Wednesday, June 29, 2011

Level of bank reserves wil not be the proximate cause of hyperinflation

Additional points from my comments here. Negative rate of return refers to what mainstream monetarists call return after 'expected future inflation’, which convinces people to put investments in higher risk-return investments to compensate for the higher expected inflation. This most affects money managers, who are expected to achieve minimum hurdle rates of return, which are now impossible due to the longstanding zero bound for treasuries. So it’s not the reserves of banks being put into high risk investments, but more likely the asset pools of money managers, which now have nowhere else to go (since the Fed has crowded them out of risk-free treasuries)


I can’t be sure, but perhaps Prof. Higgs uses the fractional reserve banking framework, which believes every $1 of reserves can be relent 9x. If you already believe reserves BY THEMSELVES can cause inflation, there’s no reason to not believe they cause hyperinflation. Of course, if you believe instead that loans are caused by loan demand and banks’ capital adequacy, then $1 lent by bank A does not mean that bank B, which gets it as a deposit, relends to the next person. Bank B may may capital-deficient, or may not focus all that much in loans (perhaps it likes to place money instead in commodities plays).I don’t even believe that 9x is even a useful benchmark. Banks will lend when are willing and able, regardless of existing level of reserves. The ability comes from equity capital cushion and the willingness comes from demand from creditworthy borrowers.

I believe that central banks cannot fully control the money supply at all, because private loan demand and government spending is what increases it. They can indirectly control it by increasing the cost of credit though, so private loan demand plummets, or by decreasing cost, so private loan demand increases. But at this point in time, when people are already over-indebted and the cost of credit is already at zero, there’s not much more it can do to increase loan demand, and hence to increase money supply.

It would be hard for regulation to know who is creditworthy and who isn’t. That’s the bank’s job. So regulation should always make sure that the bank does its job well, and never ever find itself in need of a bailout. That said, Yes, banks should always have skin in the game, and securitization and the rise of shadow banks which help them securitize bad loans allow them to shed risk prudence, and just go for immediate profits of booking more loans. This activity should be monitored and regulated more closely, because this has proven to be a much used loophole in the system.

I think ‘hyperinflation’ only ever happens when there is a general loss of faith in a currency, which results in mass flights out of it. Bank reserves have nothing to do with this phenomenon. ‘Helicopter drops’ of money to the general populace is more likely to do it, when done without corresponding increase in productive capacity.

Hyperinflation is not what should be bothering us. It should be that the Fed has induced investors to put more funds in higher risk-return investments, and stoking asset bubbles. QE2 most affected money managers, who are expected to achieve minimum hurdle rates of return, which are now impossible due to the longstanding zero bound for treasuries. It’s not the assumption of my article that “over time the past actions of the monetary and fiscal authorities will cause latent inflationary pressures to build significantly”, although it might for Prof Higg’s article.

I think the Fed is the wrong institution to cause anything right now, although I think they should maintain the zero rate for now to avoid any more crisis coming from more defaults by any of the remaining highly indebted parts of the economy. Low rates were meant to make lending more profitable for banks. But since it wasn’t incentivizing enough, QE2 was supposed to force them. Which means the solution being pursued is even more borrowing. It was Fed low rates for the past decade that encouraged people to get overleveraged in the first place, and I find it irresponsible that the solution being pursued to induce more spending is even more easing by the Fed. I agree that rates must be allowed to respond to market forces, and I’m just vacillating due to the possibility that quickly rising rates might bring its own problems. It’s a complicated mess,and solving it should involve reorganizing the financial and banking systems, but also having some kind of support for existing borrowers so we avoid having lot of them default, but certainly no more lending where the borrowers cannot absorb anymore.


Mario said...

great discussion on Fed policy.

I agree. I think Fed policy has minimal impact in actual fact and much more effect through expectation theory, and for that reason it's valid, at least for now, in our economy.

The fact is regulation (REAL REGULATION from REAL REGULATORS) is what's really necessary along with proper fiscal policy...and patience...lots of patience...America is going through a new "growing pain" in its life imho.

Rogue Economist said...

Yup, it's all come down to expectations, and the expectation that everyone's expectations will be as they expected (pun intended).

Mario said...

LOL that's a classic line!!!!

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