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.
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.
But why not buy safe public sector debt?
Here's one way to think about the liquidity trap -- a situation in which conventional monetary policy loses all traction. When short-term interest rates are close to zero, open-market operations in which the central bank prints money and buys government debt don't do anything, because you're just swapping one more or less zero-interest rate asset for another. Alternatively, you can say that there's no incentive to lend out any increase in the monetary base, because the interest rate you get isn't enough to make it worth bothering.
Jan Hatzius of Goldman Sachs has a very interesting short paper (no link, sorry) that makes it clear just how serious the zero lower bound on interest rates, aka the liquidity trap, is likely to be.
The banks are accummulating cash reserves because they need them to compensate for realised or expected losses from loans made during the bubble and gone bad. Quantitative Easing is an Central Bank operation of repair of the balance sheets of the banking sectors. This is appropriately done through the discount window and not through open-market operations which, in a liquidity trap, don't work anyway.
Quantitative Easing, though necessary, validates the credit practices of the previous bubble unless financial regulation is reformed to outlaw or at least constrain the credit instruments at the centre of the crisis. Securitisation needs to be reined in, off-balance sheet "special purpose vehicles" with lines of credit need to come onto the balance sheet. CDS need to be supplemented with the requirement to present a defaulted bond in order to collect the pay-off, making them akin to a repo and therefore relatively tame.
That's on the financial sector side. Fiscal policy is another barrel of fish and the central banks need to be accommodating by buying as much government debt as needed to fund the fiscal stimulus. Assuming, that is, that the government comes up with a sensible stimulus.
Why the above is not part of the standard discourse about the crisis is beyond me. Don't economists learn anything in school? En un viejo país ineficiente, algo así como España entre dos guerras civiles, poseer una casa y poca hacienda y memoria ninguna. -- Gil de Biedma
This is a condition for a typical liquidity trap; hence my proposal for applying a negative return, a charge, on such deposits.
I agree with Greg Mankiw[1] that it is time for central banks to stop pretending that zero is the floor for nominal interest rates. There is no theoretical or practical reason for not having the Federal Funds target rate and market rates at, say, minus five percent, if that is what your Taylor rule, or whatever heuristic guides your official policy rate, suggests.
