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Moral Hazard, part nine

Blog entry posted by anciendaze, Aug 10, 2011.

Our global education in modern economics continues apace.

Recent financial news introduced many people to the unfamiliar term 'quantitative easing', as well as the acronym FOMC (Federal Open Markets Committee). This is a measure designed to boost the money supply when ordinary fiscal and monetary policy have otherwise failed.

Normally, treasuries and central banks use a kind of two-cylinder engine to attempt to control the supply of money. One part is fiscal policy. The other part is monetary policy. Chief levers here are government spending and borrowing, plus the setting of rates at which major banks can borrow money from central banks. In the present situation, this 'rediscount rate' is practically zero. To increase the money supply, and stimulate the economy, further you would have to pay banks to borrow.

In a situation like the present, a third option comes into play. Central banks can themselves buy up assets from other banks. Effectively they are printing electronic money. An alternative view would be that central banks are now assuming any risk attached to the assets they buy, taking this off the open market. Either way, by injecting money, or by reducing risks, the effect is to increase the supply of reliable liquid capital.

This was actually a predictable action, following the turmoil of last week. During the sell-off some major banks began charging customers who wanted to temporarily park large amounts of money in accounts at those banks. In effect this was negative interest. While this was most likely a deliberate effort to reduce market volatility, and the risk to banks, it illustrated that interest rates had reached a threshold where they were no longer effective as incentives to change behavior.

"Increasing the money supply" sounds better than "inflation", yet the two are closely connected. What this action telegraphs is that central banks are far more concerned about the risks of deflation, in which major debtors sink further into real debt without any numerical increase in amounts of debt. They are also immediately concerned about a loss of liquidity which could bring major economies to a standstill.

This action is about as far as central banks can go without new authority from Congress. Other statements made at the same time indicate their policy is based on projections of an essentially flat economic outlook past the 2012 elections. I suspect this is a message to politicians about using fiscal policy to buy votes.

(While U.S. politicians have generally stopped short of emulating "Papa Doc" by having campaign workers throw money from trucks in the capital just before voting begins, fiscal trends do show a pronounced four-year periodicity, with a smaller two-year period, both in phase with elections. Announcing major projects of local interest during campaign stops is a time-honored practice, which may cost more than a limited number of truckloads of currency. N.B., this practice is not peculiar to incumbents of any party.)

The downside of this maneuver by the Fed. is three-fold: no structural changes have taken place; little in finance is more transparent; more people are now aware that central banks can print electronic money like the spam that clogs email. Indiscriminate suspicion of currencies, assets and equities based on them is tearing the fabric of economic and social cohesion, which benefits no one. We need action which supports rational, if not altruistic, behavior. In a crisis, a rush for lifeboats can end with most drowned.
anciendaze

About the Author

As the name suggests, I am old and dazed. The avatar illustrates my rule of thumb: "Hang on! This ride isn't over."