As I was reading the column, I kept asking two questions:
- Why should monetary policy be a solution for a solvency crisis; and
- Has anything changed since the 1870's when Walter Bagehot observing that savers have a strong distaste for low rates said in the Economist that "John Bull can stand many things but he cannot stand two percent"? This was the lower bound for monetary policy for the Bank of England until the financial crisis in 2007.
BOTH the American economy and the global economy are facing a familiar foe: policy defeatism. Throughout modern economic history, whether in Western Europe in the 1920s, in the United States in the 1930s, or in Japan in the 1990s, every major financial crisis has been followed by premature abandonment — if not reversal — of the stimulus policies that are necessary for sustained recovery. Sadly, the world appears to be repeating this mistake.
The right thing to do right now is for the Federal Reserve and the European Central Bank to engage in further monetary stimulus. Having lowered short-term interest rates, they should buy (or in the case of the Fed, resume buying) significant quantities of government securities to help push down long-term interest rates and encourage investment.Is there any evidence that says since the beginning of the solvency crisis that pushing down long-term interest rates has actually encouraged investment?
Since the beginning of Japan's solvency crisis, it has had over two decades of low long-term interest rates. Is Japan experiencing an investment boom?
If anything, it is past time for the Fed and its European counterpart to act. The economic outlook has turned out to be as grim as forecasts based on historical evidence predicted it would be, given the nature of the recession, the cutbacks in government spending and the simultaneity of economic problems across the Western world....There is one prediction that is left out of here. That is the prediction by Walter Bagehot that 2% is the lower boundary for effective monetary policy. Any lower and bad things happen to the economy.
Is it possible that zero interest rate policies and quantitative easing actually make the economic situation worse?
There is a significant amount of anecdotal evidence to suggest that these monetary policies do in fact make the situation worse. This evidence includes:
- Low interest rates increase the amount of money that businesses must put into their pension plans to keep them fully funded --- additional contributions are needed to offset the decline in earnings on the plans assets from the low interest rate policies. Money contributed to a pension plan is not money the company can reinvest in its core businesses.
- Low interest rates decrease demand from individuals who are savers. They need to reduce current consumption to offset the drop in earnings on their savings. The lower demand triggers a death spiral. Business sees the decline in demand from individuals and delays making investments. Central banks try cutting rates further. This increases the amount savers need to cut consumption by. Business see further decline in demand and the cycle repeats itself.
- Low interest rates provide a greater incentive for de-leveraging. For all borrowers, their highest risk-free return is to pay down their borrowings. For most of the last two decades, this was not true as the increase in asset prices was greater than the cost of borrowing.
[I]nvestment has been held back because of uncertainty over the economy’s future prospects. And the ability to attract investors is being limited by the giant burden of private-sector debt. In other words, a financing problem is inhibiting the restructuring of our economy.
Alleviating generalized financing problems and low investor confidence is precisely what monetary stimulus does....
In Japan in the 1990s, a period of insufficiently aggressive monetary stimulus fed lending to “zombie companies” — unproductive borrowers on whose loans the banks could not afford to take losses.Actually, this lending to 'zombie companies' was the result of the extend and pretend policies adopted by bank regulators. These same policies have been adopted globally today.
It is this policy that is the single biggest barrier to economic recovery.
Extend and pretend distorts markets. This blog has discussed how extend and pretend makes it very difficult for banks to lend against real estate - the banks have to factor in what would happen to real estate prices if all the bad loans on their balance sheets had to be recognized.
Regular readers know that there is no such thing as a bank that cannot afford to take its losses - banks can continue to operate with negative book capital until such time as the banking regulators close them.
There are bankers who don't want the bank to take losses to preserve their bonuses. There are regulators who do not want banks to take losses because it highlights how poorly they performed their supervision function.
It was only when macroeconomic policy led a recovery in Japan in the first decade of this century that capital flowed out of the places it had been trapped and into new and growing businesses.Actually, it was only when Japan tried to force the banks to write-down their bad assets that capital began to flow out of the places it had been trapped.
Unfortunately, bank regulators stopped the write-down process well before all the bad assets had been written off. The reason for stopping was the book capital levels at the banks. The regulators wanted to preserve positive book capital levels.
Similarly, after the American savings-and-loan crisis, real reallocation of credit from bad banks and borrowers to worthwhile investment began in earnest only when monetary policy eased in the late 1980s.Actually, the real reallocation of credit from bad banks and borrowers to worthwhile investment began in earnest only when the financial regulators stopped engaging in policies of extend and pretend.
It was only when assets had been written-down that it became easier for a good borrower to access credit than it was for a bad borrower - under extend and pretend, bad borrowers have an easier time accessing credit because the additional credit is needed to make their loan look like it is performing.
Japan and the savings and loan crisis are examples that show monetary policy is impotent during a solvency crisis when financial regulators are engaged in extend and pretend policies.
Central banks and governments can engage in forms of coordinated action that will target the burden of past debts that is hanging over the global economy.
In the United States, that means resolving the distressed mortgage debt that is weakening our financial system and reducing labor mobility, thereby constraining not only our growth but also our ability to grow. It is time for the Federal Reserve and elected officials to explore ways to jointly tackle that housing debt....Given that the Fed is the banking regulator leading the extend and pretend policy, the statement that it is time to address the solvency crisis is quite a statement. It is even more of a statement given that the Bank of England is going to become the regulator leading the extend and pretend policy when it inherits supervising banks from the FSA.
Regular readers know that the Fed does not have to talk with elected officials to tackle the housing debt problem. It simply has to end the extend and pretend policies it is implementing.
Is the Bank of England going to end extend and pretend in the UK?