The Bankruptcy of Monetary Policy
by George Hatjoullis
An alternative title for this blog might be the ‘Emperor’s Tools’. We have entered the phase of hubris in monetary policy. In an article in the FT we can read about bankers expressing great self-confidence in their ability to stimulate economic activity. Well, they must say that do they not? If they announced that they were out ammunition and clueless as to what to do now, what would happen? So they whistle loudly in the dark and during the day they parade about flaunting their invisible monetary tools. It would be amusing if it were not so serious.
The global problem would seem to be deflation in goods and services. The deflation is not equally distributed and is being moved about from nation to nation by currency movements. Nevertheless, it is evident and it is of concern to central bankers globally. In a deflation people are more inclined to hold money or near money assets. The demand for money increases. The solution is to increase supply but the central bankers are collectively failing to do so, despite their best efforts and bravado. In fact one could argue that their efforts are making matters worse.
Bank money took a huge knock when the too-big-to-fail dictum was abandoned. If you hold ‘cash’ with a bank it is only ‘cash’ in so far as it is insured. This is £75k in the UK and €100k in the euro zone. You can hold deposits with as many separately licensed banks as there are available and each will be insured, but as the number of banks is finite then the amount of insured deposits possible must also be finite. The supply of insured money is capped. Funds held above the insured amount constitute a loan to the bank and in the event of ‘resolution’ the loans are available to the creditors. This is now part of EU banking reform and was applied in Cyprus in 2013. (NB: there is some exception for large deposits under specific conditions but these exemptions have little macro significance)
An alternative to insured bank deposits is government guaranteed debt. This too is finite and has in fact been shrinking. In part the shrinkage is a direct result of the cocky bankers flaunting their monetary biceps. By buying government debt (and other quality assets) they reduce the number of alternatives to insured deposits. The result is falling bond yields (or interest rates to the layperson). The central bankers rather hoped the lower yields would stimulate economic activity. They have moved further in this direction by only offering low to zero, and in some cases negative, interest rates on excess funds held by banks with the CB. This has forced rates offered to bank deposit customers much lower. In effect by making money more expensive to hold they hope to encourage people to spend it. Also by making borrowing cheaper they hope to encourage more debt.
Encouraging debt has proved more difficult than one might imagine. The unusual level of interest rates is creating a level of uncertainty in itself which discourages borrowing nothwithstanding the cost. Moreover, the growth in debt seems to have been focused more on acquiring existing assets such as property, bonds, and equities. The result has been asset price inflation rather than goods and services inflation. This is great if you own assets but as assets are now infamously unequally distributed this gain has fallen to very few. Moreover, by being so concentrated it has limited the impact on spending on goods and services.
If you pick up any textbook on economics you will come across the notion that the central bank expands the money supply by encouraging the banks to lend. Banks appear to have not been very encouraged by the collective efforts of CBs. First, they find it hard to make money in a negative interest rate environment. Second, the new regulatory rigour has made capital demands that much greater. Banking just is not so profitable anymore and so banks are not rushing to lend. Thirdly, even if they do lend, the deposits created by the loans are not money above the insured amount. The textbook model is broken, kaput!
The low yield environment has had another less visible but caustic counter-productive unintended consequence. It has increased pension deficits. This has diverted corporate resources to bolstering pensions. It has also made those saving for pensions consider saving more. It has made those living off savings more cautious in their spending. It has also made borrowing for house purchase cheaper but as house prices are now greatly inflated (using income to price ratios) the impact of house purchase is still to divert much of disposable income to servicing debt. The net beneficiaries as those that owned property when all this began. The net effect of low rates on aggregate spending may have been less than in the past.
So what should central bankers do? First, create a digital cash that is effectively a deposit with the national central bank. Money in this account is like cash. Allow any amount to be held. Encourage and discourage holdings via interest rates. The accounts could be operated by commercial banks alongside current accounts with instant transferability between the two. This offsets the impact of losing the too-big-to-fail status. It also provides central bankers with a direct tool to influence personal and business depositors; the rate of interest on digital cash. It would no longer be necessary to keep rates low on excess bank reserves and this could restore profitability to banks. In times of deflation, the demand for digital cash would be high and the CB could impose a negative interest rate. But it would nevertheless meet the demand for money!
Second, consider debt cancellation. This could be done by converting some holdings of government debt to perpetual zero or very low coupon debt. This would allow the state to spend a little more without breaching its ‘borrowing limits’. So long as the amount of cancellation remains in the hands of an independent central bank it would be a relatively safe exercise. More of the same bravado is getting us nowhere. It is time for central bankers to exercise some imagination.