Although the Fed has resorted to increasingly unconventional approaches for combatting our financial crisis, one it has used that is widely endorsed is the generous provision of liquidity.
Luis I. Jácome H. in a VoxEU post, contends that the liberal use of central bank liquidity to stanch crises actually increased instability. One issue that will resonate with many readers is that the monetary authorities found it difficult to mop up the liquidity they had created. Rapid growth in money supply stoked serious inflation.
Admittedly, Latin America can be argued to present a different fact set than advanced economies. The flip side, however, is that Carmine Reinhart and Kenneth Rogoff, who have constructed a very large data set of financial crises, found much to their surprise, that the trajectory of advanced and emerging economy crises were very similar, so similar that they decided to put them together in recent analyses.
Note that while one might contend that the TARP constitutes bank recapitalization and thus falls outside the failed Latin American examples, the TARP has not involved balance sheet clean ups or led to price discovery. Thus at this juncture it looks like an inefficient subsidy rather than progress towards shrinking and strengthening the banking system.
Banana republic, here we come?
Not necessarily. One thing that made a bad situation worse in Latin America was that as central bank balance sheets exploded, investors shifted to foreign country assets, leading to a significant fall in local currencies. Since many companies borrowed in dollars, the credit shock increased financial pressure. The author takes great care in recommending against a monetary led approach to crisis response for emerging economies. By implication, he deems it to be less risky for mature economies, but reading his list of how crises progress and which programs appear most successful, the downside for Latin American countries could well obtain for more mature economies, albeit in a weaker form.
As the global economic crisis goes south, developing countries’ central banks must cope with financial turmoil. Recent experience in Latin America, this column argues, cautions against pouring money into the financial system. Countries that relied on prompt corrective actions managed crises well, while those relying on central bank money suffered greater instability.
Central banks have played an instrumental role in the current financial crisis in mature markets. With the aim of bringing money markets back to normal functioning and stemming financial turmoil, central banks have extended sizable financial assistance to failing banks and other intermediaries – although at the cost of increasing the size of their balance sheets and creating moral hazard and other microeconomic distortions. Today, systemic liquidity has been restored but credit conditions have not been normalised and, hence, economic activity has declined and inflation has started to fall.
While the financial crisis has receded in industrial countries, Latin America is enduring short-term capital outflows and growing liquidity and credit crunches. Central banks are intervening in the foreign exchange market to moderate currency depreciations, albeit at the cost of losing international reserves. In some cases, they are also providing liquidity assistance to troubled banks. However, if liquidity conditions continue to tighten, financial distress may jeopardise the stability of financial systems, and credit risk could be a major threat in 2009.
What should the role of central banks be in this possible scenario? Should they follow the path taken by industrial countries? And, if not, what would be an appropriate response to prevent and manage banking crises? This column addresses these questions based on the performance of central banks in several banking crisis episodes that have occurred in Latin America since the mid-1990s.
The role of central banks in past banking crises in Latin America
Injecting large amounts of central bank money to cope with banking crises has been a regular practice in Latin America, except in a handful of episodes. The intensive use of central bank money was mainly the result of inappropriate legislation that did not allow governments to address banking problems at an early stage.2 It also aimed at avoiding – or at least postponing in the short-term – the use of taxpayers’ money to finance the cost of resolving the crisis. However, in a small number of cases, governments managed market turmoil effectively without resorting to large amounts of central bank money – provided adequate institutional arrangements were in place or were introduced in a timely manner.
Central bank money was used to provide both limited and extended liquidity assistance, and also to finance bank resolution and the payment of deposit insurance and guarantees. Injecting abundant central bank money was the main policy response to banking crises amid fears of a systemic impact that could lead to the collapse of the payments system (the Dominican Republic in 2003, and Argentina and Uruguay in 2002 are relevant cases). Central banks also pumped in money or issued securities to facilitate bank resolution (Bolivia and El Salvador in 1999), and delivered partial and blanket deposit guarantees (Venezuela in 1994 and Ecuador in 1999). Central banks injected money extensively even to cope with idiosyncratic events (for instance in Guatemala in 2001 and Ecuador in 1996).
In contrast, based on adequate institutional arrangements and strong macroeconomic fundamentals, a few governments tackled banking crises by adopting bank resolution to deal with unviable banks and using central bank money in limited amounts (for example, in Argentina in 1995, Peru and Colombia in 1999, and Guatemala in 2006). In some of these cases, they also strengthened weak but viable banks, implementing capitalisation programs, restructuring assets, and assuming liabilities, among other actions.
When central bank money was intensively used, it constrained central banks’ ability to conduct an orderly monetary policy. As central bank claims on banks mounted, it became increasingly difficult for central banks to mop up liquidity and, hence, monetary aggregates exploded, leaving the economy without a nominal anchor to contain inflation. The crises in Argentina, Mexico, Uruguay, and Venezuela are relevant examples, as well as the banks’ meltdown in the Dominican Republic and Ecuador (Figures 1 and 2).
Figure 1. Outstanding balances, Dominican Republic 2003, millions of pesos
Figure 2. Outstanding balances, Ecuador 1999, billions of sucres
Source: Jácome (2008).
The size of central banks’ balance sheet ballooned and, hence, unlike in industrial countries, domestic currencies depreciated and inflation soared, eventually backfiring on financial systems. A review of 26 episodes of financial distress and crises in Latin America – from the mid-1990s onward – shows that growing financial assistance to impaired banks led market participants to shift portfolios toward foreign currency assets. Central banks tried to smooth exchange rate depreciations by intervening in the foreign currency market. Thus, as the value of central bank claims on banks multiplied by a factor of two or more, international reserves fell by 15% or more. Eventually, as international reserves reached critically low levels, central banks stopped intervening and large devaluations or depreciations materialised (more than 30% in most cases), thereby exacerbating the banking crises – in particular in countries with high financial dollarisation. Because the transmission mechanism from money to prices is generally the exchange rate in these small open economies, currency depreciations fuelled inflation. Thus, when central bank claims on banks increased by a factor of two or more, inflation generally accelerated by more than five percentage points in a one-year period and soared in systemic events.
Banking crises also inflicted lasting effects on monetary policy in a number of countries. In many cases, the recovery of assets pledged as collateral was significantly smaller than the value of the loans (plus interest) provided in the midst of the crises. With interest-bearing liabilities exceeding interest-bearing assets, central bank capital was eventually depleted. Therefore, monetary policy’s room for manoeuvre declined as central banks feared that fully implementing open market operations would further erode their already weak financial positions.
Following an alternative approach
From the previous analysis, it is clear that developing and emerging countries should not rely on central bank money if they need to tackle financial distress and crises. As opposed to what usually happens in mature markets when dealing with financial turmoil, central banks in emerging and developing countries should also care about internal and external stability as they typically face the risk of not only banking but also currency crises – the so-called twin crises (Kaminsky and Reinhart, 1999). In this environment, monetary policy must find a delicate balance. Central banks should provide financial assistance to troubled banks and simultaneously mop up excess systemic liquidity to maintain monetary control. However, interest rates should be sufficiently low to avoid damaging illiquid banks but high enough to stem possible runs on deposits and capital flights. This is particularly important in countries with financial dollarisation, where large exchange rate depreciations harm bank asset portfolios – as they hit unhedged borrowers – increasing the chances of a full-fledged banking crisis.
Thus, handling banking crises exclusively via monetary policy is restrictive and might not be effective. A broader strategy is required under the umbrella of a financial safety net that should comprise four mutually consistent pillars: (i) early corrective actions; (ii) provisos to conduct bank resolution and restructuring; (iii) deposit insurance; and (iv) central bank lender-of-last-resort provisions. Early corrective actions should have an undisputed legal support to empower regulators to impose timely remedial actions on financial institutions that are not observing prudential regulations, especially solvency requirements.
Countries should have the legal foundations and the necessary financial resources to implement bank resolution and restructuring in an orderly fashion. This is critical to enable them to close unviable banks without inducing further financial instability, while minimising the use of inflationary means. A well-designed and funded deposit insurance mechanism allows small depositors to be protected and to have them paid immediately – to prevent contagion – if a financial institution is closed. In turn, central banks should be empowered to provide limited short-term financial assistance to illiquid but solvent banks.
But, the golden rule in emerging and developing countries is to tackle banking crises at an early stage. In particular, it is critical to impose corrective actions before liquidity and capital shortages become chronic and implement bank resolution before the crisis gains momentum. Postponing a lasting response, especially the implementation of cost-effective resolution measures, generally exacerbates macroeconomic instability, risks systemic contagion, and elevates the cost of the crisis. The resulting macroeconomic effects may include a simultaneous currency crisis and even a sovereign debt crisis – in countries where high dollarisation also involves government debt (Ecuador in 1999, and Argentina and Uruguay in 2002). From a microeconomic perspective, a disorderly unravelling of the crisis may lead to the breach of financial contracts – like freezing deposits, reprogramming their maturities, and imposing capital controls – that undermines confidence in the banking system and weakens market discipline for years to come. In any case, governments and not central banks should assume directly the costs of crises. And when central banks initially bear the costs, they should be compensated by governments in order to restore their financial strength, thereby preserving central bank operational autonomy to exercise future monetary policy and credibly commit a to low and stable inflation.
I think dollar can worry less about “mopping up” liquidity for awhile yet, because the rest of planet can push around the liquidity.
The biggest problem I see right now: US defaulting on debt!
They really think the world will keep buying US government debt, when in fact it’s only temporary run to safe money from global equity implosion.
When global equity re-inflate again, It will sucks cash from US treasury bond. And THAT would be armageddon.
Let’s hope the entire planet will be in mild recession along with US, but if Asia is recovering first. It’s over. It will suck liquidity and capital like never before.
For now, investors are frantically stuffing money into the relative safety of the U.S. Treasury, which has come to serve as the world’s mattress in troubled times. Interest rates on Treasury bills have plummeted to historic lows, with some short-term investors literally giving the government money for free.
But about 40 percent of the debt held by private investors will mature in a year or less, according to Treasury officials. When those loans come due, the Treasury will have to borrow more money to repay them, even as it launches perhaps the most aggressive expansion of U.S. debt in modern history.
I can only agree with the VoxEU summary, as I’ve been saying similar things for a twelvemonth and more.
At the very least, it seems all but certain that the dollar will decline. The question is, in relation to what? The entire world has embarked upon simultaneous stimulative policies, with ultra low policy rates and gazillions in unsterilized injections. In this environment, we are beyond the event horizon of an entirely unprecedented global algae bloom of money.
Even supposing that we run into significant inflationary pressures in the US in the time fram of 12-36 months, which I would expect to be highly likely, the talk we hear about ‘Zimbabwe’ is inappropriate, because what is happening there is such an outlier. A situation more like, say, Brazil in the early 90s where the supermarket scanners had to be updated every couple of hours to keep up with the price increases would be more likely.
The oddest thing of all, though, is that real assets and physical capital may be the real items of value over the next five-ten years: paper assets seem likely to be severely impacted. So that house you own loses 35% of its value? Well your stock portfolio will, on historical comparables, lose 50+%, and your pension may take an inflation hit to single digits. Your house, your job, these may be your most durable assets.
I find it hard to understand the difference [as Richard Kline maintains] between a Zimbabwe kind of inflation, and one that requires the hourly updating of prices in Brazil.
Also, some, like Marc Faber have maintained for well over a year [& the gold bugs for decades] the eventual superiority of hard assets to currencies of any kind.
“When central bank money was intensively used, it constrained central banks’ ability to conduct an orderly monetary policy. As central bank claims on banks mounted, it became increasingly difficult for central banks to mop up liquidity and, hence, monetary aggregates exploded, leaving the economy without a nominal anchor to contain inflation.”
This is all as useful as crap when one attempts to apply it to the US. The Fed will have absolutely no problem in mopping up the excess liquidity it has created if, as, and when it decides to do so. If it’s not in the asset sale mode by that time, it has no problem in issuing interest paying liabilities in order to suck both excess reserves and an equal amount of broader money supply out of the system. It will continue to pay interest on reserves. And it has no problem in increasing the Fed funds rate when that needs to be done. The institutional capability is there in spades. And the institutional comparison with a place like the Dominican Republic is absurd.
Got gold? Get more.
I would be amazed if the US ever defaulted on its debt. The Fed will always “buy” any unsold Treasuries (effectively printing dollars). It has already embarked on this path with the $500bn purchase of the quasi-government debt of FNM and FRE. The US can do what Ecuador could not because the US has only borrowed in dollars – which it can print until its hearts content.
If Ecuador had its external debt denominated in sucres – then it too could have printed them – but it had a crisis because Ecuador cannot print dollars.
Richard points out that the dollar will decline – but there are precious few alternatives. Gold of course and currencies which are islands of semi-stability in a sea of instability (CAD, ZAR, SEK, AUD, NZD). The euro remains a big unknown. It could fail to a franco-german rump – or just as likely climb to the 65% of world reserve currency holdings which the dollar now reporesents.
Whatever happens we are entering a decade of macro-financial instability.
Monetary policy is a very blunt instrument. I think there is a real risk of unintended consequences. The most obvious one being a liquidity trap we can’t escape. The other is stagflation, which may occur if inflation due to money supply increase takes hold without the economy having recovered. As the ’70s taught us, inflation is not synonymous with full employment.
Richard Kline’s point about the possibility that real assets may be a better value over the long term than financial assets suggests an interesting point. Even if nominal money supply is increasing, real money supply can be decreasing. Of course, real economic activity decreases with real money supply. So while real assets may fall in real money terms and in nominal money terms it is likely that financial assets will fall further in real and nominal money terms. Conversely if nominal money supply is decreasing, real money supply can be increasing (it’s called deflation). Got it.
I have read during this mess that “inflation is bad”, “deflation is bad”, and “reflation is bad”?
At some point we have to move forward. From a point of view not including quantitative easing deflation is king. That is the point of capitalism, better product at a cheaper price. There is carnage with this reality but we all realize that this is the price of progress.
If American companies fail due to deflation (loss of jobs) we should be strong and accept this reality.
All great firms have strong control of their cost structures. These firms will survive deflation.
So the next time we here cowardly and negative themes for deflation we should shrug it off.
If you loose your firm or job, hunt for firms with better cost controls.
Lets keep moving forward.
Deflation is painful, especially to the privileged banker class that places leveraged bets on asset prices always going up, but it’s the fastest way out of our mess. The “deflationary spiral” is nonsense; so long as people walk the face of the earth they will trade with each other.
Printing money just means that the guys who get the printed money first (bankers) get first dibs on the redistribution of wealth which would have happened anyway.
Don’t expect to hear this from any mainstream commentator. Mike Shedlock is the only one who ‘gets it’.
“If Ecuador had its external debt denominated in sucres – then it too could have printed them – but it had a crisis because Ecuador cannot print dollars.” Why really cannot Ecuador print dollars. You don’t even need the paper and ink any more. All you need is to be skillful in setting up fraudulent accounts. How hard can that be? So the counterfeit dollars created by the FED are less likely to be a problem than counterfeit dollars created in areas in world less subject to US law. So why should we be concerned about this. If the goal is to increase liquidity then maybe we should be encouraging counterfeiting. So long as the counterfeit dollars are accepted in the market they are practically and pragmatically real dollars.
the TARP has not involved balance sheet clean ups or led to price discovery. Thus at this juncture it looks like an inefficient subsidy rather than progress towards shrinking and strengthening the banking system.
Banana republic, here we come?
Not necessarily. One thing that made a bad situation worse in Latin America was that as central bank balance sheets exploded, investors shifted to foreign country assets, leading to a significant fall in local currencies. Since many companies borrowed in dollars, the credit shock increased financial pressure.
Did Latin American countries have trillions in derivatives?
The real answer to this crisis is a Bank Holiday, Swedish Plan that will write off bad debt and rationalize derivatives in one form or another, whether it be creating markets or out and out prohibition and force de jure through a declared national financial emergency.
Of course the ultimate answer is a truly Public Central Bank that has the right, the authority and the obligation to control all credit creation and therefore a defined credit expansion limit.
Hmmm – what happens if you apply this analysis to the UK?
Looks like we have the twin crises in banking and currency. So is the UK a developing economy, or a mature economy?
The technology sector is unique in that it’s been operating in a deflationary mode for decades. Productivity and efficiency gains are so enormous, that existing capital erodes very quickly in value, and product prices decline _in the orders of magnitude_ if hedonistically adjusted. Maybe a vulgar example, but take a cassette Walkman of the early 90’s and a today’s iPod, compare the prices vs the features, and the deflation is astronomical.
And yet, the technology sector offers high-paying jobs and plenty of employment. It’s hard to pinpoint the reason for such ongoing vitality in the face of the fiercest competition known in history, but there it is.
Anon 2:13 – Guess what really got North Korea lumped into the Axis of Evil? Was it because they have several hundred thousand people in Nazi-style concentration camps? No. Was it their nuclear weapons programme? No (but it is a black mark).
The main reason is that they mastered the counterfeiting of US currency on an industrial scale. Now that really is NOT playing by the rules!
Injecting large amounts of central bank money to cope with banking crises has been a regular practice in Latin America, except in a handful of episodes. The intensive use of central bank money was mainly the result of inappropriate legislation that did not allow governments to address banking problems at an early stage.2 It also aimed at avoiding – or at least postponing in the short-term – the use of taxpayers’ money to finance the cost of resolving the crisis.
so jácome ‘neatly’ evades questions of historic context, of global trade and financial liberalization, of rent appropriation and supranational institutions such as imf and, so conveniently, plops responsibility for crises directly onto the region’s governments and central banks.
fine. Roberto Frenkel’s* slightly earlier article (8/2003):
Globalization and financial crises in Latin America complements and helps correct.
*”Senior Researcher, Centro de Estudios de Estado y Sociedad (CEDES), Professor at the University of Buenos Aires, Director of the Banco de la Provincia de Buenos Aires”
Yeah I recall that one of the bill of particulars against North Korea was the counterfeiting. The question now though, since US banks will apparently not lend, is why shouldn’t North Korea, Ecuador, Russia or whoever be encouraged to counterfeit dollars on a massive scale. It would certainly would be good for US exports. Didn’t the FED rather recently engage in multi billions (or was it multi trillions) of currency swaps with the ECB. Wasn’t that an inducement to counterfeiting by foreign banks?
Anon at 2:13
a great prescription to follow for the next credit creation bubble.
The Chinese and Japanese have slowed down their purchase of Treasuries, so the Fed is now BUYING T-Bills from the U.S. Treasury. i.e. We are buying our own debt, with fiat Fed money.
Its time to be very afraid.
The article is intellectually dishonest. The crisis in Latin America is caused by a sudden catastrophic devaluation of the local currency. Draw the chart again in US dollars and you’ll see the real picture.
Happy days are here again. Yves, thanks for posting link to the “Some Assembly Required” blog again. This time, I’ve book- marked. Insightful humor seems to be an important evolutionary device by which we humans can maintain hope that ethical reasoning may yet prevail.