Understanding the Great Deflation Part 3: Financial Stability

by George Hatjoullis

There is widespread concern that the ‘ultra-easy’ monetary policy that has prevailed globally since 2008 could pose risks to financial stability. Janet Yellen alludes to this as one reason raising interest rates might be prudent well before inflation picks up. It is also the subject of many learned papers. The risk of financial instability arising out of the ‘ultra-easy’ monetary policies is minimal and has probably never been lower since the industrial revolution. The fear resides in a fundamental misunderstanding of the nature of the ‘Great Deflation’.

The source of the problem is an often neglected aspect of the specification of the demand for money balances; credit risk. The wonderful thing about a £20 note is that it is always a £20 note. It is always available for spending. What it will buy may change but the note does not. It can get stolen but then so can your car. If you lend someone your £20 note it ceases to be your £20. It becomes an unsecured liability of the borrower to you. They will give you some form of credit note in exchange. You cannot spend the credit note. Moreover, the borrower may default on all or part of the commitment. In making the loan you have incurred a credit risk. What changed in 2008 was the abrupt, widespread awareness of credit risk.

Money in the bank was no longer the same as cash in your pocket. Banks can fail and in the process some of your cash can be lost. People woke up to the fact that uninsured deposits were senior loans to the bank that they could draw on. However, they were still uninsured loans and involved some credit risk. For many depositors this was not an immediate issue because they did not have sums in excess of the insured amount. These people were more likely to be in debt to the bank. The crisis forced banks to become a little more selective on debt and to reduce the aggregate amount. Credit conditions were tightened and bank leverage was reduced. Bank money, the aggregated amount of insured bank deposits, contracted and has since grown only slowly.

Banks create (bank) money by granting loans. They make a deposit in your account and this deposit is bank money up to the insured amount.Deposits in excess of this are not strictly speaking money as they are uninsured. If you borrow £1 million from a UK bank and keep it on deposit with the same bank then for the duration of the deposit you have £85k of cash and £915k in the form a senior loan back to the bank. Moreover, netting is not automatic. If the bank fails during the duration of the deposit, the £915k is in principle available to the regulator to recapitalize the bank. However, your debt to the bank of £1 million still stands. The fact that the bank owes you £1 million is not necessarily a consideration (if anyone has examples in which this is not the case do let me know). Historically the too-big-to-fail rule of thumb meant uninsured deposits were de facto insured. From 2008 the too-big-to-fail rule was questioned and, in the eurozone at least, ceased to be a given.

The demand for credit risk free assets as a store of wealth increased from 2008. Insured deposits, National Savings (in the UK) and (some) sovereign debt became highly valued. The deleveraging of banks meant insured bank money was created more slowly as credit conditions became tighter. Government austerity reduced the primary issuance of sovereign debt. The supply of risk free near-cash assets collapsed just as demand exploded. The generalised credit risk aversion and desire to hold more cash depressed economic activity. GDP struggled to reach potential so there was no pressure on aggregated prices. Inflation rates drifted lower. The greater demand for cash did not arise because people expected lower prices. It arose because of credit risk aversion and lower prices were a consequence.

The central banks responded with what has now come to be called ‘ultra-easy’ monetary policy. They reduced official interest rates to historically unprecedented levels. However, this had little effect. The demand for cash was too strong and the supply was shrinking. The banks were largely unmoved by cheap central bank liquidity. Micro- and macro-prudential pressure meant they needed to deleverage and so they continued to do so. The central banks decided on what are now typically referred to as unconventional policy measures; QE. They went into the market and bought sovereign debt. They removed highly sought after risk-free sovereign debt from the system and replaced it with large, hence mainly uninsured, bank deposits. The theory was that this would encourage people to move their portfolios into more risky assets. In a sense it did because bank deposits are riskier than (some) sovereign debt. However, it did not end there. The risk aversion was so great that investors chose to buy back and hold the ever-shrinking outstanding stock of sovereign debt at higher prices. The result of QE was merely lower bond yields and increasingly negative bond yields.

This raises the question of whether monetary policy has been ultra-easy. The persistent low to negative nominal interest rates and bond yields on cash and risk free sovereign debt would suggest that monetary policy has failed to satisfy the ex ante excess demand for cash and risk-free assets. Ultra-easy money policy might reasonably be considered to exist if there is ex ante excess supply of cash and risk-free sovereign debt. In the latter situation bond yields would be rising and not negative, especially on long maturity debt. QE would seem to have failed in its stated objective of forcing investors to take more risk and cannot yet be called ‘ultra-easy’. This also means the fear of financial instability arising out of excessive risk taking is being exaggerated and raising interest rates at this point is unnecessary.

Low interest rates and bond yields have generated a wealth effect through revaluation of assets. Assets offering stable and predictable cash flows have benefitted in this environment. Assets offering uncertain, long-term (i.e. risky) cash flows have not done so well. This has allowed stock markets in general and some property markets in particular to see values rise. The wealth effect has been substantial and has evidently had some positive benefit for demand and GDP (It has also exacerbated wealth inequality which is undesirable from both and ethical and economic standpoint at these extremes but this is a different discussion). There is no evidence that the low rate environment has generated the leveraged risk-taking that characterised the pre-2008 environment. The evidence is consistent with little financial stability risk in the system. There is little risk at the moment of financial instability arising out of continuing with this so-called ultra-easy money policy. There is a small risk that raising interest rates may cause some instability but even this would not be systemic.