I've been wondering about this for a while.
In comments here, reader nanute points me to the villain.
It is The Fed.
They do it by paying interest on excess reserves.
The reason is to prevent inflation.
Holy shit! We are stumbling at the edge of deflation, and the Fed is fighting inflation.
I'm no economist (so somebody help me out here if I'm all wrong) but it seems to me that if the $1 Trillion, or so, being held in excess reserves were released into the economy, we would have no need for QE II. And the $600 billion that the Fed is going to magically create via QE II will probably just result in there being about $1.6 Trillion in excess reserves by next Summer.
Now, I must go hug a squid.
Update: In comments, nanute fine-tunes the thinking.
I think the larger problem that is concerning the Fed and driving this policy is the fact that the major financial institutions are being permitted to carry high risk assets (think mbs, derivatives, etc.) at face value. I've argued for quite some time that allowing this change in policy to continue only prolongs the inevitable, and is the primary reason why the economy remains anemic. Until policy makers and financial institutions come clean, and flush all the bad debt from the system, no meaningful recovery can occur.
I do realize that such a severe shock to the system may in fact make things worse in the near term, but unless and until the individuals responsible for creating the mess are required to pay for the damage without taxpayer assistance, we will continue down the road of high unemployment and lack of demand for goods and services.
Robert Prechter pointed out years ago that debts must be repaid - If not by the borrower, then by the lender. The third possibility is pass it off to the general population. This is a drag on the system whose effects are difficult to calculate. Talk about your dead-weight losses.
It's easy to believe that this is part of why the American economy has come undone. Another thing Prechter has pointed out is that we get less bang for the debt buck now than in the past, and this mill stone could be part of the reason why.
Where I disagree with nanute is that I don't specifically relate this to the M1 collapse. I think the case for the Fed's responsibility made at Washington's Blog is pretty compelling.
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6 comments:
JzB
First off, thanks for the hat tip. I'm not an economist either, but I think that there is more to this than your assumption that the Fed is trying to minimize inflation. I think the larger problem that is concerning the Fed and driving this policy is the fact that the major financial institutions are being permitted to carry high risk assets (think mbs, derivatives, etc.) at face value. I've argued for quite some time that allowing this change in policy to continue only prolongs the inevitable, and is the primary reason why the economy remains anemic. Until policy makers and financial institutions come clean, and flush all the bad debt from the system, no meaningful recovery can occur.
I do realize that such a severe shock to the system may in fact make things worse in the near term, but unless and until the individuals responsible for creating the mess are required to pay for the damage without taxpayer assistance, we will continue down the road of high unemployment and lack of demand for goods and services. Just my 2 cents.
Somehow my name didn't appear in full. The above post is by me: nanute.
JzB: The question as to why the Fed is playing with the M1 multiplier and increasing reserve deposits is, I think part of the "solution" to the problem of overvalued assets noted previously.(Again, I'm not an economist, and I'm thinking out loud, so feel free to scold me if required.) If the increase in reserves allows the M1 Multiplier to fall below 1, the net effect is less than a dollar of currency added to the money supply. Is this a de facto devaluation of the currency? Or, is it something more? What happens when the reserves are put back in to the open markets? Does it slow the rate of increase in supply until the M1 Multiplier reaches 1?
Can the interest earned on reserve deposits be used to further deleverage, and unwind the problems associated with liabilities posing as assets without heating up the economy and causing inflationary pressure before recovery is sustainable? I don't know, and I'm just asking a bunch of honest questions that have been sparked by your concern regarding the problem. The Feds action here, does appear to be counter-intuitive with all the rhetoric concerning deflation being a bigger fear than inflation. This is a very delicate balancing act, and I'm not sure if it will work. We are in fact in uncharted territory here and the Fed is acting in a manner that has not been seen before in our history. I could go on, but I'll wait for a reaction before going further. Again, thanks for the opportunity to rant.
I don't think we are in uncharted territory. Historical examples from Japan in the 90's, and here in the 30's are highly relevant.
The whole deleverageing idea reminds me of what the much-maligned Andrew Mellon had to say in 1930: "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate . . . purge the rotteness out of the system." That got us a decade of depression and a world war.
Inflation is dead, for this cycle, at least. Deflation is a clear and present danger. I don't believe the balance is at all delicate. The M1 multiplier collapse is a symptom of deflationary forces, or at least powerful disinflation.
The problem is that inflation is too low - economists as diverse as Krugman and Sumner agree on that.
I think if QE II is going to be successful, then QE I should have had some effect on the multiplier. It didn't. Bankers are stuffing money into their vaults, aided and abetted by the FED, and the economy is suffocating. Further vault stuffing is not going to help.
I couldn't possibly scold you, BTW, since I am not an economist, either. I have lots of questions, too, and some pointed opinions. thanks for the dialog.
Cheers!
JzB
There are similarities between now, Japan in the 90's and the 30's here at home. But there are differences as well. I don't subscribe to the Mellon/Austrian School of thought.(Interesting how the Austrian economic types thinks all the unemployed are on vacation.)
I agree with your assumption, and the consensus of most economists that inflation is not a short, or even, near term concern. The problem is that the politics that will be shoved down our collective throats by the recently elected, modern day equivalent of the the Know Nothing Party, will most likely opt for a variation of the Mellon approach.
Ask yourself the question why the bankers are stuffing money in their vaults. I think part of it is pure and simple greed and leverage on policy. Moreso, it is because the balance sheets are overstated, and there is no reason to assume more risk by lending to the private sector. And what would you do if you could "borrow" money from the government at virtually zero, and get the government to pay you a premium to buy interest bearing government securities with free money?
Most of the money from QE1 was to buy up questionable assets related to GSE's and Mortgage Backed Securities. (Completed at the and of Q1 2010.) There may have been a lag on the effect of the M1, or perhaps it's possible that the policy wasn't meant to effect the M1 at that time. Remember, borrowing from the discount window, and taking the float had already started prior to QE1.
I'm somewhat ambivalent about the continuation of this type of intervention by the Fed. On the other hand, what's the alternative? Mellon style prescriptions? (Instead of QE1 we could call it Titanic 2.0.)
I'm going to Pittsburgh for a few days, in a few hours. I'll look for your response before I leave, if you wish to continue the conversation. I'm most grateful for the opportunity to express my opinion, and greatly appreciate your considered response.
nanute
n -
I discovered a conversation between Niklas Blanchard and Kevin Drum on IOR, which will lead to a new post.
Have a safe trip. I've had some good times in Pittsburgh, though it's been a while.
This afternoon were going to see one of our granddaughters in Rogers and Hammerstein's Cinderella.
Cheers!
JzB
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