We’ve explored how a zero interest rate policy can lead, paradoxically, to deflation, the exact opposite of its intent. It happens when inflated prices produce the signal that demand is expanding, when in fact it is contracting. The oversupply problem inherent with the declining demand gets worse (due to the illusory price signals) until there is so much oversupply that prices collapse. The expansive monetary regime has done nothing but exacerbate the oversupply problem, and is left with no more monetary tricks behind the curtain.
Or is it? In an economy with fiat currency that can be created at will, it seems there is no possible way that the monetary authorities can’t get the inflation after which they lust. Just drop money from helicopters (or, as it’s technically-known, do some quantitative easing), as the US Federal Reserve’s Chairman Ben Bernanke promised he would do if ever faced with such a Depression-era type calamity. But will it work? In an economy with a fully-developed financial system based on leverage, i.e., a banking system based on fractional-reserve lending, the strategy will likely backfire.
Declining demand is a disaster for fractional-reserve/leveraged lending. Price declines mean that assets against which such lending is secured lose value, while the bank’s liabilities remain the same. Some assets become virtually worthless, e.g., a subprime mortgage from a laid-off borrower that is secured by a residence whose value has been cut in half or less. Other assets only decline by an amount commensurate with the oversupplied lost demand. The end result of these declining asset values is impairment of the equity on bank’s balance sheets. Leverage goes up as the assets used to pay the demands of creditors (which in a commercial, deposit-taking bank is mostly depositors) declines. The only thing holding back insolvency is the amount of equity on hand to fill the demands of creditors, unless the central bank is able and willing to purchase the bank’s assets at above-market prices so that equity impairments don’t become black holes on bank balance sheets. This purchase of bank assets at above-market prices is one of many forms of quantitative easing, i.e., money printing. It is the main strategy the US Federal Reserve pursued during the recent financial imbroglio to shore up bank (and GSE, et al) equity balances. It is why the Fed’s balance sheet more than doubled over the course of a little more than a year.
Will it work? Just like the expansive monetary regime of zero interest rates, quantitative easing will work to temporarily provide an illusion that assets are more valuable than they really are, thus doing for banking what ZIRP did for the economy at large–exacerbating oversupply conditions. Ultimately, the oversupplied demand will send prices crashing again, this time for bank assets like commercial and residential real estate mortgages. Until such time as they inevitably crash, the oversupplied market for financial assets will push their expected return, i.e., their interest rates, to very low levels, possibly nearing zero, or even below. This is precisely where the US financial system finds itself today. Two-year US Treasuries carry an interest rate that is effectively negative, after accounting for inflation. Residential mortgage interest rates are at their lowest levels ever recorded.
What happens when declining demand in the broader economy finally filters through the smokescreen of quantitive easing? A goodly portion of banks, unable to withstand asset devaluations any longer/again, should fail, destroying trillions of dollars that have been quantitatively-eased into the financial system. If the banks’ creditors are government-insured, their losses become claims on the taxpayer’s future income. Demand declines further. The un-virtuous cycle of demand collapse yielding price collapse yielding more demand collapse continues until finally, the economic system reaches an equilibrium at a much lower level of income and activity.
However, the aim here isn’t to presage gloom and doom. So far as the US goes, its positive population growth could prevent or at least ameliorate the problems attendant to contractions in demand. It’s huge trade deficits are problematic, as well as the huge income and wage disparity between it and many of its trading partners. Average wages in the US and China will move to convergence over time, which means the US wage rate will decline and China’s will increase. How closely they will converge and how long it will take to get there are the only remaining questions if the US and China keep trade flowing between them. But the US goes into this demand contraction scenario with vast wealth, even if it’s not readily apparent when looking at its balance sheet. Economic wealth is not always readily quantifiable.
As for Japan, it seems she got stuck in place after the central bank had to purchase the bad assets on the banks’ books. As yet, the banks are being kept afloat by central bank largesse, but one wonders just how long it can continue. Japan is rapidly tearing through its equity capital. But it could easily manage declining demand and prices, if it would allow losses to ripple through its banking sector and quit pretending that demand is coming back. There would be some pain initially, but businesses and individuals could adjust to life in a declining demand/price regime and survive just fine. Declining prices temporarily have an illusory effect of making demand look lower than it really is (the opposite of the effect of increasing prices). Once the effect wears off and it is realized that prices don’t go down (nor up) forever, an equilibrium can resolve, with prices and demand more or less stable.
My aim here has been to show the ineffectiveness of central bank monetary shenanigans in accomplishing anything real. If demand, for whatever reasons, wishes to contract and take prices with it, then the central bank should step aside and let it. Demand contraction and falling prices are perfectly normal economic states. They don’t persist, anymore than demand expansion and rising prices do. Sometimes the best prescription for central bankers is to leave things alone. First, like a good physician, they should do no harm. Intervening to prevent an unwanted price decline is apt to be a cure that is harsher than the disease.