By Ronald McKinnon
This is an updated version of Liquidity traps and the credit crunch, published in this forum on August 13, 2009
Since the onset of the credit crunch and global downturn, governments everywhere have responded to the shortfall in aggregate demand in a textbook Keynesian fashion. They have adopted fiscal stimuli: ramping up government expenditures and cutting taxes. Central banks followed the lead of the Federal Reserve by driving down short-term interest rates toward zero: almost exactly zero for overnight interbank rates in the US, Japan, and Canada, and generally less than 1 per cent in Europe into the autumn of this year.
By dis-aggregating the US stimulus package into its relevant components, one can identify some elements that can and should be exited immediately without undermining – and perhaps even strengthening – the expansionary impact of the whole regime.
The Fed should raise short-term interest rates from near-zero to modest levels, say 2 per cent. Long 10 or 30-year bond rates would be largely unaffected or could even fall. But in the current zero-interest liquidity trap, such a modest increase in short rates has distinct advantages:
1. In the huge, but still constricted, wholesale interbank market, constraints on borrowing or lending at medium terms to maturity would be largely relaxed. Only then can general bank credit at “retail”, i.e. to firms and households, increase. Surprisingly, retail bank credit in the both the US and Europe is still declining.
2. The sharp weakening of the dollar would be curbed, thus preventing a new dollar carry trade that diverts American banks lending to foreigners.
3. China could better re-balance its economy. It could become more restrictive with slightly higher interest rates without again being deluged with inflows of hot money from the US.
I will here discuss only the first – the least self-evident of the three points.
Wholesale interbank markets: Counter-party risk and zero short-term interest rates
The Keynesian response of stimulating aggregate demand through easy money and loose fiscal policy is correct to a point. But flooding the system with excess liquidity that drives short-term interest rates to near zero has been a serious mistake. In this liquidity trap, the interbank market remains almost paralyzed. Further Fed injections of liquidity simply led to a buildup of excess reserves in US commercial banks without stimulating new lending to households and non-bank firms.
After the financial panic began in July 2008, figure 2 shows that the Fed responded by more than doubling the stock of base money, which reflects the huge increase in commercial bank reserves from the Fed’s extraordinary purchases of financial assets from the private sector. However, M2 – a broad measure of deposits held by the non-bank public – only increased a modest 5 per cent, reflecting an offsetting large fall in the base money multiplier. Most disappointing of all, figure 2 also shows that retail bank lending declined – and continues to decline. Insofar as US commercial banks did slightly increase their net assets as the counterpart of the modest increase in M2, it was to buy securities such as government bonds or mortgages fully insured by the government.
But increased working capital for businesses, especially small and medium-sized, languished despite the gargantuan efforts of the Fed to expand the size of the banking system.
In line with textbook economic theory, the Fed focused mainly on the shortfall in aggregate demand rather than on the underlying supply constraint on credit availability. However, starting from a position where interest rates are already very low, say 2 per cent as in early 2008, reducing them to zero has only a second-order effect on expanding aggregate demand. But going from 2 per cent to zero has a first-order effect of tightening the credit constraint on the supply side. Leaving the fed funds rate at zero makes it impossible for the resumption of normal bank credit to support investment growth in future years.
Because credit is an input into working capital, a credit constraint acts very much like a supply constraint on physical capital. In either case, dumping more liquidity into the system does not increase output. Why?
Retail lending involves making risky forward commitments, much like transacting in forward markets in foreign exchange. For example, a bank might open a line of credit to a well-known corporate customer that could be drawn upon over the next year. But below some well-defined maximum, the customer chooses when to draw it down, and by how much.
The willingness of banks to make such forward commitments to lend to non-bank firms and households depends very much on the wholesale interbank market. If the wholesale interbank market works smoothly without counter-party risk at positive interest rates, then even currently illiquid banks can make forward loan commitments to their retail customers. If such a bank happens to be still illiquid when a corporate customer suddenly draws down its credit line, the bank can cover its retail commitment by bidding for funds in the wholesale market at close to the “risk-free” interest rate. Because the riskiness of making forward retail loan commitments is thereby reduced, the bank’s willingness to do more retail lending increases. (Otherwise, without participating in the interbank market, each commercial bank would have to hold much higher liquid reserves against its potential retail lending opportunities.)
If a crash in home prices makes all mortgage-related assets on bank balance sheets suspect, then counter-party risk becomes acute, and banks become less willing to lend to each other unsecured. Because the LIBOR market is unsecured, one very rough measure of counter-party risk from the U.S. housing crash is the difference between the federal funds rate, which is fully secured by repo agreements based mainly on Treasury bonds as the collateral, and the unsecured LIBOR. Figure 1 shows that before mid-2007, the one-month LIBOR rate closely tracked the fed funds rate. Then after mid 2007, LIBOR began to edge above the federal funds rate before spiking sharply in late summer and fall of 2008 to more than 200 basis points above the fed funds rate. This was the most acute phase of last year’s financial panic-when interbank trading dried up. In 2008 the main constraint on interbank trading was counter-party risk.
Governments everywhere responded by pumping more equity into banks, greatly expanding the ambit of their deposit insurance, and opening up various central bank discount windows for distress borrowers. This gigantic effort seems to have reduced counter-party risk, the fear of bank failure, in interbank trading. Figure 1 shows the one-month LIBOR rate coming down close to the Fed funds rate, now near zero, by mid 2009.
In 2009, however, the zero interest rate policy became an important supply-side constraint on the resumption of normal interbank trading. Positive rates of interest at all terms to maturity are necessary for restoring normal borrowing and lending in the wholesale interbank market. Only then will banks that are liquid, i.e., have excess reserves but no good future lending opportunities at retail, lend to those that are illiquid-i.e., those with good retail lending opportunities in domestic or foreign trade but no excess reserves. But if the risk-free federal funds rate is close to zero, banks with excess reserves will not bother parting with them for a derisory yield.
Interest rates don’t have to be very high to unblock private interbank markets- just 1 to 2 per cent. Otherwise, the Federal Reserve itself has to be the intermediary by using the (excess) reserves of the commercial banks lodged with it to lend directly to the private sector. Apart from the potential undesirable political biases in government direct lending, small and medium-sized firms – which cannot issue marketable commercial bills – are still left starved for even normal bank credit.
Residual counter-party risk could still be lodged in smaller US banks, among which there have been numerous failures so far in 2009. Indeed, LIBOR only reflects average interest rates for trade among the world’s 20 or so largest banks in London. It need not reflect the plight of smaller banks, which have not been beneficiaries of government largess. But smaller banks are the natural lenders to small- and medium-sized enterprises, which seem the most stressed in the current downturn. Thus, figure 2 could reflect a huge build-up of excess reserves concentrated in large banks while, simultaneously, many small and medium sized banks-without easy access to the interbank market-reduce their (retail) lending, thus making a robust recovery in the US impossible.
Ronald McKinnon is William D. Eberle professor of international economics at Stanford University.