Tag: liquidity

Boost the Money Supply, Raise Interest Rates

The rate of broad money growth (M3) in the United States is weak (see the accompanying chart).  The ultra-low federal funds rate (0.25%) has acted to keep a lid on broad money growth and, in turn, economic activity.  Yes, “low” interest rates imposed by the Fed are contributing to a credit crunch and anemic money growth.  But, wait.  This is counter-intuitive.  And if that’s not enough, it’s not what the textbooks tell us, either.

While the Fed has pumped huge quantities of so-called high powered money into the economy, the U.S. is paradoxically facing a credit crunch.  Banks have utilized their liquidity to pile up cash and accumulate government bonds and securities.  In contrast, bank loans have actually decreased since May 2008.  And since credit is a source of working capital for businesses, a credit crunch acts like a supply constraint on the economy.  Even though it appears as though the economy has loads of excess capacity, the supply-side of the economy is, in fact, constrained by the credit crunch.  It is not surprising, therefore, that the economy is not firing on all cylinders.

To understand why, in the Fed’s sea of liquidity, the economy is being held back by a credit crunch, we have to focus on the workings of the loan markets.  Retail bank lending involves making risky forward commitments.  A line of credit to a corporate client, for example, represents such a commitment.  The willingness of a bank to make such forward commitments depends, to a large extent, on a well-functioning interbank market – a market operating without counterparty risks and with positive interest rates.  With the availability of such a market, even illiquid (but solvent) banks can make forward commitments (loans) to their clients because they can cover their commitments by bidding for funds in the wholesale interbank market.

At present, the major problem facing the interbank market is what can be termed a zero-interest rate trap.  In a world in which the fed funds rate is close to zero, banks with excess reserves are reluctant to part with them for virtually no yield in the interbank market.  Accordingly, the interbank market has dried up – thanks for the Fed’s “zero” interest-rate policy.  And, with that, banks have been unwilling to scale up their forward loan commitments.

But, how can banks make money without making wholesale and/or retail loans?  Well, it’s easy and “risk free” to boot.  By holding the federal funds rate near zero, the Fed creates an opportunity for banks to borrow funds at virtually no cost and use them to purchase two-year U.S. Treasury notes which yield around 40 basis points.  That doesn’t sound like much.  But, considering that banks don’t have to hold capital against U.S. Treasuries, their positions in U.S. government securities can be leveraged to the moon.  Well, not really.  But, at a leverage ratio of 20, a bank can do quite well by playing the Treasury yield curve.

It’s time for the Fed to recognize market realities and raise the federal funds rate.  A higher fed funds rate would release the credit squeeze created by the Fed’s misguided “low” interest-rate policy.  If the Fed boosted the funds rate to 2%, the all-important broad money measure – M3 – would get a boost, and so would the slumping economy.

Bubbles, Uncertainty, and QE2

Within the Federal Reserve System, there is a tug of war over QE2 (2nd Quantitative Easing).  Some, mostly outside the system, are calling for $1 trillion-plus purchases of long-term bonds.  Within the Fed, there is little taste for purchases that large. I expect a compromise, with an initial purchase perhaps as low as $100 billion.

There is widespread doubt as to the efficacy of further purchases of long-term bonds. They will supply additional liquidity, but liquidity isn’t what is needed. Businesses and banks are suffering from fear and uncertainty: new taxes, new regulations, new mandates, and, for financial services, the uncertainty of the Dodd-Frank banking bill. 

Lower interest rates on long-term bonds will do nothing to diminish fear and uncertainty. Instead, QE2 will further inflate the bond bubble and the commodities bubbles.

Would Summers Be Any Worse than Bernanke?

As I have argued elsewhere, Bernanke’s record as both a Fed governor and Chair suggest we be better off with a new Fed Chair come January 2010, when Bernanke’s term as Chair expires. Outside of those who believe the bailouts have saved capitalism, two very reasonable arguments are put forth for keeping Bernanke at the helm:  1) in a time of crisis, the markets need certainty and dislike change; and 2) the alternatives, such as Larry Summers, would be worse.  Both these points have real merit, however I believe in both cases the pros of change outweigh the cons of staying the course with Bernanke.  I will save the “certainty” debate for another time, for now, let’s ask ourselves:  Would Summers really be any worse than Bernanke?

Before I make the case for Summers, I do want to make clear, President Obama, and the country, would best be served by a “Carter picks Volcker” type moment.  Go outside the Administration, go beyond the usual circle of easy-money, new Keynesians.  The Fed lacks creditability in two (at least two) important areas: bailouts and inflation.  And one doesn’t even need to go outside of the Federal Reserve System to find candidates.  Topping my list would be Jeff Lacker (Richmond Fed), Gary Stern (Minn Fed) and Charles Plosser (Philly Fed).  Any of these three know the workings of the Fed, have the respect of the Fed staff, and have taken strong positions on both “too big to fail” and easy money.  In the case of Gary Stern, it would seem especially appropriate, as his early warnings (see his 2004 book on bank bailouts) were largely ignored and dismissed.  If we want to reward and promote those who got it right, these guys are at the top of the list.

But let’s reasonably suppose that Obama wants someone close, someone he personally knows and will stick with tradition by picking a member of his own administration.  Without going into any detail, picking Romer would offer little substantial difference with keeping Bernanke.  The case for Summers is essentially that here is one instance where his enormous ego would be an asset.  One easily gets the sense that when Summers sits next to President Obama, Summers is thinking to himself just how lucky the President is to be sitting next to Larry Summers.  One can call Summers lots of things, starstruck is not one of them.  Given what we now need most in a Fed Chair is true independence, from especially the Administration but also from Congress, Summers is the only qualified economist close to the President who displays even the slightest streak of independent thinking.  Bernanke, in contrast, has endlessly pandered to the Administration and to Congressional Democrats.  Summers has been willing on occasion to actually defend the sanctity of contract (remember the debates over the AIG bonuses), a rarity on the Left, and more than Bernanke was willing to say.  

So forced to choose between Bernanke and Summers, the need for an independent Fed Chair willing to take on the Administration and Congress, when appropriate, makes Summers a far better choice.  That said, here’s to encouraging Obama go outside his comfort zone and pick someone who has the will to remove excess liquidity from the system before the next bubble gets going.