Category Archives: Finance

Central banking like it’s 1989

Ashley Kindergan writes a great piece at The Financialist on the growing divergence between central banks, the likes of which we haven’t seen in 25 years.

In 2015, global monetary policy could look like a mirror image of its 1989 self. The Bank of Japan already expanded the scope of its asset purchases in October. The European Central Bank is expected to announce quantitative easing as early as the first quarter, while the U.S. and the U.K. are expected to start tightening monetary policy in mid-2015. That’s because policy makers’ concerns have been reversed as well, with deflation a bigger worry than inflation in Europe and Japan (a 40 percent drop in crude oil prices since June has exacerbated the deflationary dynamic), and inflation emerging as a potential concern of the Fed and the Bank of England.

One qualm: I’m a little skeptical that inflation fears will be the prime mover behind Fed policymaking in 2015. The economy may be looking up as equity values soar and unemployment continues to decline, but inflation itself remains low. Janet Yellen is a deflation hawk, anyway, having repeatedly dismissed inflation fears in the past. The collapse of oil prices adds deflationary pressures to the mix that, I think, will dissuade Fed officials from raising rates in 2015. Near-zero rates through 2016 is what Janet Yellen originally wanted, anyways.

But either way, how the world’s central banks respond to these contrasting inflationary and deflationary pressures will certainly be one of the coming months’ big stories. Here’s Barry Ritholtz saying as much at Bloomberg today:

The central bankers of the world are out of synch with each other. If the U.S. economy continues to accelerate, this disparity may become even more pronounced. How that plays out could be the big question facing central bankers in 2015.

The Fed especially has an interesting puzzle, as unemployment drops ever lower while inflation remains low—a situation The Economist calls “contradictory pressures” in it’s print edition this month. A working assumption behind the economics of the Fed’s dual mandate is that inflation and unemployment should move somewhat in tandem, and that the decision to ease off the monetary gas pedal should come when both indicators look good. But what happens when one indicator moves opposite the other—when inflation drops as job growth rises, as we’re seeing today? Can unemployment get “too low” as the Fed waits for inflation to pick up before raising interest rates? Will a rate hike spark deflationary fears if the Fed acts in response to strong jobs reports while inflation remains low?

(On that note, remember when 6.5 percent unemployment was supposed to trigger a rate hike? In retrospect, that was probably one of Ben Bernanke’s worst ideas. Pegging the end of easy money to a specific unemployment rate might have eased fears of a rate hike when unemployment was still well above 6.5 percent, but pegging the two events together like that created a perverse incentive—one I wrote about last year—that turned low unemployment into something stimulus-addicted markets didn’t like.)

There is no real trade-off between loans and reserves

In this piece at Reason.com, economist Robert Murphy writes the following:

But the U.S. economy has stayed in this holding pattern, where people expect low consumer price inflation and so commercial banks keep their excess reserves earning 25 basis points parked at the Fed rather than make new loans. Thus the process I described above has been thwarted; the quantity of money held by the public right now is much lower than it would be, if the banks decided they would rather make loans and earn a higher interest rate than the 25 basis points currently paid by the Fed.

Unfortunately, this statement implies something about how banking works that is simply untrue, which leads Murphy to some incorrect conclusions about QE’s effect on the economy and what to think about inflation. I don’t like seeing this because I like Murphy and the school of economics he espouses. I also see this same mistake made quite often by other economists, which only confuses everyone. So here’s my attempt at explaining this error in a constructive and uncritical manner:

There is no trade-off between loans and reserves except to the extent that new loans results in higher demand for banknotes.

This is seen by the fact of how the central bank’s balance sheet looks:

ΔAssets (A) = ΔReserves (R) + ΔBanknotes in circulation (BK) + ΔGovernment deposits (GD)

Rearranged, this equation looks like:

ΔR = ΔA – ΔBK – ΔGD

The implication here is that levels of reserves can change in only three ways:

  1. The central bank increases or decreases its assets (Fed action).
  2. The public increases or decreases the amount of banknotes (cash) it wants to hold (public’s actions).
  3. The government increases or decreases its deposits by making or receiving net transfers to or from the private sector (government action).

Now, Murphy’s point regards the actions of commercial banks. He says that are choosing to keep their reserves “parked” at the Fed rather than make new loans.

But as I explained above, banks cannot change the amount of reserves in the system apart from actions by the Fed, the public or the government. They cannot, by making new loans, shed reserves or somehow turn reserves into an investment that earns a higher interest rate.

But one might ask: Doesn’t a new loan involve turning reserves (low-interest into loaned funds (higher-interest)?

The answer is no. When banks make a loan, they simply credit the borrowers account at the Fed (corrected 12/28/14) with new funds. They don’t take this from their reserves. They are, however, limited in the amount of funds they can loan by mandated reserve-requirement ratios. Every new loan moves them close to becoming reserve-constrained. But when they make a loan, they move closer to this limit by increasing the size of their balance sheet all around—not by moving funds around. Their total level of reserves stays the same and the total level of loaned funds increases.

In short, a new loan’s effect on a bank, ceteris paribus, is to increase assets by the amount of the loan. A loan has no effect on reserves.

Now, what could affect reserves is how borrowers use those loaned funds (public’s actions). If the loan causes demand for banknotes (cash) to increase, then reserves will fall as banks redeem such demands with banknotes. Outflow of banknotes, as explained above, reduces reserves for the bank in question, as well as for the system as a whole (assuming those banknotes aren’t withdrawn and then deposited in another bank, which merely transfers reserves from one bank to another).

Another way reserves could fall is if the borrower writes a check against their loaned funds account to someone who uses a different bank. This would result in a transfer of reserves out of the borrower’s bank and into the bank of the person to whom the check was written. This wouldn’t result in net loss of reserves for the system as a whole, though. It just transfers reserves from one bank to another.

So when Murphy says that banks might decide to make loans “rather” than keep reserves parked at the Fed, he’s mistaken. Banks might decide to increase lending, but not at the expense of losing interest on reserves at the Fed. In fact, banks would rather earn interest on both new loans and reserves at the Fed (which is possible because new loans don’t require an outflow of reserves). Ideally, Bob would write a check against his loaned funds account that is addressed to another customer of that bank. Then the bank sees no loss in reserves (and so earns the same interest on the reserves as before) plus an increase in loaned funds which, of course, earns interest.

This is a very subtle point, but has huge implications for predicting inflation and gauging the effects of QE and growth in the monetary base. For example, there is no threat of sky-high levels of reserves “turning into” loans funds and thereby launching us into hyperinflation. Sure, a higher level of reserves pushes banks further from being constrained by their reserve-requirement ratio, which means they can increase lending. But banks are normally not reserve-constrained, so the relationship between reserves and loans is not direct, and might be hardly related at all.

This is not to say that inflation won’t happen at all, or that QE doesn’t fund malinvestment to levels that will ultimately prove unsustainable. In fact, Murphy is right about the general, distortive effects of QE. He’s just wrong about why QE induces more lending, which has implications for his predictions regarding inflation (and, I think, might explain why his original predictions were wrong).

Now, if you’re following this closely, you might have a question: If reserves can’t be lent out and don’t have a substantial effect on how much banks lend, what’s the point of increasing them with QE?

The answer is that QE changes the aggregate portfolio composition held by the private sector by buying government debt and other securities with reserves and bank deposits—something economist Paul Sheard aptly calls “portfolio rebalancing effects.” In short, this induces more confidence among borrowers and encourages banks to lend by “liquefying” their balance sheets.

In short, banks cannot lend out reserves. We shouldn’t expect to see any net outflow of reserves apart from action on the part of the Fed and the government unless the public increases it’s demand to hold cash—an event over which individual banks have virtually no control.

So Murphy is wrong to say that banks might choose to lend “rather than” keep reserves parked at the Fed. When they lend, their reserves stay parked at the Fed no matter what.

And finally, note the implication here that banks wouldn’t want to see diminished reserves as long as interest paid on those reserves is positive. Even if interest rates on loans and other investments is higher, they’d rather earn interest both on their reserves at the Fed plus on these higher-earning investments. This is possible, again, because loans do not “come from” excess reserves. As Sheard explains:

…banks do not need excess reserves to be able to lend. They need willing borrowers and enough capital – the central bank will always supply the necessary amount of reserves, given its monetary stance (policy rate and reserve requirements).

For further reading, check out this short, excellent paper by Paul Sheard (here’s a one-page summary if you really don’t have time). I’m channeling him, really, as well as Forbes’ Frances Coppola and Nathan Lewis.

Finally, while I think I understand this issue quite well, I’m no expert on banking. Let me know if I’ve made a mistake and I’ll make updates as appropriate.

Up stocks, down fixed-capital

Thad Beversdorf with a nice piece at Voices of Libertyon why the Fed is destroying the middle class.

However, we have to remember that at the end of the day corporations are just money allocators like any hedge fund or mutual fund manager. CEOs are sworn to maximize shareholder funds. Understanding this we must expect corporations to invest based on the best risk/reward scenario available to them as we do for any other investors. Herein lies the invalidity of the Fed’s assumptions.

The Fed assumed that low borrowing costs and high equity values would drive corporate fixed capital investment. It did drive investment, but not fixed capital investment. Corporations, like all other investors, realized the stock market was being backstopped by the Fed. This essentially gave all market long side participants a free put option. In other words, the Fed was protecting folks from any downside risk by explicitly stating they were targeting higher stock prices. Thus corporations and everyone else realized the smart money was directly tied to the market.

The result, Beversdorf argues, is inflated stock prices at the expense of fixed capital investments. This promotes economic stagnation–no real growth in job-creating, fixed capital investments concurrent with strong growth in financial markets.

Has the ‘gun bubble’ popped?

Has the ‘gun bubble’ popped? David M. Levitt at Bloomberg thinks so, and I think with good reason (see chart below).

Peak Gun – Bloomberg

Sturm Ruger and Smith & Wesson are the only two publicly traded U.S. gunmakers. Their sales have plummeted (down 13.4 percent and 23 percent, respectively) and stock values each cut by more than one-third.

Levitt relates the spike in gun sales to to Obama–namely, fears on the part of gun owners that Obama’s anti-gun agenda would gain ground. The failure of his agenda to get off the ground, then, explains the sudden drop.

I think he’s right, not in the least because I know people who bought guns for that very reason.

Student loan debt is hardly a “crisis”

Here’s an interesting study from the Brookings Institution. It shows that the mean payment-to-income ratio on student loan debt repayments is lower than it was in 1989, which does damage to the claim that student loan debt is the reason why young people are seemingly absent from the home and stock markets.

Ratio of Loan Payments to Income

Hard to argue with that. Additionally, I found this chart from College Board (below) showing that while the number of student borrowers has indeed increased, the average amount borrowed has remained relatively stable since 2002.

The only indication I can find in favor of a student loan debt “crisis” is that the number of borrowers has risen considerably over the past decade. As the chart above shows, the number of undergraduate borrowers has risen from around 5 million in 2002 to upwards of 8 million in 2013.

Of course, my mini-analysis here doesn’t address the fact that twentysomethings’ 6.6 percent unemployment rate remains well above rates for older, more experienced workers. Unemployment, of course, makes payment-to-income ratios on student loan debt worse, leaving less left over to invest in homes and stocks. But I don’t think this is significant toward explaining why young people aren’t investing. 6.6 isn’t super high, and I’m assuming at least some of that number includes twentysomethings without a college education and, therefore, with no student loan debt. In fact, such people are probably over-represented in that 6.6 percent rate.

Finally, it’s interesting that just as much student loan debt is held by 30-39 year olds as by 20-29 year olds. This doesn’t seem intuitive — 30-39 year olds have had much longer time to pay off debt. But throw grad school into the mix, and it begins to make sense. As the chart above shows, graduate students — while representing just 15 percent of student borrowers — take on about three times as much debt as undergraduate students. This debt is usually not in repayment until after or about age 30.

I’ll have a longer, more formal report on this issue coming out soon. I link to that here when it’s available. In the meantime, any thoughts?

QOTD: Doug Bandow

From Cato scholar Doug Bandow, writing in the Orange County Register:

As applied, the insider-trading laws push in only one direction, punishing action. Yet a smart investor also knows when not to buy and sell. It is virtually impossible to punish someone for not acting, even if he or she did so in reliance on inside information. Thus, the government has an enforcement bias against action, whether buying or selling. That is unlikely to improve investment decisions or market efficiency.

How the Fed Makes Unemployment a Good Thing

This article was originally published at Valuesandcapitalism.com on December 3, 2013.

Imagine a world where unemployment is good—where fewer people working means more prosperity. Both time and resources would be infinitely abundant. Consumer goods would invent themselves. The standard of living would improve most swiftly when human beings stay out of the way.

This world, of course, is a fantasy. Until someone invents a self-improving robot fueled by human indolence, unemployment only hampers economic growth.

That is, until November 2013.

If history is any guide, the Labor Department’s announcement earlier this month that the U.S. economy added 204,000 jobs in October—twice what most economists expected—should have sparked excitement across Wall Street and the nation. But while markets did gain on the day, early-morning futures turned quickly negative after gaining before the report’s release. The talk of the town was anything but positive.

Explanations for this twist of events were quick and forthright: Indications of economic progress sparked fear that the Federal Reserve would taper its bond-buying program.

Since 2009, the Federal Reserve has created money to funnel into the economy via bond-buying and bailouts (a.k.a. “quantitative easing”). This policy was designed to lower interest rates, create credit, and stimulate demand with the ultimate goal of lowering unemployment. The result has been significant growth in stock prices and apparent economic recovery evidenced by a slow and steady drop in unemployment.

Understandably, investors have come to love quantitative easing. Though many voice concerns about the long-term effects of this policy, few deny that quantitative easing mitigated the immediate effects of the 2008 financial crisis. Even fewer would deny that quantitative easing is now vital to the health of many major financial institutions.

But of course, such a policy cannot continue forever. Quantitative easing must eventually come to an end—a fact even Fed officials often note. It is this ominous thought that sparked last month’s scare. Lower unemployment signals economic recovery. Economic recovery signals a sooner end to the Fed’s bond-buying and bailouts.

A similar episode occurred earlier this year when Federal Reserve Chairman Ben Bernanke hinted that quantitative easing may taper off if inflation remains steady and unemployment continues to drop. The stock market lost 4.3 percent over the three trading days following his comments.

U.S. Treasury Securities

This last episode was different, though, because no announcement was needed. The strong jobs report alone was enough to spook investors even before the Fed could announce changes to quantitative easing. What is good news at almost any other time and in any other place is bad news on Wall Street today.

This spells disaster for the American economy. The same quantitative easing policy designed to decrease unemployment is itself the cause of investors’ fear of strong jobs reports and other positive economic news in general. The fact that lower unemployment hurts the stock market means the Fed has created a lose-lose situation whereby lowering unemployment creates a simultaneous collapse in stock prices. They have kept up their money-printing too long. The Fed has become its own worst enemy.

But even worse, the Federal Reserve has pitted Wall Street against the American people by inadvertently linking lower unemployment with lower stock prices. Big banks now have reason to want high unemployment in order to extend the life of quantitative easing. While bankers themselves do not make economic policy, they do control the flow of money into and out of their vaults. They can tighten and expand credit. Conspiracy theories aside, banks do have considerable power over the rate of economic growth, and knowing that investors at-large fear a slow-down to quantitative easing does anything but encourage them to help speed up the recovery process.

While high unemployment will never be good news for the real economy, that doesn’t mean that financial institutions and the economic powers that be will always feel the same crunch. When economic stimulus is directly linked to the unemployment rate, like the Fed has done with quantitative easing, those depending on stimulus for their profits should only be expected to react negatively to news of job growth.