Slow Motion Depression
Early this week, the world's largest central bank, the Federal Reserve, announced plans to exit its monetary stimulus efforts. It unveiled a new tool - reverse repos - to help speed the work.
The private sector debt crisis of 2008-2009 will almost certainly lead to a public sector debt crisis sometime between now and eternity, if not sooner. In the standard narrative, governments must stimulate their economies out of the slump. Leading economists propose it, then defend it...and then, when it doesn't work, they call for more of it.
Now those economists are claiming victory and many are calling on the Fed to withdraw its monetary stimulus before it shows up as consumer price inflation. They're hoping the Fed can head it off by sopping up the surplus liquidity before it is too late.
Optimists expect mild inflation in a decent recovery. Pessimists fear the feds may have waited too long; they think they see higher rates of inflation coming. Here on the back page we see no recovery...nor any inflation. At least, not yet. Instead, we are blind. We see nothing. But as for what is coming...a slow motion depression wouldn't surprise us. Neither would the collapse of the public debt market
There is always a wide gap between the feds' reach into the economy and their grasp of what they are really doing. When the Fed increased reserves in the banking system, the idea was simple enough. More reserves would allow the banks to lend more. In turn, more credit would allow consumers to spend more. Ergo, the recession would soon be over.
But the more reserves the Fed pumped into the banking system, the more reserves the bankers didn't lend out. In 24 months, excess reserves (beyond what was needed for loans) expanded 500 times from the level they had been for the previous 30 years. If the banks chose to lend these reserves they could multiply them into another $10 trillion to add to the money supply. Instead, in the third quarter, the US suffered a record contraction of bank lending, according to the Federal Deposit Insurance Corporation. Lending to households and business is in a steep decline. Nothing like it has happened since WWII. Total credit outstanding is falling too. The banks are barely even lending to the US government from which they got the money in the first place.
"Banks, in aggregate, just absorbed the additional reserves by allowing their ratio of reserves to deposits to balloon," reports Charles Goodhart in The Financial Times, "...so the multiplier collapsed to zero... Why?"
Quantitative easing had "unintended consequences." Bankers competed for yield with the deepest pockets in the monetary universe - the central bank itself. When the feds bought Treasury bills they drove yields down to such skimpy levels that the incentive for risky private loans was nearly lost all together. Better to leave the money on deposit at the Fed.
No loans, no multiplier. No multiplier, no recovery. Instead, the feds take a dollar's worth of supposedly "idle" resources out of the private economy (actually, savings that people hoped to spend or invest later); squander it on bribes, bailouts or boondoggles; and get 90 cents worth of 'recovery.' Then, when a real recovery doesn't come, they spend two dollars.
Where this will end up? With the multiplier out of action, consumer price inflation - and a recovery - seem far away. And the feds are helpless. What? What about more government spending? Or dropping hundred-dollar bills from airplanes? But those tools have self- mutilating effects too. They jeopardize governments' access to deficit financing.
"Britain risks becoming the first country in the G10 bloc of major economies to risk capital flight and a full-blown debt crisis over coming months," said an article in Tuesday's Daily Telegraph.
Sooner or later, lenders will worry about inflation and the risk of default. They'll demand higher interest rates. Treasury bond yields will rise, in real terms, even in a deflationary world. These higher rates affect public finances like a cold draft on a pneumonia patient. As governments pay more to borrow, their condition deteriorates. The odds of default increase. Some, like Dubai World, will be forced to postpone payments. Others just shake and shiver. The slow motion depression continues. If we are lucky...and nothing goes wrong.