Some important comments from Richard Koo, chief economist at Nomura Research Institute, detailing the limitations of monetary policy in the current economic environment (Also see the Third Wave Finance post Economic Constraints and Policy Options)
Comment regarding the inability of large-scale asset purchases (LSAP) and quantitative easing (QE) to reach the broad economy:
“In reality, however, neither private credit nor the money supply have demonstrated meaningful growth in spite of massive infusions of liquidity by the central banks of Japan, the US, and the UK — as should have been expected given the absence of borrowers.”
“The lack of growth in private credit in these three countries means most of the funds supplied by the Fed, the BOE, and the BOJ never reached the real economy, which in turn explains why inflation rates remain so low.”
– Richard Koo (from the Business Insider article The Struggle Between Markets and Central Banks Has Only Just Begun)
Comment regarding the potential for high inflation, which depends on the speed and accuracy with which the central banks can withdraw the currency that was created from LSAP:
“There’s already $2.3 trillion dollars of excess reserves sitting in the U.S. banking system. If we go back to a ‘normal’ world, where the private sector is forward-looking, borrowing money, that $2.3 trillion is enough to increase U.S. money supply 16 times. So we’re potentially facing a 1600% inflation rate, but we haven’t seen anything like that because the private sector hasn’t been borrowing money, they’ve actually been paying down debt.”
– Richard Koo (from the CNBC article No Right Answer On When the Fed Could Raise Rates)
Highlights and quotes below from a presentation by Richard Koo (R.K.), at the 2016 ACATIS Konferenz, entitled Surviving in the Intellectually Bankrupt Monetary Policy Environment:
“Why are central bankers and many economists (theoretical economists and academic economists) still saying, ‘do more, do more, do more…if the quantitative easing doesn’t work try the negative interest rates. If the negative interest rate doesn’t work lets try the helicopter money’. Why are they talking like this?
It’s because the economics we were taught in universities were basically built on one key assumption…that the private sector is always maximizing profits — that there are always borrowers for the money: if only the central bank brings interest rates down low enough these borrowers will show up, take the money, and the economy will improve…
But for the private sector to be maximizing profits two conditions will have to be met: [that] they have clean balance sheets and [that] there are interesting investment opportunities; if you don’t have these two, they have no reason to borrow money.” – R.K.
• • •
He looks at four borrowing and lending situations, where there are or aren’t, borrowers or lenders available, and details the difficulties of case 3.
Case 1: Borrowers Available. Lenders Available.
- The textbook ‘good’ lending environment where the economy isn’t in crisis.
Case 2: Borrowers Available. Lenders Not Available.
- Financial crisis environment (still within the “textbook world”)
- Textbook says: inject capital, central bank acts as lender of last resort, and/or loan forbearance — to help make lenders available again to move from Case 2 to Case 1.
Case 3: Borrowers Not Available. Lenders Available.
- The current environment for many developed economies.
- Not in the “textbook world”
- Deleveraging environment that economies can be stuck in for a very, very long time.
Case 4: Borrowers Not Available. Lenders Not Available.
- Financial crisis environment.
- Textbook response: inject capital, central bank acts as lender of last resort, and/or loan forbearance — to help make lenders available again to move from case 4 to case 3.
“The old economics that we learned in universities is that there are always borrowers and occasionally there are no lenders (because banks lent money to the wrong people that could not pay back). The banks have a problem and so forth…a financial crisis. But we know what to do when the banks have problems; you inject capital, the central bank acts as the lender of last resort, you do a forbearance…
But once every several decades the private sector goes crazy over the bubble — they borrow tons of money to leverage themselves up. Once the bubble bursts, asset prices collapse, liabilities remain, and their balance sheets are underwater…which means they are bankrupt…and don’t borrow money. And the banks can not lend money to the people who are bankrupt…
When the [housing] bubble collapsed many financial institutions also got into trouble, so there may be no lenders and no borrowers; but for the lack-of-lenders part we all know what to do (inject capital, central bank providing liquidity) and you can fix the lenders problem relatively quickly if there’s a will from the government.
In the case of the United States, with the big housing bubble (this involved millions of households)…you can get stuck in case 3 for a very long time, and Japan has been stuck on case 3 for the last 25 years — many European countries for the last 8 years.” – R.K.
• • •
His comment below is on the inability of monetary policy to affect the broad economy when interest rates are zero or negative. Note that, whenever possible, the majority of the money that you save in your bank account is lent out by the bank to other individuals. However, when borrowing is low, the money is not lent out and it gets trapped in the financial sector resulting in economic growth that deteriorates even though interest rates are zero or negative:
“A central bank can add all the reserves, in the banking system, it wants…but for the money to come out of the banking system and enter the real economy banks can not give away money, they have to lend money [because] it’s basically depositors money to begin with…This is how much money American banks lent: 21% increase in almost 8 years [2008-2016]; it’s next to nothing. So the actual money circulating in the U.S. economy hasn’t actually increased all that much, which explains why inflation numbers are so low.”
“No one borrows money after the bursting of the bubble [Japanese housing bubble 1991]…Japanese corporate demand for funds (how much Japanese companies raise from the capital market and the banking system)…starts falling very, very rapidly. The bank of Japan realizing the economy was weakening brought rates almost down to zero by 1995. Then the demand for funds in Japan goes negative…that means at zero interest rates, Japanese companies are all paying down debt.
We never learned this in universities. Right? Companies are not supposed to pay down debt when interest rates are at zero. They should be borrowing money — expanding businesses, but for the Japanese case, for the entire corporate sector, they were paying down debt with zero interest rates…and this is happening today all over the western world — exactly the same pattern.
At zero interest rates [and] negative interest rates people are paying down debt. Why? Because their balance sheets are in trouble. Their balance sheets are under water. This is the case 3: no borrowers and zero interest rates; even at negative interest rates these people will still be paying down debt.
Then what happens? [Money that is saved] will come into the financial sector and get stuck in the financial sector; it can not go out because no one is borrowing. So [money that is saved] can do crazy things within the financial sector, but it can not come out.”
“That’s what happens when the whole private sector begins to deleverage. And you may wonder, has anything like this ever happened before? Yes, it did. It happened during the great depression in the United States from 1929-1933. Before 1929, all these Americans were excited with the bubble, borrowed tons of money, and once the bubble burst everyone started paying down debt all at the same time, but there was nobody on [the borrowing] side. So that’s how dangerous this world is [case 3].” – R.K.
• • •
He mentions that “There is a bubble growing in certain asset classes in the United States” and says it’s because too much money from stimulus programs is stuck in the financial sector with no place to go.
• • •
He comments on the difficulty in removing excess reserves created by stimulus programs and compares our economic world to an attempt at navigation in pitch darkness; nobody knows which way to go:
“There are so many economists…the university-types, telling central bankers, ‘Do QE. Do QE. Everything will be fine with the QE.’ They tell us how to get in; there’s no paper telling us how to get out. And I actually asked a very important person in the federal reserve myself, because the federal reserve has something like a couple hundred PhDs checking all the economic papers written around the world; so I asked this person, ‘I haven’t seen a single paper telling us how to get out, have you seen one?’, and this person said, ‘I haven’t seen one either’. What does that mean? That means we have no clue as to what the right conditions [are], that have to be met, for the central bank to ‘turn the wheel’…
So when something happens, the chance of having a very volatile market reaction is almost assured, and unfortunately…it’s not just the United States but all the central banks [that] did it. And so, there are not too many places we can hide either… So we’re going to be in very choppy, very volatile markets going forward… For those countries that did QE or didn’t do the proper fiscal stimulus, we’re going to have a very volatile world going forward.” – R.K.
I would also add that although fiscal policy may still be able to stimulate growth as Richard mentions, it depends on whether the spending can reduce unproductive debt, likely without increasing aggregate debt. (See the Third Wave Finance post Economic Constraints and Policy Options)