Macro Policy

Potential Limits on Monetary Transmission

In the classical model of monetary theory, central banks are able to affect real economic activity through control of interest rates. In practice, it is thought that control over short-term rates such as the cash and federal-funds rates is potent due to a mechanism known as the ‘lending channel’.

According to the lending channel model, central bank control of reserves affects the supply of deposit financing available to banks. In turn, this allows the commercial banks to greatly expand their lending capacities.

Whilst this mechanism is widely known by economists, the assumptions that underlie it are not so familiar. In particular there are 3 critical requirements for the model. (I use vocabulary corresponding to a contraction in reserves)

  • banks can do stuff. The neutrality postulate of money breaks down in the short term. Price adjustments are imperfect such that that nominal changes have large bearings on real outcomes.

  • Demand for banks. Firms in the economy are reliant on the efficiency of banks such that bank loans and public finance via bonds are not perfect substitutes. In other words, the Modigliani-Miller theorem breaks down in a particular way implying firms cannot offset decreased credit from commercial banks with public credit.

  • Supply of bank credit is affected by the Central Bank. Commercial banks do not insulate their lending actions from central bank operations. This is interpreted as a reluctance from the banking sector to switch from deposit funding to other forms of finance such as commercial paper and equity which are less reserve-intensive.

(These assumptions were identified by Kashyap and Stein (1994))

Both empirically and intuitively conditions 1) and 2) are likely valid, but the 3rd is not self-evidently sound. In fact, it relies on the assumption that for commercial banks debt instruments such as commercial paper are not good substitutes for reserves. The substitutability between these two instruments is thus the focus of this post.

Luckily, the extreme monetary conditions of this decade have provided a clearer view of the situation which I hope will become the topic of more analysis going into the future.

To see how extreme monetary conditions can give us a clear view of the fault lines in condition 3, we must first look at how Quantitative Easing (QE) worked in the U.S. I will not give the full mechanistic exposition (though at some point I probably should since it is a frequently asked question), but rather will attempt to explain some stylistic elements which shed light on the Monetary Transmission mechanism.

When the Federal Reserve embarked on QE3, the most expansive and concentrated of the QE iterations, it underwent a series of huge purchases of long term government debt (to the tune of $80 billion per month). In exchange for these purchases of government debt it credited the equivalent amount of reserves into the banking sector. In addition, as a precaution to stop runaway credit growth, the Fed paid 0.25% interest on ‘excess reserves’ (the reserves that banks held above their 10% requirement).

The goal of course was to reduce long term rates via the purchase of long term assets. But there is something else here. Now that the Fed was paying 0.25% interest on excess reserves, reserves themselves had become a highly liquid asset that in all but name resembled short-term bonds issued by the Fed. Hence, what we would expect to see is not just a series of purchases that pull down the yield curve on the long end; but rather a series of purchases balanced by sales which should push up the yield curve on the short end. In other words, this operation should not have just compressed the term structure of interest, but actually twisted it. One can think of it as an increase of short term debt supply as well as an increase in long term debt demand.

Nevertheless, throughout QE3 there was a persistent fact that came to the surprise of quite a few monetary economists. Namely, the yield curve in the US did not actually twist, but in fact was compressed in many markets- contrary to expectations. Commercial paper markets for example in commercial banks fell quite dramatically over the period 2011-13. Thus, on balance there was likely a reduction in the issuance of commercial paper by financial institutions who instead financed operations through the deposit account as availability of reserves increased. Thus, the new reserves served simultaneously as debt issuances by the Fed but to some extent also capitalised bank balance sheets just as commercial paper would in other contexts. Remarkably, the increased issuance of debt by the Fed via QE was offset by decreased issuance of commercial paper by banks to fund their assets.

If this analysis is right, and there are no other factors at work, (even if there are I think the scope of QE3 would be enough to swamp most other financial forces) the conclusion of such an unexpected repression of the yield curve is that financial institutions may perceive commercial paper issuance as a substitute for deposit funding. This gives a view into the financing of assets which actively undermines the idea that banks do NOT insulate their balance sheets from central bank operations. The lending channel may be less potent than we think.

A Word Against the Gold Standard

Now that we’re now warming up for another GOP and democrat debate in the US, I thought it was time to expound some more economic consensus. Namely, discussion over the Gold Standard.

To be honest, I find it surprising that the Gold Bug continues to consume many fringe elements of the political spectrum given what we’ve observed in Europe since 2009. Economically, Europe’s problems are almost wholly due to the difficulties of holding a fixed exchange rate over sub-optimal currency zones. The Gold Standard, in light of this, has all the features of such a fixed exchange rate with the added inflexibility of weakened central banks. Is this what the world needs in the future? The contention of most economists is that it is not; that it is a ‘barbarous relic belonging to the dustbin of history’. This is insisted for the following reasons:

  • Capital flow Bias.
    As suggested by Peter Temin, a fundamental structural flaw of the Gold Standard was the asymmetry of price-specie flows between surplus and deficit countries. In theory, the Gold Standard should have corrected trade imbalances since a country with trade surpluses (deficits) would receive capital inflows (outflows) in the form of gold. These specie inflows in turn would expand (contract) the money supply and raise (dampen) the price level. Thus, correcting the imbalance of competitiveness between countries and balancing trade. In practice however, it was very easy for trade surplus nations to sterilise inflows whilst deficit nations were forced to contract the domestic money supply in an effort to ‘catch-up’. Overall this had the effect of pronouncing the demand-side impact of trade imbalances rather than alleviating them, in turn creating a deflationary bias.Sound familiar? This line of thought, whereby deficit nations are forced into internal devaluation as surplus nations sterilise the inflows, is the key issue underlying Europe’s sovereign debt crisis.
  • Macroeconomic contagion.
    Picture what happens when an economy that forms part of the Gold Standard enters a recession. Wages and prices fall as per usual, and competitiveness is increased. This all happens under floating exchange rates as well. The difference in the Gold Standard however is that this fall in wages and prices, through the trade account, creates an inflow of specie domestically that must be matched by a global outflow. Thus, though the domestic money supply may be allowed to expand as per usual, overseas markets are forced into a contraction. In this sense, economic contraction in a few major markets has an added contagion effect that is wholly divorced from economic fundamentals; caused instead by monetary rigidities.
  • Short-Term Volatility.
    Whilst it is true that the under the Gold Standard the world witnessed a more stable long-run price level, in the short run there was far greater volatility. This came from the fact that the conduct of monetary policy would be subjected to supply-side concerns amounting from the industrial demand and supply of gold.  In addition, financial speculation on commodity prices would tangibly affect coverage ratios and thus monetary policy. Overall, this had the effect of destabilising commercial balance sheets and frustrating macroeconomic management.
  • Practicality
    According to recent estimates by the Federal Reserve, M2 in the U.S alone today is estimated at about $10.5 trillion, whilst the value of all gold ever mined amounts to around $8.2 trillion. If the Gold Standard were to be implemented today, it would require one of two things. In the first instance, central banks across the globe could contract the money supply by a huge quantity and inflate the price of gold past all industrial applications. Or, central bank reserve requirements could fall precipitously. The trade-off is most definitely between a calamitous recession on the one hand and a destabilisation of global finance on the other.
  • Speculative Attack.
    We’ve all seen what happens to central banks that can’t maintain their pegs, or fall victim of severe financial speculation. It has happened in both the developed and developing economies in the post-war era. When foreign reserves fall to levels that make effective coverage of the exchange rate impossible they fall victim to sharp and intense financial panics. The Gold Standard would entail a Global Return to policies that risk the same situation.

In Defence of OMT

The German Constitutional Court’s recent ruling to rein in the ECB operations known as “Outright Monetary Transactions” (OMT) as unconstitutional, has elated many German politicians and Euro-sceptic economists. But this is a pyrrhic victory for Germany, and a sad week for the European periphery.

Princeton University economist Ashoka Mody for example has labelled the OMT as economically “ill-conceived” in his recent Project Syndicate article. The argument goes that ECB claims that risk premiums reflect unfounded fear were based on “Cherry-picked evidence” and that the OMT program by definition conceded that “assessments of creditworthiness reflected a real default risk”. Thus, one should let the market price this risk adequately to create an optimal solution. In other words, the ECB has given periphery Europe a free lunch, and distorted the sovereign bond pricing system in the Eurozone.

An implicit notion in this argument however is that causality between finance and fundamentals is a one-way street. Financial feed-back loops, either do not affect the real economy, or they are completely rational and optimise results. This is clearly fallacious. The risk of Sovereign default is almost purely a function of the interest rates that must be paid on their debt. In addition, risky markets do not operate anything like their safer financial and real counterparts in reducing volatility and allocating capital.

In financial markets optimal results requires a balance of speculators and fundamentals traders (value investors). The speculators, supply liquidity to the market and trade in line with trends. The value investors however, absorb this liquidity and tend to trade against trends. The result is a stable asset pricing system, where small shocks do not get blown out of proportion and liquidity is sufficient.

So who are the value traders in Sovereign debt markets? When it’s high grade, there are sovereign wealth funds, superannuation funds, etc. that all use these low-risk assets to hedge against adverse economic shocks. The problem is though, that periphery European debt markets nowadays are no longer high-grade. Indeed, risk premiums have consumed a major part of debt repayments from peripheral Eurozone countries and many of the historical value investors have moved away. Thus the speculative component of these markets is probably too high.

And so the periphery of Europe is faced with a double dilemma. Two positive feedback loops that can cause the downfall of the Eurozone. If individual country risk premiums reach a point where they begin to threaten national solvency, then speculative component of the asset holders will do the rest. They will begin shorting the debt and creating higher interest rates whilst pulling back liquidity lines. Any sizeable shift in fundamentals therefore (such as an elimination of OMT) will cause carnage.

For example, Spain’s public debt still only hovers at around 90% of annualised GDP, and risk premiums are far higher than in the US where debt as a percentage of GDP is around 130%. Risk premiums cause default risk, and more risk premiums. This is an equilibrium reached under artificial circumstances, and it should not be tolerated. It is clearly a market flaw. If Sovereigns are able to repay their debt reasonably, that should be strived for. OMT facilitates this by a reduction in national stress, and reduces actual risk in a very real sense. It breaks the speculative loop and changes the fundamental solvency of the beneficiaries.

Attempts at destroying OMT are thus almost wholly political, and are not astute economic policies. Attempts at diluting it are even worse. To date, OMT has managed to avoid speculative attacks on the ECB’s commitment to do “whatever it takes”, and premia have been meaningfully reduced. If the German High Court, and the European Court of Justice however, choose to dilute the OMT program then a very different scenario could emerge, and the ECB could lose the credibility it’s fought so hard for these past few years.