this feedback loop of increasing asset prices will encourage more shadow players to buy more assets as they inch up, thereby reinforcing the convictions that they started out with. This mechanism also includes the general public, primarily via pensions and investment funds, which are major transmission channels of the wealth effect, via asset appreciation**

I began to doubt the notion, about a year ago, that central banks could induce asset bubbles. But now I have erased all doubt. Nothing can stop a determined central banker, one with the power of fiat, and a market that knows how to play along and game the game.

Since monetary easing's stimulative effects are transmitted via increasing inflation expectations and asset appreciation, it is utter irresponsibility and pure madness to embark on it without an adequate macroprudential framework. And constantly subjecting all financial entities to macroprudential measures, and using macroprudential tools whenever necessary, and constantly monitoring various assets for potential bubbles.

* Even if not so much in core inflation, but so much in consumer staples inflation
** Thanks to Andy Harless for reminding me that QE need not be limited or targeted only to banks

Sunday, February 20, 2011

How Bernanke stimulates?

It’s party night over at DJ Ben’s.
DJ Ben: Party people! The music’s playin’, and I want all of you out here on the dance floor!
(Crowds cheer and feet start stomping madly on the floor).

DJ Ben: You’re gonna love tonight’s music, ladies and gents. I’ll be playing a lot of your retro favourites from DJ Maestro’s time. I want you all to have a great time, and start shakin’ those booties. (Somewhere outside, DJ Maestro, long since retired, shakes in head in disapproval).

One of the fiercest clubbers, Goldie Sexy: I just love this groove. I haven’t danced this hard in like, ever. I’m so glad DJ Ben allowed me inside his exclusive club! Now I’m going to show him how dancing is really supposed to be like. (starts bumping and grinding seductively, that a lot of suitors start drooling and rush over)

Outside the club, behind the velvet line to get in, Blackie Rockie and Pim Coss shout out over the deafening music: We love you, DJ Ben! We groove to your music and just idolize you. If you let us into your exclusive club, we’ll dance the way you want us to. We won’t let you down!

Also heard outside, among the long queue of people trying to get in, are people with hedge haircuts shouting the same thing. They are none too happy to see a group of people wearing European fashion get head of the line and get inside the club. They swear among themselves they will beat these people up ‘shortly’ after these go back out of the club.

Another partier inside, JP Mortimer: I’m always uneasy with how these parties here at DJ Ben’s always end up. But hey, for as long as afterwards, these parties send over all the most booze and drug-addled partiers over to my place, for a night of guilt-free copulation, I’m not complaining. (smirks)

Neighbour HU Jinkshow(who lives next door to the club) forcibly goes inside the club and talks to the DJ: DJ Ben, your music is too loud. I can hear it all over my house, and I can’t sleep.

DJ Ben strains to hear him. What? You have to speak louder over all the noise.

Neighbour HU: I said your noise is too loud. It’s already broken several windows in my house. That’s how loud you’re playing. You have to tone it down, otherwise I’m going to have to take matters into my own hands.

DJ Ben: Hey! If you don’t like loud music, you shouldn’t be attaching my amplifiers straight up to speakers all over your fuckin’ house. You’ve been amplifying my music, so don’t blame it all on me!

Neighbour HU (sheepishly): Hey, guilty as charged, DJ Ben. Your music is ‘da bomb! And I groove to your beats. I can’t help myself.

Police knock on the club’s door, and accosts the DJ.
IMF squad: We’ve been hearing reports that you’ve been playing loud music, and awaking all the neighbours. You’re going to have to tone it down, because you’re disturbing everybody’s sleep.

DJ Ben: We’re doing just fine here, officer. No loud music.

IMF squad: Ok, thank you for your cooperation.

On the way out, one of the officers asks the other: Why are we letting this pass?

Other officer: Oh hell, there’s really nothing we can do about it. DJ Ben owns the entire property here, and everybody’s just renting. So let’s best be on our way.

Meanwhile, insider the ladies room, Anna Inga Gardiner is still retching on the toilet, still reeling from the alcohol excess of the previous night’s reckless dancing. And meanwhile, another reveller from the previous revelry, Lem, is now in the morgue.

Back on the floor.
DJ Ben: Hey, party people! I can’t seem to see enough dancing out there. I’m going to have to turn up the music further. I want all of you to be dancing harder and faster. If you don’t, I’m just going to keep turning the music up further.

Random reveller: Everybody start dancing harder. We don’t want the DJ to make good on his threat. (He then starts up a conga line, which a lot people follow).

Meanwhile, across the pond, another frenetic DJ is whipping up the crowd with his house music and techno beats......
Deejay 3-shay: Everybody on the floor, feel the rhythm!
(And at that, dancers turn up the heat on the floor, and groove with moves like the Irish jig, sizzling flamenco, Thracian plate dancing, and mandolin dancing).

Back over at DJ Ben’s.
Another clubber, Biff Amra: I’m having the time of my life. I swear, I’m going to be tonight’s dance champ. I really am! Nobody’s gonna dance harder and longer than I do.

Some random reveller: Good luck on that, but that’s likely not gonna happen. C.T. over there is our reigning champ, has always been. More likely, long after everyone’s tired, but for as long as the music’s still playing, he’ll still be dancing.

Biff Amra: I just can’t stand it. How does C.T. do it?

Random reveller: It’s simple really. C.T. never sleeps.

Thursday, February 17, 2011

Some questions for proponents of NGDP targeting

There is a growing body of economists now trumpeting NGDP level targeting as the best way to get the US economy out of recession. This idea seems to be propounded mostly by Scott Sumner.

Now that rates are at the zero bound, the Fed can no longer stimulate the economy via its regular policy tool – decreasing interest rates. But this fact, as its proponents say, does not limit the Fed’s ability to stimulate the economy via unconventional tools, i.e., NGDP level targeting. The basic idea seems to involve the Fed involving in programs to loosen monetary base, QE being such a program. As the monetary base gets larger, this increases everybody’s expectations of inflation, thereby getting people to spend more now, instead of later. The increasing monetary base, along with the additional economic activity nudged into existence by the increasing inflationary expectation, will then lead to an increase in nominal GDP.

NGDP targeting proponents seem to recommend a 5% annual NGDP growth as a target.

I have attacked and berated additional monetary easing numerous times in this blog in the last few months, but in the interest of open-mindedness, I would like to learn more about this NGDP level targeting and its policy assumptions. If I can get some answers from anyone reading this who may know more about the idea, I could change my mind and my violent opposition to it.

Firstly, operationalizing NGDP targeting, as I understand it, will be via an increase in bank reserves (since this is the policy tool left for the Fed to loosen monetary policy). As such, the way for this new reserves to go out into the broader economy is via increased lending/investing activity by banks.

Since the objective of an effective NGDP level targeting central bank is to grow NGDP by 5% a year, I present the following chart which shows where NGDP should go, from now until 2020. Given the annual growth, we can now calculate what incremental nominal GDP is added for each succeeding year from now until 2020.

Now again, if my understanding is correct, all this additional NGDP will be due to additional lending. Am I wrong? Inaccurate? I know I’m oversimplifying things, since I’m assuming no organic growth, assuming instead that every $1 of incremental NGDP equals $1 of additional debt in the system. But I’m also assuming that there was no additional deflationary counter-pressure necessitating a greater than $1 debt for each $1 NGDP growth. In reality, if NGDP targeting were to be successful, there would probably more loosening than growth in the early years, while gradually less loosening to growth ratio would be needed, as the economy begins to grow back its legs.

But for simplicity sake, my chart shows me that to get to the policy objective of growing from $14.7 trillion GDP in 2010, to $23.9 trillion in 2020, we would be adding about $9.2 trillion of new money/new debt into the system in the coming 10 years. Is this accurate? To put this additional debt into perspective, given 310 million US population, this means $30,000 new debt per capita in the next 10 years. That’s 30 grand of additional debt per man, woman, and child now living in the US in the next 10 years.

Now the next column assumes that banks follow the Basel-approved leverage cap of about 10x capital. That means over the next 10 years, for banks to be able to lend $9.2 trillion, it has to set aside/raise almost a trillion in new capital. Where will this new capital come from?

Now I’m oversimplifying again, since not all incremental debt will need some form of capital to back it. If US banks were to simply buy new government debt in the next 10 years to attain each year’s NGDP growth target, then no additional capital need be raised. But then, this means, QE and /or NGDP targeting, is really just a mechanism to allow for more fiscal policy action, and/or deficit government spending. In which case, it is compatible to greater fiscal policy. Is this an accurate description?

Now again, we’ve also seen instances of banks being able to lend without setting aside capital. All banks need do is pass the loans on to another investor who intends to keep it as an investment. Now we know that there are millions of people from the rising investor class in the developing world who could be ‘prime’ candidates to pass these new debts along to. They are people who likely still cannot distinguish a leveraged mortgage security from a regular fixed income bond, and who cannot identify a toxic asset if they were staring at it with their very eyes. These are people who ‘theoretically’ can fund the capital needs of the new lending, by taking it away from the originating bank’s balance sheet. Multinational US banks can do this right now. Now, is this side effect a possibility that proponents have considered, and is the possible meltdown of the rest of the world worth it, for the sake of being able to conduct this NGDP targeting experiment?

Update: Many thanks to Andy Harless for engaging me in the comments, and for reminding me that QE2 involves buying bonds not just from banks, but from the entire bond-buying public. Do read the comments for more analysis.

Thursday, February 10, 2011

Why aren’t banks lending their excess reserves?

This question keeps getting asked, since a cornerstone of the move to increase bank reserves is to stimulate more lending. To be plain, let’s make our explanation in the form of an analogy. -between a bank and a retail shop.

A retail shop needs a trade credit line in its normal course of business. With this credit line, it finances many of it purchase of inventories, so it can resell them to the general public. But before it qualifies to get such line, it first needs to have shareholder’s equity in the business. This is proof that the owner has personally invested into the business, and serves to give comfort to the line giver that there is a cushion which will eat the first instance of loss.

In the same manner, a bank needs reserves (whether from deposits or the Fed) in its normal banking business. Via its reserves, it is able to undertake its everyday business of making and disbursing payments, including loans, and paying back depositors on demand.* But before it qualifies for Fed facilities, or before it can attract new deposits, it needs to show that it has adequate equity in the bank first. This is proof that the owner has personally invested into the business, and serves to give comfort to the reserve giver that there is a cushion which will eat the first instance of loss.

For a retail shop, as more of a credit line is used, more equity needs to be set aside in the business, so as to keep from getting insolvent, should a large chunk of line givers suddenly demand their money back. It is also prudent management not to let leverage get out of hand.

With a bank, the more reserves it raises (or borrows), more equity needs to be set aside, so as to keep from getting insolvent, should a large chunk of funders suddenly demand their money back. This is also a requirement of Basel, which if unheeded, causes a bank to get a rating downgrade.

As more lenders provide a retail shop with credit, the greater volume of inventory it can purchase, and hence give discounts to its buyers.

Similarly, the more reserves a bank is given, it is believed, the greater volume of lending it can provide, and hence, and at cheaper rates, to its borrowers.

Given sufficient credit, (and assuming adequate equity), the retail shop eventually runs into the upper limit of saleable inventory it can accumulate. The upper limit is determined by the population of end buyers who can afford to pay for its goods.

Given sufficient reserves, (and assuming adequate equity), the bank eventually runs into the upper limit of prudent lending it can accommodate. The upper limit is determined by the population of good credit borrowers who can afford to pay back their loan.

Of course, if the storekeeper thinks the risk is worth it, he will invest in more inventory using credit. If he sells all of it, he will get rich. But if previous inventory is not selling well, a shopkeeper will use more credit to pay off old credit. If debt accumulates on top of debt, he will have to eat the loss, and at worst, declare bankruptcy. Before this happens, some foolish line givers might decide to give more credit just to postpone the inevitable. But once the credit line has been used, and it was used for reckless inventory hoarding, it can no longer be demanded back.

Of course, if the banker thinks the risk is worth it, he will lend more at inadequate equity (provided he can get away with it). If the loans pay off, he will get rich. If previous loans are getting sour, the bank will use existing reserves to keep paying its daily obligations, including paying back depositors who demand their money back. If there aren’t enough reserves when a large multitude of depositors are demanding their money back, he will have to eat the loss, and at worst, declare bank holiday. But once the Fed has already printed so much reserves into existence, and it was used in reckless lending and speculation, the monetary easing can no longer be reversed without causing a systemic meltdown.

*Not necessarily saying banks lend reserves. If you have a line at the Fed, it becomes fungible with existing reserves.

Saturday, February 5, 2011

Not another rant against monetary easing? Thoughts on encouraging risk

It has often been stated that a major objective of the QE2 monetary expansion is to encourage people to take on more risk, and to discourage them from hoarding money into savings. QE2 is meant to create an environment which creates incentives for people to put money into circulation via spending and investment. Well, as it happens, proponents of QE2 are setting up a straw man. Who needs to take on more risk? Companies? Individual savers? Institutional investors?

Monetary easing is a potent economic weapon, and just like an atom bomb, it doesn’t make a distinction of who its target is. It doesn’t care whether you’re rich or poor, whether you’re a consummate saver or you’re a consummate debtor. Monetary easing will always have one effect on you – take on more risk.

And so it has been since it was called a Greenspan put (now it goes by the updated name of Bernanke put). Whenever the economy starts to slow down, the solution has been to avoid incurring fiscal deficit at all costs (It increases government debt) and substitute it with activist monetary policy – which in the case of a slowdown means monetary easing.

During Greenspan’s time, the solution was lowering interest rate. Lower interest rate (or Fed funds rate, to be exact) is supposed to encourage more company investment. But the straw man also includes pension and money fund managers. You know them- the people you entrust your retirement savings to, with a mandate to ensure 10% annual yields (or better). They have promised to turn your savings into a nest egg that can fund your lifestyle in your retirement years. So what happens when rates are made lower, but their marching orders are still to generate 10% annual yield (or better)? That’s right. Take on more risk.

Well, let’s qualify that. They are supposed to safeguard the principal of their investors, because these are meant to be there when they retire. So, you look for yield while maintaining the illusion of safety.

During Greenspan’s time, the process became – lower interest rates – hunt for higher yield (more risk) – this leads to a bubble, turbocharged by leverage, which deflates – large losses, which, coupled with leverage, leads to a bigger downturn, as investors take stock of their losses and deleverage.

Now, during Bernanke’s time, the process is the same. A downturn leads to….well now that we are at the zero-bound as a starting point, the idea is to make interest rates negative in real terms. That means nominally increasing money supply, via QE2. So….. negative interest rates – hunt for higher yield (more risk) – this leads to a bubble, turbocharged by leverage, which deflates – large losses, which, coupled with leverage, leads to a bigger downturn, as investors take stock of their losses and deleverage.

During Greenspan’s time the investment of choice for the bravest and fiercest was leveraged mortgage bonds. It promised yield while maintaining the illusion of safety.

Fast forward to now, Bernanke’s time, the investment of choice seems to be commodities and emerging market debt. After all, when money is replicating faster than amoeba, the effect should be a turbocharged increase in the value of “scarce” resources, right? And so we see yield hungry investors fleeing into commodities and commodity-rich economies (and economies which are just now starting to develop).

But what happens when this leads to an inevitable bubble, which then bursts? What will save leveraged investors from falling price of commodities? (And why shouldn’t you eventually leverage up, when interest rates are negative?) What will save the economy from going into a bigger tailspin?

Well, if we are to believe the all-encompassing usefulness of monetary policy, monetary easing should do the trick. QE9? QE10? After all, there’s no problem that can’t be solved by throwing more money into it (No matter if it leads to the next, bigger problem). Just don’t let it lead to a fiscal deficit.