Tuesday, September 20, 2011

When the Lender of Last Resort Fails


Charlie only had one life jacket on his pontoon boat. Pete fell overboard and Charlie thought about throwing it to him but then realized that if he did, he would no longer have one for himself.  Being a true friend he threw it to him but unfortunately Pete went over the falls anyway – life jacket and all. Then Charlie noticed the leak in the boat.

I studied a lot of macro but I never got to the chapter that says what happens when the lender of last resort fails.  It is a widely shared view that the Fed has the right and the privilege to be the lender of last resort. So if the US economy is sinking and sinking badly, the Fed is supposed to use monetary policy to keep us all from drowning. We saw the lender of last resort activity in the last couple of years. Now the Fed has announced that it will be the lender of last resort for French and other European banks.

It all sounds pretty rational. Economic systems are prone to boom and bust cycles. We think we learned from the Great Depression and from other financial crises that monetary policy should play a stabilizing role. But one thing we didn’t learn is what happens when the central bank plays the role of lender of last resort and they fail. That is, Pete goes over the waterfall and there are no life jackets left. What now?

If there will be a lesson to be learned from the present global financial crisis it will be that central banks really did play their lender as last resort roles. Europeans often bemoan the fact that the European Central Bank did not bail out Greece and other countries fast enough or with enough gusto, but even the ECB has come forth with plenty of cash. Now the FED, ECB, and a few other central banks are printing money to help key European banks get enough dollars. There is enough money out there to sink a very large boat.

What is reassuring to some folks and frightening to others is that the lender of last resort role has no finite amount of ammunition. Unlike Charlie’s life jacket, the Fed has plenty of bullets. Why? Because modern central banks can print money whenever they want.  It is virtually costless to pump out another $100 billion. The problem is not so much the number of bullets – it is their impact. Maybe we should be using pharma as our example. Mike has a headache. Give him a couple of aspirins. Mike still has a headache. Give him a few more aspirins. The truth is that Mike has a headache because is wearing the wrong size undershorts. Aspirin isn’t going to help. Mike needs a bigger thong.

When the Fed was doling out all that dough last year did it ever wonder what would be left for them to do in a double dip? I don’t know what goes on behind those gold laden walls, but I didn’t hear much on this topic. And their seeming unflagging duty to pour in even more money recently suggests that the thought has not even entered their minds.  If one tranche wasn’t enough try two. If two wasn’t enough try three. It’s just math. It’s math at least until you realize that more and more aspirin in going to give Mike a bad stomach problem to complicate his undershorts issue. 

So there are two points to cover. First, why didn’t the earlier money expansions work? Second, why are they creating even worst problems as a result of the monetary addiction? The first part is easy. Monetary stimulus (and fiscal stimulus) do not address the most pressing problems. The causes of the Wall and Main Street problems were financial – too much leverage on top of two much leverage.  Very little has been done to solve those problems because politicians don’t have the guts to tell people there is no easy way out of that dilemma. So they prefer to drag us through a decade of horrible economic malaise instead. Don’t rip off the band-aid. Pull it off a little at a time. Only a politician would do this. Doctors don’t get paid for being popular. They rip off band-aids with fervor and sometimes glee. Our politicians use money as a drug to counter some of the negative side-effects of the slow band-aid pull.

So the answer to question 1 is simple – politicians give us money instead of real solutions. The second question is more interesting. Okay – so we slowly bleed for a while. Isn’t that better than the intense pain of a quick solution? I think the answer is no. Here are five why.

Reason #1. Weakening the economy for a long time makes it very sensitive to every economic virus that goes around. A strong patient bounces back from the flu quickly. The weak one may not survive. What economic shocks are around the corner? Clearly whether it is a jolt in energy prices or a spike in food prices after flooding, the economy will adjust more slowly and with less elasticity. This is very risky behavior!

Reason #2. Keynes was very specific in his book the General Theory that when credit markets lack confidence, the impact of monetary policy on output and employment all but disappears. There may still be a few people around who trust Bernanke, but as more and more money seems to work less and less, we are getting closer and closer to Keynes’ liquidity trap wherein money is totally useless to stimulate the economy.

Reason #3. The low interest rate environment just compounds our problems. So long as people cannot get decent returns on assets they will pressure financial institutions to innovate and create ways for them to take higher risk and get high returns. Banks would rather facilitate this madness than loan money to entrepreneurs. Isn’t it interesting that the Fed says they are saving us yet what they are really doing is engineering a repeat of the past financial crisis! Why does the Fed want to perpetuate leverage and risky investments? This could mean more downgrades and another financial crisis

Reason #4. All this focus on monetary policy diverts our attention away from reforms that would regulate the most egregious factors in the housing and financial markets. It is true that the positive effects of these kinds of policies will be slow in coming. But the longer you wait, the more the problems fester. The more the problem festers the more we raise the probability that a new shock will throw us for a loop.  

Reason# 5.The Fed has discounted an increase in inflation despite the fact that most indicators and expectations measures show it is bubbling below the surface. Despite all this economic sluggishness and large and persistent excess capacity, the psychological link between money and inflation remains as strong as ever. Inflation will not simply rise gradually. At some point it will explode. When it does it will be too late for the Fed to reverse engines. Bernanke stares at the cameras and solemnly says for us to trust him. The Fed is a very modern and scientific institution. When the economy recovers and inflation begins to be a larger threat, the Fed with utmost precision will remove money in the perfect amounts that will guarantee growth in output with stable inflation. Woowee. And if you believe that have I got a bridge to sell you!

In short, the Fed is entering uncharted waters. They seem to see no end and no risk to their policy of lender of last resort. They REALLY need to think about this some more. It is a very dangerous game they are playing with our jobs and welfare.  

13 comments:

  1. Prof, how did you know about my headache and stomach problem, & why have you been snooping in my underwear drawer...again? I had to read that "thong" remark about 5 times. I thought that maybe you had put on "o" where an "i" should have been.

    You know my feelings about central banks and particularly the Fed. That issue is the only thing I really admire about Andy Jackson. Actually, Greenspan did a fairly credible job as the Fed chairman all those years. But, as you said, the Fed's true function has been misused and abused. Which leads me to the other thing about which you know my feelings, and that is that "we the people" are collectively dumber than a defensive tackle when it comes to economics. I tried to explain hyperinflation to an individual who is a college grad with a modicum of exposure to Econ 101/102. The expression on his face resembled that of a porcine creature gazing upon a wrist-bound time piece. Hey, there's an unlimited supply of paper and ink, and those printing presses can run 24/7/365. When I mentioned Keynes, his response was something akin to "Why are you bringing up walking sticks?" The preferred observation seems to be "There's plenty of money. Why can't we spend another $450B to grow jobs?"

    We are our own worst enemy.

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  2. Love the slow band aid pull analogy. But think about it rationally, would you vote to re-elect the doctor who almost took ur arm away in pulling the band aid off even though it means ur kids will have a better life???
    I think there are very few of us who's that large hearted.

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  3. Dear Ban,

    Good point. Intergenerational transfer is part of the dilemma. But those of us who plan to live at least a few years into the future, it is rational to have a quick pull. Most of us have enough years to live and can tolerat a government that uses common sense rather than populism. Slow pull means I would live with bad reasults too long. Also, I like my kids too.

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  4. Dear Al,

    You are not the only Al in the world. I profess to know nothing about your underware situation. :-)

    As for economic ignorance, that is what has kept me in business for the last 40 years. Luckily I never get bored talking and writing about econ and I figure it is a great challenge to try to help people understnad these issues. On a bad day I wonder if the effort is worth it. But then, what would I do if I just gave up?

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  5. Mr. LSD. Thanks again for a very concise and clear explanation/insight into the latest financial fiasco. So, what happens when all the liquidity (U.S. and European) meets pent-up demand (assuming unemployment ever decreases . . . )? Sort of like Godzilla meets King Kong? Hm-m-m-m-m, let’s fantasize about what music is playing during this mega conflict musical chairs when it stops . . . will it be Brahms' Lullaby, Janis Joplin’s (Take Another) Piece of My Heart, or Berry McGuire’s Eve of Destruction? How about “Can’t Buy Me Love” but I duz luv more (printed) money!

    Looks like a repeat of the Nixon/Burns situation 1970-71 where Nixon acquiesced Burns’ expansion of money supply to avoid a/more recession, but eventually lead to price/wage controls (hey, hey . . . another temporary fix that lasted to Phase III, ending in 1974 after 3 years . . . ). Inflation increased nonetheless ( . . . and in large part to exiting the gold standard).

    Excepting the gold standard, today mirrors much of what transpired then – increasing the money supply to ward off unemployment (but not inflation?). History repeating itself? Although Nixon/Burns/Connally pursued the slow band aid approach to avoid recession/high(er) unemployment , they didn’t have the housing/financial crises we have now . . . . their situation was different . . . a run on (U.S.-held) gold by Euro countries to offset their own inflation and expanding trade surpluses with the U.S. Now we’ve got not only the U.S. economic/financial situation but also the Euro Zone. Still a domestic and international situation. Hm-m-m-m-m, a tough situation for Big Ben, eh, being in uncharted waters, as some macro-guru-man said, once. Do you think Big Ben can hum the tune, “Twist” (and Shout)? today letting long-term bond rates drop down to almost negative territory hoping (no, fantasizing) that that will “stimmilate” some spurt of growth and generate ‘bout 350,000 (new) jobs next 3-5 years?

    So, macro-guru-man poignantly says “ . . . .politicians give us money instead of real solutions.” Yepper, fer shure. Tippin’ me hat to macro-guru-man, there ain’t no quick fix. But, on the positive side, me thinks history will repeat . . . Jimmy Carter couldn’t handle the hyper-inflation his predecessor gave him ( . . . can you say it was Bush’s fault??? ) and Obummer can’t/won’t escape the hand cuffs even Big Ben can’t find the key for.

    Clue: When all the fiat money can’t buy us love, will we find enjoyment in learning the winner of Godzilla meets King Kong?

    Epilogue: Pete thanks Charlie for the life vest --- it allowed him to fall the falls and still keep hold of his Stoli . . . . without spilling a drop . . . .

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  6. Dear Charles,

    Glad to hear that Pete and Charlie lived happily ever after. Thanks for all the kudos and good points. I would say there will be one difference between the good old days you mentioned and those coming. In the good old days it was still possible to fool the public and therefore the stimulus seemed to work -- and then the inflation came. In our present situation I believe the stimulus will not work to strengthen the economy and instead precipitate further financial problems. I don't see the inflation coming very soon. What I see is more money, no ooompf, and then a big financial bang. I used to say that Bernanke was playing with a wet firecracker. Now I believe he is about to set off a nuclear weapon.

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  7. And I quote"

    BOSTON (TheStreet) -- Oliver Pursche, manager of the GMG Defensive Beta Fund(MPDAX_), says the Federal Reserve's "Operation Twist" plan should instead be called "The Kardashian."

    "The idea came from seeing my wife read a magazine article about Kim Kardashian," Pursche says, referring to the reality-TV star of "Keeping Up With the Kardashians." "She's inexplicably popular, fairly useless and all about the back end. And that sums up Operation Twist pretty well."

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  8. The market really seems to love Operation Twist.

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  9. Dear Macro-poignant-guru man. ‘splain please, since I’m prone to press a point pointedlyless . . . . How can there not be (impending) inflation with all the money “released” ( . . . er, I mean, printed . . . ) at us (yet still recessing on the pot . . . er, I mean, dormant . . . on the sidelines as if in timeout . . . waiting for the yard markers to reset . . . . ) only to be suddenly called onto the field to do what money is supposed to do? The only catalyst I’m aware of (per the other econ-guru talking heads) that would release the inflation Godzilla is reduced unemployment that would pressure up wages . . . which, according to recent GDP/growth projections will take years at current meager job creation rates. Is that your basis for saying the inflation Godzilla is not on the horizon . . . very soon? Is the Big Ben nuclear weapon to which you refer the title match betwixt Godzilla and King Kong? If so, I guess the match will be globally available – free at your local cable TV – or at Home Depot, your grocery store, dentist, dry cleaner, or . . . oh, no . . . your liquor store. But, I didn’t read that inflation is not . . . not . . . on the horizon.

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  10. Oh Great Tuna of the Starkist,

    The statistical relationship between the supply of money and inflation has always been a tricky thing to estimate. While the long run impact of a 1% rise in money will be a 1% rise in inflation, the way the increase is distributed over time is highly variable. This is another way of saying that it might take some time before inflation shows its ugly head. What I was saying in the above comment is that I believe that any additional monetary increase piled on top of previous ones will be explosive. While I agree that the eventual impact will show up in inflation, I think the special circumstances of today imply that the most immediate consequences will be in declining financial markets. Just the announcement of more money should weaken our markets for stocks and bonds and other financial instruments. That was my main reason for writing the post -- what happens when the lender of last resort fails yet keeps on trying!

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  11. Thank you again for an entertaining (in a horror movie kind of way) blog post about how the US Govt and the Fed are just making matters worse.

    I only have a MBA level of econ knowledge, so maybe I could be included in the dumb masses category, but I had a question regarding your statement that politicians just give us money instead of solutions.

    What I remember from my MBA Macro class is that the more independent a country's central bank is from its government, the more financial stable and economically sound the country will be. I seem to remember the US was ranked rather highly. Are you saying that Ben and the Fed are just bowing to political pressure and firing up the printing press? Or am a so naive as to have believed the ranking of country/central bank independence. Maybe I still believe in the tooth fairy as well. Oh wait, the tooth fairy is the US government/Central Bank that keeps putting money under my pillow!?! No wonder candy keeps getting more expensive.

    I understand that the US and most developed economies are no where near the likes of the Zimbabwe's or Argentina's of the past. So I'm not really worried about hyperinflation in the US and Eurozone, or should I be?

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  12. Good points Brad. Your MBA education must have been a good one! Yes, Bernanke is in cahoots with Geithner more closely than I can remember ever in the US. Bernanke has done more in a few years to disparage the notion of an independent central bank than anyone I know. His recent actions suggest this will continue for the foreseeable future. With respect to inflation, my last post was basically saying that the bigger likelihood is that the monetization will lead to a financial collapse -- not immediate higher inflation. We could be at least a year or two away from any real inflation threat.

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  13. http://finance.townhall.com/columnists/peterschiff/2011/09/25/arranging_the_deck_chairs_on_qe3

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