Monday, September 26, 2011

Enough with calling for more Fed action already

Operation Twist. There goes the Fed again with its endless bag of tricks. QE2 did not work as expected. Now they hope the Twist will do the job. The ironic thing is that for the past two years, Bernanke himself has been saying that the government needs to undertake more fiscal policy. Read between the lines, and you'll see that he is already very reluctant to do more on the monetary policy front as it just introduces more complications to an already fragile economy, leads to more malinvestment, more market uncertainty, without really achieving its real aim, which is to encourage more economic activity in the economy. At this point, the fed is doing the Twist likely only to promote the perception that the fed is doing something.

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. Many monetarists who subscribe to the beneficial effect of monetary easing are blindsided by the debt problem. Many people who subscribe to monetarism don’t believe in the existence of banks or debt, and think that increasing the money supply automatically results in a higher price level. Those that do believe in the existence of banks think that banks automatically lend what funds land on their laps without consequence. And that they can just find additional capable borrowers out on the street like Mcdonalds finds new patrons for new stores.

Monetarist proposals ignore Debt's downside effects on economic agents, while over-estimating easing's effects on inflation expectations. But debt does make a difference -a very large difference. Inflationary measures can be hindered in a recession economy with a lot of debt, because the indebted that are undergoing deflation, i.e. balance sheet recession, will not be induced to make more purchases if paying off the debt is already eating up much of their income. Monetarists hope that the non-indebted ones will come to the economy's rescue, and be induced to consume more, because of increased inflation expectations (they will consume now before prices get more expensive). But then, the non-indebted have to first be convinced that the ongoing balance sheet recession among the indebted will not counteract any of the inflationary measures. Thus far, nobody's convinced. Not in numbers big enough to achieve what monetarists want. The question is, should the Fed be ready to do whatever is necessary to move everyone's expectations? What are the unintended consequences of printing whatever it takes to move everyone's expectations? (Of course I say no, and have said so here, here, and here).

Indeed, Fed policy has come down to managing expectations. And it’s all about the expectation that everyone’s expectations will be as the monetarists expected (pun intended). Just like people who try to drive their cars by only looking at their rear view mirror, monetarists believe that the Fed can run the economy by looking at the stock/asset markets. Yet the monetarist view is so widely held by many economists that several have proposed changing the Fed's charter and increasing the Fed's powers to be able to invest not just in governments bonds, but also in private sector corporate bonds and equities. All this talk of the Fed using unconventional monetary policy tools has had the effect of making many economists propose even more far out Fed actions than its charter already allows.

But is this a good idea? Should government be allowed to buy corporate stocks and bonds? Assuming that central bankers are allowed to buy stocks, why consider only select companies in the S&P? Why create an uneven playing field by giving these already large publicly-listed companies a lower cost of capital over other companies? Why not issue new money to fund new ventures instead? After all, small businesses not listed in the stock market probably have better prospects for growing the economy, and returning better yields to government, no? And if these small businesses fail, the act still boosted money supply going around in the system, which is the intention (of this proposal) anyway. Government getting into the public stock market only rigs the stock investing game more than it already is.

Throughout its existence, the Fed has had an escalating mission creep. It started with merely being the lender of last resort, to help banks undergoing liquidity problems. Then it was given the dual mandate of price stability and controlling unemployment. It therefore now uses its rate-setting power to control economy-wide inflation, control aggregate employment, control system-wide bank lending, and control over-all asset speculation. As a secondary effect, its power has had control of the stock and bond markets, and therefore it has control of industrial policy.

The Fed has control of the currency's value, and as the issuer of the global default currency, therefore controls international capital flows and international trade flows. It therefore has indirect control of foreign countries' monetary policy, and therefore indirectly controls foreign inflation, controls foreign stock and bond markets, controls foreign industrial policy and other countries' experience of international flows. If we increase the scope of its mandate, who knows what secondary effects are next?

If we allow the Fed to invest in corporate bonds and equities, where does Fed intervention end? If the Fed's charter is further increased, the Fed may just as well dictate who people marry, and how many children they sire. After all, these decisions have economic repercussions, right? Allowing more kids is easing, restricting having them is tightening. Is this where all this is heading?

Tuesday, September 20, 2011

National accounting equation by itself does not answer flow and causation among its components

The national accounting equation is an accounting of this year’s composition of national income as caused by the different actors of the economy. The GDP/Income equation by itself doesn’t tell us anything about what will cause income or savings or consumption to rise or fall, and it’s wrong to assume we can infer anything other than this year’s composition. The equation also does not tell us anything about what makes people desire more consumption or investment. All we know is what cleared, i.e., what goods were bought/sold.

These equations

1. Y = C + I + G + X - M

Income = Consumption + Investment +Government spending + exports - imports

2. S = Y - T - C

Savings = income -tax - consumption

do not answer the question 'What causes Y to rise or fall?' or 'What causes S to rise or fall?' We need completely new tools that better describe about flow and causation. We cannot infer flows from one factor going to other factors of the equation, and hence cannot infer from the equation which factor creates new money and hence increase general income level.

This is why many economists are in disagreement and each tends to use the equation to bolster his belief of what is needed to improve the current economic environment. Some believe that it is private sector C and I that increases Y, and that G, which drains money via T, lessens private sector S and therefore their C and I.

But it is equally believable, and in fact, a more compelling explanation, that it is G that increases Y and therefore helps induce more private sector C and I. If you have no government deficit spending, there is no new currency to go around, nothing to save, no money people can use to spend, no money to buy Government treasuries with.

Why is the concept that money should be existing first before government can borrow it more believable than the concept that government has to issue money first by spending before people can have money to lend back to government? Did some people create the first money before government decided it can take some away via T? How then did those people decide when to stop creating money? Why can't anyone just create money now as he likes? What mechanism made everyone at that time stop creating together? In other words, why is the framework that people created money easier to accept than the framework where government created it?

Equation 2 above for example leads some people to make this statement: “if you like, you could define S as “national saving” to include both private saving plus government saving.” Why claim that national saving is government plus private saving? Doesn’t a flow from one lead to an increase in stock of the other? I.e., ‘Private saving’ increases with more government spending, and ‘government saving’ increases with private dis-saving (greater taxation), and at an extreme (forgetting foreigners) adding both together results in zero.

Now let's think beyond the domestic system, to get to the X and M of national accounting equation. If there is more M than X, then money is getting out of the domestic economy. This by itself would mean that in the next period, there would be less domestic Y to fund that period's C and I. G will have to increase, such that it may need more funds than what it can get via T. If there is less money now in the economy, how does G fund itself? Where would the Government Treasury buyer's money come from?

Well, if money is getting out of the system, someone outside is getting more money than he wants to consume. That person now has excess reserves of money. In the extreme that everyone in the domestic system is short money, therefore cannot fund G, perhaps because in the last period they all spent their last cent buying the latest gadget from Mr foreigner, then those dollar reserves now owned by Mr. Foreigner is brought back into the domestic system via G, funded by treasury sales to Mr Foreigner.

Those excess reserves could not have gone to Mr Foreigner's bank account unless they were issued into existence first. That's why there's most often a buyer when the government issues a treasury, because the previously issued and spent dollar eventually gets to someone who just needs to save it for future consumption.

In short, G enables Y not to fall even when X-M is a negative number. G also creates the Y that enables both domestic and foreign investors to fund future G that is funded by borrowing.

Monday, September 12, 2011

Raising bank capital requirements a better malinvestment prevention than raising fed rates

This continues from my comments here. Banks are already an oligopoly now, and they already try to control the price whatever way they can (but always around fed's determined rate). My focus on this point is not so much on how they want to price each individual loan, but how much more capital buffer they will be required to raise for each loan they make. When I say capital in this post, I mean bank equity. Banks are not reserve-constrained when they make loans, but they're capital-constrained.

Banks don't need to have the reserves/deposits firsthand when they make loans,but the central bank will want to see that they have adequate equity buffer for the loans they make. This means that at least 6% (the current standard) of their loans are backed by shareholder equity, and not 100% is funded by reserves/deposits. That implication is that if they make bad loans, there is an equity amount that will get the first haircut before depositors' funds are in danger. Central banks that enforce Basel standards want to see adequate capital in the banks. That Basel-mandated ratio is 6%, or lending at 15 times capital (equity). I'm suggesting that should be higher, so that even at zero fed rates, banks are not tempted to play the interest spread carry game.

My take on 'The natural rate is zero' is that when the Fed stands ready to lend banks any reserves they need, then then it is tantamount to saying they are practically zero rate. Any amount is available as necessary. My use of it in this post is that Fed discount is not what should determine cost of loans to the public (since the Fed manipulates it all the time, and cause a lot of distortions). What should determine cost is the level of risk. The riskier a loan a bank makes the more costly it should be. The most efficient way I think risk is costed is via the amount of equity capital a bank should set aside to back the loan.

Equity is not cheap. Shareholders will demand a higher return if they know a bank is being risky. Whereas fed rate can be made s cheap that it doesn't matter to banks whether they are extending risky loans (they know the Fed stands ready to bail them out). But if the banks stand to lose a lot of equity before the fed steps in, that's real cost, and determined by market sentiments, not the Fed's. If they have to raise more equity, their cost of capital gets higher the more risk they take. This is of course assuming shareholders are given the right assessment of the bank.

The fed keeps bailing out the banks because it is culpable in making them extend so many loans because of the low interest it charged them, while at the same time deregulating banks and enforcing a low capital environment. If the fed continues to throw money at banks and forces to make more loans than is prudent, then they will have to stand ready to bail them out again.

Monday, September 5, 2011

Bank capital and zero Fed rates

This post aggregates some comments I made in previous posts. Thanks to questions and comments by the likes of Arthurian, Mario, and Hans, I'm able to to further refine my points, and try to understand better even my own specific views and position.

Money from government a.k.a. government deficit spending is added money that was not borrowed into existence. Whether it goes through a bank (via funding a bank loan), or government pays you direct (doubtful), it adds to reserves/deposits. Creating/printing money via a bank loan is riskier, and eventually gets unprinted when it's paid back. 'Printing' via government spending never has to be paid back if it was paid for services rendered, and therefore, more permanent.

Writedown of upside down private sector debt

Printing money to extinguish private sector debt seems like a good plan at first, but it doesn't take into consideration that a lot of the debt was incurred to finance non-productive endeavors, such as asset speculation. In other words, this plan would be like printing money without increasing productive capacity. This would likely lead to inflation. It's so much better to print money in exchange for work which leads to productive capacity. Plus, paying people for their debts is unfair. What would that tell people going forward? That it pays to get into debt? And what if people in the future get excessively into debt in order to get ahead, i.e, bid up asset prices while trying to corner assets in the economy. In the end, you'll have people with all the assets and no debt, and then people who never went into debt and don't have any assets. Not fair, and could lead to gross misallocation and crises.

But then, I see that this scenario causes the newly-printed money to be destroyed (along without the debt), and hence not cause inflation. It also frees private sector from the peachy burden of deleveraging, and get private sector demand moving again. Therefore, I gee that there should be an element of debt writedown in solving the current mess, but there should also be a rule that says people forgiven their debt should not turn around, and use their now increased net equity to again speculate on more assets. after all, with their debt erased, they can now sell their assets and bid up on new assets,(and especially if NGDP proponents are listened to, and money is thrown to people to BORROW again. After all, if people don't borrow, how does NGDP grow constantly?) If this scenario happens, we'll now have inflation, and we're right back to people with heavy debt.

End fed distortion of rates

I'm not sure if the Fed should do anything anymore to move rates, even if to make it go up. Right now, I'm thinking just keep rates at zero, but neither should it pay interest on reserves. This way, private sector banks don't make lending decisions based on fed rates, but on real market considerations. This is hardly a set position for me yet. I'm not sure if there's a downside to this approach, but I think Warren Mosler is proposing something on this line, and I think it considers a lot of the unseen pitfalls and distortions that interest rate setting does to the financial market.

The Fed just could lend at zero to a bank that needs reserves for payment purposes. It could also lend at zero to a bank that wants to lend, but it will now need to insist on a high capital equity ratio, higher than what it is now (Capital ratio pertains to bank capital. This is owner's equity that will bear the first risk of loss if the bank ends up with a soured loan, before depositors start losing their money. Basel recommends a loan ratio of no more than 15 times capital. Bigger than that, the depositors' money starts getting more at risk).

Increase bank capital requirements

Banks should hold a larger chunk of capital as buffer agains loan loss, and that should be the first to get a haircut when loans go sour. It will then be the cost raising equity capital that will keep the banks from making loans that could just be misallocated. The pain of losing their own equity therefore should be strong enough to keep them from making sketchy loans, despite zero fed rates. If any bank is left with any excess reserves, they shouldn't get any wild ideas, by lending it to the first subprime who promises high yield.

Fed setting of rates is too distortionary, and may result in misallocation. Having a mandated loan capital ratio of between 5 to 10 times capital helps keep excessive risk-taking at bay, without creating boom busts associated with gaming the interest carry spread.

The bank owner should have main responsibility for solvency and prudence, that's why there should be enough owner's capital to begin with. However, with banks now owned hundreds of thousands of nameless shareholders, while bank decisions are made by executives whose only skin in the game is their bonus, this ideal is easier said than done. And yes, the government ends up having the main responsibility, when banks with insufficient capital take on more risk than they can. But I don't think keeping banks private (as opposed to widely-held) is a good contravening measure, even though being a public company dilutes bank ownership (and dilutes the prudential control and prudence that comes with concentrated ownership). If you prohibit banks from going public, it becomes harder for them to raise capital, and hence, to grow loans to help grow the economy during expansions (the more equity, the more loans they're allowed to make).

Better regulation and risk monitoring

The problem of widely-held banks should be solved by better regulation of executives. You can't run banks the way you run companies that maximize revenues. Executives who think sales are the prime objective are just talking their book, and thinking of their bonus. Because of the implicit government commitment to protect it, it should be run like a utility, and with risk management as prime objective.

The fed has a bias to protect banks because that was its original mandate, to be the lender of last resort. In an ideal world, the Fed monitors (and understands) the kind if risks banks take, because they will have to come in and rescue them if a run happens. Though Fed-injected reserves help against a bank run, it is a loan from the fed to the bank. It has to be paid back by either raising capital or getting back the depositors. If a bank is unable to, the fed essentially bails out the bank.

I'm not there yet on taking off the cap on FDIC. I think this will increase moral hazard among banks. Banks may increase their rates to depositors, knowing people would put their deposits on any bank that promises the highest rates, because they know all their money is guaranteed by the government. Although as mentioned, I'm not sure yet how the dynamics would change if rates are permanently at zero. 100% FDIC guarantee may induce banks to compete on higher rates to depositors, but then again maybe not.

...more discussion in the comments...