Monday, October 12, 2009

Debt Monetization: He's heading for that small moon

I received numerous e-mails and comments in response to Friday’s piece, many of which were very reasonable critiques, all of which I appreciated. One basic question which was asked multiple times was why I make a distinction between what the Fed is currently doing (quantitative easing) and debt monetization. I’m going to try to answer this question below. As always, please feel free to comment and/or write me an e-mail if you have further questions. I welcome the debate. If however you start an e-mail with, “You idiot!” I am somewhat less likely to respond.

First, let’s frame the discussion. If one defines debt monetization as simply the creation of money for purpose of buying government debt, then there isn’t a distinction between the Fed’s quantitative easing program and debt monetization. In fact, by that simple definition, there is no difference between the Fed’s normal open market operations, which often involve doing repos with Treasury collateral, and debt monetization. But as a trader, I don’t give a dewback's tail what you call it. I care what the effect is. Clearly there is some distinction to be drawn between old-school open market operations, today’s quantitative easing program, and full scale debt monetization, at least in terms of degrees. So let’s agree that there is no utility in turning this into a discussion of semantics.

Is this a case of the argument of the beard? That is to say there is no difference between $1 of debt monetization and $1 trillion because you can’t pin down exactly where it stops being open market operations and when it becomes something else? No. We can draw a distinction, even if its somewhat subjective. And from this distinction we can create more objective signposts for when there is an evolution of the policy.

Consider what the definition of quantitative easing is. Its simply the process of printing a small moon-sized amount of new money (or creating bank reserves as its done in practice) and unleashing it on the economy. It is not necessarily the process of buying government debt with the proceeds of created bank reserves. The purchasing of government debt is merely a convenient, and potentially highly effective, means of getting that new money out into the economy.

The intent of quantitative easing is to create inflation. I know, shocking thought, right? But the reality is that sometimes the market-clearing rate of interest is actually below zero. That is that demand for savings is so great that it overwhelms demand for credit. This is the so-called liquidity trap. Real interest rates need to be negative, but nominal interest rates can never be negative. The Fed can only cut to zero. Thus we need more inflation. That would allow nominal rates to fall below the inflation rate, resulting in a negative real rate. Here is a good piece by Paul Krugman on the subject. It was written in 1998 to describe the problems in Japan, but its relevant for the U.S. today. I’ll pull out one section to save you the trouble:

"If this… [liquidity trap]… bears any resemblance to the real problem facing Japan, the policy implications are radical. Structural reforms that raise the long-run growth rate (or relax non-price credit constraints) might alleviate the problem; so might deficit-financed government spending. But the simplest way out of the slump is to give the economy the inflationary expectations it needs. This means that the central bank must make a credible commitment to engage in what would in other contexts be regarded as irresponsible monetary policy - that is, convince the private sector that it will not reverse its current monetary expansion when prices begin to rise!"

Ben Bernanke himself referenced this strategy back in 2002, before he was Fed chair. (By the way, a time when the deficit wasn't nearly the problem it is now). Currency, he explains, only has value because of its scarcity. If you need inflation (i.e., you need the currency’s value to decline), just make more money! "The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

So we can debate whether or not the U.S. is in such a dire predicament as to necessitate this radical monetary maneuver, but its clear to me that the Fed’s current programs are designed around the above thinking. We’re trying to fight deflation to prevent a Japanese-style disaster.

Debt monetization, on the other hand, has the intention of extinguishing government debt through creation of new money. That is, the government is alleviated from its debt burden by way of the printing press. Has this, in fact, occurred? Any honest person, no matter what your opinion on the situation, can only answer maybe. As I stand here now, this 12th day of October in the Year of our Lord Two Thousand and Nine, I don’t know what the Fed will eventually do with the Treasuries it has purchased. If they are held to maturity, I’d have to admit that the Fed did indeed participate in debt monetization. Maybe it was on a limited scale, but it was monetization none-the-less. I also don’t draw any distinction between Agency debt (Fannie Mae/Freddie Mac/Federal Home Loan Bank) and Treasury debt. Both are de facto debt of the tax-payers. I’ll make some distinction in regards to Agency MBS which isn't debt of the government, rather a guarantee by the government.

Whether you agree with me or not, there is my view on the current situation. What’s more interesting is what it all means for the markets. One commenter accused me of drawing a distinction without a difference. Very fair. I basically just said that I don’t know whether the Fed is going to monetize the debt or not. Does it actually matter which it is?

Let’s say, for the sake of argument, that the Fed ends its bond buying program by March 2010 without increasing the amount purchased, as they currently have pledged. I know the hard-core monetization believers believe they will need to keep the printing presses going in order to nominally service our debt. That’s not my view, and I don’t know if anything other than time will convince that group otherwise anyway. So I’m going to let that go for now.

I’m saying if they finish buying all they said they’d buy and do no more, they could either figure out some means of unloading their positions over time, or else hold to maturity, effectively monetizing that portion of the debt. Does it matter?

One way to think about this is just to consider the impact of printing money, regardless of what is done with the proceeds. Classically, we’d expect the impact to all be related to inflation: higher interest rates, weaker dollar, higher commodities prices, higher inflation.

The Fed announced its program to purchase Agency and Agency MBS on November 25, 2008. Here is where we were the day before the announcement.

  • 10-year Treasury: 3.32%. We’re marginally higher now at 3.38%.
  • 2-year Treasury: 1.21%. We’re marginally lower now at 0.97%.
  • Dollar: The DXY was 86.081 on 11/24. Now 76.139. 11.55% lower.
  • Commodities: The CRB was 243.80 on 11/24. Now 266.26, or 9.21% higher.
  • CPI: The All Items Index stood at 216.889 in October 2008. Now its 0.67% lower at 215.428.

Mixed record. Really Treasury rates are basically unchanged and consumer prices are marginally lower. Not what you’d expect. Commodities and the dollar are reacting exactly as you’d expect.

Interesting to note that the Treasury program was announced on March 18. The Agency program was expanded on that same date. Same info from March 17:

  • 10-year Treasury: 3.01% on 3/17, now 3.38%.
  • 2-year Treasury: 1.03%, now 0.97%.
  • Dollar: 86.933 vs. 76.139. Shows just about all the dollar decline came after the announcement of the expansion.
  • Commodities: The CRB was 216.46, now 266.26. Here again, all the gain has been post expansion of quantitative easing.

So if the Fed’s goal was to weaken the dollar in order to create inflation, it looks like its working. Maybe it isn't showing up in the CPI numbers much yet, but it certainly is showing up in actively traded markets where the purchasing power of a dollar is most relevant. Furthermore, the market may be telling us that the first foray into QE wasn't enough. Only with our combined strength can we bring an end to this destructive deflation!

And that’s just the question, isn't it? No one would claim that printing money was a good idea if deflation weren't such a legitimate threat. To me, the fact that the Fed decided to buy Treasuries isn't the important point. Just the act of printing $1.5 trillion dollars to finance all these purchases is the key. They claim that part of their goal was to lower interest rates and thus encourage borrowing. Maybe that was part of the motivation. But I truly believe the Fed saw consumer and business borrowing collapsing at a disastrous pace and choose to answer with a deflation busting level of quantitative easing. Dropping the newly printed money from a helicopter isn't practical. Buying Treasury bonds is.

I’m asking you, dear reader, that if you object to what the Fed is doing, ask yourself why? Is it because you object to printing money? Or buying of government debt? Because if it’s the later and not the former, then ask yourself what else was the Fed supposed to do with the money? If it’s the former and not the later, then you must argue that deflation isn't a threat. That the complete collapse of credit creation has no impact on the de facto money supply. That’s a legitimate point of view, but not one where I can concur.

So then it comes to a matter of the exit strategy. If the Fed holds on to the debt, then the impact of the recently created new cash will reverberate beyond the current crisis and into a time when economic activity has normalized. That’s the dark path the Fed must not go down. Fed officials have recently said that an accommodative policy is warranted for an extended period. But policy needn't be this accommodative for an extended period! We've heard that the Fed is testing reverse repos as a means of removing excess reserves when the time comes. Here’s to hoping that they start removing those excess reserves is a measured way sooner rather than later.

That being said, what if the Fed uses reverse repos to remove all monetary impact of their quantitative easing project and yet never actually sells any securities. They just let everything roll off. By my original definition, that’s debt monetization. But would it matter? Would the impact on inflation, the dollar, commodities, etc., be radically different than if they slowly sold off their Treasury and Agency portfolios? Probably not.

So then it comes back to intention. Why did the Fed decide to embark on this QE journey? Is it the Fed’s intention to help the Treasury service its debt? Or is it to battle the economic circumstances in which we've put ourselves? I can’t answer that question definitively. I think it’s the later, but I’m not in on the FOMC meetings. I don’t really know.

Bringing all of this back to Echo Base, here are my conclusions. If you focus too much on the Treasury/Agency purchases, you are missing the key likely market impact. The new money creation is the primary thing here. What is done with the money is secondary. A weaker dollar, higher gold/oil/agricultural prices are not symptoms of a run-away Fed, but symptoms of an economy that was threatening deflation and now is more normalized. Finally, we need to watch how committed the Fed is to an exit. Are they willing to risk a double dip recession? Because that might be what it takes to remove the massive monetary stimulus that’s been created thus far. So far they've talked a good game. Let’s see what they actually do.


Anonymous said...

Hi Jon,

Thanks for the post, it is a great review. I love the blog and have been a regular reader for a long time, keep up the good work.

I have a different esplanation of why QE is not debt monetization in its classical sense, ie. printing money to buy back debt.

The reason it is different is because the Fed now pays interest on reserves. The net effect is that the Fed swaps shorter duration reserves for longer duration Treasury bonds, ie. all they have done is reduce the duration of outstanding debt.

One thing I do not understand is how you can distinguish between the Agency MBS program and the Agency debt program. The Treasury has clearly backstopped the Agency market, and while not explicit, Agency bonds still have the "full faith and credit" of the US Treasury behind it hence are pari passu to Treasury bonds.

Accrued Interest said...

I'm not Jon.

I'm distinguishing from Agency MBS and Agency debt. MBS aren't new debt. The debt resides with the mortgage holder, not the agency. So you can't say its "debt monetization" because buying the MBS can't possible eliminate the debt.

Anonymous said...

Great blog, albeit I'm more of a Battlestar than Star Wars fan but I'll overlook it if you will.

Technically when the fed buys open market debt - whether we call it QE or monetization - isn't it to create bank reserves that are then lent increasing the money supply. I don't have the data in front of me but I have read the level of bank reserves held with the Fed is also massive. So if the Fed creates reserves but the banks don't lend those reserves through the wonders of fractional reserve banking, money supply doesn't increase and deflation isn't eased. In other words isn't there a second step - lend the reserves to increase demand (ie make me a loan to buy a new care) to get inflation that isn't happening so the QE is also pushing on a string?


Hopefully there are no dumb questions but one other thing I read that I'm not sure is related to this or completely separate is that we also read of massive reserves held by banks with the Fed. Isn't that the other side of monetization and if the banks are lending out those reserves (say to me to buy a new car) then the QE isn't

Anonymous said...

sorry on garbled 2nd part - thought it had been deleted


fresno dan said...

It strikes me that good deal of this thinking is based on Great Depression history. Unfortunately, the US nation, energy independent and a creditor nation, may have been able to alleviate some of the problems back than.
But Japan has been trying it for 20 years. And one only has to remember the seventies to understand that inflation can cause more problems than it solves.

Anonymous said...

there is nothing wrong with deflation except to those persons/entities that are over-levered and their real obligations are increasing.

to the rest, deflation actually increases living standards. QE is just another form of tax at the end of the day, as the currency debasement just means you can't buy as many foreign goods as was the case. it ignores the notion that we live in a globalized world of limited resources.

the funny thing is that for anyone who has visited or lived in japan, the observation that living standards have remained high persists. the same notion applies to GDP ... what really matters is GDP per capita and productivity.

the academic notion of what the world should or shouldn't be (just as that imposed by political classes) ignores the role of individuals and companies and allocation of capital/resources. last time i checked it was capitalism that is being destroyed through all these great deeds.


Flo said...

What's wrong with deflation?

It's going to happen one way or another so we'd probably be better off preparing for it rather than driving the world over a cliff in trying to prevent it.

Anonymous said...

Hi Jon..I am going to call myself an idiot in case that makes you more willing to read my comment! I think the issue here is one of credibility. When the Government issues debt, the ability to rasie sufficient taxes lies behind the servicing costs. These are real dollars taken from tax payers that would otherwise be redeployed in the economy or not raised as taxes in the first place. When the Fed acts to print money, it is stating an opinion of its own perceptions of a need. There is nothing real about the Fed, it doesnt pay tax, doesnt work and doesnt produce a social good. It expresses opinions and these day the opinions are increasingly political. Again not in the party political sense, but in the demographic, age cohort sense. What the Fed has done by engaging its opinions is reduce the wealth of the baby boomers by the 50% cut in interest rates the baby boomers should be earning at 5% instead of (say) 2.5% for ten years before baby boomers drop dead once they retire. Exactly where is it written than a few percent of deflation is any worse than a few percent of inflation? We as tax payers will pay for this mirage of ideas that the Fed uses to "manage" the economy based on narrow ideas with no value created and no work done. The fact that the debt might be "sterilized", "monetized" or "exited" is irrelevant. Our government debt is robbing us of living standards. The Fed is impoverishing baby boomers by managing the business cycle away (no more boom and bust as an objective, so 2% GDP and CPI is fine, like only ever eating baby food). Why even bother with a tax cut, when taxes on the economy are alreayd down by 20%? Hope I got your interest cos the Fed aint paying any! :)

AllanF said...

OK, with this Anon repeatedly calling you Jon, I have to ask, AI, are you still keeping your cover? I ask because I presumed you'd given it up after blowing it last year (or was it year before last?) double posting here and elsewhere.

And I like your distinction between QE and monetization viz a viz intent. I suppose the rub is with the Federal budget in such shambles and the unemployment rate appearing to be settling in for the long haul there runs very real risk that QE hangs around for longer than it should as an expedient for the Treasury.

Last I want to reiterate what another commenter said, that deflation is not the horrible calamity to most Americans that it is presented as. The things that made the Great Depression so horrible, balloon mortgages that couldn't be rolled and uninsured bank deposits, have been fixed. The only people to whom deflation today is an unmitigated disaster are the egregiously over-leveraged financial companies. They made their bed. It is an outrage savers and taxpayers must now bail them out. But the bums in Congress are never held accountable for their actions.

Accrued Interest said...

My cover remains! I am like the Dark Blogger. I do not have a name. I am one with the Force. (See how many get that one!)

I do think deflation is potentially problematic in a way that inflation isn't. Without QE, deflation is a problem with no potential answer. Whereas with inflation you can always just raise rates. I will concede that deflation doesn't automatically mean Depression, but I'd rather bet on QE than risk it.

On Japan, I think they waited too long to really try it. Plus I think there is a cultural difference that works in our favor. I think they started out as a big saver mentality. We have a spender mentality. At least in terms of deflation, that's to our benefit.

Daniel Newby said...

"The debt resides with the mortgage holder, not the agency."

This is your core fallacy. The debt, in fact, resides with no one, having been defaulted. The Fed is buying this crap so the banks and pension funds can pretend they are still going concerns despite being in run-off mode.

The trouble is that most financial institutions only have a portion of their holdings in Agencies. When those run out, the Fed will have to haircut them into receivership, which as far as I can tell is the Fed's intent. Instead of an apocalypse triggered by Lehman Brothers, we get a gradual rolling collapse. Get ready for a lost decade. Or two.

I'm not sure what this means for munis. On one hand, collateral held in foreclosure limbo (to make the MBS look good to the Fed) cannot be taxed. On the other hand, they get to overtax property valued at bubble prices. On the left foot, the overtaxees are thereby squeezed, crimping economic expansion.

Accrued Interest said...


Just so we're all grounded in reality and facts, here we're talking about Agency MBS. Among Fannie Mae's, the serious delinquency rate is only 4%. So to say that the Fed is buying defaulted debt isn't accurate at all.

Advant Guard said...

The Fed has always bought Treasury Bonds, it bids at every auction, though it never reveals how much of its bid is for its own account and how much is for Foreign Central banks accounts until much later. The current level of Treasury Bonds held by the Fed is still much lower than when the crisis first erupted, despite the $300 billion of purchases. In effect, the Fed purchase merely slowed down the rate at which they tightened monetary policy. We have seen no growth (and occasional shrinkage) in the Fed balance sheet since the beginning of the year. Fed Policy is too tight. Print more money!

Anonymous said...

As the QE wanes, does anyone see a bear flattener as a strong possibility? Many institutions are afraid of rising rates and will eventually brace for the reality that the 10year at 3.5% might be attractive, and subsequently move further out the curve. Thoughts?

Buck Woodford said...

i'm with "anonymous".. why would one buy treasuries vs agencies in this day/age? they are exactly the same. what was (10 yrs ago) implicit is now very explicit.

TraderJay said...

Indeed, the Fed's objective is to create an inflation in wages and income that will support a return of asset values (read real estate) to former levels in nominal (not real) terms.

Only by doing this can the Fed prevent the failure of large numbers of additional financial institutions and minimize the number of individuals who lose their home to foreclosure.

The process will generally be perceived as pleasurable as economic growth recovers, but prices for commodities will rise, and the dollar will weaken. As noted, these signs already are visible.

It will take some time, but eventually the medicine will come to be seen as a new disease.

These two phases generally equate to the late-60s and the early-70s, respectively. Unfortunately, new medicine will be needed. Hopefully, Paul Volcker will still be around.

Anonymous said...

With all this talk of QE working, it is fascinating that M2 is essentially flat over the past six months despite the asset base being significantly higher.

Anonymous said...

Deflation may not be a huge problem for the individual (overleveraged or not), but it is an unmistakable disaster for the Govt.

They need inflation to make sure that the national debt can continue to be serviced.

They need inflation even more to keep the social security cash flow moving.

The US is not like Japan in the sense that 20 years of a deflationary environment would destroy the machinery of government, for better or worse.

The whole point of the fiat currency is so that you can have inflation, and all the tricks that come along with it that only the Govt. can exploit.

In Debt We Trust said...


Can you address the issue of debt vs. equity?

The big question a lot of people are asking now:

Is it time to shift from buying debt to buying equities?

Suppose for argument's sake that yes it's time to load up on stocks and dump bonds:

In that case, co.'s will spend more on the things typically associated w/expansion - e.g. stock buybacks, dividends, pickup in m+a deal flow, cap investment, and (always lastly) increase hiring. All this activity will be reflected on a co.'s balance sheet and industry publications.

Here is the kcicker - till now, the corp bond mkt has favored the big names while equities have favored total trash (see zerohedge daily rants about casinos, pool cleaning companies, pet hotels, ec.)

If you believe in worldwide recovery then sell bonds and buy stocks. But if you are a believer in the opposite camp, well treasuries on a dip is your style right?

For my part, I highly doubt we will see the corp expansion - we are entering the new normal phase described by mo-el arian of pimco. All the bullish valuations are the result of carry trades in the dollar and pound (for industrial metals).

Certainly in the corporate legal world, deals are not happening w/the frequency that they used to (unless you are in bankruptcy practice).

AllanF said...

Alright, if you're keeping your cover I'll not divulge anything, Jon.

Accrued Interest said...

As I've said many times, I don't understand the stock market. My impression, however, is that stocks are getting a lot of flows from large investors exiting non-traditional investment vehicles. At some point, that runs dry. That doesn't mean it all comes crashing down, but I can't see how we don't have a correction here.

The biggest problem with the correction thesis is every one is looking for it!

Anonymous said...

Deflation IS a problem because companies close down capacity, produce less, fire people, who have lower wages...and especially, productivity and good management disappear because you are reducing productivity, not increasing in - meaning that if you are lucky to survive until an upturn, you have an extremely rusty skill set.

Anonymous said...

accrued interest,
Super post - but can you explain your point further to this financial Luddite regarding the Fed holding the bonds to maturity? At this point, the Treasury would have to repay the Fed, which would have a massive tightening impact, no?

SDRII said...

Not a very lucid discussion of the issue. you dance around it with intent and outcomes unknown masquerading about a collpasing economy. Wasn;t this the argument Paulson made? This is the same failed logic of the LEH caused the crisis. One thing you never discuss is the alternative to the Fed's program., namely the very question that Chris Whalen asks: how much of a bond haircut would it take to fix BAC? That is the operative queastion. The debate about monetization is a red herring. Forget what they are doing now and normalize interest rates and compare that against tanking tax revenue to see where those buidget deficits come in. The US is bankrupt and the Fed is simply conducting triage with a prayer for the dying. Perhaps the question you should anwser is evalauting the alterative to currency debasement - a historically flawed solution (and no it is not creative)

Wagner2626 said...

I think that the impact of the debt monatization has been severely impacted by the banks hording money. Look at the size of the Fed Balance sheet on Dec 31. $2.265 Trillion and the excess reserve balances of the member banks was $848 Billion. The excess reserves balance represents the amount that banks keep on deposit at the Fed. Let us now look at the end of september. Fed Balnce sheet $2.144Tr a decrease of $121 Billion. The excess reserve balance on Sept 30 was $924 bn an increase of $76 bn. So in a period that the Fed was going through QE, the banks were piling cash at the Fed at an even faster pace. Has QE helped in 2009? If we are buying securities of whatever kind from the market, but that cash is not going into anything useful, what's the point?

One of the other blogs I read is John Williams does a good job of breaking down some of the statistics that the government puts out. His commentary runs a bit to the conspiricy theorist level, but is interesting nonetheless. He has constructed a continuation of M3 since the Fed stopped publishing this in 2006. Even his levels show that M3 have fallen over the course of 2009. Which is the effect that you see in the negative real monitary stimulus that I mentioned above.

But What do I Know? said...

Great post--there are a plehtora of good topics here; maybe you could break out some of them in another discussion. Just two points I'd like to throw out.

1) In reality, Mr. Bernancke is being quite coy with his printing press, attempting to cause inflation through existing channels and old methods--giving the banks money and giving the government money. If these don't work, and he really, really wants to cause inflation, he could give the general public money--i.e., fire up the helicopter. Perhaps then you couldn't use those Republic credits on Tatooine, but if he really, really wants inflation, he can cause it.

2) What is the difference between the Fed buying long Treasuries and providing the liquidity (in the form of zero-reserve requirements) to the banks so that they can buy long Treasuries? That is, the Fed puts cash into the system to keep short-term rates low, so that the leveraged players (the banks) can hold a low-yielding portfolio of long-term Treasuries. Isn't this why the Japanese have been able to run up a deficit of 250% of GDP--because their banks can hold JGB's with no reserve requirements? What of the idea that the world has been in a monetization environment for a long time already, and Senator Palpatine has been running the show for some time already?

In Debt We Trust said...

Zerohedge issues a rebuttal to your rebuttal of his article. He even included a star wars reference!

Accrued Interest said...

Unexpected this is... unexpected and unfortunate.

Accrued Interest said...

No link back to this website. Classy.

With the blast shield down I can't even see, how am I supposed to fight?

trotsky said...

The really pertinent point about quantitative easing is that it further distorts the economy, and wreaks structural damage. the whole 'liquidity trap' idea is basically nonsense. the cost of capital can never be at zero or below zero - capital has a time value, regardless of the demand for cash balances.
furthermore, it should be clear that no wealth can be created by printing money - it is therefore a priori impossible for money printing to have a positive economic effect. there is never 'too little' money in the economy. the market economy can adjust to any given amount of money supply, provided it is left alone. what the Fed's inflationary policy does is to distort relative prices and divert real resources into activities that do not generate wealth, thereby depriving wealth creators of said resources (if the housing bubble has not vividly illustrated this concept, nothing will).
Krugman's description of Japan's problem entirely misses the point. Japan is not in a funk for the past 20 years because its government has not intervened ENOUGH (via deficit spending and quantitative easing, precisely the policy prescriptions Krugman favors), but BECAUSE the government has effected these interventions. it is akin to pumping water from the deep end of the pool to the shallow end using a very leaky garden hose.
i'm always astonished at how people can look at Japan after two decades demonstrating the utter failure of Keynesian interventionism and STILL come away with the wrong conclusions.

Anonymous said...

I forget who, but someone framed the problem as this: the private sector/households have a certain X number of assets and Y number of liabilities (including the problematic mortgages, other debt, etc). Over the last few years the asset side of the balance sheet declined so the fed wants to create inflation to fix the problem.

However, the Fed is essentially rewarding the asset speculators and socializing their losses and basically saying hang on a minute we'll give you inflation so everyone can go back to speculating on assets just the way they were doing pre-crisis.

The other way to fix the problem (and in my view the right way) is to write off the liabilities but not mess with asset inflation.

Oh but writing off liabilities would cause powerful banks and credit originators to take writedowns and fail and they hold a gun to our heads and will cause all hell to break loose if they failed. But, a government with balls could have nationalized the banks in order to avoid the chaos. There is technical problem of expertise in the govt to liquidate banks but there are lots of private companies who can do it. I would have hired another sober private company with govt backing to liquidate Lehman and keep all the profits while unwinding all contracts with counterparties in an organized way. There would have been no irrational fear of counterparty risk but lots of organized failures - just how it should have been.

Instead, its easier to put an inflation tax on the people who didn't do anything wrong and force up the asset side of the balance sheet.

AI, please back up this statement of yours: "Without QE, deflation is a problem with no potential answer."

I say there is an alternative: deflation can be correctly fixed/avoided by having banks take writedowns quickly and moving forward with a clean and sanitized financial sector.

QE and forced inflation will only create all sorts of asset bubbles and a weak currency is not in the interest of the non-leveraged majority of the taxpayers. Not to speak of the fiscal stimulus thats needed along with QE which could have been avoided.

And by the way, I don't want any inflation ideally but understand the presence of natural inflation due to demand/supply. I do not in ANY environment want the fed to be targeting any inflation. Volcker said it best - why should the Fed have a specific inflation target?

Gold tripled from 2004 to 2007 pre-crisis, we've already had enough asset inflation for a generation. Lets have some deflation so assets come back to decent levels and lets have the guys that made bad bets take losses. That would be something the Fed should aspire to not stupid Dr. Strangelove ideas of QE and inflation targeting.

TraderJay said...

I believe I was the one who posited that the Fed is trying to inflate asset values.

I can't disagree with the essence of your argument that this rewards the speculators (evildoers?) at the expense of those who did not do stupid things. However, a few points are in order.

The first is that many of the evildoers already have had their equity shorn like a sheep at shearing time. Witness the dilution of shareholders at Citi, Bear, Lehman, etc., etc. These are real losses that have been borne by those (in hindsight) unwise investors.

Where you err, I think, is in the idea that society would be better off if ALL of the losses were borne by those who "over-speculated." Indeed, you claim that we would recover sooner if that were the case.

This ignores the immense side effects being borne by those who did not "over-speculate" in the form of reductions in retirement account balances, reduction in home prices, reduced employment, etc.

The losses on that side already are being realized and will unfortunately continue to be unrealized through the cumulative "output gap" that will exist for years to come, if not generations to come.

In a normal cyclical contraction, that would certainly be the preferable course, as it was in the most-recent several economic downturns.

Sometimes, though, the bear is so big, and so mean, that extreme measures are needed. You have to take out the shotgun of inflation, even if its unpleasant side effects already are known.

At the end of the day, modern economics has experienced two defining moments: The Thirties and the Seventies. In the view of those on the Fed (and I agree) the specter of the Thirties is FAR FAR scarier.


Salmo Trutta said...

Exit strategy? Doubtful. Too much federal debt. Foreigners have reduced their demand for governments, et. al. The decline in the exchange value of the dollar has accelerated with no foreseeable bottom. The dollar vis a’ vis other currencies is the real crisis. The FED has no power over the dollar. The FED’s mandate is soley to influence (minimize) the rate of inflation. It is utter naiveté to assume the FED can increase employment simply by buying a few treasury bills.

The Federal Deficit: See Fullwiler: “With IBRBs eventually the entire national debt could be held exclusively as reserve balances” (same thing could be accomplished by raising reserve ratios).

Liquidity trap? Doesn’t exist. Why? Because of Alfred Marshall’s money paradox. Go tell Krugman.

Member banks don’t loan out excess reserves. Excess reserves are earning assets (secondary liquidity reserves). Member banks are unencumbered in their lending capacity. The remuneration rate on excess & required reserves is .25%. The effective FFR is .12%. Lower the remuneration rate and the banks would find more borrowers.

Quantitative easing? All-inclusive operations and or rules that result in an increase in loans-deposits?

Debt monetization? Example: Roosevelt got his “2 percent war”. This was achieved by having the Fed stand ready to buy (or sell) all Treasury obligations at a price which would keep the interest rate on “T” bills below one percent, and long-term bonds around 2 -1/2 percent, and all other obligations in between. This was achieved through totalitarian means; involving the control of total bank credit and the specific rationing of that credit we had official price stability and “black market” inflation. The production of houses and automobiles was virtually stopped, and credit rationing severely reduced the demand for all types of goods and services not directly connected to the war effort. This plus controls on prices and wages kept the reported rate of inflation down. Financing nearly 40% of WWII’s deficits through the creation of new money laid the basis for the chronic inflation this country has experienced since 1945. Interest rates, especially long-term, would have averaged much higher had investors foreseen this inflation. This was reflected in the price indices as soon as price controls were removed.

Percentage of reserves to note and deposit liabilities was 91.1 in 1941 and 42.7 in 1946. Reserve bank credit rose from 3.5b in 1942 to 25b in 1945. This expansion was required to provide reserves to the banking system to provide needed reserves to the banks to enable them to sop up the excessive supply of government security floatation’s.

All the accolades attributed to Volcker are misplaced. They originate from those that lack an adequate knowledge of money & central banking

Salmo Trutta said...

"to all be related to inflation: higher interest rates, weaker dollar, higher commodities prices, higher inflation."

Inflation is the consequence an excessive flow of money relative to the volume of financial transactions consummated, and the volume of goods and services offered in the market place.

Inflation is a chronic “across-the-board” increase in prices; or, looking at the other side of the coin, depreciation of money.

The evidence of inflation cannot be conclusively deduced from the monthly changes in the price indices. The price indices are passive indicators of the average change of a group of prices. They do not reveal why prices rise or fall.

Inflation cannot occur unless fueled by a chronic increase in the volume and/or velocity of money. A chronic increase in means-of-payment money cannot occur unless the FED, through e.g., excessive open market operations of the buying type, supplies the commercial banks with an excessive volume of legal reserves, (excessive, of course, in terms of rates-of-change in real-output, and changes in the velocity of money).

No money figure standing alone is adequate as a guide post to monetary policy (M*).

Matt Johnson said...

i think that the hold to maturity distinction is a mistake. surely it's the maturity of the bond that takes the money back out of the system - that is, the fed funds created to buy the USTs are removed from the system by redemption.

re monitisation, it sort of is, but not really. fed funds aren't 'printing money' - they are a loan from member banks at the depo rate - so in that sense it's not monetisation. it's just a transformation of the consolidated US govt balance sheet's liability duration (zero duration o/n cash for longer liabilities).

if the banks weren't broken, we might see lending growth that made this optically similar to printing 1tn of cash and leaving it in town squares - but that's not going to happen. right now it's just giving banks risk free assets (and marking up existing positions on the way).

Anonymous said...

"But, a government with balls could have nationalized the banks in order to avoid the chaos."
- - - - - - - - - - - - - - - -
No, that would be a government with peanuts inside its bald head.
Go tell Krugman that too.

Anonymous said...

TraderJay: "reductions in retirement account balances, reduction in home prices, reduced employment"

The side effects you talk about are only to be avoided if it happens because of artificial short term extreme pressures and disorganized failure of credit institutions.
If the people responsible took the losses in an organized manner it would not spill over into the rest of the economy and would be much better over the longer term. If banks failed in an organized way the rest of the economy wouldn't care just as fdic closes down smaller banks every friday. Reduction of home prices was happening since 2006 anyway and much of the reduced employment would have been restricted to the financial sector as it should have.

"No, that would be a government with peanuts inside its bald head."

Care to explain why? Citigroup is part nationalized anyway. Lots of countries have nationalized banks and by the way I would qualify it by saying that it would have been a temporary step to sell of the bank in parts. I have mentioned that there is the technical issue of expertise in the govt to run banks and hence a better option would have been a controlled bankruptcy via a private player.

Anonymous said...

inflation is a can't raise taxes in a slowdown/recession and expect real growth to improve.

Salmo Trutta said...

"ability to pay interest on reserves will enable us to raise short-term interest rates even while the quantity of assets we hold is still quite elevated and while the reserve base of the banking system is extraordinarily high" - Donald Kohn

I see no exit.

GS751 said...

Is it just me or does this debate fundamentally just come back to fed's intentions?

In Debt We Trust said...

AI, I know you don't like to talk about equities but you can't deny the effects of the inter-linked stock and bond markets.

Just look at what happened this week:

The steepener crowd killed the flattener crowd (which includes Bill Gross) these past 5 trading days.

Your MA post on the TNX was very prescient - once those levels had been hit,yields skyrocketed north!

Thai said...