Saturday, September 22, 2012

Quantitative easing isn't magic nor will it solve the economic problems

In his Guardian column, James K. Galbraith looks at what central banks can do and what central banks cannot do.

Regular readers know we are facing a bank led solvency crisis that central bank monetary policy tools cannot fix.
  • What central banks can do is keep banks with low or negative book capital levels alive.  They can do this by lending against "good" collateral.
  • What central banks cannot do is absorb all the losses on the excess debt in the financial system or make these losses go away.  Only banks can absorb these losses.  In a modern banking system, banks are designed to absorb these losses and to continue to support the real economy even when absorbing the losses causes them to have low to negative book capital levels.
  • What central banks cannot do is restart lending.  Lending requires a willing borrower, a source of repayment for the loan and collateral with a knowable value.  The problem today is valuing the collateral.  Collateral values are distorted as a result of not making the banks absorb the losses at the beginning of the financial crisis.  Instead regulatory forbearance was implemented which allows the banks to create 'zombie' loans by engaging in 'extend and pretend'.  This distorts collateral values by holding collateral off the market.
Problems and disappointment arise when there is confusion over what central banks can and cannot do.

Central banks can engage in policies like Quantitative Easing.
Quantitative easing, the third tranche of which was announced in the US last week (QE3), is just a fancy phrase for buying bonds, notably mortgage-backed-securities, in which operation the Federal Reserve takes assets from the banks and gives them cash. This raises the bond price and lowers the yield. It also tends to boost stock prices – very nice for people who own stock – and it can spur mortgage refinancing, improving the cashflow of solvent homeowners. 
And what should we expect from the policies that central banks can engage in?
And the effect on the economy of all this is? Mostly indirect and quite small. People don't generally spend capital gains as windfalls. Saving on mortgage debt helps to support spending but some of it goes to paying down other debts. People who are already underwater on their mortgages can't refinance anyway, and are not affected. Yes, there is some effect. But powerful stimulus, this is not....
 What can central banks not do?
Some people in high places – Tim Geithner, the US treasury secretary, for example – profess that restarting bank lending is the key to economic recovery, and increasing bank reserves will spur them to lend. (What else are banks really good for?) But if anyone believes that reserves are key to lending, they deeply misunderstand what banks do. 
As Hyman Minsky used to say: banks are not moneylenders! Banks don't lend reserves, and they don't need reserves in order to lend. Banks create money by lending. They need a client willing to borrow, a project worth lending to, and collateral to protect against risk. If these are lacking, no amount of reserves will turn the trick. And especially not when the government is willing to pay interest on their reserves: the truest form of welfare, income for doing nothing.  
In a debt-deflation, actually there's even worse news. When asset prices are falling, how do banks make money? Not by fighting the trend but by riding it. If they withhold loans, prices will fall even further, and the assets can be bought later for even less. You might call this shorting the entire economic system.
This is a very important point.  Banks have an ability to make money in both good and bad economic environments.
You can't blame the banks for this, it's how money makes money in hard times. But to expect them to act as the agents of economic growth in such conditions is foolish.... 
So in summary,
Yes, [central banks] can usually forestall panic. Yes, for better or worse they can keep zombie banks alive. 
No, they cannot bring on economic recovery or solve any of our deeper economic problems, from unemployment and foreclosures in America to unemployment and economic collapse in Greece and elsewhere. 
The sooner we stop thinking of central bankers as wizards and magicians, the better.

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