This posting responds to a lively and insightful commentary on my Column (February 15, 2010) on Paul Krugman and the liquidity trap. Let me start by outlining some relevant statistics.
1. The debt overhang: Since Irving Fisher’s famous 1933 paper, it has been well known that high and rising levels of debt in an economy impact adversely on economic growth. In the third quarter of 2009, the total amount of debt in the United States (private as well as public) amounted to $3.70 for every dollar of gross domestic product (370 per cent). This reflects an exponential rate of growth from $1.60 per dollar of gross domestic product (160 per cent) in 1980. The growth rate accelerated dramatically from 2001 under the administrations of George W. Bush and Barack Obama.
2. The expansion of high-powered money: Since Irving Fisher’s famous 1911 paper, it has been suspected that a significant increase in the quantity of high-powered money will generate price inflation within an economy. Since September 2008, the Federal Reserve has engaged in a massive expansion of Federal Reserve Bank credit from $1 trillion to $2.2 trillion. Under normal circumstances, the money supply (M2) might well have expanded to this increase in reserves by $4 trillion, or 96 per cent, triggering an extremely high rate of price inflation. Milton Friedman’s research certainly would predict such a response. Many economists, myself included, expect a significant hike in the inflation rate unless, somehow, the Fed can stem the impact of excess bank reserves. This expectation can be seen in the rising price of gold on world markets. As yet, however, the link between an increase in M and an increase in P has not manifested itself.
3. The stagnation of M2: The money supply (M2) has manifestly failed to increase at a rate consistent with the monetarist model. Instead, through 2009, M2 rose only 3 per cent, less than one half its average growth rate over the previous 50 years. If as Friedman assumed, the income velocity of circulation of money is stable (MV=GDP) then nominal GDP expansion through 2010 can be expected to grow at approximately 3 per cent. With the inflation rate hovering around 1.5 per cent, the real rate of growth of GDP would also hover around 1.5 per cent, way below the level necessary to restore the US economy to anything approaching full employment. In fact, during the last two quarters of 2009, the growth rate of M2 slowed to zero. This implies that, by early 2011, the growth rate of GDP in the United States will fall to zero, with no change in the price level (Hoisington. Quarterly Review and Outlook, Fourth Quarter 2009).
What has happened?
Let me outline two alternative theories that attempt to explain this unusual phenomenon. The first relies upon the debt overhang statistic and the associated fear of price deflation. In their 2009 book – This Time is Different-Eight Centuries of Financial Folly – Reinhart and Rogoff analyze the role of debt in creating financial crises in 66 countries over a period of 800 years. They demonstrate that the principal factor that explains more than 250 crises was excessive debt relative to national income. They conclude that this time is no different, that excessive debt has led to major economic contraction and deflation as individuals and governments seek to pay down their debts. If this theory indeed is accurate, then the deficit spending by Bush and , especially, by Obama, in the United States and by Gordon Brown in the United Kingdom, is simply disastrous, prolonging and deepening the deflationary phase. Just as in the case of Hoover and FDR, presidential policies turn a limited recession into a Great Depression. Under this theory, the banks do not lend because there are few customers for fixed interest loans in a climate of pessimistic, deflationary expectations.
The second explanation focuses attention on the relationship between the Federal Reserve and the banks, upon monetary rather than fiscal policy, and suggests that flooding the system with excess liquidity has been a serious mistake of policy. The policy error, it is suggested, occurred because the Fed wrongly focused on the shortfall in aggregate demand rather than on the underlying supply constraint of credit availability (Ronald McKinnon, ‘Why Banks Aren’t Lending’, The International Economy , Fall 2009). By driving short term interest rates down to zero, the Fed provided incentives for risk-averse banks to borrow virtually for nothing and to invest in low yield Treasury notes, rather than running the risk of a repeat of September 2008, by purchasing higher- risk assets. The solution to this credit rationing, McKinnon argues, is to elevate very short term borrowing rates on the banks, without disturbing (much) longer-term rates on Treasury notes, thus forcing profit-seeking banks to invest in riskier waters, thereby expanding M2 in the usual manner.
In my judgment, both theories are relevant. For Ben Bernanke, they combine to bring to the fore his worst nightmare. If he jacks up short-term rates, and forces the banks to lend, up jumps the money multiplier and, with it, the risk of inflation. If he reverses course and pays the banks not to lend, then he generates price deflation. Bad luck, Bad Ben!
Now if only he could mop up the excess reserves while forcing the banks to lend, he would be in Monetary Paradise. But, for Bad Ben, Monetary Paradise is Lost. His balance sheet is highly leveraged, saddled with toxic assets rather than Treasury notes. Like Old Mother Hubbard, his cupboard is all but bare. He cannot give his presidential dog its much needed bone.
Tags: Ben Bernanke's nightmare, counterparty risk, credit rationing, excess debt, money multiplier, price deflation, price inflation, short term interest rates
Charles Rowley's Blog 
February 16, 2010 at 6:31 pm |
I think this analysis is in error.
Why are high levels of debt associated with low rates of growth? There could be many possible explanations, and the supply-side ones will very much depend on what the debt was used to finance.
The demand side explanation, where high debt results in low spending, and low spending results in low sales and output, is the argument that is too facile.
At its most superficial, the “theory” is bad macroeconomics. It is a partial analysis that fails as a macro theory because it fails to account for the entire of the economy.
An individual with high debts may borrow less or repay debts. That individual presumably spends less out of current income on goods and services. The particular firms that individual patronizes will sell less to that individual.
The reason this argument fails as a macroeconomic theory is that ignores the creditor who is being repaid by the debtor. Even if the heavily indebted refrains for increased borrowing, it ignores what that prospective lender does.
While those refraining from borrowing or paying down loans may spend less, the person receiving loan repayments or else not lending funds can spend more. In aggregate, total expenditure are not effected.
And that leads, of course, to monetary disequilibrium. Perhaps those receiving repayment of debts increase money holdings. Perhaps the prospective lender holds money that is not being lent because potential borrowers already have excessive debt.
And so, if that is the theory, then it is a complete macro theory, but it is just bad monetary theory. The worst is remnant approach. Money holdings passively adjust to whatever it is people are trying to do.
A good monetary theory requires that we understand not only that people simultaneously choose how much money to hold, along with spending and lending, but also, that the equilibrium conditions will depend on the quantity of money in relation to the demand to hold it.
In particular, if excess debt is going to result in people spending less on current output, then it must somehow cause an imbalance between the demand to hold money and the quantity of money.
Such processes are possible. If the quantity of money is unchanged, and those who would have lent money choose to hold more, then there is an excess demand for money. Or, because of the connections between banking and the quantity of money, perhaps an unwillings of people to borrow from banks or else banks not willing to make loans might reduce the quantity of money. Or, perhaps both occur together.
The second part of the analysis is close to the mark– the analysis using the equation of exchange. However, there is no reason why the M2 measure of the money supply is particuarly useful. That combination of assets–currency, checkable deposits, savings accounts, and CDs worth less than 100,000 is pretty arbitrary. And while there have been historical periods where it has tracked closely with nominal expenditures, the puzzle should have always been, why? There is no reason for it.
Even if M2 actually tracked the concept of the medium of exchange, there is no particular reason why the real demand for money should be strictly proportional to real output. Just as the demand for automobiles as a fraction of total income might change, so might the demand to hold money.
As for looking at growth rates of M2 and inflation and the like, the problem is that nominal expenditure has fallen about 10% below its long term trend. The demand for money has apparently risen more than the quantity of money. Assuming that the current level of the demand to hold the combination of assets that make up M2 will remain at its depressed level, is implausible.
Further, it is entirely possible, and likely even, that the demand for money will fall, in much the same way that the demand for reserves is likely to fall as well, so that the quantity of money will expand greatly.
In other words, all of the analysis of the old monetarists that was pointed towards rationalizing the desirability of maintaining slow, steady growth of M2, because that would create slow steady growth in nominal expenditure, appears to have been a dead end.
My suggestion is to forget M2, and any notion that changes in its growth rate make much differnce. It is the quantity of money and the demand to hold it that matter. Inflation (and nominal expenditure) are monetary phenomenon, but it is the quantity of money and the demand to hold it that count.
The banking analysis–banks holding bonds rather than making loans, is certainly important for some purposes. However, it makes no difference regarding the money multiplier. That banks are holding reserves rather than government bonds or loans does mean that the more than doubling of the monetary base has only had a more modest impact on the quantity of money. And, as noted above, the demand to hold money has evidently grown more than the quantity of money. That is why nominal income is 10% below its previous growth path.
With the price level being about 1.5% below its previous growth path, real exenditure is 8.5 % below its previous growth path.
It is possible, of course, that productive capacity has dropped. Perhaps it is even due to a lack of business credit. I don’t believe it.
If that were the situation, then there would be great profits from making business loans. Small banks could take advantage of those profits, using FDIC insured deposits, and newly issued stock, to rapidly grow.
That doesn’t mean that there would be no difficulties for businesses having to find these newly growing banks. It is just that we would see this–rapid growth of new entrants.
If, instead, the problem is that low spending has resulted in poor business performance, and banks don’t want to lend to poorly performing firms, and poorly performing firms don’t have much need to borrow to expand, then we wouldn’t see great profit opportunties for new entrants in banking. That appears to be the actual situation.
Why do some macroeconomists jump towards the credit contraint interpretation? Because their methodology requires that nominal prices and wages always adjust so that real expenditure is equal to capacity. They cannot accept that a 10% drop in nominal expenditure relative to trend could create a problem–would cause real output to drop far below productive capacity. They say, now.. prices and wages will just drop until real expenditure equals capacity. It must be a problem with productive capacity. Somehow…
As for the analysis of the Fed, quite the contrary. The Fed did not focus enough on nominal expenditure (aggregate demand.) First, like always, the Fed focused on slow, steady changes in short term interest rates. And then, they tried to patch up credit markets, particulary, to encourage loan securitization markets, hoping that such would solve “problems” in the credit markets as well as maintain nominal expenditure. Further, this would allow the problem to be solved without sharp fluctuation in short term interest rates.
There was obviously an increase in the demand to hold money, much greater than the increase in the quantity of money. There was a much larger increase in the demand to hold base money relative to the remarkably large increase in the quantity of base money. We know this, because nominal expenditure dropped.
If the shadow banking house of cards could have been rebuilt, then maybe the demand for money (and base money) would have subsided, and those currently holding money would have returned to holding asset backed commercial paper issued by investment banks. The investment banks would be saved, and nominal expenditure recovered. It didn’t work.
So, the Fed was too focused on credit market problems and not enough focused on “aggregate demand.” And part of the problem is the Fed is too focused on interest rate targets. And, I think, they need to think more about the growth path of nominal expenditure and less about the CPI inflation rate.
February 16, 2010 at 7:36 pm |
Has Pigou blown a hole into the *liquidity trap* using constant dollar underlying book value? Or has Kalecki blown a hole into the *Pigou’s hypothesis* by highlighting increases in real value of debts leading wholesale bankruptcy? Or have we all failed to account for the difference between short term rates and long term rates. Does our negligence constantly allow us to refer to *interest rates* without specifying which?
U B Judge
U B Thurgood
Hey, man! There are many gamuts of foreign and local interest rates out there in cyber-space, Space Cadet! They do not always move together but often in opposite directions. Get real! Get realistic mathematical models.
Grazia
February 17, 2010 at 2:42 am |
Bill,
Was it the Fed that caused the 10% (or so) drop in nominal GDP relative to its trend? I assume you don’t accept the Keynesian “autonomous” decline in AD explanation.
And in a world of private money, I assume the supply and demand for money would continually clear the money market, with no untoward macro consequences.
Would you say that your view is consistent with an Austrian view? If not, what is the biggest point of difference?
February 17, 2010 at 12:48 pm |
Bill Woolsey writes:
“An individual with high debts may borrow less or repay debts. That individual presumably spends less out of current income on goods and services. The particular firms that individual patronizes will sell less to that individual.
“The reason this argument fails as a macroeconomic theory is that ignores the creditor who is being repaid by the debtor. Even if the heavily indebted refrains for increased borrowing, it ignores what that prospective lender does.
“While those refraining from borrowing or paying down loans may spend less, the person receiving loan repayments or else not lending funds can spend more. In aggregate, total expenditure are not effected.”
But what happened when Goldman Sachs, a creditor of AIG, required that the latter put up more collateral to cover its credit default swap obligations? AIG looked at its balance sheet and realized that its assets had been marked down in price by Mr. Market to reflect changing economic reality. During the Easy Al easy credit boom, interest rates had been marked down, which meant that the demand for investment goods outpaced their supply. Investors valued long-dated cash flows with lower discount rates, which kicked up the prices of assets pretty much across the board, especially in the real estate secotr(s). When Stein’s Law kicked in, the party revelers headed for the door. Interest rates and discount rates rose; and cash flows started to reflect economic reality, which meant creditors got nervous and started demanding more collateral, higher underwriting standards, etc. Thus did AIG hit the skids; Goldman’s stock also took a 50% hit before starting to recover.
I’d say the Austrians have it right, or are at least closer to the mark.
February 17, 2010 at 2:19 pm |
Next James Cameron 3D epic: “The Austroids.”
February 17, 2010 at 6:00 pm |
Dr. Woosley,
A quick comment on your reply.
“And that leads, of course, to monetary disequilibrium. Perhaps those receiving repayment of debts increase money holdings. Perhaps the prospective lender holds money that is not being lent because potential borrowers already have excessive debt.”
But where does a lender put his money if he does not lend it?
He deposits it in a bank account.
What does a bank do with the money?
Lend it.
So, I do not agree the monetary disequilibrium exists due to the lender saving his money.
In our current situation, the bankers are scared. As you noted, they are stacking their excess reserves and not lending – essentially de-inflating the inflating economy.
This essentially monetary EQUILIBRIUM, true? – the dollars the FED has poured into the economy has been withdrawn into excess reserves by the banks – keeping the rates of monetary inflation to under 3%?
January 31, 2011 at 5:55 pm |
My wife and I opened a couple businesses in 2009. That is right against the odds and when things couldn’t get worse in our economy we opened our own businesses. We deposited over $35,000.00 our first year,not bad since the companies were not fully operational until April of 2009. Last year we almost tripled our business depositing over $127,000 dollars. We have never been late on any payments, we also have plenty of credit letters from companies who do not report to the credit report, but instead will issue you a payment history and account statement, and in most cases will also give you a letter of good credit standing, our bank accounts have never gone into the negative, never accessed any overdraft charges, insufficient funds fees, no late fees, Nothing negative at all. Credit Score in the 700’s. Average balance in our First Citizens Bank of SC accounts well over $2,000.00 a month. Here is how the banks are lending!!
We had to spend $3,500.00 of our own money to secure a credit card thru Bank of America in order to get a credit card. Never been late on the payment, and never maxed out the card, and still to this day 2 years later, they refuse to roll it into a regular unsecured credit card. We need an expansion loan, do not need the money to progress forward, we make a profit in the company, but I am at a flat line, Better advertising, or the ability to secure an equitable asset that brings in revenue will help boost our current revenue and leave more profit at the end of the year! This Loan is meant only to help us to make even more money. So the need for the loan is not to survive, not to keep our business afloat, but merely to increase my revenue only. We asked for a 7,500 dollar loan from First Citizens Bank of SC 2 years ago, when we first opened, they had ridiculous application fees up to $3,000.00 dollars on a $7,500.00 loan. We were not worthy enough for that loan. This loan was to purchase equipment 2 years ago that would have benefited us and could have enabled us to secure an account that was guaranteed for 2 years at $125,000.00 a year. So First Citizens Bank of SC used their better judgment and said no to a $7,500 loan that would have resulted in $250,000.00 of revenue 2 years later. They also declined us for a credit card, but offered us a secured credit card with 120% down on the card. NOPE went to Bank of America and got the $3,500.00 secured card there. We then go back to First Citizens Bank of SC. We found another investment opportunity but needed $15,000 To purchase the existing business. The owners got what they wanted out of the business and wanted to move abroad for retirement. I turned in a 19 page business plan, included with it another 12 pages of financial and projections. THEY LOST THE APPLICATION. Said I had to resubmit my application, buy the time First Citizens Bank of SC wasted a month the opportunity was gone, they packed up the shop and moved out of the country like they told us. This business was doing $98,000 a year in revenue. So again First Citizens Bank of SC Lost another $100,000 over a $15,000.00 Loan. SO far the bank and their upstanding intelligence on lending practices, kept them from investing $22,500 dollars that would have resulted in $348,000 of revenue. We Are now in our last argument with First Citizens Bank of SC,we are asking for a $30,000.00 Line of credit, we deposited over $125,000.00 in their bank last year and hmaintain an average in one of our 3 accounts at $1500 dollars a month, the other accounts are still quite positive, and we have all our letters of credit. They are still fighting me on the application, they do not seem to want to lend any money at all. If they don’t we will pull our money out and go to a 1 single branch bank, not county wide coverage, or state wide and definitely not nation wide. 1 Bank 1 Location. Then I will be important, and my banking relationship will finally be a relationship with a bank that meets me in the middle, instead of sitting in their million dollar mansion on the other side of the road waiting for me to do all the work! TRUST ME THE BANKS ARE NOT LENDING, not even Bank of America who our tax dollars bailed out of their bad judgments!
October 14, 2011 at 1:34 pm |
Dead rising 2 trainer…
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November 6, 2011 at 11:35 am |
state flags…
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