A Modest Proposal

A post by Annaly Capital Management

Some recent economic data (like today’s downwardly-revised “final” reading on 1Q 2010 GDP) have suggested that the economic recovery is waning. Not surprisingly, talk of additional stimulus has started to show up. A widely circulated column from today’s UK Telegraph titled “Ben Bernanke Needs Fresh Monetary Blitz as US Recovery Falters” theorizes that the Fed is debating further asset purchases. The rationale is that since there is reduced appetite for further fiscal stimulus, the Fed will pick up the baton and expand its balance sheet, possibly to $5 trillion.

Our modest proposal? Don’t.

The Fed should certainly do its part to facilitate the orderly functioning of financial markets, through the various lending facilities it has already set up (and in some cases shut down). But more asset purchases? What is the point? The 10-year Treasury is already approaching 3%, and corporate borrowing rates are more than reasonable on an absolute basis. 30-year fixed mortgage rates are already at brand new lows, and this is after the Fed concluded its Agency MBS purchase program.

fed-purchases

There is an iron-clad law in economics called the law of diminishing marginal returns, which usually refers to labor. The more workers you continue to add, holding all other inputs constant, the less productive are those additional new workers. As we’ve already seen by looking at the money multiplier, the Fed’s balance sheet is also subject to diminishing marginal returns. The Fed’s expansion of the monetary base is having a smaller and smaller effect on the overall money supply. We believe further growth of the Fed’s balance sheet will have an even smaller effect than the first expansion, which seems to have only given us a ripping year-long rally in risk assets.

In the light of calls for new government stimulus, we should point out that the same law of diminishing marginal returns applies to total debt outstanding in the economy. As the total amount of debt to GDP has grown , the marginal return of an additional dollar of debt has shrunk dramatically. The chart below breaks out by decade the addition to GDP per each additional dollar of credit market debt outstanding.

gdp-debt-growth

To construct this chart, we looked at the nominal growth in GDP and divided it by the nominal growth in total credit market debt outstanding. As you can see, in the 1960s each additional dollar of debt created just over $0.65 of GDP. The 1980s saw this ratio cut in half to $0.34 dollars of marginal GDP per $1 of marginal debt, and we have since cut that in half again to $0.18 of GDP per $1 of debt created. We seem to be quickly approaching a level of total debt outstanding where additional indebtedness doesn’t add to economic growth at all. And the Fed has already reached a level in its Federal Funds Rate where it can’t cut any lower.

Attempts to stop a deleveraging economy with quantitative easing and government deficit spending have reached a point of no (marginal) return. Recessions, though painful, have the effect of purging the economy’s excesses and setting the stage for future growth. Preventing this process often causes more problems than it solves. Just ask the Japanese.

9 Comments
  1. sigma_x says

    Very informative piece. Like everything you post, this one leaves me with the distinct impression that we’re headed for a severe drop in equities. The Fed is out of bullets. Or, if they do have any left, they’re blanks. You’re correct in that the delaying of the inevitable and not allowing the recession to proceed unhindered in an effort to flush out all of the bad paper that’s out there is going to make this go from bad to worse.Want to turn a recession into a full blown depression? It’s easy: just add deflation! And that’s what the Fed is going to insure if they opt for Q/E round II (or is it III by now?)

    The total world GDP adds up to about $65T. The (unregulated) Derivatives Market totals about $635T. Everyone owes everyone else and no one can pay; the entire planet is bankrupt.

    1. Edward Harrison says

      The interesting thing about this piece is that it something that Paul Krugman could agree with – namely that monetary policy becomes impotent as you reach the zero bound in a debt deflationary environment. Quantitative easing has been a bust so far. And if the Fed wants to get any traction its really going to have to crank up the printing presses to get asset prices to react.

      1. Marshall Auerback says

        And QE will be equally ineffective if tried again. The central bank is
        simply buying one type of financial asset (private holdings of bonds, company
        paper) and exchanging it for another (reserve balances at the BOE). The
        net financial assets in the private sector are in fact unchanged although the
        portfolio composition of those assets is altered (maturity substitution)
        which changes yields and returns.
        In terms of changing portfolio compositions, quantitative easing increases
        central bank demand for “long maturity” assets held in the private sector
        which reduces interest rates at the longer end of the yield curve. These
        are traditionally thought of as the investment rates. This might increase
        aggregate demand given the cost of investment funds is likely to drop. But on
        the other hand, the lower rates reduce the interest-income of savers who
        will reduce consumption (demand) accordingly.
        How these opposing effects balance out is unclear. The central banks
        certainly don’t know! Overall, this uncertainty points to the problems involved
        in using monetary policy to stimulate (or contract) the economy. It is a
        blunt policy instrument with ambiguous impacts.
        Quantitative easing merely involves the central bank buying bonds (or
        other bank assets) in exchange for deposits made by the central bank in the
        commercial banking system – that is, crediting their reserve accounts. The aim
        is to create excess reserves which will then be loaned to chase a positive
        rate of return. So the central bank exchanges non- or low interest-bearing
        assets (which we might simply think of as reserve balances in the
        commercial banks) for higher yielding and longer term assets (securities).
        So quantitative easing is really just an accounting adjustment in the
        various accounts to reflect the asset exchange. The commercial banks get a new
        deposit (central bank funds) and they reduce their holdings of the asset
        they sell.
        It is based on the erroneous belief that the banks need reserves before
        they can lend and that quantitative easing provides those reserves. That is a
        major misrepresentation of the way the banking system actually operates.
        But the mainstream position asserts (wrongly) that banks only lend if they
        have prior reserves. The illusion is that a bank is an institution that
        accepts deposits to build up reserves and then on-lends them at a margin to
        make money. The conceptualisation suggests that if it doesn’t have adequate
        reserves then it cannot lend. So the presupposition is that by adding to bank
        reserves, quantitative easing will help lending.
        But this is a completely incorrect depiction of how banks operate. Bank
        lending is not “reserve constrained”. Banks lend to any credit worthy
        customer they can find and then worry about their reserve positions afterwards. If
        they are short of reserves (their reserve accounts have to be in positive
        balance each day and in some countries central banks require certain ratios
        to be maintained) then they borrow from each other in the interbank market
        or, ultimately, they will borrow from the central bank through the
        so-called discount window. They are reluctant to use the latter facility because
        it carries a penalty (higher interest cost).
        The point is that building bank reserves will not increase the bank’s
        capacity to lend. Loans create deposits which generate reserves.
        To get a credit system going, you need CREDITWORTHY customers, which means
        generating rising aggregate demand, job growth and rising incomes. Which
        means fiscal policy (whoops, I’ve said it…the dirty “F” word).

        In a message dated 6/25/2010 9:17:02 P.M. Mountain Daylight Time,
        writes:

        Edward Harrison wrote, in response to Sigma X:

        The interesting thing about this piece is that it something that Paul
        Krugman could agree with – namely that monetary policy becomes impotent as you
        reach the zero bound in a debt deflationary environment. Quantitative
        easing has been a bust so far. And if the Fed wants to get any traction its
        really going to have to crank up the printing presses to get asset prices to
        react.

        Link to comment: http://disq.us/f71ya

        1. Edward Harrison says

          Exactly.

          Perhaps someone in the Fed understands this but I suspect the purpose of QE is really about asset prices rather than actual economic growth. If the Fed bids up the price of particular financial assets, this puts a floor on those markets. That is certainly what we saw with MBS paper. And we know that the Greenspan Fed actively targetted asset prices. Greenspan is still saying things that point to his belief in an asset-based economy.

          To the degree that suppressing long rates puts a floor under all long-lived financial assets like MBS paper, equities, high yield bonds etc by reducing the forward rate of interest, it can boost asset prices and that’s important when banks are undercapitalised and need their collateral to hold up in value.

          Will it have any sustainable increase in demand? I am as sceptical as you, Marshall.

          1. Marshall Auerback says

            I suspect you are right Ed. God forbid that anybody at the Fed would
            admit this, though.

            Here’s a thought: Instead of having the Fed buy up all of this MBS,
            wouldn’t it make more sense to set up something like the HOLC (a Roosevelt era
            innovation) to buy the homes and then let them out to the occupier with an
            option to buy? There’s no rush to sell them in that situation. In fact,
            the HOLC sold its last house in the 1970s and actually finished with a
            profit. You don’t want to dump a bunch of houses on distressed banks, which are
            keen to get them off their books as quickly as possible, as this simply
            exacerbates the debt deflation dynamic.

            In a message dated 6/25/2010 9:48:56 P.M. Mountain Daylight Time,
            writes:

            Edward Harrison wrote, in response to Marshall Auerback:

            Exactly.

            Perhaps someone in the Fed understands this but I suspect the purpose of
            QE is really about asset prices rather than actual economic growth. If the
            Fed bids up the price of particular financial assets, this puts a floor on
            those markets. That is certainly what we saw with MBS paper. And we know
            that the Greenspan Fed actively targetted asset prices. Greenspan is still
            saying things that point to his belief in an asset-based economy.

            To the degree that suppressing long rates puts a floor under all
            long-lived financial assets like MBS paper, equities, high yield bonds etc by
            reducing the forward rate of interest, it can boost asset prices and that’s
            important when banks are undercapitalised and need their collateral to hold up
            in value.

            Will it have any sustainable increase in demand? I am as sceptical as
            you, Marshall.

            Link to comment: http://disq.us/f74lc

  2. dansecrest says

    The federal deficit does not result in debt. Au contraire, the federal deficit allows the private sector to reduce debt…

    1. Marshall Auerback says

      Exactly! It’s amazing how few people understand basic accounting
      identities. The preference for zero or greater than zero fiscal balances
      DEMANDS/REQUIRES that the private sector reduce its net saving…and, since most
      people who hate government spending always concede that private saving is
      sacred to them, the manna from heaven from which all good things flow
      (investment, low inflation, low interest rates, high capital asset prices, virtue,
      beauty, and truth), then it’s important for them to answer the question
      where this comes from if the government cuts back its deficits. We can’t all
      be export superpowers, so it can’t come from the external sector.
      The deficit hawks are conflicted. They want gravity and weightlessness at
      the same time, and they want it all now, especially when they deny private
      net saving must fall if the fiscal deficit is reduced. People respond to
      these arguments with great hostility, because they don’t like to deal with the
      fiscal balance as a financial flow connected to other financial flows in
      the economy – they are interdependent, not isolated, and only a fool or a
      brainwashed cult member would even dare think the fiscal balance is an
      isolated, unconnected flow.

      That’s 500 years of double entry book keeping.

      In a message dated 6/26/2010 9:51:48 A.M. Mountain Daylight Time,
      writes:

Comments are closed.

This website uses cookies to improve your experience. We'll assume you're ok with this, but you can opt-out if you wish. Accept Read More