Friday, August 13, 2010

Has Monetary Policy Jumped the Shark?

(Sorry for the long absence. But look! A new design! Thank you, point-and-click Blogger templates.)

The last week has been a rough one for the economy and financial markets, and those that love them...or are paid to watch/analyze/capitalize on them. Last Friday's jobs report showed that employment growth has slowed, and the Fed has taken this and other recent indicators as a sign that more needs to be done. In their most recent statement, the members of the FOMC directed the New York Fed to maintain the present level of the Fed's securities holdings by reinvesting principal payments from existing holdings. Not too aggressive, but also more monetary stimulus than was previously being supplied.

For the likes of Paul Krugman, the Fed's paralysis with regard to continued aggressive intervention is reason to get apoplectic. But for perennial FOMC dissenter Thomas Hoenig of the Kansas City Fed, the central bank has already besieged the economic recession with necessarily excessive force, only to find its true enemies (leverage, too-big-to-fail) still standing tall. What's more, he argues that continued stimulus will only aggravate the kinds of debt and risk-taking distortions that prompted the recent financial crisis. Which economist is correct?

First, it's useful to think about what securities purchases by the Fed accomplish. Quite simply, they supply additional loanable funds to the Treasury and Agency MBS markets. Holding the demand for these assets by other investors constant, interest rates on these securities will fall. (Sorry to mix supply and demand here. The supply of loanable funds is the same as saying "demand for these securities".) The hope is that by lowering the yield on the safest non-cash assets, investors who want to take any risk or earn any yield will be forced to look into other asset classes, such as stocks and corporate bonds. If this occurs, funds flow more bountifully to the private sector, and the economy (fingers crossed) heals itself as individuals flock to cheaper mortgages and businesses turn others' savings into productive investments.

The problem, though, is that this strategy -- and the Fed's monetary policy transmission mechanism, generally -- relies primarily on a steady or higher level of overall debt in the system if it is to work quickly.
  • Businesses: With a lower cost-of-capital, projects that had previously not been economically viable may suddenly look profitable. Banks or investors lend them funds, which are used to buy equipment and materials, and to hire employees.
  • Individuals: Lower interest rates persuade would-be homeowners to buy homes, stimulating demand for a larger housing supply (oops, looks like we already have enough of that!) and pushing up home values and property-owner wealth in regional markets. Existing homeowners choose to refinance their home or borrow against the equity they have (oops, where did all that go?) and use the cash they save to consume more.
For individuals, lower borrowing rates aren't going to do much. The housing bust has put serious downward pressure on their homes' values, so their net worth has similarly declined. They're not looking to take on more debt, and banks aren't looking to give them more. Those homeowners who still could have refinanced at lower rates (and those first-time buyers interested in a mortgage) would have refinanced, and probably did, over the last 18 months when rates were at historic lows.

Businesses could save the day, but a lot of them already have large debt loads from the 2004-2007 credit bubble. If a debt-swaddled company is lucky enough to find more credit, it can either (a) use the funds to invest in a new project, or (b) refinance existing debt. If it opts for (a), it further leverages the company at a time when future earnings are uncertain at best: where's the demand going to come from? Consumers are hunkered down trying to cut their expenses and debt burdens. (Note that this is a problem for all companies, including those with healthy balance sheets.) If instead the company refinances old debt, then nothing really happens immediately. Lower interest payments mean that future profits will be higher, ceteris paribus, but those are future profits. They don't help the economy much now, though they may slightly boost the company's equity value. However, if the projects don't pan out, or if the company is actually already too indebted and the refinancing just prolongs its inevitable bankruptcy/restructuring, then the new debt actually just draws out our economic pain.

Finally, the banks. Many financial institutions are still sick (or recovering) from the toxicity of their loan and securities portfolios. As long as individuals and businesses are too heavily indebted to carry on normally in this macroeconomic environment, banks will remain risk-averse. If they behave responsibly, the uncertain economy will prompt risk premiums that wipe out the lower levels seen in the funding markets. And if the economic cycle worsens, the banks' funding costs themselves will rise for those institutions that use interbank funding and capital markets.

The point is that the Fed's transmission mechanism, which uses equilibrium levels in debt markets to nudge all other financial markets and transactions, cannot account for the stock of debt already outstanding in the national economy, which dwarfs levels seen historically. As long as individuals are too indebted to borrow more or consume like they did during those inglorious years past, businesses will be unable to count on strong earnings to justify new projects. And businesses themselves that gorged too heavily on cheap credit will have to forgo new borrowing for new projects, go bankrupt, or slowly pay down their debt, which means fewer resources dedicated to new consumption or investment.

What can the Fed do? At this point, not much. Its low rates probably helped still-financially-viable companies and homeowners refinance their debts, but the scale of over-indebtedness in the economy remains too great for these cash infusions to have an effect that creates enough jobs and investment opportunities to lift us out of low growth or even continued recession. I'm afraid we've already seen the most creative and useful brand of Fed policymaking, and that it will fall to fiscal actors to splurge for direct, immediate intervention (or not) while the bankruptcy lawyers and FDIC receivers slowly extricate us from this colossal mess. Paul Krugman may be right that it's too soon to tighten monetary policy. And Thomas Hoenig may be right to say that economic salvation won't come from low interest rates. But neither leaves us with a clear sense of what the Fed can do if things get worse, or stay, miserably, the same.

UPDATE (Monday, August 16)
On the related note of global imbalances and fiscal intervention vs. austerity, I recommend checking out Paul McCulley's most recent "Global Central Bank Focus" article.

UPDATE II (Monday, August 16)
Also, I just found this very creative post by Steve Randy Waldman today at interfluidity that contemplates various alternatives to traditional Fed policy. Like me, Waldman is concerned that modern monetary policy tools lean too heavily on capital markets and asset pricing, which not only has the effect of promoting asset price bubbles and bursts, but also favors capital over labor. Before you drop the s-word, note that this is relevant to the efficiency of the transmission mechanism as well as politics. Waldman says that central banks could use direct cash transfers to individuals (not reserves invested in fixed-income assets, as is currently the case) to strengthen worker influence while rendering unions less relevant:

That we’ve spent 40 years increasing the bargaining power of capital over labor doesn’t make it “fair”, or good economics. Supplementary incomes are a cleaner way of increasing labor bargaining power than unionization. Unionization forces collective bargaining, which leads to one-size-fits-all work rules and inflexible hiring, firing, and promotion policies, in addition to higher wages. If workers have supplementary incomes, employment arrangements can be negotiated on terms specific to individuals and business circumstances, but outcomes will be more favorable to workers than they would have been absent an income to fall back upon.
I highly recommend this post. It represents a step forward in finding new policy levers that move away from the ambiguities of effectiveness, causality, and fairness in the Fed's traditional tools.

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