Economics 18: deflation, regulation and unconventional monetary policy
by George Hatjoullis
Deflation is the structural expectation of falling prices. One behavioral consequence is that economic agents are predisposed to hold money, or near money, rather than ‘real’ assets. It is important to note that it is the sustained expectation of falling prices that is the essence of deflation and not the extent of measured price falls. A condition for a deflation to persist is that economic agents cannot satisfy their demand for money balances. Money is created by the banking system through the extension of credit. Deflation is thus linked to the ability and willingness of the banking system to create money. The central banks can encourage the banks to expand credit but they cannot force them to do so. Deflation, or rather the fear deflation, is a prominent headline in the press of late. Frustration with bank lending growth is also evident from politicians and central bankers. However, regulators do not share this frustration.
Regulators are concerned with the integrity and stability of the financial system. The sensitivity of the system to shocks is inextricably linked to the degree of leverage in the system. Regulators everywhere seem concerned to reduce leverage. The preferred method of reducing leverage is to increase the equity allocated to financial activities. Banks are leveraged institutions and much regulatory activity has been directed at reducing and controlling the degree of leverage within the system. This can be done by increasing bank capital and/or reducing the size of bank balance sheets. Money is nothing more than the liability of a bank so if banks choose to meet regulatory leverage restrictions by reducing their balance sheet, rather than raising capital, then the stock of bank money does not grow as fast as it might. At a time of deflation concern this would be a disconcerting situation.
Leverage makes the system sensitive to shocks but is not the of cause crises. The system needs to be ‘shocked’ for a crisis to emerge. The conventional wisdom is that certain assets are more prone to disappoint and thus should require a greater equity capital buffer. Hence a loan from a bank to a small business needs a larger capital buffer than a loan to the state of the jurisdiction in which the bank operates. The small business is historically more likely to default than the state. The bank naturally wishes to achieve the same risk-adjusted return on equity employed from all lending activities which is why it charges small businesses more for loans than governments (as a rule). Importantly, if it cannot charge small businesses enough to make them equivalent (risk and equity adjusted) to loans to governments it will logically not lend as much to small businesses as it might have. The regulator influences the structure of a banks balance sheet through the capital it requires banks to hold against various classes of assets.
The central bank may have a regulatory role in some jurisdictions but its prime function is to determine the stock of money. It does so in normal circumstances by determining the price of money balances or the rate of interest. The precise mechanics vary across jurisdictions but the essential tool is the cost of acquiring central bank money by the banks. This establishes the basic interest rate from which all other rates flow. If the CB wants to contract the money supply it raises this CB determined interest rate and this raises all other rates. This reduces the demand for credit and contracts the supply of bank money. This seems to work well enough for reducing the demand for credit but runs into a problem when the desire is to increase the demand for credit. What if the CB determined interest rate is at or close to zero and the stock of bank money is still not growing fast enough to ward off deflation?
This is the situation that has confronted the Bank of Japan for years. It confronted virtually all central banks after August 2007 and still concerns the major central banks. The banks were essentially offered access to reserves at zero cost but were still reluctant to lend. The reasons are complex but the attempt by the regulator to reduce leverage was likely a factor. Frustrated by the reluctance and/or inability of banks to expand bank money, the CBs embarked upon unconventional policy initiatives. They all eschewed the most obvious and most effective, namely deficit financing, partly because it is taboo and partly because it is typically illegal. The most popular was the next best thing, which was to buy government debt in the secondary market (referred to as quantitative easing or QE). The action lowered the yield on these assets to below what it might have been and encouraged investors to hold other, more risky assets. Banks are typically large holders of such bonds and by removing them from circulation and lowering the yield it was hoped the banks would seeks other assets such as risky loans. The policy does not seem to have been very effective. The growth of bank money is still lackluster and deflation is still a concern.
The problem was largely the disinclination of banks to take on capital-demanding risky assets. The cost of funding was so low that they could still earn a return holding government bonds and they did so rather than lend to small businesses. The situation has eased in some jurisdictions but even the UK has finally hit its inflation target! UK inflation has typically been above target since 2004. After several years of QE it has fallen to 2%. This is a worrying sign for the deflation outlook. The US Federal Reserve has begun the process of exit from the QE programme but it remains anxious about the state of inflation expectations. In Europe the concern has reached levels that is eliciting truly unconventional monetary policy ideas.
On January 26, 2014, the Financial Times (http://on.ft.com/1ljgNeF) published a story suggesting that Mario Draghi, the President of the ECB, would consider buying securitized bank loans if necessary. The idea did not elicit much comment but it should have. This is quite unconventional and indicative of the serious situation confronting the ECB within the eurozone. The implication is that the eurozone banking system is unable/unwilling to raise further capital. The purchase of loans by the ECB would free up eurozone bank capital and enable them to initiate new loans. It is tantamount to the CB lending directly to the private sector. The ECB cannot by law lend directly to states but can, it seems, lend directly to households. The suggestion begs many questions, not the least about the quality of the loans the ECB would purchase, but it is innovative. It is also an indication of concern.
The central banks are confronted with an unusual dilemma. In the eurozone it is particularly complex. Deflation is a concern (and a reality in some eurozone states) but banks are not creating enough bank money. In part this reflects regulation and the uncertainty created by the continuing efforts to construct a eurozone/EU regulatory framework (banking union). The eurozone banks wish to de-leverage by shedding assets (the implication of Draghi’s observation) so bank money growth will remain challenging. The situation in the eurozone is so serious that the President of the CB publicly discusses directly financing households and corporations. In this context the banks become originators of loans rather than principals.
The Draghi observation may never become a reality but it does highlight the extent of the present problem. In many ways the eurozone situation is reminiscent of the Japan bank crisis of the early 1990s. The banks failed to de-leverage and bank money growth did not keep up with demand. Deflation was the inevitable outcome and has persisted. It is only now with Abeconomics that the situation in Japan is being addressed and this too may fail without some even more remarkable and unconventional monetary policy initiatives (deficit financing).
For the foreseeable future, global banking systems will continue to struggle to create bank money. The recent crisis has had a profound and as yet not fully apparent impact on banking culture and practice. Banks will henceforth err on the side of over-capitalisation and will be very sensitive to the risk-adjusted return on equity from assets. The regulator will have a big influence on the shape of the balance sheet of the banking system through capital requirements. Banks will no longer be compliant vehicles for government policies even in countries in which this practice has a long tradition. States may need to enter the banking business directly to achieve their aims. The incentive to do this will be failure to defuse the risk of deflation.