Why Monetary Stimulus Is Broken

I am trying to understand the broken transmission vectors for monetary policy. It is clear that the gearboxes between the monetary base and the money supply and between the money supply and NGDP are stuck in low gear, and that the more that the Fed pushes, the lower the gearing goes. We are stuck in first gear, whereas we should by now be in at least third gear. Something is wrong.

Two gearboxes are broken: the one between the monetary base and the money supply, and the one between the money supply and nominal growth.

Let’s start with the first gearbox: the one between MB and M2 (M2/MB). The Fed has bought truckloads of bonds from the banks, creating massive free reserves ($2T) that should be used to fund loans. Instead, the banks are keeping these excess reserves on deposit at the Fed. Why? Well, for one thing, reserves pay .25% but attract a zero capital coefficient. That is a .25% return on nothing, which is attractive in a world where 1% is high yield. (Memo to Ben: the yield on excess reserves should be zero.) Another reason is that Dodd-Frank and Basel are imposing higher capital ratios on the banks, which makes it very expensive to grow loan books. (I am in total agreement with Dodd-Frank on this, but it’s timing is inopportune; it should have happened before the Crash.) So right now, banks are happy to have huge deposits at the Fed, which means that they are liquid and feel good about themselves. But this also means that the Fed is pushing on a string when it creates free reserves: the credit transmission vehicle is broken. And the credit aggregates bear this out. While private sector credit growth is no longer in reverse, it remains stuck in first gear: “No Cash for No Body”, as the Texans used to say. The good news here is that the trend-lines have now inflected and we should see household and corporate credit starting to grow (fingers crossed).

Next we come to velocity, the V in the quantity theorem (NGDP/M2). We appear to be stuck in what Keynes called the liquidity trap, when monetary stimulus loses its power because of diminishing returns (V goes down as M goes up). Why has V been declining since the Crash? V is the liquidity preference, the desire to hold liquid cash. There are two cohorts to consider: households and corporations.

For households, the Crash cut stock prices in half which put a psychological premium on capital preservation: cash may yield nothing but it cannot go down in value (and inflation is low). So households still have a cyclically high liquidity preference. I have seen this in my own infantile investing behavior: I placed capital preservation above capital appreciation for much too long after the Crash, even though I was smart enough to be able to calculate the ERP. Emotion overwhelmed reason; I couldn’t “afford” to have my wealth cut in half again. I’m sure some rational actors went from cash to stocks in March of 2009, but not me. I was just another risk-averse rabbit.

Next are the corporations. Here is where I think I have some valuable insight, having been inside the minds of CFOs for thirty years. This is the key factoid that explains corporations’ high liquidity preference: there were two major credit breakdowns in the past decade. First, there was the credit meltdown of 2001-2, when the credit markets panicked after the carnage in the merchant energy and telecom industries. The debt markets closed for most of 2002 (and many companies got downgraded), which pushed many corporate treasurers to the edge. When you can’t roll your paper, you have to call the commercial loan officer whom you have been ignoring for years, and beg him for a loan. I have been that neglected loan officer (in 1985); I wasn’t exactly Father Christmas when the CFO called me; for once I had him over a barrel. That was a chastening experience for Mr. CFO. And then, only six years later, Lehman defaulted and the same scenario was repeated: the CP market closed, banks couldn’t lend, and the debt markets had a massive heart attack. What was a CFO to do? It took heroic extra-legal measures by the Fed and the Treasury to prevent liquidity-driven defaults by major US corporations; the name GE comes to mind. No CFO has forgotten Christmas of 2008, when they were begging for money.

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CFOs today still suffer from PTSD arising from the Enron and Lehman crises. They can’t count on the credit markets or the banks to be there when they need cash in the next crunch. Hence, they are keeping bucketloads of cash on their balance sheets as a precaution against the next credit shock. This explains their high liquidity preference.

I’m not blaming anyone for the broken credit markets, but I would observe that a disintermediated financial system means that the commercial bankers at Chase and Citi are not sitting around hoping for the next opportunity to rescue GE. How often do Jeff Immelt or Keith Sherin play golf with their commercial loan officers? Answer: never. Instead, Immelt plays golf with the president. But can Obama offer GE a loan during the next credit crunch? CEOs never learn that their commercial bankers are more important than presidents, even if they don’t own a 747.

The foregoing explains why the amount of QE required to create X% of NGDP growth has become so high. The banks don’t want to create credit, and the private sector is still shell-shocked from the Crash.

However, both of these neuroses are abating as confidence slowly returns.

It is certainly very constructive that, at this juncture, the FOMC is debating when and how to end QE3. Nothing is more likely to restore confidence at this delicate moment than the prospect of the withdrawal of liquidity and a shrinking of the Fed’s balance sheet. This is precisely the mistake that the Fed made in 1937, which cratered the recovery and prolonged the Great Depression by another three years. Millions lost their jobs. Bernanke wrote about it. Let’s try that experiment again--maybe it will turn out differently this time!

To recap: the power of conventional monetary stimulus has been severely attenuated by the psychological trauma of the 2002 and 2008 financial crises. There is no reason to assume that this trauma will dissipate, since the credit machine remains permanently broken and can’t be fixed without massive reintermediation, which will never happen. Thus, ever greater stimulus will be required to push up NGDP. And the Fed is now debating how to retract QE3.

Of course, this doesn’t bother me because I am wealthy and retired; it only affects hopeless young people and terrified unemployed dads. Who cares about them?

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