Fed easy money punishes middle class Americans

John Maynard Keynes first noted that labor market equilibrium may be impacted by price inflation.  He noted workers’ strong preference for a 2 per cent wage increase in a 4 per cent inflation environment over a 2 per cent decrease in nominal wages during a period of constant prices. For many years politicians attempted to exploit this illusion by hiking up inflation rates.  Ultimately, the entire process collapsed in 1970’s stagflation, as the Phillips curve became upward sloping in price inflation/rate of unemployment space.

Money illusion has not disappeared, however, from the box of tools of the Federal Reserve. Indeed it is alive and well in the easy money policies emanating from the Fed since September 2008. Indeed, the Fed, under the chairmanship of Ben Bernanke, has becoming increasingly bold in exploiting money illusion. With inflationary expectations not yet rattled by the Fed’s $2 trillion balance-sheet expansion, Bernanke has now committed the Fed to an open-ended round of quantitative easing in the expectation of trading a little extra inflation for a little short-term employment.

These actions hurt the middle class – the group for which the policy is designed – as low interest rates sap their investment returns and as creeping inflation erodes their perceived real living standards.

“The more than five-fold increase in the median income of the American household since 1971, to $50,000 from $9,000, certainly provides the clear appearance of progress.  But after the dollar’s 82% loss of purchasing power over the same period is factored in, the median household income rose just 12%.  This much more modest increase is largely the result of the growing prevalence of two-income households.  The median real income for working men over the same 40-year period rose just 8%.  And thaat improvement only accrued to the ever-shrinking percentage of men fortunate enough to still have full-time jobs – just 67% according to the latest data from the Bureau of labor Statistics, within a percentage point of the lowest level on record since the figure was first recorded in 1948.”  Sean Fieler,  ‘Easy Money Is Punishing the Middle Class’, The Wall Street Journal,  September 27, 2012

As price inflation creeps upwards, from 2 per cent per annum to 4 per cent per annum, the price signals necessary for American workers to compete in the global market-place are dulled and incentives to re-educate and re-adjust are dimmed.  The end result is serious structural unemployment of the kind that now seriously hinders economic recovery in the United States. Ben Bernanke is the worst enemy that working Americans could ever wish to avoid. For he is working on their perceived cognitive deficiencies to gain short-term advantage for his Wall Street friends and cronies.

 

Brain-Dead US Banks Survive on Life Support

“Them that die’ll be the lucky ones.”  (Long John Silver, pirate leader, himself responding to the threat of the Black Spot from his own treacherous brigands,  as he storms away from the stockade on Treasure Island behind which Captain Smollett, Squire Trelawney, Dr. Livesey and their few loyal supporters shelter, when they reject his request that they should  surrender)

Robert Louis Stevenson, Treasure Island 

“Troubled banking industry pulls back: Lending down $587 billion.” Binyamin Applebaum, The Washington Post, February 24, 2010.

The FDIC reported on February 23, 2010 that lending by United States banks fell by $587 billion (or 7.5 per cent) in 2009.  This is the largest annual decline since the 1940s. The FDIC also reported that the nation’s 8,012 banks posted an aggregate profit of $12.5 billion in 2009, an increase over 2008, but well below the levels achieved during the mid-2000s.  The largest banks accounted for most of these reported profits. 

 A growing number of smaller banks are struggling to survive losses on commercial real estate loans.  Almost 30 per cent of such smaller banks reported losses in 2009, the largest proportion in the 26 years of available data.  And the FDIC does not mention that a major collapse in the commercial real estate market is the second shoe about to drop on the teetering US economy in 2010. Regulators shuttered 140 banks in 2009.  This number is expected to rise during 2010 with 702 banks considered by the FDIC to be at risk of failure. If the commercial real estate market truly collapses, many more banks assuredly will fail in the absence of bail-out funding.  Predictably, the Obama administration is racing to the rescue, with a proposal to pump $30 million in new federal aid into community banks, yet more hard-earned taxpayers’ wealth to be flushed down the toilet.

According to the FDIC, the vast majority of the decline in lending was the result of cutbacks by the nation’s largest banks.  These banks have tightened qualification standards for borrowers and increased the proportion of money that they hold in reserve against unexpected losses. FDIC Chairman, Sheila C. Bair, was critical of these actions: “Large banks do need to do a better job of stepping up to the plate here” she complained.  The banks cut back most sharply on lending for construction and development, reducing the volume of such loans by 23.6 per cent.  Business lending followed closely behind, down 18.3 per cent.  Lending to individuals also declined, but more modestly.

I am now going to try to interpret these statistics against the backcloth of the discussion that followed my column dated February 16, 2010, wherein Bill Woolsey took me to task for omitting important considerations. His thoughtful  intervention renders my task more complex, but not at all impossible. Among other things, it requires me to make a clear distinction between banks that are illiquid and banks that are insolvent (something that Nathanael Smith and I did in our 2009 book).

A solvent bank enjoys an excess of assets over non-equity liabilities, whereas a non-solvent bank does not.  Solvent banks that are also liquid banks hold sufficient reserves of cash , either in their vaults or in the cash reserve at the central bank, to take care of demands made upon such resources.  Solvent banks that are illiquid do not hold such a sufficiency of cash reserves.  If a financial panic picks up, in the absence of central bank intervention, both insolvent banks and illiquid but solvent  banks will be shuttered.  The traditional good banking doctrine is that the insolvent banks should go under,  but that the illiquid banks should be provided ‘lender of last resort’ cover by the central bank to enable them to mend their over-leveraged ways and to ride out the storm.

The Federal Reserve and the Treasury Department, responding to political pressure from the Bush and the Obama White House, threw good banking practice to the winds in late 2008 and early 2009, and bailed out both insolvent and  illiquid banks via massive injections of TARP monies and quantitative easing of the money supply. Subsequently, the Department of the Treasury imposed stress tests on all the major banks to determine whether they were simply illiquid, or possibly insolvent. In my judgment, either the stress tests were rigged, or the Treasury Secretary was duped.  Every bank came through with flying colors, although at least 4 of the 10 largest banks – Bank of America, Citicorp, Wells Fargo and GMAC – were and still are insolvent.  And several more are teetering on the brink, reliant on the fact that their toxic mortgage-securitized assets are not exposed to market valuations. 

Now, let me try to answer two important questions once  again: why are the banks not lending?  Why has the injection of high-powered money into the system not  triggered the usual money multiplier effect? Let me concede to Bill Woolsey the observation that nominal expenditure is running approximately 10 per cent below its long term trend, and that this reflects (at least in part) an upward shift in the demand for money  function. Where does this leave us?

In my judgment, a large part of the explanation why the banks are not lending, are not expanding the size of their balance sheets to reflect the insertion of high-powered money, lies on the supply side of the money market equation. The insolvent banks are desperate to pull their chestnuts out of the fire by rebuilding their financial reserves while investing in a limited fashion in Treasury notes as a means of boosting earnings without significant exposure to risk, while they wait hopefully for some of their toxic assets to mature under the security blanket of Obama’s mortgage rescue program. Little or no money multiplier can be expected from these basket-cases. 

The illiquid banks are similarly engaged, though with a greater willingness to lend in multiples of their increments in cash reserves.  The community banks are shutting down to weather the coming commercial real estate market storm.  Yes, the demand for money function has also shifted upwards so that evidence of credit rationing is less pronounced than otherwise would be the case.

Now just suppose, Dear Readers, that all the insolvent banks had been allowed to fail during 2008-9, without any bail-out from the federal government. Suppose that the Federal Reserve had protected illiquid banks by lending at penal rates through the lender of last resort facility, while holding interest rates down through open-market operations restricted to the purchasing of Treasury notes. In such circumstances, new banks would have emerged (always assuming that the Fed allowed new entry into the banking industry) and the insured deposits in the insolvent banks would have found their way into banks that were not incumbered by huge volumes of toxic assets.

The money multiplier would have operated, albeit somewhat dampened by the recession, credit rationing would be much weaker, and private investment would be exerting a much more significant positive effect on the macroeconomy.  Surely, banks would not be investing significantly in the construction industry, until the real estate markets have reached full equilibrium.  But credit would be much more forthcoming for small firms and new ventures, both of which are capital starved in the current financial climate. Inevitably, the Fed would then confront the specter of inflation. But, without any toxic assets on its balance sheet, it would be able to reverse open market operations to reduce the supply of high-powered money as the economy rebounded to full employment. As Bill Woolsey suggests, the Fed’s interventions arguably should be targeted  on some appropriate level of nominal income for the economy as a whole.

 

 

Why US Banks Are Not Lending

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.