Recapitalize the non-Govt Sector, not the Financial Sector

When you have a credit bubble -- ie. banks make loans that do not get paid back -- then the subsequent credit bust de-capitalizes banks (as they must write down assets and equity) constraining their ability to lend anew.

As the non-government sector needs additional financial assets to grow, if banks cannot lend (capital constrained) then the economy as a whole starts to trouble.

This, in a nutshell, is where the "Too Big to Fail", "We Must Bail Out the Banks" argument comes from, and it is true, as far as it goes.

Nevertheless, there is more to the story. First, if banks were making loans that did not get paid back, then they were not doing their primary job which is to make good credit decisions. Bad credit decisions should be punished, and the owners and operators of such companies should be fired and/or wiped out. This is how markets work. Rewarding such behavior only encourages more bad practices in the future, and people (rightly) start to wonder why we have a financial system at all.

Second, if banks fail, that contraction in private financial asset growth can be balanced by "capitalizing" the rest of the non-Governmental sector directly (through some combination of tax cuts and spending increases -- whatever increases the deficit). Since economists at Harvard and Princeton do not understand that the Government is the sole creator of net financial assets (equity) for the private sector, they do not know that this policy lever is on the table. So we are where we are.

From Macroeconomic Resilience

My policy proposal has three legs all of which need to be implemented simultaneously:

* Allow Failure: Allow insolvent banks and financialised corporations to fail.
* The Helicopter Drop: Institute a system of direct transfers to individuals (a helicopter drop) to mitigate the deflationary fallout from bank failure.
* Entry of New Banks: Allow fast-track approvals of new banks to restore banking capacity in the economy.

The argument against allowing bank and corporate failure is that it will trigger off a catastrophic deflationary collapse in the economy while at the same time crippling the lending capacity available to businesses and households. The helicopter drop of direct transfers helps prevent a deflationary collapse and the entry of new banks helps maintain lending capacity thus negating both concerns.

The Impotence of Monetary Policy

Bernanke's Jackson Hole speech was meant to give some insight into what the Fed might do in coming months. I think it reveals how powerless the Fed is in general, and how little it understands the economy it is meant to oversee.

The prospects for household spending depend to a significant extent on how the jobs situation evolves. But the pace of spending will also depend on the progress that households make in repairing their financial positions... But on the other hand, the upward revision to the saving rate also implies greater progress in the repair of household balance sheets. Stronger balance sheets should in turn allow households to increase their spending more rapidly as credit conditions ease and the overall economy improves.

Agreed. But then here are the policy options he puts forth.

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve's holdings of longer-term securities

How does changing the term structure of Fed assets help households repair their balance sheet?

A second policy option for the FOMC would be to ease financial conditions through its communication, for example, by modifying its post-meeting statement.

How does the Fed saying different words help households repair their balance sheet?

A third option for further monetary policy easing is to lower the rate of interest that the Fed pays banks on the reserves they hold with the Federal Reserve System

How does lower IOER (already just 0.25%) help households repair their balance sheet? Actually, this seems to make things worse, whereas the others have simply been irrelevant.

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability.

And what mechanisms does the Fed have in place to help it achieve its "medium-term inflation goal" regardless of where that goal is set?

What's happening is that, in a time of over-indebted households and weak aggregate demand, workers are simply losing their jobs and remaining unemployed. While unemployed, they draw Government benefits, and thus maintain some baseline level of consumption, avoiding 1930s style debt deflation. At the same time, this large pool of unemployed workers mean businesses can keep wages down, sell into what Government supported aggregate demand is there, and pocket the rest as profits.

The big lever here is fiscal policy -- announce a payroll tax holiday, and let households actually repair their balance sheets.

UPDATE: In the meantime, low interest rates take income out of the economy. Their net effect is very unclear.

The impotence of monetary policy

This post by Krugman sums it up. It's a pity things are even worse than he suspects:

A problem with the current BOJ policy, however, is its vagueness. What precisely is meant by the phrase “until deflationary concerns
subside”? Krugman (1999) and others have suggested that the BOJ quantify its objectives by announcing an inflation target, and further that it be a fairly high target. I agree that this approach would be helpful, in that it would give private decision-makers more information about the objectives of monetary policy. In particular, a target in the 3-4% range for inflation, to be maintained for a number of years, would confirm not only that the BOJ is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation.

…

BOJ officials have strongly resisted the suggestion of installing an explicit inflation target. Their often-stated concern is that announcing a target that they are not sure they know how to achieve will endanger the Bank’s credibility; and they have expressed
skepticism that simple announcements can have any effects on expectations.

OK, so say the BOJ or Fed announce a higher inflation target. Now what? Inflation means higher price levels, and for a price, you need a transaction. Announcing a target does not create a transaction, and therefore, does not influence a price. The BOJ's concerns that their credibility is on the line are right on -- the standard monetary mechanism (overnight interbank interest rates) has no impact on prices.

Unconventional monetary mechanisms, like changing other rates, have no impacts for the same reason. The only thing that has impact are transactions, a transfer of nominal assets from the Govt to the non-Govt sector. And this is fiscal policy, not monetary policy.

Two threads -- what I learned

I strongly recommend the thread on Unqualified Reservations (not the post). Some key things I learned:

1. Even people in banking do not seem to understand how banking works. The Academy, and therefore the Fed, are most clueless though.
2. Post-Keynesians tend to focus on how loans create reserves, that then get cycled into deposits via the overnight interbank lending market. In practice, banks run a day-to-day Treasury function that tries to fund assets with liabilities other than borrowed bank reserves overnight. The degree to which banks utilize the overnight interbank market varies by bank and bank business model, but generally, they try to get deposits and other liabilities instead.

This makes sense since bank profit is generated by the spread, and the lower your cost of capital, the higher your profit margins (as lending is capital constrained).