Sunday, January 11, 2009

Zen and the Art of Printing Confidence

I was in the middle of writing a piece explaining what I mean when I said there's no such thing as "just printing money," when Willem Buiter totally scooped me.  Go there and read the masterpiece on printing money in its entirety.  Once you've finished, you can read this appendix on how printed money might, or might not, turn into economic activity.

Just as in Zen, this post is mostly questions intended to lead to enlightenment or confusion.

Buiter describes the two major goals in our current round of printing:

1)  Prevent the system, and entities with such large tendrils they might as well be the system, from collapsing under their own weight.  Mission accomplished, for now.
2)  Get private credit creation started again, generally by inspiring risk-taking by private market participants as currency becomes a poor store of value and long or risky interest rates fall.

Confidence in Traction

Number two, the generation of private confidence, is where our financial market policies would lead to real economic traction.  Buiter writes:
When fear and panic eventually desist, however, it is essential that the central bank stand ready to take back the injection of liquidity provided since September 2008.
There is an explicit supposition here that the reluctance of the private sector to extend credit and create money is simply a matter of fear, panic, and a lack of confidence.  Krugman calls this the slap in the face principle: clearly, everyone has lost their minds in a collective hyperventilation, and with a couple shots of whiskey and a paper bag, we can go back to trading as usual.

We've tried slapping this particular pig a lot of times over the last two years, and yet, nobody seems to wake up, no matter how large a slap is delivered.  The TAF, the PDCF/TSLF, the TARP, FDIC-backed bonds, and so forth, yet nothing much has happened.  All the money we've created is surging forth like a cypress swamp in Florida as excess reserves sitting on deposit at the Fed.

Forced Investment

So why has none of this led to increased private credit creation, or increased confidence?  Well, what if the private market is not being completely irrational as it fails to fund further investment?  Can we be in a situation where there are not enough appealing risk/return opportunities on our zero bound, resulting in no good reason to extend or borrow cash for investment?

I think it's possible.  We've seen very little investment in tradeables in the US for many years, and strong investment in areas like residential real estate, a sectoral mix probably resulting from our exceedingly strong currency relative to other nations.  Most of our GDP has been allocated towards consumer spending.  There is major overcapacity in most sectors resulting from the rapid global growth of the last ten years.

Forced further investment through somehow getting real interest rates sufficiently negative, while a temporary palliative, will only make structural oversupply and misalignment worse.

We've successfully rolled the dead whales back into the ocean and reduced the nominal cost of funding somewhat.  But without fixing the fundamental misalignments that have led to unbalanced global growth, I'm not sure successfully forcing further investment or consumption represents victory.

Printing Uncertainty

Getting slapped in the face doesn't generally build confidence, and can lead to uncertainty of pick-up line quality.  Quantitative and qualitative easing do not necessarily lead to a risk-taking appetite in the private sector, nor do they necessarily lead to serious inflation, which depends on many factors.

Intervention clouds economic signals, the ones the private hand uses to direct us in the right endeavors.  It's very hard for anyone to get a handle on relative pricing in the near future and present, or judge a worthy risk, when second-round effects from deflation, credit creation, and strenuous government intervention must be factored in.  This can lead us to do the wrong thing, or more likely in our modern day and age, do nothing at all.

Banks might be worried about Buiter's sudden resurgence in inflation creaming them on a long-term loan they make for development.  Borrowers might take a sober assessment of pricing power and expenses in their industry, look at end unit sales projections, and fear deflation will persist.  While strong inflation would be good for the borrower, and strong deflation might sorta possibly be good for the lender, both face extreme uncertainty in their projections, and paralysis results.

The slaps themselves might actually be contributing to the paralysis in the financial markets, too.  The Fed and the government can crowd the private sector out of these marketplaces by setting artificial clearing prices.  Imagine there's a lender who sees a 10% risk of default by a borrower.  They then might be willing to lend out money at 12%.  However, if the government intervenes to drive the rate down to 8% forcibly, that loan will not be made by the private sector at all.

If I knew I were trading in a market where the Fed were present, I would have precisely one strategy: front-run the Fed.  This front-running makes intervention more expensive for the Fed, and is profitable for the front-runners, but it doesn't encourage the private sector to take the reins again.  As the most visible example, the Fed now owns roughly 20.5% of the commercial paper outstanding.  The latest release shows this has little to do with year-end effects, and the percentage has been gradually increasing since the program was initiated.  The government will gradually issue or own more and more loans, and the private sector could continue to recede.

Finally, just to throw in one more feedback loop, let's imagine we hit moderate to high inflation.  As readers observed on my last post, the value of a phenomenal amount of longer-dated fixed coupon assets outstanding would get crushed, destroying a lot of players and money.  That -- or even its credible possibility -- isn't good for real investment or certainty either, and would require even more rescues by the government.

The paralysis and uncertainty engendered by our intervention are, in my opinion, worse even than the alternatives.  People must have faith in currency as a mechanism for accurate pricing information and storing wealth.  If we destroy that in our quest to inflate our way to victory, what have we won?

I'll write a separate post on the other issue Buiter raises, central bank solvency, at some point in the future.

11 comments:

S said...

Agree. You should post a bit of a profile.

ndk said...

Agree. You should post a bit of a profile.

I absolutely can't fathom why anyone would be interested in me as a person. I also don't understand why people bother to read the other things I write. So, I've fleshed it out a little for you. :D

Anonymous said...

Great stuff, ndk. Thank you for your efforts.

Mikkel said...

ndk:

Do you mind if I ask what you think the best course of action in all this is?

Notice I didn't say solution...

ndk said...

Do you mind if I ask what you think the best course of action in all this is?

Notice I didn't say solution...


I'm a Mellonite at heart, Mikkel, and would have preferred to see rapid liquidation in a credit collapse followed by collection of the remaining pieces. I wrote about it in early November. The writing isn't very polished, but at least it captures the gist of it.

Thanks again to all you readers! This is kinda cool.

Mikkel said...

Your prescription (and conclusion) is almost letter for letter where I've come to [er well not to brag but where I started from actually nearly two years ago]. It's some weird amalgamation of freer markets in some areas and stronger government intervention in others.

I would just say the one thing you didn't mention is massive investment in research -- both basic and applicative...perhaps with some sort of licensing fees for companies that use the research.

Given that backdrop, you have more fortitude than I do. I think that "we must protect the integrity of and trust in our government" and I'd add to that "project integrity of our food and shelter supply/distribution..." but I fail to see how any of this economic hand waving will accomplish any of that. I am interested in nonlinear system dynamics in general and have some experience in applying them to biological systems, and there are blindingly obvious feedback loops that prevent a successful resolution IMO. The biggest one of all is our petroleum powered economic structure...

At this point it seems to me to be primarily a political problem, where the impetus should be on trying to get the political backing for a radical change like you laid out. The problem is that by definition, that requires acceptance of a decrease in standard of living and destroyed dreams of tens of millions (especially any one over 55). No one wants to give anything up, and so we'll all go down.

Maybe you disagree with that premise, but it's become very difficult to even focus on the ins and outs of the economic situation, instead of thinking more about likely geopolitical actions...and even self reflection. I read people like you and Yves because you have the requisite
understanding but also intuitive skepticism. I wish that one of these days people like you will say something that makes me question my understanding but you're just making it more concrete...thanks a lot!

ndk said...

I would just say the one thing you didn't mention is massive investment in research -- both basic and applicative...perhaps with some sort of licensing fees for companies that use the research.

Given that backdrop, you have more fortitude than I do. I think that "we must protect the integrity of and trust in our government" and I'd add to that "project integrity of our food and shelter supply/distribution...


I'd also be happy to see these two additional focus areas.

I am interested in nonlinear system dynamics in general and have some experience in applying them to biological systems, and there are blindingly obvious feedback loops that prevent a successful resolution IMO. The biggest one of all is our petroleum powered economic structure...

I think the biggest one of all is vendor financing flows, but our petroleum requirements are a close runner up. Economics does involve extensive study of feedback loops, but there are so many to consider that it's difficult to isolate what effect is strongest. What really bothers me is these feedback loops are primarily considered in single iterations, and longer term effects over multiple business cycles are generally ignored.

Jubilee Year said...

I think you, and Krugman, are overlooking the role of deflation related to the drying up of bank lending. It is not just a case of lost confidence, it is perfectly rational to not extend loans in a deflation. Loans in a deflation are sure losers. Plus the deflation is constantly undermining bank assets, so they can't give out loans even if they wanted to. The deflation has to be stopped first.

ndk said...

I think you, and Krugman, are overlooking the role of deflation related to the drying up of bank lending. It is not just a case of lost confidence, it is perfectly rational to not extend loans in a deflation.

I would agree with you, but I don't think I'm overlooking the need to stop deflation. On the contrary -- and this is very contrary to most everyone -- I don't believe our actions, quantitative easing and fiscal stimulus included, are conducive to stopping deflation.

In particular, for this loan to make sense, the value of the goods or services provided by the business must be increasing in the future. I don't see likely transmission mechanisms from increased domestic money supply or increased government spending to higher pricing and wage levels when constraints like the Chinese currency peg, zombie corporations and banks, and deflation are imposed. I hope my posts here have helped explain why, but maybe I need to try again.

It's a very falsifiable claim, bold and seemingly crazy. But I feel pretty confident about it, Jubilee Year. Keep me honest to that.

john bougearel said...

ndk

It is precisely because you weigh in on these heavy matters so well, and because the crisis has heightened our willingness to pay attention that your own personal capital has skyrocketed of late. That should address both why we read and why we should care a little bit about you. Just do it! :-)

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