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The Bear's Lair: Where's the link to inflation broken?

April 21, 2014

Monetary economists around 2009-10 were sure of one thing: the Fed's unprecedented creation of "narrow money" in the form of bank reserves would show up fairly quickly in a burst of inflation. Clearly, they were wrong.

 
The Fed has created $2.7 trillion of bank reserves, increasing the monetary base by $3 trillion, or 319%, since September 2008. Yet inflation remains very subdued, indeed, at 1.5% in the past year, according to the U.S. Consumer Price Index statistics. So why aren't we suffering from incipient hyperinflation?

The leading monetary economist Allan Meltzer of Carnegie Mellon University last August identified the route by which the monetary base should increase inflation. Banks have $2.7 trillion in excess reserves, so they should lend them out to companies, which in turn would redeposit them with the banks, creating more broad money and leading to economic expansion. With the amounts involved, we would pretty soon have inflation advancing a brisk trot, and not just in asset prices.

Since this isn't happening, there are two possibilities to explain it. Either monetary theory must be wrong or, even though monetary theory is generally correct, the recent extreme monetary policy, far outside the normal range, must be producing pathological behavior in the banking system.

Even the solidest economic theory can fail to work in extreme cases. For example, Adam Smith's description of the price mechanism is accepted by more or less all economists, and regarded as a universal truth. However, even early in the theory's life, Charles Jenkinson (Prime Minister Lord Liverpool's father, the first Earl, then President of the Committee on Trade) discovered flaws in it. Observing market behavior at a time of corn scarcity in 1800, he wrote to Sir Joseph Banks (the botanist, President of the Royal Society and used by Jenkinson as an agricultural forecaster):  "In time of distress the Seller becomes Master of the Market and it then becomes absurd to rest one's confidence in Adam Smith, who has Pushed his Principles to an extravagant Length, and in some respects, has erred."

Jenkinson therefore imported corn at government expense and sold it domestically at a subsidized price, thus preventing the onset of starvation. Fifty years later, Lord John Russell's Whig government stuck to its Smithian free-market principles, refused to purchase grain and distribute it at a loss—and produced the worst period of the Irish potato famine.

Just as the severe wartime dearth of 1800 and the Irish potato crop failures of 1846-50 produced extreme situations in which Smith's price mechanism failed, so the recent extreme monetary policies followed since 2008 appear to have produced a similar failure of normal market mechanisms.

To see what's going on, we should look at Federal Reserve Publication H8, the assets and liabilities of banks doing business in the U.S., and compare bank balance sheets from January 2008, before the crisis began, with their state in March 2014. Bank balance sheets have expanded from $10.9 trillion to $14.4 trillion, a growth of 31% compared with growth of only about 16% in nominal GDP (we don't yet have the figures for the first quarter of 2014). In spite of a major financial crisis, there has therefore been no restriction of the banking system, which has expanded further its weight in the U.S. economy.

However, when you look at the composition of bank balance sheets, you see what has gone awry. Cash, which in January 2008 represented only 2.9% of total assets, now represents 19.3% of assets. There are those excess reserves, lying on banks' balance sheets like great lumps of suet, doing nothing useful at all. Since the Fed is paying interest at 0.25% per annum on the excess reserves, and the banks can count them at zero when calculating their required capital, there is no incentive for banks to do anything with them. The return on them is simply free money.

Total credits, which include loans and securities, have fallen from 81.9% of the banks' combined balance sheet to 71.6%. Indeed, the amount of total credits has increased by only 15%, less than the increase in nominal GDP. So even though the banks have bloated themselves in size at almost double the rate of GDP growth, their actual working assets have grown more slowly. In other words, they have been slightly restrictive in their impact on the economy.

The impact of banks on the economy becomes even clearer when we look at the breakdown of the "total credits" figure. Treasury and agency securities have grown from 10.2% of banks' balance sheets to 12.8%, a nominal growth of no less than 64% at a time GDP has grown by only 16%. But this is completely worthless activity, other than to bank profits. It consists of using the Fed's guaranteed zero short-term interest rates to load up on Treasuries yielding 2.7% in the 10-year range or Federal Agency securities yielding about 1% more.

The banks are thus making 2% plus on this money, and, again, they are able to leverage it ad infinitum because the foolish Basel rules allow them to zero-weight government and agency paper. The activity does little or no economic good; it simply finances the damaging government deficit. The banks doubtless consider it risk-free, but of course it isn't. A default on government or agency debt, with the amounts held by the U.S. banking system, would collapse the banks as well as the government, causing immeasurably worse economic chaos than a simple government default.

Finally we get to loans and leases, the productive part of the banks' activities, the purpose for their existence (since their other purpose, providing a safe haven for deposits, is today rendered nugatory by deposit insurance). Total loans and leases have declined from 63% to 52% of banks' balance sheets, increasing in nominal terms by only 9%, much slower than GDP. However there is some leaven here. For commercial and industrial loans, the most productive part of banks' balance sheets and that finance actual businesses, have increased by 15% over the period, while real-estate loans have actually shrunk (or doubtless in many cases been written off).

The only real growth in lending has come in consumer loans, up 43% since 2008, rising at more than double the rate of GDP. Keynesians will jump for joy at this; the banks are encouraging wonderful consumption, causing GDP to grow faster. But of course we know better; this surge in consumer lending is merely pushing U.S. consumers further into debt, making it impossible for them to pay off their obligations (especially to the extent they consist of student loans, which have trebled to over $1 trillion since 2004.) This is not healthy growth; it's merely storing up trouble for the future.

The banking system is thus not doing its job. This is not entirely surprising. Lending to small and medium businesses is difficult and risky and requires high-level, specialist staff to accomplish. Ramping up such lending without the right people on board simply leads to mass defaults down the road. Consumer lending leads equally to defaults, but can be done by robots. Investing in government bonds requires no skill at all, especially as you can today reverse the interest rate risk quickly in the swap market. Thus pumping $3 trillion into the banks, as the Fed has done in the last five years, achieves absolutely nothing. Nor would pumping in $30 trillion—something the Bank of Japan, with its much larger quantitative easing program (relative to the size of the economy), is about to find out.

If the Fed wants to make its monetary policy truly stimulative (which will stoke up inflation, but it's not currently worried about that) it can take the following policy steps to do so:

  1. Instead of paying interest of 0.25% per annum on those $2.7 trillion of excess reserves, charge 0.5% per annum on them. You'd be surprised how quickly the banks would get rid of them in that event. Balance sheets would shrink, and lending efforts would be redoubled.
  2. Increase the federal funds rate to, say, 2.5%, and close to the yield on 10-year government bonds. The banks' bond portfolios would thereby become only marginally profitable and would be sold. Again, more effort would go into lending.
  3. Wind down the Fed balance sheet as quickly as possible, reducing the level of excess reserves in the system. The banks will be begging you to do this anyway, because they are losing money on the excess reserves. In practice it will take you several years to sell over $3 trillion of long-term Treasury and agency bonds, so the system will remain very "stimulative" while you do so. However, not doing this will make the inflationary whammy even worse.

The results of these policies will be a surge in lending, accompanied by a surge in economic growth and reduction in unemployment. That's the good news; there are however two items of bad news. First, since the excess reserves will now be recycled into lending, inflation will reappear surprisingly rapidly. Second, with the Fed selling government bonds instead of buying them, the $500 billion government deficit will become difficult to finance. Thank goodness the Republican Congress, in about its only useful act, has stopped the explosion of deficit spending of 2006-10. With faster growth reducing the deficit further, then, provided the spendaholics don't regain control of Congress, the deficit should decline toward zero and remain financeable.

Assuming the Fed doesn't adopt these policies, consumer price inflation may be slow to reappear, although with $3 trillion just parked on bank balance sheets, the potential is always there. However asset price inflation, in the stock market and elsewhere, is in full swing. At some point, that bubble will burst, causing the father and mother of all stock market crashes, accompanied by a junk bond crash and another real estate crash. Needless to say, that will cause another banking crisis and prolonged recession. Overall, by the end of this period, we'll be longing for some good healthy consumer price inflation.

There's one consolation. Once we have fully mapped out this unpleasant economic terrain, we should be able to prevent Fed policymakers from ever taking us here again.

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