By Ronald McKinnon
The global credit crunch which began in 2007 but became acute in 2008, originated from the collapse in the bubble in US house prices and, to a lesser extent, in European ones.
Unsurprisingly, the declining home values made people feel poorer, so consumption spending fell. This fall in aggregate demand in the US and Europe reduced demand for imports and caused a parallel slump in the rest of the world, including in emerging markets.
Governments have responded to this shortfall in aggregate demand in a standard textbook Keynesian fashion. They followed the lead of the US by driving short-term interest rates toward zero: almost exactly zero for overnight interbank rates in the US, Japan, and Canada, with European rates generally being less than 1 per cent. To varying degrees, they have adopted fiscal stimuli: ramping up government expenditures and cutting taxes.
But is the zero interest rate the appropriate response?
The downturn in economic activity was not just the result of a fall in aggregate demand. The impairment of credit markets led to supply constraints in domestic and foreign trade.
During the bubble, the big US investment banks had securitised home mortgages into complex risk tranches and then sold them to other banks and financial institutions, mainly in the US and Europe. The collapse in home prices impaired the values of these mortgage-backed securities in the portfolios of banks everywhere.
Consequently, banks are fearful of trading with each other: the so-called counterparty risk of a trading partner going bust. Because banks could not easily cover retail commitments in the wholesale interbank markets, they became, and remain, reluctant to make forward commitments to lend normally at retail to business firms and households at medium terms to maturity.
Even in mid-2009, after large recapitalisations by the US Treasury to big banks, net retail bank credit outstanding in the US is contracting. A survey of 15 large US banks by The Wall Street Journal showed a net average decline of 2.8 per cent from the first to the second quarter in 2009, despite much talk about seeing “green shoots” in the US economy.
Generally, the downturn was much steeper in foreign trade than in domestic trade. Although the slump in world demand, particularly for manufactures, was important, the supply constraint on credit for foreign trade seemed to be more restrictive than for domestic trade.
Foreign trade involves more counterparty risk, because exporters in country A are less familiar with the credit risk of importers in country B, and there is the further risk of exchange rate fluctuations.
Thus the use of formal bank letters of credit is more common in foreign trade than in domestic trade, and these are designed to facilitate normal trade credit from exporter to importer, when the foreign importer may not be as well known to the domestic exporter, the natural counterparty risk is high. But if the solvency of the bank providing the letter of credit becomes suspect, this risk-reducing mechanism breaks down.
Even more subtly, the impairment from counterparty risk of US and European interbank markets at wholesale makes forward foreign exchange transacting more difficult and expensive. Thus, at retail, importers or exporters find it more difficult to hedge themselves from currency fluctuations. Without forward cover, they find it more difficult to secure credible bank letters of credit.
The upshot is that foreign trade finance around the world has become more expensive.
Reviving the interbank markets
In the current crisis, 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 is a mistake.
Although Japan has been stuck in a zero interest liquidity trap for a decade and a half, in 2008 the US Federal Reserve deliberately flooded the dollar-based financial markets with base money so that by the end of the year the federal funds rates became virtually zero, where it remains.
In this liquidity trap, further injections of liquidity by the Fed led to a buildup of excess reserves in US commercial banks without stimulating new lending to households and non-banks.
Moreover, the importance of the dollar in the world’s monetary system has forced other central banks to lower their interest rates unduly to prevent their currencies from appreciating against the dollar at a time of a slump in exports.
Why did the Fed make this incredible mistake? In line with textbook theory, it focused 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 low, say 2 per cent, reducing them to zero has only a second-order effect on expanding aggregate demand.
But going from 2 per cent to zero leads to a tightening of the credit constraint on the supply side. Although there may be a “dead cat bounce” to the economy on the demand side in 2009, leaving the Fed funds rate at zero makes it impossible for the resumption of “normal” bank credit to support growth in future.
A condition for restoring normal borrowing and lending in the interbank market is to have positive rates of interest at all terms to maturity. Only then will banks that are liquid lend to those that are illiquid. But if the risk free (i.e. federal funds) rate is close to zero, banks with excess reserves will not bother parting with them for a derisory yield.
Interest rates do not have to be high to potentially unblock interbank markets, say, just 1 to 2 per cent. But surplus banks need profit margin for them to play their intermediary role, a reason for avoiding zero interest rate liquidity traps.
The troubled asset relief programme carried a provision that allows the Fed to pay interest on commercial bank reserves held with it. The European Central Bank pays interest on required commercial bank reserves but only recently introduced a rule that allows it to pay interest on excess reserves. These two central banks are now equipped to act as broker-dealers in their respective interbank markets-but with one further change in mindset.
Traditionally, commercial bank reserves with the central bank have been treated as short-term demand deposits, which makes sense if the commercial bank in question has an unexpected liquidity squeeze. However, to replicate conditions in the pre-crisis interbank market, central banks would also accept interest-bearing-term deposits for 30, 60, or 90 days, up to a year or more.
On the asset side of the Fed’s balance sheet, it would lend to credit-worthy commercial banks at similar terms to maturity. The central bank would determine interest rates to balance the flow of funds at each term, with a small bid-ask spread. The yield curve would slope, with long rates as much as 3 percentage points higher than short rates, as in today’s Treasury bond markets. But counterparty risk would have been eliminated because commercial banks, as either borrowers or depositors, deal only with the Fed, which is assuming the default risk but has the power to make it very uncomfortable for banks that do default.
However, even if such an idealised clearing house is established for interbank trading, it is not going to work if short-term “risk-free” interest rates are stuck near zero. Counterparty risk or not, liquid banks will not want to lend to less liquid ones, thus impairing both domestic credit markets and forward markets in foreign exchange.
It would be difficult to escape the near zero interest rate liquidity traps in which so many countries find themselves. To avoid undue fluctuations in exchange rates, the main central banks should cooperate to raise interest rates and clear excess bank reserves simultaneously, if only modestly. But that is a long story for another time.
Ronald McKinnon is William D. Eberle professor of international economics at Stanford University
