The Filter^: A couple of thoughts

November 22, 2010

A couple of thoughts

"Saying that low bond yields reflect market confidence is like the captain of the Titanic boasting that high demand for lifeboats reflects satisfaction with the overall liner" Discuss
"Arguing that QE1 had no impact on the economy is like putting up an umbrella before it starts to rain, and then complaining that you're not any dryer" Discuss.

By aje
Nov 22, 2010 6:09:30 PM | Monetary theory

27 Comments

I think both of these points are essentially correct.

> "Saying that low bond yields reflect market
> confidence is like the captain of the Titanic
> boasting that high demand for lifeboats reflects
> satisfaction with the overall liner" Discuss

One way to think about taxation is that the government have an option on any income. So, the government's position is always the most stable of any institution in the economy, as long as it can maintain it's monopoly of coercion. But, this doesn't mean what some think it does.

I hear post-Keynesians claiming that the low interest rates on state debt mean that the state can borrow to fund all sorts of projects. This view has always assumed that the private sector's unwillingness to invest is independent of the actions of state. But, the point of Higgs is that it isn't, it's all intimately tied together. When the state do stupid things and increase uncertainty they always increase the uncertainty of private sector incomes more than their own, because the state income is an option on everyone else's.

> "Arguing that QE1 had no impact on the economy
> is like putting up an umbrella before it starts
> to rain, and then complaining that you're not
> any dryer" Discuss.

Perhaps, but do you mean QE1 in the US or Britain? The problem is that at the time of QE1 the US the Fed weren't really clear about their plan, which generated uncertainty.

Posted by: Current | November 23, 2010 at 01:25 AM

Thanks, I was referring more to the UK. I'm glad that you've referenced Higgs in both points. I hope that one of the few things mainstream economists take from the crisis is the role of regime uncertainty.

Posted by: aje | November 23, 2010 at 10:38 AM

I don't know to what extent the Fed (or whoever else) is creating uncertainty. The Fed clearly sayd "I will monetize all sorts of cr*p, I will give funds at zero rates, I will do everything to keep rates low at all terms, I will avoid to everyone the possibility of suffering losses, I will assure liquidity, I will give value to what has no value, I will bail you out".

This is not uncertainty. In normal times,this policy would have reflated the boom by effectively insuring all investors against losses.

The problem is that the structural problems within the economy have grown so huge that they can no longer be hidden by creating imaginary credit in unlimited amounts and at zero cost to investors.

People do not want to lend even by borrowing against cr*p, at no cost, with no quantitative limitations, and even with insurance of low or zero costs beyond the short run.

Posted by: Pietro M. | November 23, 2010 at 03:51 PM

* "Saying that low bond yields reflect market confidence is like the captain of the Titanic boasting that high demand for lifeboats reflects satisfaction with the overall liner"

Long rates are the expected compounded value of short rates. If the latter are zero, the former is zero, except for the risk premium on maturity transformation.

This policy should have spelt a bout of inflation. It didn't, and as far as the banking sector is not ok, it won't. Even if it happened, the central banks would close one eye and accept inflation wholeheartedly. So long terms will remain low, because short terms will remain low for the long term, even if prices started to rise. This policy requires the monetary base to grow without limits: everybody's believing the central bank will do it if need be.

* "Arguing that QE1 had no impact on the economy is like putting up an umbrella before it starts to rain, and then complaining that you're not any dryer" Discuss.

So far we have postponed the crisis without solving the underlying problems, by saying banks "ehi! don't worry! you won't pay for your mistakes". By recapitalizing the banks, we may have soothed one of the structural probems of the economy, at the expense of additional doses of moral hazard. QE1 is just a more credible commitment to give unrestricted amounts of cheap credit in the long run.

Posted by: Pietro M. | November 23, 2010 at 04:00 PM

Pietro M,

I certainly agree that there are structural problems.

But, I don't agree with you view on interest rates or on the behaviour of banks.

To a bank monetary base is an asset that allows them to use other assets (mostly loans) to back on-demand liabilities. The question we must ask is: why isn't cheap base leading banks to produce more bank account money?

If you think about it though it's not really that mysterious. Put yourself in the shoes of a banker. To create 1 million $ of bank account money you need some base, which is cheap. But, you also need to make a loan. That part is the real stubbling block. Over the length of the loan a decision has to be made on the interest rate asked.

If all parties were certain that the future would bring high inflation then making loans wouldn't be so difficult. An inflation premium would be added to all loans by savers. On the other hand, if it were certain that the future would bring low inflation then making loans would be just as simple. Savers and borrowers would accept low interest rates.

But, the situation isn't so clear if nobody really knows what the price level will be in the future. In that case it may not be a good idea to make the loan in the first place because if it's made at the wrong rate then the lender will suffer.

Notice that the same applies even if the lender passes the risk to the borrower. In Britain where Anthony and I are from most mortgages are variable rate. The bank sets the rate if you don't like it you have to remortgage. That system doesn't fundamentally solve the problem I mention, it just punts it from the lender to the borrower.

This is why the words said by the Fed board are so important. If the Fed indicate that they will allow inflation then that allows plans to be made, similarly if they say that they will prevent it. But, if they say they're worried about inflation one week, then say that they'll relaxed about it a few weeks later then nobody knows what's going on. Radically different views exist between lenders and borrowers and few loans can be made.

Posted by: Current | November 23, 2010 at 09:06 PM

I have a very complex argument regarding this point: the present uncertainty regarding inflation vs deflation is the result of structural problems in the real and in the financial sector, not the Fed's guilt.

The paper I wrote on this issues was so badly written that reviewers rejected it without realizing what I was talking about. :-)

Anyway, the Fed hasn't caused inflation uncertainty. The Fed has pushed on the monetary accelerator with full force, by using every means in its disposal, and creating new facilities. The fact that it failed doesn't mean it created uncertainty: it means that it lost its power to create booms because of some economic factor.

Inflation uncertainty has other causes: it is equally likely that the economy will experience a deflationary recession because of banking problems, or a stagflation because the Fed finds a way to bypass the banks and create money without their assistance (healing the banks's balance sheets may not help), for instance by giving money for free through a helicopter.

The only alternative we don't have is healthy growth: too many structural problems have accumulated during the past 20 years and more.

We don't know what form the crisis will take in the future, because prices could fall or rise depending on many factors. They did both in the last three years, depending on which force prevailed between real problems (bottlenecks pushing for inflation) and fiancial problems (disintermediation pushing for deflation).

If the Fed wanted, it could create inflation with a whim: by just printing banknotes and giving them around.

But it is very likely that we will not experience a boom, because the economy is structurally flawed. If these problems are not solved, and they can't be solved by the Fed, then the problem may last very long. In Japan, it has lasted two decades, so far.

Posted by: Pietro M. | November 24, 2010 at 04:49 PM

I wrote: "healing the banks's balance sheets may not help"

Let me expand.

Banks are financial intermediaries. They lend at the return rate (the price difference between output and input goods), they borrow at the deposit rate (set by the Fed), and they gain a gross profit which has to be adjusted to risks.

One of the risks is maturity mismatch risk: banks need be sure to be able to get sufficient funds not only today, but throughout the period their funds are invested. They is no reason why they should fear this now: funds are abundant an cheap and no one doubts the Fed will stick on this policy.

Other risks are due to the repayment of investments. These risks cannot be eliminated by the Fed, at least when monetary policy is ineffective.

Anyway, the "problem" for banks is:

(1) price differentials - (2) market risks - (3) banks' balance sheet risks - (4) funding risks - (5) funding costs = profits.

Unfortunately for banks:

1. price differentials fall during the boom because investment goods gain in value against final goods.

2. market risks rise with the recession, especially if the structural problems are huge.

3. banks' balance sheets may suddenly appear to be in terrible shape.

If problems (1), (2) and (3) are sufficiently bad, then assuring persistently abundant and cheap funds on the interbank market (terms 4 and 5) may not help enough to avoid a recession.

This said, if risks are due to (3) and not to (2), for instance if banks have excessive financial leverage, then recapitalizing the banks may help jump starting the credit creation machinery.

But if (1) and (2) are huge, (3) doesn't help. I don't know in which world we live, but it looks like banks are not willing to lend even if all forms of risk are removed from their investment plans. This looks like (1) and (2).

Posted by: Pietro M. | November 24, 2010 at 05:03 PM

Pietro,

I think you are overestimating the influence of structural problems. In a sense I think you're working backwards, your thinking "monetary policy is sufficiently loose, so what's the problem?"

You write above:
> Anyway, the Fed hasn't caused inflation
> uncertainty. The Fed has pushed on the
> monetary accelerator with full force, by
> using every means in its disposal, and
> creating new facilities.

You can't look at things so simply. When discussing this Scott Sumner often gives the example of something Joan Robinson said in ~1938. She said that during the German hyperinflation of the early 20s interest rates were very high, and therefore monetary policy was tight. She therefore concluded that the hyperinflation didn't have a monetary cause.

This is, of-course, wrong. The reason it's wrong is that the interest rate and monetary policy are much more loosely linked than people commonly suppose. (Mises doesn't link them very closely, I think that when people read him they just think this view is old-fashioned, but it's not.)

The Fed's short-run actions affect short-run interest rates. Those effects do leak in to long-run interest rates, and that's one thing ABCT is about. But, there is still a distinction. The fed has pushed the "monetary accelerator with full force" only in the short-run. But, it has hummed and haed about the medium-term. It has sometimes said that it fears inflation and sometimes that it fears deflation, etc. That causes uncertainty. You wrote: "They is no reason why they should fear this now: funds are abundant an cheap and no one doubts the Fed will stick on this policy". Nobody believes that the Fed's short-run monetary policy necessarily represents it's longer run policy. The Fed has mandates for inflation and employment. It's policy clearly will change at some point the question is in what direction.

Posted by: Current | November 26, 2010 at 12:34 PM

This is not uncertainty. In normal times,this policy would have reflated the boom by effectively insuring all investors against losses.

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