The nuclear option: Will it work?

Économiste Monétaire

As people are probably aware, the Fed reduced its target on the federal funds rate, to between 0 and .25%, yesterday--purely a cosmetic change considering that the effective rate has been around .3% for the last month. So, we're now fully into a liquidity trap.

The option we're left with is the nuclear option, that being: quantitative easing. For the lurkers who have never heard this term, it's where the central bank prints of reams and reams of currency to buy assets, attempting to flood the economy with cash; MBS and long term Treasuries seem to be the most looked at option by the Fed, progressing from their POMO of the GSE short-term discos a few months ago (and the already announced fixed purchase of $150bn of MBS underwritten by the GSEs). The obvious problem is that, even with the very large increase in the monetary base, banks may not lend to the general public and businesses at the desirable level. This already occurred in Japan in the early 2000's. Banks there simply stocked the excess reserves in their reserve accounts at the central bank--they increased somewhere near 10 fold.

The way around this, at least partially, is to go Zimbabwe style, i.e. Debt monetization. Printing currency to pay for a government's deficits, somewhat circumventing the transmission mechanism. However, how will the government spend this: of a current nature? Capital nature? It may be months or years before the cash finds its way to the real economy, i.e. fiscal lags. There are also the obvious consequences of monetizing debt, that are already visible in Zimbabwe.

I would wonder if all this is an effort, by the student of history, to avoid Milton Friedman's ghost this Christmas? The memory of Great Depression Fed policy of Christmas past... A depression may be coming, according to some, most likely made worse by an inevitable amount of deleveraging. Just wondering what other people's thoughts are, really.

Rant over :pac:

cavedave

I don't understand whats going on. I don't believe anyone else does.
I also don't understand the liquidity trap and was going to ask here for an explanation. I think this thread may provide that anyway.

If you drop money out of helicopters there would seem to be a risk of Hyperinflation. Hyperinflation when deflation seems to be what everyone is predicting? Deflation came before hyperinflation in the weimar republic*



*evidence for this was supposed to be this picture http://4.bp.blogspot.com/_EZMGVwURo3M/SUYsg05Aw0I/AAAAAAAAAJE/CMvzg_rwrqc/s1600-h/inflation%5B1%5D-782970.jpg
but it is not appearing

Économiste Monétaire

cavedave wrote: »

I don't understand whats going on. I don't believe anyone else does.
I also don't understand the liquidity trap and was going to ask here for an explanation. I think this thread may provide that anyway.

If you drop money out of helicopters there would seem to be a risk of Hyperinflation. Hyperinflation when deflation seems to be what everyone is predicting? Deflation came before hyperinflation in the weimar republic*



*evidence for this was supposed to be this picture http://4.bp.blogspot.com/_EZMGVwURo3M/SUYsg05Aw0I/AAAAAAAAAJE/CMvzg_rwrqc/s1600-h/inflation%5B1%5D-782970.jpg
but it is not appearing

A liquidity trap is where reducing nominal interest rates fails to have any real effect on the economy. Banks won't lend out the excess reserves, maybe they don't have the capital to take the risk of businesses not repaying, and it becomes a self-reinforcing extreme event. Banks refuse to lend, businesses go bust, banks tighten credit further, et cetera. Banks will simply keep the excess reserves in their reserve accounts, rather than trying to restart the credit cycle. It's understandable from each bank's position, but it's not a socially optimal solution, so to speak :pac:

Hyper-inflation is a possibility if they go too far. What they're really trying to do is to keep the money supply increasing a steady rate, but are failing to do that with regular monetary policy because banks are effectively hoarding cash. The Weimar republic monetized debt because it was broke, the Fed is doing it because the transmission mechanism isn't working.

The real problem I have with the idea is that it will be difficult to get right, it's not as easy to mop up excess liquidity when/if this is all over, unlike when you simply lower rates for regular OMOs.

BenjAii

I wanted to vote for no1 and no3 in that poll.

Here is a couple of links to articles in The FT I've found useful in gaining some understanding of this issue.

http://blogs.ft.com/maverecon/2008/12/confessions-of-a-crass-keynesian/#more-387

http://www.ft.com/cms/s/0/d049482c-cb8f-11dd-ba02-000077b07658.html

Broadly speaking they both advocate the view that something has to be done despite the risk of high inflation, but point out The Fed has tools at it's disposal to mop up these extra inflation causing dollars after the current recession.

As the basic problem at hand is banks & investors reluctance to lend/invest, I'm surprised there are not calls for more creative ways of solving this problem.

Temporary tax breaks for different types of direct investments ? Might be a start in encouraging some activity.

defiantshrimp

Économiste Monétaire wrote: »

The real problem I have with the idea is that it will be difficult to get right, it's not as easy to mop up excess liquidity when/if this is all over, unlike when you simply lower rates for regular OMOs.

I agree it could overshoot. But you also have to look at the dramatic costs that deflation would bring versus the potential less dramatic (though still sizable) costs high inflation would bring. My guess is that the banks will take a while to fix themselves and thus the money multiplier will tend to increase slowly over time, hopefully allowing any excess liquidity to be mopped up.

On the bright side of things the CBs around the world seem to be a lot quicker to respond than that BoJ was in the 90s. That could of course just be a reflection of how bad things are.

Économiste Monétaire

BenjAii wrote: »

I wanted to vote for no1 and no3 in that poll.

Here is a couple of links to articles in The FT I've found useful in gaining some understanding of this issue.

http://blogs.ft.com/maverecon/2008/12/confessions-of-a-crass-keynesian/#more-387

http://www.ft.com/cms/s/0/d049482c-cb8f-11dd-ba02-000077b07658.html

Broadly speaking they both advocate the view that something has to be done despite the risk of high inflation, but point out The Fed has tools at it's disposal to mop up these extra inflation causing dollars after the current recession.

As the basic problem at hand is banks & investors reluctance to lend/invest, I'm surprised there are not calls for more creative ways of solving this problem.

Temporary tax breaks for different types of direct investments ? Might be a start in encouraging some activity.

Good links. Tax breaks are on the fiscal arm of the solution, which should be used to complement the Fed's policy. How much the U.S. can afford to provide tax cuts (even temporary ones) is questionable from a fiscal responsibility standpoint. However, they can afford to borrow quite a bit more, and I have no doubt Obama will be looking to tap the huge demand for Treasuries and, effective, free money in the capital market. Tax breaks will get to the economy quicker than his infrastructure programme.

defiantshrimp wrote: »

I agree it could overshoot. But you also have to look at the dramatic costs that deflation would bring versus the potential less dramatic (though still sizable) costs high inflation would bring. My guess is that the banks will take a while to fix themselves and thus the money multiplier will tend to increase slowly over time, hopefully allowing any excess liquidity to be mopped up.

On the bright side of things the CBs around the world seem to be a lot quicker to respond than that BoJ was in the 90s. That could of course just be a reflection of how bad things are.

I agree that doing nothing will mean a definite Great Depression v. 2.0. Rather, I was just trying to look at possibly long-term implications of this, because it will be quite difficult not to overshoot (or undershoot, too). The CBs have reacted quicker; though, the ECB might need to be slightly more proactive, rather than reactive. Coordination has been quite good.

I wonder if it will be a creeping policy of injecting so much every month, or in good American tradition, some shock and awe. Increase the monetary base by, say, $1.5tn in a month? That should shake things up.

Digi_Tilmitt

I think it may be necessary for the fed to maintain quantitative easing for an extended period of time with lethargic economic activity. If they move further into government debt monetization it would likely hasten the recovery but runs the risk of triggering a significant amount of future inflation and/or asset price bubbles which there may not be the political will and/or means to control. In addition to that it would create dangerous incentives for the government to recklessly cut taxes and raise spending.

Basically from a monetary perspective I think they should do as the BoJ did. Undertake quantitative easing but resist pressure to monetise government debt. However given the large body of criticism from Bernanke and other academics that the BoJ's policies have received, I think it is likely he will go down the road of debt monetisation.

Also I think that without the removal of the bad assets from bank's balance sheets, a recovery will be very difficult. I think it was a mistake to change the TARP's focus from asset purchases to equity infusions. It has been clearly stated by a number of Japanese officials who worked towards resolving their problems in the 1990s and early 2000s, that the removal of bad assets from balance sheets was critical to economic recovery.

BenjAii

I think the effect of deflation on economies like the US or ours, where debt levels are very high, would be far more pernicious than it has been on Japan.

They after all are a nation of savers, for whom some at least, a period of deflation must look attractive as it increases the value of their investments.

Deflation for the US is a far bigger problem than it has been for Japan. The US is a nation of credit and indebtedness, both personal and corporate, so deflation grows the size of your debt.

Which leads to less spending/investment, more insolvencies, etc, etc in a self-accelerating deflation spiral, that could very well turn into a 1930's depression.

The Fed has no choice but to be far more aggressive than the BOJ ever was, the real nuclear option would be The Fed doing nothing.

SimpleSam06

A couple of things here; the USD is the de facto global currency, most large international trades are done in dollars, which means effectively that we are living in their Zimbabwe. This would somewhat mitigate the effect of printing reams of cash to the US, but wouldn't do the rest of the world any favours. Secondly the prospect of inflation or hyperinflation in the rest of the world is particularly frightening in view of the likelihood of wage stagnation - this is the fast track to being a third world country, where the basic neccessities are affordable, but things like electronics and cars are restricted to relatively few people.

silverharp

Good comments from all. I'll start off by saying you are watching financial history unfold before your eyes, your grandkids are gong to know about what happens over the next few years




EM wrote-I would wonder if all this is an effort, by the student of history, to avoid Milton Friedman's ghost this Christmas? The memory of Great Depression Fed policy of Christmas past... A depression may be coming, according to some, most likely made worse by an inevitable amount of deleveraging. Just wondering what other people's thoughts are, really.



Yep, the Fed has never been worried about inflation, it has always been about avoiding deflation. Can they stop it? I dont think so , on a global basis every country is going throw the kitchen sink at this so It is unlikely that the dollar will hyperinflate against other currencies as every other major currency is going to suffer the same macro issues.
The big mistakes that were made during the 30's which made the depression worse were trade barriers, price fixing and high taxes hopefully at least Ben and co know enough not to make these obvious mistakes again
Why wont the measures work? Incomes are falling , house prices need to fall to affordable levels. There are no rising asset prices to create leverage against. Individulas need to rebuilt their “balance sheets” & the past over investment in the consumer economy need to be restructured and written down.
One issue that doesnt get a big press is the age profile in the US , over the next few years the US is going to hit a peak in 44-54 year old, these are the peak spenders and buyers of stocks etc. This factor alone would guarantee a Japanese style slow down (which had demographic causes as well).

Flamed Diving

I have been harping on about this for ages, but I think that CB's should be aiding the more prudent banks to take-over the less prudent, taking some of the bad debt onto their balance sheets, if necessary. It will result in a more concentrated financial system (which will be more stable) and will remove most of the panic in the inter-bank markets. I feel that this move by The Fed will solve nothing. It may even make things worse.

silverharp

Flamed Diving wrote: »

I have been harping on about this for ages, but I think that CB's should be aiding the more prudent banks to take-over the less prudent, taking some of the bad debt onto their balance sheets, if necessary. It will result in a more concentrated financial system (which will be more stable) and will remove most of the panic in the inter-bank markets. I feel that this move by The Fed will solve nothing. It may even make things worse.

Its part of the recovery if the solution was more market oriented, here is a scenario for you, China and the soverign funds get together and create several new banks from scratch (better then investing in citibank for sure) with conservative lending standards and even some gold backing ;-) so depositers dont think their cash would be inflated away
It wouldnt create any new lending straight away however when the next business cycle kicks of maybe based on energy/renewables for example a large pool of savings would be available to deploy.
If we end up with some form of state ownership of banks the usual corruption will set in and the reserves will used to finance roads to nowhere

cavedave

Taiwan has started to treat its liquidity trap with vouchers.

If deflation effects Ireland what can be done? Interest rate changes:No. Vouchers: we'd buy Taiwanese Televisions so it would not really help. Increased Government spending? With current debt levels that might be tough we are already paying 1/4 more for our debt then Germany.

Deflation will happen here, simply the fact of having a much cheaper market on the same landmass is already causing price drops.

BenjAii

Flamed Diving wrote: »

It will result in a more concentrated financial system (which will be more stable)

So the next time huge mistakes and/or fraud happen (and there will be more next times) they happen on an even bigger scale as the affect of mega bank collapse reverberates around the global financial system.

Flamed Diving

BenjAii wrote: »

So the next time huge mistakes and/or fraud happen (and there will be more next times) they happen on an even bigger scale as the affect of mega bank collapse reverberates around the global financial system.

No. We had a more concentrated/regulated banking system between WWII and the 1970's, when the process of deregulation began to be rolled out. How many banking crises did we have in this period?

forkassed

Heres 2 folks that called the American economy downturn a couple of years in advance.

Peter Schiff & Ron Paul

http://www.youtube.com/watch?v=8PIEGK0IbA4

As for whether the Nuclear Option will work or not, i dont think anyone knows

BenjAii

Flamed Diving wrote: »

No. We had a more concentrated/regulated banking system between WWII and the 1970's, when the process of deregulation began to be rolled out. How many banking crises did we have in this period?

I agree more regulation/due diligence will have to be the order of the day, especially as we now have the issue of moral hazard with the precedent for unlimited taxpayer support of the banking sector.

Even if regulation functioned perfectly the argument against a few huge banks is the obvious one of monopolies & competition.

cavedave

There were a fair number of libertarians/ Aurstian economists who predicted this.

In reference to what to do now we are in this situation there is an analysis here of how Japan dealt with similar problems. This magazine is also libertarian.

SimpleSam06

cavedave wrote: »

There were a fair number of libertarians/ Aurstian economists who predicted this.

In fairness the cats and dogs in the street were predicting this. How bad is was going to be was one place where all the predictions fell short.

Économiste Monétaire

silverharp wrote: »

Good comments from all. I'll start off by saying you are watching financial history unfold before your eyes, your grandkids are gong to know about what happens over the next few years




EM wrote-I would wonder if all this is an effort, by the student of history, to avoid Milton Friedman's ghost this Christmas? The memory of Great Depression Fed policy of Christmas past... A depression may be coming, according to some, most likely made worse by an inevitable amount of deleveraging. Just wondering what other people's thoughts are, really.



Yep, the Fed has never been worried about inflation, it has always been about avoiding deflation. Can they stop it? I dont think so , on a global basis every country is going throw the kitchen sink at this so It is unlikely that the dollar will hyperinflate against other currencies as every other major currency is going to suffer the same macro issues.
The big mistakes that were made during the 30's which made the depression worse were trade barriers, price fixing and high taxes hopefully at least Ben and co know enough not to make these obvious mistakes again
Why wont the measures work? Incomes are falling , house prices need to fall to affordable levels. There are no rising asset prices to create leverage against. Individulas need to rebuilt their “balance sheets” & the past over investment in the consumer economy need to be restructured and written down.
One issue that doesnt get a big press is the age profile in the US , over the next few years the US is going to hit a peak in 44-54 year old, these are the peak spenders and buyers of stocks etc. This factor alone would guarantee a Japanese style slow down (which had demographic causes as well).

I don't think the Fed believes that it can avoid deflation (just look at the CPI figure for November), rather, in future will people remember policies that, in some way, dissipated the effects of depression/deflation; as opposed to the inaction of the 30s. That's a good point about the ageing population--something that Obama will hopefully respond to after years of inaction vis-a-vis social security. Protectionist policies always become popular in the U.S. when recession comes around, hopefully they'll hold off.

Thinking past this: if large scale inflation were to take hold, like that of the mid to late 70s and early 80s, would Obama hold steadfast, like Reagan, in support of Bernanke? I have a gut feeling that he wouldn't; I'm not entirely sure why. Although the Fed is in theory independent, it does require political support. We may be forced to go back to specific monetary targeting if the dragon re-awakens--which brings its own problems of greater interest rate uncertainty. (There's a new book out recently about the political unwillingness to tackle the inflationary problem of 3-4 decades ago.)

The ECB, today, announced a re-widening of the standing facilities to 200 basis points after late January, however we're not back to variable bid processes for MROs. Germany's outlook seems quite poor; we're lucky in that our problems have coincided with Germany's general economic problems, i.e. a country with a large weighting in any index and AWR/NAWR model in use by the ECB. The German HICP actually dropped lower than ours did, on a monthly basis, in November (the Euro 15 dropped 50 basis points in monthly HICP). Although, I just can't see Helicopter Trichet coming to fruition in the near-term, considering that nearly all of that drop is in energy, rather than the serious problem of asset price correction for Ireland and Spain. There is a possible upside in the long-term: maybe we are moving ever closer to convergence... But, I hazard in saying that As Zaraba says, some deflation is inevitable when correcting to a new level of agg demand. How bad it could/will get is up in the air , the ESRI didn't paint a pretty vision in its latest forecast.

Helicopter King on the other hand... Better-than-fair bet? :pac:

(Also, I probably should have made an amalgamated choice in the poll of 1 and 3. Whoops.)

silverharp

Économiste Monétaire wrote: »

Thinking past this: if large scale inflation were to take hold, like that of the mid to late 70s and early 80s, would Obama hold steadfast, like Reagan, in support of Bernanke? I have a gut feeling that he wouldn't; I'm not entirely sure why. Although the Fed is in theory independent, it does require political support. We may be forced to go back to specific monetary targeting if the dragon re-awakens--which brings its own problems of greater interest rate uncertainty. (There's a new book out recently about the political unwillingness to tackle the inflationary problem of 3-4 decades ago.)

The way I have understood inflation and the market is that at some point you come to a face off with the bond market. if the market was to view that the authorities effectively wanted to put an extra 0 on the currency , bond values would "deflate" very quickly which would create deflation faster then a central bank could create inflation. I dont know if this was a factor in the way Paulson dealt with the Chinese when Fannie and Freddy became inslovent. There primary concern seemed to be to look after the interest of the bond holders, was there an implied threat of dumping US bonds unless?

Économiste Monétaire

silverharp wrote: »

The way I have understood inflation and the market is that at some point you come to a face off with the bond market. if the market was to view that the authorities effectively wanted to put an extra 0 on the currency , bond values would "deflate" very quickly which would create deflation faster then a central bank could create inflation. I dont know if this was a factor in the way Paulson dealt with the Chinese when Fannie and Freddy became inslovent. There primary concern seemed to be to look after the interest of the bond holders, was there an implied threat of dumping US bonds unless?

That could force the hand of Obama to support anti-inflationary policy (financial pressure reminiscent of Britain and the threat to dump the Pound, and sterling bonds, over the Suez canal incident back in the 50s.) TIPS might become more appealing for China et al quite soon. Although, I doubt inflation would be on the scale of adding zeros; you're probably more pessimistic than I

silverharp

Économiste Monétaire wrote: »

That could force the hand of Obama to support anti-inflationary policy (financial pressure reminiscent of Britain and the threat to dump the Pound, and sterling bonds, over the Suez canal incident back in the 50s.) TIPS might become more appealing for China et al quite soon. Although, I doubt inflation would be on the scale of adding zeros; you're probably more pessimistic than I

I'm not expecting Hyperinflation in the US anything above 7%/10% would spook the market and they would be forced to pull back.
A bond trader last year put me on to the idea to look for the short end to drop in yield and eventually the long end to beakdown pricewise , he reckoned the best place to be invested was in 5 to 7 year bonds as it acted as a "fulcrum" on the curve.
It will be interesting to see if this happens as its the last asset class the Fed has been able to inflate. I cant see what asset will be rising in 09 to create credit against

Économiste Monétaire

Robert Lucas' WSJ piece about monetary policy was making the rounds yesterday--find it here.

Greg Mankiw's blog had a video on quantitative easing; it's worth a look for a basic outline of what will, hopefully, occur. Find it here. (I don't know if we can embed Vimeo videos here...) There are also some other videos there, about leveraging and such, for anyone who might be interested.

Found on the Irish Economy Blog; there's a piece on Bloomberg about a shift from fringe free market paradigm, to a more moderate approach, at the Chicago School, apparently :pac:. Read about it here.