The Fed seems to be exhibiting a pretty bad case of “if all you have is a hammer, every problem looks like a nail” syndrome, particularly when it has (or perhaps more accurately, had) other tools at its disposal.
In case you somehow missed it, global markets got a bad case of deflation heebie jeebies over the last few days. Equity markets had shrugged off piss poor economic news during July, but continued rallying of bonds suggested slowdown fears were rising, and more often than not, bond markets lead equity markets in registering deterioration in economic fundamentals (while also registering some false positives). Yet more disappointing employment data, flat retail sales, unexpected growth in China’s trade surplus and in the US’s deficit (which implies GDP revisions downward), deepening consumer pessimism (and note this list isn’t complete) finally started weighing on markets.
The FOMC meeting was almost textbook “buy on rumor, sell on fact.” Analysts and investors were lobbying for some form of Fed action, and the step the Fed took, holding the line on balance sheet size and signaling concern, looked eminently reasonable if you buy into the “Daddy Fed can’t be too unresponsive” view of the world. Yet that move proved to be somehow not reassuring, and global financial markets fixated on Worries About Growth.
But the worry instead ought to be about debt. And we don’t mean sovereign debt, we mean the refusal to deal with a private sector debt overhang. The lesson of past financial crises is that cleaning up the bad debt on bank balance sheets is on the critical path as far as real recovery is concerned. And by the way, that isn’t merely for the benefit of the banks (although policy thinking does seem to revolve around them); it’s for the benefit of borrowers too. Letting bad debt fester means you have two dynamics going: one is that you get borrower collapse (bankruptcy of businesses and individuals), which if it occurs on a large enough scale, can then pull down affected business partners (banks, customers, suppliers) or to avoid that, you have zombie borrowers, ones who have defaulted, but the loans are not resolved. In Japan, it happened with corporate borrowers; in the US, we see it in residential mortgages, with banks not foreclosing on severely delinquent borrowers.
A Bloomberg story, taking up the current mood of pessimism, notes parallels between the Fed’s actions and failed policies of the Bank of Japan, with the US central bank predictably insisting that it isn’t following the Japanese playbook:
A policy that associates the Fed with the Bank of Japan’s unsuccessful strategy of expanding reserves poses a risk for U.S. central bankers, said Stephen Stanley, a former Fed researcher. Chairman Ben S. Bernanke has called Fed policy credit easing to differentiate it from Japan’s so-called quantitative easing from 2001 until 2006, which failed to spur bank lending in the world’s No. 2 economy….
The Bank of Japan kept its benchmark rate near zero as it used quantitative easing, becoming the first central bank in modern history to embark on the policy. The BOJ targeted the level of reserves and pumped trillions of yen in excess cash into the economy, trying to encourage bank lending to companies and beat deflation.
The policy failed because the BOJ’s funds sat static in commercial lenders’ accounts at the central bank, even though the target was increased by almost nine times to 35 trillion yen ($411 billion) by early 2004. The money didn’t spark business investment and consumption, and deflation plagued the economy through 2005.
The Fed, by comparison, is trying to lower borrowing costs by targeting the level and composition of assets it holds that correspond with bank reserves instead of the actual level of excess reserves, which totaled $1.01 trillion as of July 28.
Yves here. Can you see why this won’t work? The Fed’s implicit reasoning is that the BoJ didn’t shove money into the banking system in a way that would lead businesses to borrow, but the Fed has a better mousetrap. Huh? This is the loanable funds fallacy, that if you make money cheap enough, firms will borrow and invest.
But the cost of money is only one factor in a business’s decision to expand, and outside of financial firms, it’s typically a constraint, not a spur. If you run a dry cleaner, are you going to say, “Gee, my borrowing rate went down a point, I think I’ll open that new store”? The fall in the cost of money would change your action only if it was a critical factor, at the margin, and had restricted you. And for the vast majority of enterprises, the decision of whether to grow or not is based first and foremost on their reading of the environment, which includes the strength of the market for their services, the likelihood of competitor response, whether there are steps they can take to alleviate risk, like securing commitments from prospective customers or tying up critical technology or vendors. (Separately, the Fed has published a paper by Seth B. Carpenter and Selva Demiralp that challenges the existence of the money multiplier and thus disputes the logic of the FOMC’s recent program)
The underlying problem is overreliance on monetary policy, when what is needed is more aggressive measures to force resolution and restructuring of private sector debt, with stimulus to offset the downdraft of the resulting losses (note the losses really are there, but in a reverse Tinker Bell syndrome, if we all quit clapping, the economy might die). But we instead wrote large, close to blank checks to big banks, and provided them with even more backdoor subsidies, and voters have lost patience with fiscal deficits, even if we might finally be getting around to more deserving and useful targets.
Unfortunately, as Financial Times columnist Samuel Brittain reminded us recently, there has been “a shift from an excessive preoccupation by central banks with financial institutions to the other extreme of their becoming virtual econometrics factories.” And that puts them at an even further remove from an operational grasp of how the real economy works.