March 14, 2008
When is increasing liquidity or the monetary base not inflationary?
Two comments on an earlier blog of mine made the point that the Fed’s swap of Treasuries for MBS with the primary dealers had been motivated by the desire not to increase system-wide liquidity (monetise the MBS), but simply to allow existing pockets of liquidity to be mobilised more effectively. I commented on Miranda Xafa’s post but I had missed Alfred Smith’s remark that “The striking inpact of the Fed’s action is enhancing mortgage market depth without adding to the monetary base. In this respect, it has filled the role of lender of last resort while minimizing the inflationary bias of this role.” The statement is descriptively correct as regards the effect of the Fed’s action on the monetary base/liquidity but analytically wrong as regards the inflationary implications of monetising the MBS. It may be worth repeating the difference, in the context of the quantity of money, between a movement along the demand curve and a shift of the demand curve.
An increase in liquidity, or an increase in the monetary base that accommodates an increase in the demand for real liquidity (i.e. an increase in the demand for liquidity at a given general price level) is not inflationary. The accomodation, through an increase in the nominal quantity of liquidity (or base money) of an increase in the quantity of real liquidity demanded, instead avoids the need for deflation - a decline in the general price level.
The increase in the quantity of real liquidity demanded is a fact - a consequence of the liquidity crunch. What will be key is that, when markets normalise and the credit crunch vanishes, the Fed withdraws the liquidity it has injected, because this liquidity will at that point become inflationary. But that will be then. This is now, and the non-inflationary-if-properly-handled-in-the future increase in liquidity and the monetary base is needed now.
The Fed’s swap of Treasury bonds for MBS with the Primary Dealers substituted liquid Treasury bonds for illiquid MBS in the portfolios of Primary Dealers. If there were pockets of underutilized but mobilizable ultimate liquidity in the private sector (unused claims on central bank money in excess of what the private party holding them would want to hold if the alternative of Treasury Bills were on offer, but not in excess of what that same private party would want to hold if only MBS were on offer), then the Fed’s swap with the primary dealers would indeed increase effective liquidity in the system, by permitting the more efficient utilisation of these idle pockets of ultimate liquidity already out there.
I don’t know how many pockets of unutilised or underutilised ultimate liquidity are out there that could be mobilised by MBS being exchanged for Treasuries. I doubt whether they would make much of a collective dent in the liquidity drought we are experiencing. So, much better not to futz around, but instead to increase the quantity of ultimately liquidity (and of base money) in the economy either through collateralised loans from the Fed to the primary dealers against MBS or through the outright purchase of MBS by the Fed from the primary dealers and anyone else who wants to get rid of them. All this to be done at properly punitive prices for the MBS, topped with an appropriate hefty haircut to minimize moral hazard and to give the tax payer a fair crack at making some money on the deal. Life is beautiful.
Financial institutions are holding worthless paper that they refuse to write down. The Fed is bailing them out at what will be great cost to the American public. The market is showing it with the big hit on the dollar and continued rises in gold and oil.
Why not just let the banks fail and give each household $50k? It seems more equitable to me.
Posted by: joe smith | March 14th, 2008 at 1:09 pm | Report this commentWhy should the banks get bailed out when the dotcoms weren’t?
From Boudewijn Wegerif’s CLEAN SLATE:
“The stubborn refusal to stop ‘thieving’ and lift the cross of debt off the back of humanity has spread right round the world. From Jerusalem, through Rome and Constantinople, to Venice and Florence, Genoa, Amsterdam and Antwerp, London, New York, Tokyo, Frankfurt and Paris, Quebec, Moscow, Delhi, Buenos Ayres, Johannesburg, Sydney and Stockholm.
The record of debts has grown and grown, and is now digitised in a world wide web of electronic accounts. The whole is controlled by a thousand commercial banks of consequence, 125 or so central banks, and four mainstays – the World Bank, the IMF, the Bank of International Settlements in Basle and the WTO World Trade Organisation.
“A washing away of the debt records”, as the clean slate was called in Anatolia three thousand years ago would mean, in today’s terms, deleting all financial obligations, as electronically digitised. A tall order, yes; but until there is a clean slate for justice and righteousness’ sake, the global desolation that is already on us will grow worse and worse.”
Posted by: Return of the Sabbath Laws | March 14th, 2008 at 3:27 pm | Report this commentWillem, what do you hear about the “Bear Bailout”. Will the FED repo or monetize the JPM triage?
Posted by: groucho | March 14th, 2008 at 3:40 pm | Report this commentThe role of the Fed as a banker of the last resort will,in my opinion,very shortly be put to the test.The question I would like answered is just how deep are the pockets of the Fed?After all there will be plenty of candidates for a bail out,the worst or best of the crisis is yet to come.Odd that the perpetrators of the crisis should be asking for help by using taxpayers dollars,the very sector suffering from the devastating effect of the credit crisis.Where will it all end ?
Posted by: raymonda@kennyconsultinginc.com | March 14th, 2008 at 5:03 pm | Report this commentClean Slate:
Nice theory, but a Micorsoft Windows version CTRL-ALT-DEL of the economy is probably not a viable option. Ya think?
Posted by: fattyk | March 14th, 2008 at 5:45 pm | Report this commentAnd everyone in the States wants to forget that they need USD 2bln per day to stay afloat. We don’t need the Fed! We need those investing foreigners! But look at the outside looking in: Interest rate down, outlook for soaring inflation, muddling administration touting “benign neglect”(but approaching “committed panic shortly),30%+ of the population which lives on or about the poverty threshold, another 30% which threw savings out the window (whether to shop or to make ends meet), “2-20-formula over-priced exotic finance managers” who are stuck in a dark alley of over-leverage with always an excuse and a new graph to depict “the hope that things will get better”. Fast forward: the foreign investors say “we don’t believe (in) you anymore!” See the USD go to Euro 1.85 and Yen 80, commodities heaping on an extra 30%, auctions where foreign interest is nil and Middle East and Asian Wealth Funds saying “What am I doing with this pile of greenbacks?!” Will someone wake up and provide a sense of confidence to those foreigners? It is them who have the money to turn this around by sheer confidence in “the American miracle” and it is them who hold the majority of US debt!
Posted by: Johan van Waveren | March 14th, 2008 at 6:20 pm | Report this commentI have long argued that the definition of inflation as reported by the Labor Department is a bit restricted. It convemiently excludes asset bubbles in equity and credit markets and failed to measure the magnitude of appreciation in the housing market with owner equivalent rents. The ridiculous leverage that permeates the entire shadow banking community and its clients and counterparties inflated the size of the economy. As we delever this mess output will shrink at the levered rate rather than dollar for dollar. If I’m levered 20:1 and loose my buck I face 20 times that in loss. Just ask the guys at Bear.I can hear the wizards of finance screaming now that I don’t understand how finance works. But as Bear crumbles and banks teeter and brokers shudder and they all turn to the Fed for a flotation device I believe a rethinking of how finance works (or doesn’t) is in order. Will this latest attempt at rescuing the owners and creditors of an illiquid asset class prove benign regarding future inflation? Yes if: those who obtain the liquidity refrain from creating more leveraged financing for the next asset bubble.The explosive growth of the derivatives market and its subsequent implosion is a sobering harbinger for the “real” economy if there is such a thing any more. Too many of these institutions gambled with other people’s money and lost big. In the real world the bookie breaks your thumbs, he doesn’t lend you the money to do it again. But then the mob doesn’t own a printing press, or does it??
Posted by: gym-bob | March 14th, 2008 at 9:09 pm | Report this commentI like the comment about wiping out the debts. I think our government should print a large coin and roll it up the the Federal Reserve and they could pay off the US debt. Inflationary you scream, well hang on with Bernanke you too could be pushing money around in a wheel barrel.
Posted by: Brent H. | March 14th, 2008 at 11:00 pm | Report this comment[…] an earlier blog of mine I discussed the view that the Fed’s swap of Treasuries for MBS with the primary dealers had been […]
Posted by: FT.com | Willem Buiter’s Maverecon | A liquidity vade mecum | March 27th, 2008 at 5:04 pm | Report this comment