Macro: liquidity trap and money supply

Charles Goodhart comments on the collapse in the money multiplier and advocates continuing quantitative easing. The discussion nicely illustrate the difficulties that the central banks face now in an attempt to increase liquidity:

Insight: Deflating the bubble By Charles Goodhart

Published: November 30 2009 16:35 | Last updated: November 30 2009 16:35

Between the failure of Lehman Brothers in September 2008 and March 2009 asset prices in financial markets, world trade, confidence and real output dropped faster than in 1929.

Since then there has been an, almost miraculous, recovery in financial markets and confidence, and a stabilisation and incipient recovery in trade and output. The turning point coincided with the aggressive adoption of quantitative easing (QE), especially in the US and UK. The most common explanation of this recovery in financial markets is that it has been due to the abundant provision of liquidity; and liquidity is exactly what QE generates.

Yet QE has not worked as many had first expected. A now defunct theory of the supply of money had the central bank controlling this by operating to adjust the reserve base of the banking system. Banks were expected to maintain a reasonably stable ratio of reserves to assets/deposits so, if the authorities should raise their reserve base, primarily their deposits with the central bank, then total assets/deposits should rise by the same level.

Since total assets/deposits are normally a large multiple, say 25 times or more, of the reserve base, this relationship appeared to enable the central bank to adjust total bank assets/deposits by a multiple of their open market operations to affect the reserve base, the “money multiplier” as the theory was known.

From June 2008 to June 2009, reserves held by commercial banks with their central bank doubled in the eurozone, and increased by an even greater percentage in the UK and US, yet bank deposits and total bank assets barely changed, so the multiplier collapsed to zero. Banks, in aggregate, just absorbed the additional reserves by allowing their ratio of reserves to deposits to balloon, without any attempt to use their greater liquidity/reserves to expand their balance sheet. Why?

This may appear to have been a purely passive response to cash injection, but nevertheless commercial bank treasurers will have consciously decided that accumulating vast cash reserves was preferable to using them in any other way. This may be partly insurance against uncertain future needs to roll-over wholesale funding. At a time of tightening bank capital requirements, and rising prospective defaults, the limitations on lending to private sector borrowers, except on most favourable terms, are obvious.

But why not buy safe public sector debt? Lower yields on short-dated government bonds, pushed down by QE, as well as interest rate risk, enhanced by rising debt ratios, may make public sector debt appear less attractive compared to the safe remuneration on deposits at the central bank. This is a condition for a typical liquidity trap; hence my proposal for applying a negative return, a charge, on such deposits. Perhaps a lesson that should be learned is that the relativities between the interest rate on bank deposits with, and borrowing from, central banks gives each central bank another degree of instrumental freedom, on top of their control over the official short-term rate.

Despite the total collapse of the money multiplier, QE has, I believe, been a major factor in the recovery of financial markets and confidence. The scale of asset purchases has been so large that it has led to a huge injection of liquidity, and to portfolio rebalancing, on a large scale amongst non-bank financial intermediaries and financial market participants more widely. Bond yields have come down quite sharply, more so in riskier corporate debt than in government debt, as risk premia also get reduced. Equities rise, and exchange rates fall in countries pursuing QE more aggressively (USA and UK) relative to those doing less (eurozone and Japan). The rise in asset prices and fall in yields, has allowed large corporates, including banks, to refinance themselves in capital markets; with fixed and inventory investment still low, such fund raising allowed repayment of bank loans. It is ironic that QE may have facilitated a reduction in bank lending and deleveraging.

So if QE has been such a success, and the prospective recovery still looks anaemic, why not continue it? Partly because the money multiplier has been defunct, QE has operated primarily via a restoration of prices, confidence and capital gains in financial markets rather than impinging directly on the access to credit and expenditure decisions of small and medium enterprises and households, where the real problems remain. If the authorities go on blowing up financial markets too much, at some point yet another bubble will develop. The last time the financial bubble burst, the taxpayers got soaked. There will not be a next time for this support mechanism, since the taxpayer neither can, nor will, repeat it. Central banks need to check their proclivity for generating a further bubble to overcome the effects of the previous bust. Certainly, we can never get the timing exactly right, but now does seem the moment to declare victory for QE and withdraw.