Saturday, 7 November 2009

An unanticipated surge of lending?

I've had this article in draft for about three weeks. Paul Krugman's latest item seemed an opportune moment to finish it.

Intriguing article by Sheng and Pomerleano in the Economists' Forum about zero interest rate policy. I don't think I agree with what they are saying (insofar as I can even tell what they're saying) but it stimulates a few thoughts along Scott Sumnerish lines.

One bit (from Kevin Warsh, quoted approvingly by the authors) jumped out at me:
A complication is the large volume of banking system reserves created by the non-traditional policy responses. There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending.
Now surely a surge in lending is exactly what we want? Isn't all this monetary activism meant to increase the effective money supply (or counter a fall in velocity) therefore sustaining nominal GDP? After all, this year's collapse in new loans is meant to be one of the main causes of the recession.

The problem, according to Scott, is that the Fed has created a trillion dollars or so of extra money which banks are hoarding because they are earning interest on it. I am also unsure about this argument - would the small difference between +0.25% and -0.25% really make the difference between whether or not banks lending into a market they see as having a high risk of default?

Surely the issue is, instead, that banks don't think there are enough creditworthy borrowers; in effect, their expected return on the marginal loan is negative. While that half-percent makes a marginal difference, it is likely that the banks' expected average return on capital has fallen much more than that - and only a -5% or -10% rate would be enough to make lending attractive.

Despite Scott's heated response to Paul today, I actually think they agree on many points:
  • Falling real GDP is a problem
  • Falling nominal GDP is a problem
  • Nominal GDP is directly affected by tight money (and money is tight now)
  • Sticky prices are the reason real GDP falls in consequence
  • Real GDP is path-dependent, so monetary policy does matter for the real economy
  • If the Fed were willing to target inflation, nominal GDP could be increased and this would help with real GDP
Scott doesn't acknowledge the importance of real GDP very much - because it's hard to observe or even estimate realistically. Paul on the other hand overemphasises the binding constraint of the zero interest rate bound. But if they could just get past that, they'd be pretty close.

After these cosmetic issues, the disagreement is about how to get out of the zero interest rate trap and expand the amount of money circulating in the economy. Scott's view is that if the central bank targeted an NGDP forecast, this would stimulate appropriate behaviour in the private sector to achieve its target. Paul's view is that - in today's institutional and political climate - fiscal stimulus is the right way out of the trap.

To resolve this argument, we need to understand behaviour at a lower level.

We need to understand the behavioural relationship between base money, broad money supply and velocity. In particular, given that MV = PY, what other factors apart from the size of M affect Y (and P)? That is, what are the determinants of velocity?

We don't know what those behavioural stimuli are in any detail. We do know that the government can directly manipulate some of them by spending money and employing people (Paul's approach); and we know that expectations of future economic performance affect them too (Scott's approach).

Some more careful analysis - or even some experimentation - would give us a better theory of monetary behaviour which would help us be sure of how to restore economic growth.

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