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Could Central Banks do More during the Crisis?

September 7, 2018 3 comments

I rarely disagree with Martin Sandbu’s Free Lunch. But today’s piece on central banks is one of these cases.

In short, Martin argues that while the main culprit for the slow recovery is fiscal policy, almost everywhere too timid if not outright procyclical (we are all on board on that!), the mistakes of fiscal authorities do not exempt central banks from bearing part of the responsibility. In particular, he dismisses the claim that it was technically impossible to lower long-term interest rates further, and/or bring policy rates even more into negative territory.

I agree with this point. Interest rates could have been lowered further. Nevertheless, I think that this would have made very little difference, because after 2008 central banks were essentially pushing on a string.  This point of disagreement between us can be traced to a different view about what is the liquidity trap.

I recently published a book, La Scienza inutile (a general public account of a century of debates in macroeconomics. For the moment it is in Italian and in French, English translation in progress), in which I discuss the different notions of liquidity trap. Here is the quote (sorry, a bit too long):

 The first source of trouble that Keynes considers is the most extreme, the so-called liquidity trap: `There is the possibility, […] that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest’ (Keynes 1936, p.207). In slightly more technical terms, the interest elasticity of money demand is near-infinite: no matter how much liquidity the central bank injects into the economy, it is entirely hoarded by agents and hence it leaks out of the system in its entirety. Monetary expansion is not effective in lowering interest rates.

There may be different reasons why the economy enters a liquidity trap. Keynes argued, by looking at the great depression, that this usually happens at very low (but not necessarily nil) levels of the interest rate, because in this case agents would expect interest rates to rise in the future and thus would be willing to hold any extra amount of money and postpone the purchase of bonds to the moment when interest rates will be up again. More recently the liquidity trap has been defined as a situation in which the interest rate that equates savings and investment is negative, and therefore cannot be attained by the central bank (the so-called Zero Lower Bound, or ZLB; see e.g. Krugman 2000). This latter definition leaves some room for monetary policy effectiveness: if the central bank manages to trigger the expectation of positive inflation, the real interest rate (the nominal interest rate minus the inflation rate) will become negative and lead to the full employment equilibrium.

So, if we think in terms of ZLB, it exists a real interest rate at which the output gap would be closed. If that interest rate is negative, then it is harder to reach, as central banks need to raise inflation expectations and try to push short term rates as much as possible in negative territory, which requires boldness and creativity (we have seen this). But, once again I agree with Martin on that, this can be done. If instead private expenditure becomes irresponsive to interest rates, the ‘Keynes definition’, then there is little central banks could do. I had noticed, back in 2016, that while it succeeded in easing credit conditions, EMU Quantitative Easing seemed to have done little to boost confidence and expected demand (the ultimate driver of firm’s credit needs). The EMU most recent Bank Lending Survey seems to confirm the prediction of the time. Both chart 4 (enterprises) and chart 12 (households) depict a flat demand for loans, that picks up only when the EMU economic outlook brightens.

This is by no means hard evidence (I am not aware of any papers thoroughly investigating the impact of QE on credit demand). But stylized facts seem to acquit central bankers.

 

 

ps

The two works cited in the quote:

Keynes, J. M. (1936). The General Theory of Employment, Interest, and Money. London: McMillan.

Krugman, P. (2000). Thinking About the Liquidity Trap. Journal of the Japanese and International Economies 14(4), 221–237.

ECB: Great Expectations

June 5, 2014 7 comments

After the latest disappointing data on growth and indeflation in the Eurozone, all eyes are on today’s ECB meeting. Politicians and commentators speculate about the shape that QE, Eurozone edition, will take. A bold move to contrast lowflation would be welcome news, but a close look at the data suggests that the messianic expectation of the next “whatever it takes” may be misplaced.

Faced with mounting deflationary pressures, policy makers rely on the probable loosening of the monetary stance. While necessary and welcome, such loosening may not allow embarking the Eurozone on a robust growth path. The April 2014 ECB survey on bank lending confirms that, since 2011, demand for credit has been stagnant at least as much as credit conditions have been tight. Easing monetary policy may increase the supply for credit, but as long as demand remains anemic, the transmission of monetary policy to the real economy will remain limited. Since the beginning of the crisis, central banks (including the ECB) have been very effective in preventing the meltdown of the financial sector. The ECB was also pivotal, with the OMT, in providing an insurance mechanism for troubled sovereigns in 2012. But the impact of monetary policy on growth, on both sides of the Atlantic, is more controversial. This should not be a surprise, as balance sheet recessions increase the propensity to hoard of households, firms and financial institutions. We know since Keynes that in a liquidity trap monetary policy loses traction. Today, a depressed economy, stagnant income, high unemployment, uncertainty about the future, all contribute to compress private spending and demand for credit across the Eurozone, while they increase the appetite for liquidity. At the end of 2013, private spending in consumption and investment was 7% lower than in 2008 (a figure that reaches a staggering 18% for peripheral countries). Granted, radical ECB moves, like announcing a higher inflation target, could have an impact on expectations, and trigger increased spending; but these are politically unfeasible. It is not improbable, therefore, that a “simple” quantitative easing program may amount to pushing on a string. The ECB had already accomplished half a miracle, stretching its mandate to become de facto a Lender of Last Resort, and defusing speculation. It can’t be asked to do much more than this.

While monetary policy is given almost obsessive attention, there is virtually no discussion about the instrument that in a liquidity trap should be given priority: fiscal policy. The main task of countercyclical fiscal policy should be to step in to sustain economic activity when, for whatever reason, private spending falters. This is what happened in 2009, before the hasty and disastrous fiscal stance reversal that followed the Greek crisis. The result of austerity is that while in every single year since 2009 the output gap was negative, discretionary policy (defined as change in government deficit net of cyclical factors and interest payment) was restrictive. In truth, a similar pattern can be observed in the US, where nevertheless private spending recovered and hence sustained fiscal expansion was less needed. Only in Japan, fiscal policy was frankly countercyclical in the past five years.

As Larry Summers recently argued, with interest rates at all times low, the expected return of investment in infrastructures for the United States is particularly high. This is even truer for the Eurozone where, with debt at 92%, sustainability is a non-issue. Ideally the EMU should launch a vast public investment plan, for example in energetic transition projects, jointly financed by some sort of Eurobond. This is not going to happen for the opposition of Germany and a handful of other countries. A second best solution would then be for a group of countries to jointly announce that the next national budget laws will contain important (and coordinated) investment provisions , and therefore temporarily break the 3% deficit limit. France and Italy, which lately have been vocal in asking for a change in European policies, should open the way and federate as many other governments as possible. Public investment seems the only way to reverse the fiscal stance and move the Eurozone economy away from the lowflation trap. It is safe to bet that even financial markets, faced with bold action by a large number of countries, would be ready to accept a temporary deterioration of public finances in exchange for the prospects of that robust recovery that eluded the Eurozone economy since 2008. A change in fiscal policy, more than further action by the ECB, would be the real game changer for the EMU. But unfortunately, fiscal policy has become a ghost. A ghost that is haunting Europe…