The Plan

From Tyler Cowen's Marginal Revolution.

Long story short, the ECB will print money to purchase its less responsible member-states' bonds to keep borrowing costs low and banks' balance sheets positive. This is basically what the Fed did in 2008 when the banking system realized that all those $300K houses out there weren't actually worth $300K. So they printed $2T to buy up all the worthless MBS's and other financial instruments so banks wouldn't have to show that they were insolvent. The Fed is still doing this with USG bond purchases. I read somewhere that the Fed purchased 60% of UST's in 2011, which is why the government is essentially being paid to borrow money. Krugman thinks that's great and from the taxpayer's perspective, he's right.

The new money is "sterilized" per the linked article through complex transactions designed to keep the new money from flooding the economy and showing up in far higher real prices. These methods include just keeping the assets stowed on the central bank's balance sheet, paying higher interest on the member banks' own deposits with the central bank, and requiring that the assets be repurchased when, presumably, the banks' balance sheets are stronger.

Mainstream economists all seem to agree it's A New Era and this can be done. The goal is apparently to paper over the liquidity shock until the real economy strengthens and the new money can be absorbed without sparking inflation.

Instinctively, this doesn't seem sustainable or we surely would have figured this out by now. The Austrians would say that we need to think forward to all possible effects from the central banks' actions. My stab at this would be that productive sectors continue to be starved of capital and outbid for resources by the unproductive sectors. The real economy continues to hollow out as productive sectors fold and labor/capital stays in subsidized industries like health care and education, FIRE sectors which should have been liquidated in 2008, public works, etc. Demand is maintained but on the supply side, interest rates do not reflect real world events like no outlet for culinary school grads, China's used up all the concrete, consumers are tapped out, etc. (Sorry--that's the best I can do on such a complex issue). So the central bank has to continue its easing to maintain the structure of production in a nominal state as if the real world events weren't happening.

At this point, economic reality should hit. Investors should dump the government bonds and other instruments knowing that current yields will never be positive in real terms. Rates jump sharply to reflect the reality, the sectors coasting along on continued artificially cheap credit go up in smoke, asset values collapse, and we are back where we started. What does the central bank do then, print up quadrillion Euros/dollars?

BUT, this hasn't happened and according to mainstream economists, it doesn't have to. They claim their models are good enough and that they can keep demand up without inflation. We seem to be muddling along without $10 bread so far, and sovereigns all over the globe are still being paid to borrow money.

So, what am I missing? Do the central banks really, finally have it all figured out?


Visibilium said…
The linked article sucks. Your posting is better.

If the central banks had had it all figured out, unemployment wouldn't have been so high for so long.

There's no price inflation because the reserves aren't circulating. They aren't circulating because banks are uncertain about their future capital adequacy, not because the Fed is paying small peanuts to keep the reserves locked up or reversing repurchases at some unknown future time. Future capital adequacy is a moving and subjective target when banking, bankers' pay, and banks' profitability are demonized.
Obviously, everybody was in on the game so there's plenty of blame to go around. But banks were allowed to socialize their losses on non-bankers.

What assets are banks holding now? If they are still worried about future capital adequacy then $2T later, we are back where we started.
Visibilium said…
Obviously, everybody was in on the game so there's plenty of blame to go around.

Not really. That's hindsight quarterbacking. Some of us knew as early as late 2002 that the pre-2008 real estate mania was unnatural, but identifying which elements among many were unnatural and how the correction of those elements would ensue weren't precisely predictable. Everyone else accepted what was going on as part of the ever-changing economic conditions of existence and tried to cut the best deal for themselves, given the circumstances that they faced. They accepted the circumstances as given and had no reason to think otherwise, given their status as economic laymen. All of the schmexperts had been telling folks that real estate never lost money because no one's making more land.

The regulators were looking over everyone's shoulders at the no-doc loans, CDCs, and other phenomena that look that now look quirky to the hordes of hindsight seers. Bankers and regulators and rating agencies were using the same models, which had worked ok before. I'm not trying to be too cruel here, but I'm painting a picture of how insidious the effects of the Fed's discretionary monetary policy are. The effects are indirect and not easily identifiable. They blend into the economic landscape, which makes sense since money is the medium of exchange. Monetary policy is transmitted visibly by the banks and therefore the banks are singled out for blame. Proximate causes are confused with root causes; means confused with ends. The Fed escapes censure, and asshole Greenspan blames greedy bankers.

Furthermore, remember that things didn't get really shitty until the premier bond houses went south, especially Lehman. Lehman essentially was forced to dump its inventory on the sidewalk, and yields went haywire for several weeks. Banking assets, newly subject to mark-to-market accounting rules, were undervalued and placed even prudent banks in capital jeopardy.

I don't think that I'm betraying my anonymity by saying that I was in the thick of the shit at the time. I stopped watching news programs and reading financial publications (other than WSJ) to escape the useless, mindless commentary, which either whined about not knowing what the fuck was going on or else predicted a linear extrapolation of complete financial annihilation.

But banks were allowed to socialize their losses on non-bankers.

Your causality is wrong. TARP, demonized by demogogues and other imbeciles as a banking bailout, was forced on bankers by Hank Paulson, accompanied by Ben Bernancke. The reason why it was forced on bankers was because (1)the US was confronting the complete destruction of the banking system without TARP and (2)reluctant bankers didn't want the government telling them how to run their businesses (other than leverage management). Far from blaming Paulson and Bernanke, I think that they're national heroes for outright threatening the bankers into taking TARP money. Next time you think that TARP was an act of charity for banks, realize that the efficient payment system that you take for granted was at risk.

What assets are banks holding now?

They are holding lots of Treasuries

we are back where we started.

In a world of discretionary monetary policy and fractional reserve banking, we are always back where we're started, when viewed from an Austrian business cycle theoretical perspective.
Next time you think that TARP was an act of charity for banks, realize that the efficient payment system that you take for granted was at risk.

OK, now THAT'S a banking crisis, when my bank tells me they can't honor the check to my landlord. And presumably, that's what the FDIC is for. Failing that, the Fed can print enough money to cover every demand deposit without so much as hiccup.

If that's still not enough, then the problem is way bigger than we realize and TARP does nothing to address it.
Visibilium said…
Take a look at the list of banks receiving TARP infusions. When the biggest fail in a tidal wave, what happens to the smallest and most prudent? How does the FDIC conduct reimbursements during large numbers of large failures? How does the Fed operate as lender of last resort when no one is left to borrow against good collateral? Most important, who honors your check to your landlord under what time constraint?

TARP permitted the existing infrastructure to operate routinely during a temporary insolvency brought about by an artificial and panic-originated undervaluation of banking assets. TARP was a temporary resolution of an acute issue, not a long-term fix.
a temporary insolvency brought about by an artificial and panic-originated undervaluation of banking assets.

Uh, no. Houses in the Central Valley and Compton and a lot of other places are not actually worth $300K. Solution: inflate until they are!
Visibilium said…
Overvalued housing was a Fannie and Freddie securitization issue. Fannie's output is now as default-free as Treasuries. Sleep easy. Your tax dollars are working hard for you. Unless someone dismantles Fannie, that particular alchemy is on track to becoming a permanent fixture.

Originating mortgages and getting them out the door to the packagers was lots more lucrative for banks than actually holding onto and servicing the stuff.