Tuesday, August 28, 2012

Waiting For Jackson Hole: More Life at the Zero Bound

It's testimony to the lack of a fundamental underpinning for our Smiley Face financial markets when the only big news is an upcoming Friday speech from Fed Chairman Ben Bernanke.  Instead of the Oracle from Omaha, we have the Oracle of Jackson Hole. 

We've posted before on Philadelphia Fed President Plosser's concerns about ongoing quantitative easing.  Professor Jonathan Wright's work, cited by Plosser, suggests that early, announcement effects of the QEs are significant, but they seem to taper off and fade quickly.  We've also talked about distortions in resource allocation caused by financial rates and asset prices being so heavily influenced by this unprecedented monetary intervention of the Bernanke Fed.

Dallas Fed President Richard Fisher has commissioned a paper by William R. White, former Head of the Monetary and Economic Department of the Bank for International Settlements. It is a useful and thorough survey paper about the evidence and theoretical underpinnings for and against quantitative easing.  It also makes a strong case for how the backwash from the unintended consequences of the QEs may exacerbate any future downturn.  It is very useful reading, and it is accessible to non-economists. 

White notes that the policy rates and longer-term interest rates we've experienced are even lower than those experienced in the aftermath of the Great Depression. Macroeconomics is a shaky science in the best of cases, but when we can't look at historical antecedents for guidance, we need to be afraid.  The prevailing orthodoxy, including a 2002 paper by Fed Chair Bernanke, suggests that monetary policy going in the aftermath of the Great Depression had not been easy enough.  Intellectually, Bernanke feels the weight of history telling him that the Fed must not be reticent as central banks were after the Great Depression. 

In addition, from 2003-2006, a number of papers were written purporting to demonstrate that a central bank could perform maturity swaps that would have the effect of lowering ten-year rates just as if the central bank had used fresh reserves to buy paper.  From this was born the mania for QEs. 

White's paper notes the work of Professor Axel Leijonhufvud, a distinguished Keynesian economist who has some interesting things to say about Keynesian policies in the aftermath of the financial crisis.  In the world of the Keynesian model, there is no explicit sub-model of the financial sector and no explicit regard for the balance sheets, either of firms or the government.  This, he says, has led to a "fiasco" when Keynesian stimulation has been applied post-crisis. 

If there is a balance sheet meltdown in the shadow banking sector, driven by counterparty performance failures, collateral fire sales, and liquidity issues, then the world will move down a deflationary path. If, on the other hand, the balance sheet issues occur on the sovereign government side, particularly in the United States, then we will have an inflationary surge. The global system could go either way.  Reinhart and Rogoff also document historical precedents for both of these scenarios.

Our current shadow banking credit system was procyclical in the credit upswing.  White makes a convincing case that the same, unreformed system will be procyclical in the inevitable credit downswing.

The paper also brings in Knut Wicksell's concepts of the natural rate of interest versus the financial rate of interest set by markets.  We have been in an environment were the financial rates are well below the natural rate, driven by trend growth rates of GDP.  In Wicksell's model, this disequilibrium creates "malinvestments." 

The paper concludes by saying that central bank actions in the current crisis have served to "buy time" for governments to get their houses in order, by balancing their budgets and by putting in place policies and regulations that provide an environment for sustainable, economic growth.  If governments here and in Europe don't make use of this breathing space, then this crisis will end in "lost decades" for the developed market economies. 

Don't expect much of substance from Jackson Hole.  Do expect the markets to get what they want.  They will party hard going into Labor Day.

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