Risks of Additional "Monetary Easing"

Back on August 1, Kevin Drum commented:

Easier monetary policy might or might not be effective, but it seems like even the Fed thinks it would be a pretty low risk thing to try. So why not try it? 
Kevin Drum, 8/1/2012

Since then, I've been collecting reasons why this might not be a good idea.  

As far as I know, the only monetary action under consideration is additional asset purchases, i.e. more bond swaps for reserves.   Here are some reasons why this "monetary easing" might be counterproductive:

- Lowering interest rates (by liquidating bonds) is fundamentally deflationary.  Injections of 5% or more annual interest paid on long term bonds are replaced by reserves which earn 1/4% interest.  See Ed Harrison, for example:

in periods of low credit demand growth, it is the effect on lost interest income that overwhelms the effect on credit growth. In fact, I would argue that this policy actually helps tip economies into deflation... the same people who were concerned about low rates stealing interest income become coupon clippers, knowing that deflation will bail them out. Suddenly, your economy is trapped in a deflationary rut – and central bank policy of zero rates helped to get it there.

- Banks make money by borrowing short and lending long.  You can only reduce long term rates so much before such a business model collapses.  Ed Harrison again:

the signs of malinvestment excess from extremely low interest rates are all around us. When recession hits, these losses will crystallize. And there will be no steep yield curve to bail out the banks as we saw in in the early 1990s. The banks will have to take it on the chin like the Japanese banks did in 1997 – and we know what happened there...

- Focus on Fed fixes diverts attention from the fiscal fixes that are needed.

- Removal of interest bearing bonds leads some investors to alternative investments such as commodities, pushing up the price of gasoline, for example.  Any inflation caused by debt monetization is in assets, which is the bad kind of inflation in the present economy.

- Money market funds are already unstable, as they are not legally guaranteed but cannot be allowed to fail. Reducing the interest on reserves from the current 1/4% to 0% could cause failure in this part of the financial system.  The prospect of further bailouts for the banks and the wealthy will not be popular and could cause political turmoil.  Here's a post by Cardiff Garcia of FTalphaville on this subject:

The ECB’s recent decision to lower its deposit rate to zero raised speculation in the market that the FOMC might be considering the reduction or elimination of the 0.25 per cent interest the Fed pays on excess reserves.

interest on excess reserves is like a safe asset for banks — you can consider it an imperfect near-substitute for the Treasuries and agency MBS that the Fed has removed from the market. And along with the unlimited deposit insurance on non-interest bearing accounts, it is (from a certain point of view) a kind of ongoing bailout for money market fund investors.

The risks, in sum, are that rates will plunge to zero or negative, money market funds and their investors would panic as their sources of yield disappeared, and that banks will follow Bank of New York Mellon’s lead last year and consider the (politically uber-controversial, btw) possibility of charging fees on deposits.

Money market funds would likely be subsidised for a time by their sponsors, but that can’t be counted on to the extent that it was before the crisis. Were this to pass, we couldn’t with any certainty predict the consequences — but given the panic that ensued when Reserve Primary broke the buck, it’s worth taking none of this lightly.

But in addition to general chaos in money markets, here are three more possible worries resulting from the above...

it is just as possible to imagine how, regrettably and almost perversely, negative rates would actually make things worse. How they would lead to higher demand for money itself — to deflationary expectations.

So if the economy slides back into recession in 2013, which is a likely prospect given the approaching fiscal cliff and our highly polarized and dysfunctional political environment, visions of hyperinflation caused by debt monetization may give way to a deflationary reality.  We'll see soon enough...

Second Dip Coming?

A good post by Ed Harrison got me thinking about the severity of the next recession.  The economy has been weak for the last 5 years (and was unhealthy for the previous 8 or so).  Some people (the majority of the outspoken financial community) seem to think that this means we are due for a bull market / growing economy.  My take is that we are not out of the woods yet, and in fact may be taking some counterproductive measures.  Moreover, the (neo)liberal Democratic commentariat is just as counterproductive in one respect as everybody else.

Specifically, I think that efforts to use monetary policy to boost the economy may be counterproductive.  To start with, monetary policy is massively misunderstood, as noted in my March 2012 post here.  The ongoing push, mainly by the (neo)liberals, to push interest rates down even further may be deflationary in the long run.    This is obvious from the fact that interest paid by the federal government represents money given to the private sector.  In other words, lower interest payments decrease the fiscal deficit.

So what is the real problem facing the economy, and how will decreasing the fiscal deficit affect the fundamentals? The basic problem is stagnating wage incomes, which have gotten out of whack with asset prices and consumption habits. The gap has been filled with unsustainable household debt, and this is still a problem. While housing prices have come down substantially, other asset prices, including the common stocks that many depend upon for retirement, are still overvalued. Decades of investment incentives (e.g. reduction of capital gains tax) have led to excess investment.

By seeking to further reduce interest rates in order to stimulate more investment, the neo-liberals are foolishly trying to reblow the same bubble that popped 4 years ago. Only deficit spending can provide the needed boost to household income that is needed.  As noted above, reducing interest rates reduces the desparately needed fiscal stimulus.  Trying to reignite private borrowing will just exacerbate the problem. When the next downturn comes, zero interest rates will be telling indicator of deflation, not the go signal that so many seem to assume….

Will Corporate Bosses Keep Republicans in Line?

The corporate bosses that call the shots in the Republican Party can't have been happy with the debt ceiling shenanigans last year. Rich people do not look kindly on anyone messing with their financial instruments. This year we face the "fiscal cliff". Corporate folks surely do not want economic warfare, which can only hurt them.

Obama should have a lot of leverage to follow through on his pledge to raise taxes on the wealthy. In return he'll probably make concessions on entitlements. That is, if (relative) sanity prevails. If this is how it plays out (a best case, as far as the status quo goes), then this will have a slight depressing effect on the economy next year, as increased taxes for the wealthy will mean less money around to invest in stocks and other assets. 

Here are a few things that could go wrong and make 2013 even worse:

- The temporary payroll tax cuts are allowed to expire.  This is actually likely and will be a significant blow to the economy in 2013.
- Romney gets elected and foolishly cuts government spending.
- Israel and/or U.S. attacks Iran and oil supply is disrupted.
- Obama caves and cuts spending sooner rather than later.
- A faction of Republicans favors economic pain to teach the Dems (another) lesson.  Chaos ensues, as in the debt ceiling negotiations.  To save face, the Republicans insist on some stupid budget cuts.