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Given the duel problem of correcting an income and asset recession the government needs to support both.  The income support comes from spending, most of which is automatic such as unemployment insurance and some of which is discretionary stimulus and some is in the form of tax rebates.  However the consumer sector is upside down and is in a deleveraging mode and it has been shown that consumers saved approximately 80% of the tax rebates of 2008.  With such a high saving propensity and taking account of other offsets to spending, the GDP multiplier is less than one and causes more government debt creation than income.

(See… for a more detailed explanation of why the GDP multiplier is so small and renders fiscal policy ineffective.)

In addition to expansionary fiscal policy to correct the spending/income problem, the TARP program was put together to support asset prices and eliminate the upside-down balance sheets of the consumer and banks (see Reality Bites Part 1.2).  However it was quickly discovered that the $700 billion was insufficient purchasing power to drive financial market prices back to bubble levels.   Instead, greater leverage of the $700 billion could be achieved by restoring bank capital and in so doing allow them to resurrect asset values as they can leverage approximately 10 times their capital. This obvious worked as financial market prices quickly snapped back in 2009. The details of how the financial markets were able to respond are contained in the next section (called the Carry Trade and the Repo Market.)

In addition the Federal Reserve went to work on the asset value-financial market problem in the upside down recession. The Fed purchased private assets at the time of the Lehman collapse in the fall of 2008.  The Fed increased its balance sheet by 144% which amounted to nearly a normal 50 year increase in the monetary base almost overnight as seen below. The initial asset purchases were loans to financial institutions desperate for funding sources to replace Repo and other loans that were called when the market value of the collateral supporting the loans became insufficient.  The replacement funding for financial institutions was essential to prevent the financial institutions from further deleveraging that would have crushed financial asset prices even further.  More recently, the Fed has shifted to supporting consumer debt securitizations.  In 2009-10 they have accumulate $1.25 Trillion of residential mortgage backed securities.

While this asset purchasing program supported both the funding sources for banks so they would not implode and directly supported financial market assets, one would anticipate Fed balance sheet expansion and the printing of money would also allow commercial banks to expand further with the usual money supply multiplier.  However, in the Great Recession with insufficient bank capital, banks did not have the capital required to ramp up lending. In fact, as shown below loans from commercial banks in 2009 declined by $300 Billion despite the biggest expansion of bank cash reserves in the history of the Fed.  See WSJ, Bank Lending Falls At Epic Pace (04188104575083332005461558.htm)
Excess Reserves

This is profound. In the Great Recession the GDP multiplier as discussed above dwindled to near zero and the money supply multiplier was NEGATIVE. Hence the whole basis for fiscal and monetary policy to be the solution to a spending recession dwindled to naught.

The graph indicates as far as lending is concerned the banking system consists of Zombie banks that exist, earn a good net interest margin, but do not make loans.  The consequences are that bank dependent borrowers which are consumers and small  businesses and commercial real estate owners have become cut off from credit which not only adversely affects new projects and spending going forward but causes existing loans to be not be extended.

Despite the shrinkage of bank loans to the private economy, the Fed had committed to EXITing the market because its huge 2008 expansion created inflation fears and flight from the Dollar.  In the last month with the reconfirmation of Bernanke by the Senate, the Fed thought it was time for less expansionary monetary policy.  However such a move would reduce the support for the financial markets so the Fed cleverly chose to eliminate the source of inflation fears which was the excess liquidity reserves of the banking system as shown in the graph below but without a net sell off of assets from its balance sheet.
Credit Crunch
The Fed’s Exit scheme of eliminating excess cash reserves will occur by refinancing the liability side of the Fed’s balance sheet by replacing cash (Federal Reserve Notes) with interest bearing debt, none of which satisfies the liquidity reserve requirement of commercial banks.

Hence, the Fed is in the process of seeking interest bearing Term Deposits by commercials banks (in place of Member Bank Reserve Deposits ((overnight deposits)) because Term Deposit held as a  bank asset do not satisfying the bank’s liquidity reserves.  In addition the Fed has accepted a $200 Billion Treasury deposit (financed by a Treasury offering of corresponding sum) which further soaks up excess cash liquidity from the banking system Lastly the Fed is in the process of setting up a system to borrow funds from money market mutuals.  Since the money market funds paid Fed cash for the Fed short term Repo debt, the cash is retired from the Fed balance sheet and is replaced by short term debt that does not satisfy bank liquidity reserves.  Hence, the Fed could eliminate the excess cash reserves of the commercial banking system shown above by refinancing the liability side of its balance sheet. The Fed borrowed and replacing cash outstanding with short term debt from banks, money market mutuals and the US Treasury.  Basically the Fed refinanced the liability side of its balance sheet without the need to shrink their balance sheet and throw more assets onto the financial markets and depress financial market prices.

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