How can the Fed unlimited QE be deflationary?

[Cigarbutt]

^Interesting stuff wabuffo.

Of course, you're allowed in-house definitions of terms 8) but, for discussion sake, it may be helpful to make sure we use the same language.

 

You seem to equate government savings as an equal opposite to private savings which is an accounting truism (asset versus liabilities) but it may be more valuable to look at this aspect from a flow perspective. Government issuing debt results in a liability but the asset may end up on the household, corporate or even foreign ledger. From a flow perspective, the net investment for a nation will be a function (basic equation) of government, private and foreign savings. Private players, including individuals in households take decisions about savings that, in the aggregate, will be influenced by savings decisions by other agents, but will not necessarily exactly offset although the whole thing has to balance in toto.

 

Take a look at the following if you have an interest:

https://www150.statcan.gc.ca/n1/pub/11f0027m/11f0027m2014093-eng.htm

 

BTW, Hodrick Prescott statistical adjustments will not help in making investments in shuttle tankers and they use a gross savings methodology which does not really change the conclusions or inferences. Gross savings only include depreciation which has remained relatively stable over time. You can see from Chart 1 that, in the US, during WWII, private savings more than compensated public deficits. You can also see the global savings glut (chicken or egg question) playing out in the early 2000s with 'foreigners' compensating for other agents.

 

It's a dynamic picture and outside of unusual interest in numbers, this may have interesting ramifications and you should update your numbers to 2020 'cause the times they are changin'. In Canada (who cares?), households have been saving less because (among other reasons) of the 'equity' in housing. We saw how this turned out for you American friends just a short while ago. Liabilities are stickier. In both Canada and the US, household savings rate are on the rise (very recent in Canada) but national savings rate are still way down and, as mentioned above, net national savings will go negative (VERY unusual). In the US, this dynamic is playing out when there is a building consensus to kill the trade deficit... There is also the sense that individuals don't need to save because the government is there as a backstop. The example above about Social Security shows that individuals may end up with more dollars (perhaps a lot more) but the unit of dollars may be worth much less. Central banks will mop it up somehow but the potential interim effects on consumption are mind-boggling.

 

Why does this matter? From the statcan article: "An economy’s access to saving influences its investment prospects, and hence, its ability to increase productivity, capital stocks, and living standards."

[Munger_Disciple]

I have a question on this fiscal/monetary macro stuff. My knowledge is rudimentary at best in the area so I apologize in advance if this is an ignorant question.

 

Consider the following hypothetical situation and tell me what is wrong with it. Suppose trade deficit is zero and the govt runs a fiscal deficit equal to 10% of GDP every year. As soon the treasury issues debt, the fed immediately buys all the debt by printing money. So in this situation by using wabuffo's analysis, private domestic savings =10% of GDP every year. So to increase domestic private savings, govt can simply run massive deficits and the fed can just monetize the govt debt. Naturally something is wrong with this scenario.

 

 

 

 

[vinod1]

This is by far the best explanation of how QE works and its effects on inflation/deflation.

 

Pretty long article, but well worth the effort.

 

https://seekingalpha.com/article/4343574-qe-mmt-and-inflation-deflation

 

It even goes into the Repo spike in 2019 and explains why it happened. Good stuff.

 

An Example of Running Out of Real Borrowers

...

But by September 2019, foreigners stopped buying Treasuries again, and became net sellers of them instead. At the same time, most domestic lenders weren't able to buy more Treasuries either. Corporations weren't buying. Pensions weren't buying. Insurance companies weren't buying. Traders and mutual funds were only buying a little bit. Model 1 of domestic government financing started to run out of lenders.

...

The U.S. government literally ran out of cash dollar lenders for their Treasury securities; both domestic and foreign. In reality, the root cause was that the U.S. government ran out of lenders. Foreigners, pensions, insurance companies, retail investors, and finally large banks and hedge funds, simply weren't buying enough Treasuries at that point compared to how many Treasuries the government was issuing, at over $1 trillion annualized. They had no excess dollars from which to lend to the U.S. government at those rates.

In one alternative world, the repo rate would have remained very elevated, and repo borrowers like hedge funds basically would have had to stop buying Treasuries and even start outright selling them (you can't borrow at a 7% repo rate to hold 2%-yielding Treasuries on a sustained basis). The interest rates on Treasury securities would have had to rise considerably to attract a totally new pool of buyers (such as foreign pension funds), and even that would have probably been insufficient. With interest rates much higher, that would have put massive downward pressure on equity prices and other risk assets, and would have put immense pressure on the U.S. government budget due to higher interest expense and lower capital gains tax revenue.

In the real world, since the U.S. is a monetary sovereign, the Federal Reserve stepped in with newly-printed dollars out of thin air, and started buying Treasury securities, due to a lack of any more real buyers at those low rates. For the first two weeks starting the day after the repo spike, the Fed lent newly-created dollars to other institutions to buy Treasuries with (basically nationalizing the repo market to reduce the interest rates), but when that quickly proved insufficient, the Federal Reserve began outright buying Treasury bills with newly-created dollars. In other words, the Federal Reserve allowed the U.S. government to keep funding its domestic spending plans at current interest rates, without finding new real lenders for their rising deficits. They just created new dollars to buy Treasury bills and fill the difference between what the government wanted/needed to borrow, and the dollars that real lenders were able to lend.

....

 

When banks ran out of cash to buy more Treasuries, the Federal Reserve printed up some digital cash and took their place as the primary accumulator of Treasuries. Months before the economic crisis from COVID-19, the Federal Reserve began accumulating Treasuries at basically the same rate they were issued, meaning it was monetizing virtually all net new government debt.

...

 

Imagine, for example, that the Treasury (authorized by Congress and the President) decides to spend a trillion dollars to send every American $3,000 in the next round as a stimulus. The Treasury would issue Treasury bonds to pay for it, primary dealer banks would buy them at auction, and the Federal Reserve would create new digital dollars to buy them from the primary dealer banks and accumulate them on their central bank balance sheet. If we follow the flow from beginning to end, new dollars were created at the Federal Reserve, sent to primary dealer banks, sent to the Treasury Department, and sent to the public, which get deposited in their accounts via direct deposit or mailed checks (which directly increases broad M2 money supply). The Treasury security moves the other direction, from the Treasury Department to the banks and then ultimately to the Federal Reserve's balance sheet. This is an example of QE truly "printing money" and getting that money to the public.

Similar capital flow models apply for corporate bonds, mortgage-backed securities, or other securities. If they wind up on the central bank balance sheet, bought with newly-created dollars, it effectively means that money was created from thin air to provide capital funding for a company or the mortgage market, rather than extracted from elsewhere in the economy. New money entered the system. This set of funding doesn't really reach Main Street like it does when QE is used to fund Treasury securities, but it does enter the financial system as it relates to asset prices.

So, "does QE money make it to Main Street?" is not the main question because it depends specifically on what securities are bought with QE. When QE is used to buy mortgage-backed securities, corporate bonds, stocks, or other things, it mainly goes to financial markets rather than Main Street. When QE is used to buy Treasuries in a normal sense, it makes it to Main Street in the form of supporting existing government spending (much of it on Social Security, Medicare, and military) that isn't fully supported by taxation or real lenders. If QE is used to buy Treasuries for crisis-level helicopter money (checks in the mail, direct deposits, extra unemployment benefits, negative payroll taxes, or whatever the case may be), then it gets to Main Street more obviously.

 

 

Vinod

[Spekulatius]

^ Interesting. The repo issue also caused a mini hiccup in the equity markets in Sept 2019 that quickly reversed after the Fed stepped in. It seems like following what the Fed does is key to market movements rather than look at fundamentals (valuations ) or even macro economic indicators. The stock market performance during this crisis has shown this more than anything else. The problem seems to be that we need more and more of these sugar rushes to prevent meltdowns. Seems like treating a toddler prone to meltdowns with candy  and Ice cream each time when a tantrum is due. I am not an economist, but I know that at least with kids, this method doesn’t really work in the long run and I think many have tried.

[wabuffo]

Suppose trade deficit is zero and the govt runs a fiscal deficit equal to 10% of GDP every year. As soon the treasury issues debt, the fed immediately buys all the debt by printing money. So in this situation by using wabuffo's analysis, private domestic savings =10% of GDP every year. So to increase domestic private savings, govt can simply run massive deficits and the fed can just monetize the govt debt. Naturally something is wrong with this scenario.

 

Munger_Disciple, nothing is wrong with this scenario.  The Fed in this hypothetical scenario is not monetizing govt debt.  It is removing excess reserves that would pile up in the banking sector and drive interest rates to zero.  The US Treasury does this too when it issues Treasury debt.  You can get this if you do a debit/credit accounting of these transactions.  Let's just rename the fiscal deficit as $1t instead of 10% of GDP and let's make it happen in one single transaction:

 

1) The US Treasury buys $1t of goods and labor via its Treasury general account at the Federal Reserve.  The funds flow through a)the Fed, then b)the banks, to c)the private sector.

 

Federal Reserve:

US Treasury General Acct liability:            -$1t

Private Sector Bank Reserves liability:      +$1t

 

Commercial Banks:

Private Sector Bank Reserves asset:        +$1t

Private Sector Bank Deposits liability:      +$1t

 

Private Sector:

Bank Deposit assets:                              +$1t

Private Sector savings equity:                  +$1t

 

You can see how this transaction creates new bank deposits/financial assets out of thin air (think about the recent mailings/direct deposits of checks to every US taxpayer as part of the CARES Act).  But the effect of no US Treasury debt issuance is that bank reserves at the Fed = the amount of US Treasury debt issuance that should've been issued but wasn't.  These reserves are stuck on bank balance sheets since they are inert and trapped in a deposit at the Federal Reserve because they can only move between accounts at the Fed (and US Treasury).  This drives all interest rates to zero because there are more reserves than are required to meet regulatory requirements and payment clearing.

 

So there are two options to remove the excess reserves that have piled up in the banking system:

a) the Federal Reserve can remove the excess reserves via a reverse-repo operation (trading US T-bills/bonds on its b/s to banks for their excess reserves), and/or

b) the US Treasury can issue Treasury debt to remove the bank reserves and give the private sector a savings vehicle beyond its deposits in checking accounts.

 

Note that these activities (a and b) are bank reserve maintenance functions.  They both set govt risk-free interest rates - the Fed for short-term rates and the US Treasury for the rest of the yield curve. 

 

So let's look at the accounting/funds flow of both of these options.

 

2) The Federal Reserve (in order to keep its interest rate at target) performs a $1t reverse-repo operation with the banks (assume that in previous years the Treasury issued debt so that there is more than enough Treasury debt supply on the Fed's balance sheet from previous years' repo operations):

 

Federal Reserve repo:

US Treasury Debt asset:                          -$1t

Private Sector Bank Reserves liability:      -$1t

 

Commercial Banks:

Private Sector Bank Reserves asset:        -$1t

Private Sector Bank Tsy Bonds asset:      +$1t

 

3) The other option is the more normal one - the US Treasury issues debt and this activity also removes the excess bank reserves via the private sector exchanging its cash for a new type of savings vehicle with higher interest income (say, a 30-year bond).

 

Federal Reserve:

US Treasury General Acct liability:            +$1t

Private Sector Bank Reserves liability:        -$1t

 

Commercial Banks:

Private Sector Bank Reserves asset:        -$1t

Private Sector Bank Deposits liability:      -$1t

 

Private Sector:

US Treasury bills/bonds asset:                +$1t

Bank Deposit asset:                              -$1t

 

These transactions also demonstrate that operation 1) is the only one that increases private sector financial assets.  Operations 2) and 3) only swap assets and leave everyone where they were before with no greater savings (just the form of the savings changes).

 

The bottom line is I think we all are learning that the Fed Govt via US Treasury deficit spending has more fiscal capacity than anyone truly realized. This is also partly because the foreign sector is also demanding USD assets.  There is always a risk of inflation if the US Treasury tries to commandeer too much of the private sector goods and labor.  We might be testing that limit in 2020.

 

wabuffo

[JimBowerman]

1) QE should *raise* rates, not lower them.

Huh?  You should tell that to the Fed.  They think they are doing long-term yield curve suppression.  The Fed lowered short-term rates to zero.  The talk now is over yield curve control.

 

wabuffo

 

This is what makes monetary policy so confusing.  It works so counterintuitively.  For me its helpful to think of the 10 year interest rate as having a fixed spread between nominal GDP growth.  Its of course not always true, but over the long term is accurate and will help with our cause and effect understanding.  For most of the 20th century, lets say NGDP averaged say 6.5% while bond yields averaged say 5% (spread of 1.5%).  This was approximately the scenario in the 2005/2006 time frame. 

 

Now imagine, that with our 4.5% 10 year bond yield, the Fed suddenly announces yield curve control. In this case the Fed promises to keep the 10 year yield at 0%. Many people (including many at the FOMC  >:( ) would think this signifies easy monetary policy.  Unfortunately this is exactly wrong.  When the Fed promises to keep 10 year bond yields at 0%, the market will instantly recognize that this also means NGDP growth will have to drop from 6.5% to say 1.5% or so (to keep our original 1.5% spread in tact).  In order to keep NGDP this low, and keep bond yields this low, the Fed will actually start to decrease the future path of the monetary base.  They'll signal that they are going to make less money in the future (remember, NGDP is simply the velocity adjusted monetary base).

 

We saw this in Japan and we will see this in the US if they implement yield curve control.  Yield curve control simply bakes in low growth expectations going forward and will not stoke inflation or higher nominal GDP growth

 

If a central bank really wants high inflation they need to set their 10 year bond yield target above the current 10 year yield, not below it.  If the Fed said "We promise to do unlimited Open Market Operations until the 10 year bond yield reaches 4%"...well then i'd really start to worry about inflation.  The Fed usually only considers how their purcheses of bonds lowers the yeilds. They ignore how these bond purchases by the Fed also signal to the market that higher growth is coming.  QE, If done correctly, will lead to the market *raising* its demand for interest rates which more than counteracts any depressing effect on yields from direct Fed purchases of bonds.  FOMC and pundits also assume the market won't adjust to Fed signals...But the market most certainly will.  its why we had huge inflation in the 1980s with a Fed balance sheet at only 5% of GDP...Its also why we can't get any inflation now, despite a Fed balance sheet of 30% of GDP.  The market sniffs all this out and knows what the Fed is going to do better than the Fed itself

 

 

Until the Fed makes the above quote, i'm not worried about inflation much at all (and of course, in my ideal world they wouldn't target the 10 year yield, but would target nominal GDP growth instead)

 

 

[Cigarbutt]

Suppose trade deficit is zero and the govt runs a fiscal deficit equal to 10% of GDP every year. As soon the treasury issues debt, the fed immediately buys all the debt by printing money. So in this situation by using wabuffo's analysis, private domestic savings =10% of GDP every year. So to increase domestic private savings, govt can simply run massive deficits and the fed can just monetize the govt debt. Naturally something is wrong with this scenario.

 

Munger_Disciple, nothing is wrong with this scenario.  The Fed in this hypothetical scenario is not monetizing govt debt.  It is removing excess reserves that would pile up in the banking sector and drive interest rates to zero.  The US Treasury does this too when it issues Treasury debt.  You can get this if you do a debit/credit accounting of these transactions.  Let's just rename the fiscal deficit as $1t instead of 10% of GDP and let's make it happen in one single transaction:

...

These transactions also demonstrate that operation 1) is the only one that increases private sector financial assets.  Operations 2) and 3) only swap assets and leave everyone where they were before with no greater savings (just the form of the savings changes).

 

The bottom line is I think we all are learning that the Fed Govt via US Treasury deficit spending has more fiscal capacity than anyone truly realized. This is also partly because the foreign sector is also demanding USD assets.  There is always a risk of inflation if the US Treasury tries to commandeer too much of the private sector goods and labor.  We might be testing that limit in 2020.

 

wabuffo

^I think you effectively dodged Munger_Disciple's question. 8)

 

The 'investment' a country or region makes is based on the total of government, private (household and corporate) and 'foreign' sector. There are methodological issues but it is basically a simple equation. In the end, net savings =net investment. Over time, net investment as a percentage of GDP has been coming down.

 

The QE subterfuge lies in the scenario whereby it is assumed that money can be created and added to this savings equation without a proportionate decrease in the value of the currency. This assumption so far has been 'true' only because the Fed cannot force private entities to hold currency or excess reserves in the circulating economy. So far, the money created somehow circulated through the system (raising asset prices (wealth effect), with the help of supressed interest rates) and came back in depository institutions as excess reserves. The money velocity concept applies here: the money supply increased but the velocity decline offsets the M2 increase. This is why inflation has not picked up and this is why the extra currency has not contributed to the savings equation. Adding currency to the savings equation needs to account for the fact, over time and if money stays in the system, that more money means less value per unit of money. Unfortunately, the QE 'temporary' and now found to be difficult to reverse dynamic contributed to an environment where it became easier to issue debt in an already over-indebted global system. It appears that QE had minimal effect on the output gap over time and by trying to start quantitative tightening (going back to 'normal'), the Fed found out that this would have resulted in higher interest rates, asset price deflation etc etc.

 

It's boring and perhaps considered obsolete but savings and investments are connected at the hip. In a way, it's too bad that we end up painted in a corner, left with the best scenario being to go through a period that includes at least some level of asset deflation.

 

Also related to the savings issue is the fact that the savings glut situation not only applies to the 'foreign' sector but also to the rich sector. The savings rate has increased for the household sector but up until recently this reflected a much higher savings rate by the top 1 and 10% more than compensating lower savings rate by the rest. This can be interpreted many ways but the numbers tend to indicate that the group saving more has not really invested in productive capacity and the savings as an asset effectively became, over time, a liability for the rest. This may help to explain the dynamics playing now in several downtown areas although the focus is applied elsewhere at this point. An interesting feature is that the populace may become more conscious about the value of savings and they are the group who has historically manifested the greatest propensity to consume.

 

As usual, Spekulatius got it right using a few toddler words. In my very anecdotal experience, parents who have tended to use the delayed inverse gratification rules to raise children are the ones also pushing for relaxation of diagnostic criteria for the autism spectrum 'disorder'.

[JimBowerman]

Would also note while private debt is an important factor in the 2008 crisis, I'd argue the drop in NGDP growth was much much more important.  Private Debt to GDP went from 310% in 2005 to 370% in 2009.  This likely isn't ideal, but much of this increase also occured as a result of NGDP (ie income) dropping yet nominal debts remaining fixed.  If NGDP had maintained on a steady 5% growth path, I think private debt % would have been lower.  We've also reached a steady state in the decade since 2008 with no major problems (see graph below). I argue that this is because NGDP was relatively stable until recently.

 

I can imagine a world where we keep private debt to GDP in the 330% range forever with no problems, but only if NGDP is also kept stable on a 5% growth path.  We can't let NGDP drop to even a 3% path, much less *negative* as we saw in 2008.  The 2008 crisis was primarily a monetary policy failure, not a private debt problem

 

https://fred.stlouisfed.org/graph/?graph_id=316529

[wabuffo]

The U.S. government literally ran out of cash dollar lenders for their Treasury securities; both domestic and foreign. In reality, the root cause was that the U.S. government ran out of lenders. Foreigners, pensions, insurance companies, retail investors, and finally large banks and hedge funds, simply weren't buying enough Treasuries at that point compared to how many Treasuries the government was issuing, at over $1 trillion annualized. They had no excess dollars from which to lend to the U.S. government at those rates.

 

Vinod - her explanation of the Sept repo crisis is just goofy....and wrong.  I don't think she totally understands how any of this works.

 

In order to understand the Sept repo "crisis' - you have to understand that this was the Federal Reserve causing a self-inflicted wound to itself by not keeping its eye on the ball when it comes to its most important function - running the US payment clearing system between banks. 

 

US PAYMENT CLEARING SYSTEM:

The Federal Reserve manages the US payment clearing and settlement process between federally-chartered banks and thrifts (also includes a few other financial firms but also the US Treasury, of course).  Banks have checking accounts at the Fed and those balances (reserves) are used to make sure all inter-bank payments clear and no bank overdraws its account during daylight hours.  Despite all the focus on FOMC meetings, etc - this is the single most important reason why the Federal Reserve system exists.

 

So what is the sum total of financial transactions processed in a day, a week, a year?  The Fed provides this data for the two major payment clearing systems (Fedwire - which is run by the Fed) and (CHiPS - which is run by ~50 big US banks and the US subs of foreign banks but does the final settlement with the Fed).  Here are their transaction volume summaries:

 

FEDWIRE:

https://www.frbservices.org/resources/financial-services/wires/volume-value-stats/monthly-stats.html

 

CHIPS:

https://www.theclearinghouse.org/-/media/new/tch/documents/payment-systems/chips-volume-and-value.pdf

 

In 2019, Fedwire processed $696t in US payments while CHIPS processed $417t in US payments. That's a total of $1.13 quadrillion in annual financial payments cleared (vs $21t US GDP)  There are also a small amount of transactions settled in cash but we can ignore those.  That's over $3.1t per day.  But I do like to say "$1 Quadrillion Dollars!"

 

ROLE OF BANK RESERVES IN PAYMENT CLEARING:

All inter-bank payment clearing happens at the Fed.  To participate in this activity, banks have "checking accounts" at the Federal Reserve.  The key question is what is the right amount to keep at the Fed given the very high transaction amounts.  What governs the amounts banks have to have there is the Federal Reserve itself (including its regulations and practices).  Let's use our own experience with a checking account and how we would manage our finances - one with overdraft protection and one without.  Since we are all investors, we would prefer to keep the minimum possible in this checking account because there is an opportunity cost to keep large balances vs holding stocks, etc.

 

So on a particular day, we have a large bill payment to make but we are also expecting our bi-weekly pay via direct deposit to come in that day as well. What we don't know is the order in which these transactions will hit our account (plus there could be a surprise outflow we forgot about).  If we keep the balance low and the bill payment goes out before the pay comes in, we'll go into a daylight overdraft and get hit with large overdraft fees by the bank.  But if we have overdraft protection from the bank, we don't care what the order of transactions is, because the bank will cover us for any short-term negative balances.

 

Banks manage their reserves with the same thought process - do they lend out reserves to other banks for some income or do they play it safe.  This is where the Fed, its interest rate management policy and its regulatory rules come in.  Pre-GFC, the Federal Reserve would allow banks to run negative reserve balances intra-day (which the Fed would cover) so long as they ended up at the end of each day with a positive reserve balance.  If some bank looked like it was going to be short, it would try to borrow reserves from banks that would be over.  This might cause interest rates for Fed funds (reserve balances) to increase.  If this was threatening to make the Fed funds rate to rise above the target of the Fed, the Fed would come in with a repo operation - supplying reserves for Treasuries to get the interest rate back to target.  This Fed interest rate targetting is called a corridor system (ie, the interest rate on fed funds stays within a band target set by the Fed and the Fed intervenes when it threatens to break above or below the band - thus the "corridor")

 

But back then, the total excess reserves at the Fed were less than $10B - to clear daily payments of $2-3t per day.  Just like us with overdraft protection at the bank, the banks had daily overdraft protection at the Fed and ran with extremely low reserve balances.

 

After the GFC, the Fed changed the rules for banks.  Daylight overdrafts were no longer permitted (the Fed would cover in an emergency because the Fed must ensure no payment ever fails to clear, but basically the bank CEO would lose his/her job), In addition, there were other rules imposed - there were "living will" requirements that forced banks to hold reserves to cover a certain number of days of payment clearing, etc.. In addition, the Fed expanded its balance sheet to force reserves to expand in size. (remember its the Fed, and not the banks, that control the size of total bank reserves).  Now the Fed changed its interest rate management strategy.  It no longer needed a corridor, since there were more reserves than banks needed - it went to a "floor" system and paid an interest rate on excess reserves.  Fed repo operations basically ceased.  The problem for the Fed is no one really knew where the 'floor' was anymore.  I mean when you have trillions in excess reserves - how can any payments not be cleared?

 

JPM MORGAN CHASE & RESERVES/REPO:

JPMorgan is the biggest and most important bank in the US.  It also has the largest amount of bank reserves since the GFC and thus is, at the margin, the lender of last resort to other banks who need reserves.  Here is a chart that shows quarterly bank reserves for JPM since the GFC (these are from the FFIEC's quarterly bank Call Reports).

So a few things to note about this chart.  Prior to the GFC, JPM managed its payment clearing at the Fed with only $2-4B in reserves.  Payment clearing volumes have not changed much over that time - total payments grow in line with GDP growth.  Then when the Fed started doing all of its QE, JPM's reserves grew to a peak of $450B (over 100x pre-GFC) in March, 2015.  As the Fed began to shrink its balance sheet in 2016-2019, total bank reserves began to shrink (and JPMs reserves shrink too).  But where is the redline?  Especially under the new regulations?  At what point do individual banks like JPM think - I don't feel that I have any excess reserves to lend because of the new rules and regulations?

 

Well - it turns out that point was reached in mid-Sept 2019!  All it took was three days (Sept 13, 16, 17th, 2019) of large tax payments by the US private sector to the US Treasury (in excess of Treasury daily spending) that moved a net $125B from bank reserves to the US Treasury's general account at the Fed (data from the US Treasury Daily Statements for that period).  On Sept. 11, 2019 - total bank reserves per the Fed H.4.1 report stood at $1.458T.  Normally (125/1458 =) a 8.6% short-term reduction of bank reserves shouldn't push the payment system from Defcon 5 to Defcon 1 in the space of a few days.  But unbeknownst to the Federal Reserve, the regulations and rules imposed on the banks limited their ability to deploy their excess reserves to help each other square up at the end of each of those days.  JPM's reserves stood at ~$119b at June 30 and Sep 30, 2019 (which were their lowest levels since the GFC).  The signs were there, though, at previous quarter-ends there were very brief spikes in fed funds rates but nowhere near what happened on Monday and Tuesday Sept 16 and 17.

 

Here's JPM's  Jamie Dimon on his Sept 30 earnings conference call:

..we [JPMorgan Chase] have a checking account at the Fed with a certain amount of cash in it. Last year, we had more cash than we needed for regulatory requirements. ... But now the cash in the account, which is still huge. It's $120 billion in the morning, and it goes down to $60 billion during the course of the day and back to $120 billion at the end of the day. That cash, we believe, is required under resolution and recovery and liquidity stress testing. And therefore, we could not redeploy it into repo market, which we'd have been happy to do."

 

“... we believe the requirement under CLAR and resolution recovery is that we need enough in that account such that if there’s extreme stress, during the course of the day, it doesn’t go below zero.  You go back to before the crisis, you’d go below zero all the time during the day. So the question is, how far is that as a red line? Was the intent to regulate it between CLAR resolution to lock up that much of reserves in account at the Fed.  And that will be up to regulators to decide.  But right now, we have to meet those rules.  And we don’t want to violate anything we told them we’re going to do."

 

So there you have it.  This was a bureaucratic and regulatory FUBAR that forced the Fed to resume its repo operations (and thus go back to a 'corridor' system from a 'floor' system in terms of controlling the fed funds rate).  Nothing more or less than that.  It wasn't because the US Treasury was issuing too much debt -- quite the contrary, the cause was actually the opposite - i.e, the US Treasury running a small 3-day surplus.  I'm not a conspiracy theorist - but as the biggest bank, did JPM force the Fed's hand here?  Was Jamie Dimon chafing at holding too much cash at the Fed and wanted a little loosening of the regulations?  I would never want to accuse Jamie Dimon of anything here, but nor would I want to play poker with him.  But if I had to bet between the bureaucrats at the Fed vs Jamie Dimon, I know who I would bet on. 

 

Once again, sorry for the long-winded response but my wife always jokes that she doesn't want to ask me the time, because I go into explaining how the watch is made.

 

wabuffo

 

[wabuffo]

Seems like treating a toddler prone to meltdowns with candy  and Ice cream each time when a tantrum is due.

 

Spek - I may agree with your general comment overall - but as I indicated, the Fed is a side-show.  Its like the Wizard of Oz - its voice booms over the economy, but it is a meek little man behind the curtain who can't even do his basic job sometimes (as in the Sept repo mess).

 

Its unfortunate that the Fed runs its affairs the way it does - with excess reserves and an interest rate on excess reserves.  It is probably the only central bank that does this -- and it is totally unnecessary.  So it draws oohs and ahs when its balance sheet expands.  As I've said before, I think the Fed could run with zero reserves, no problem.

 

It would then retreat into the background, and economic conspiracy theorists would have to find something else to point to...

 

The real heavy hitter to pay attention to is the US Treasury (and Congress).  But they like to avoid the spotlight and push the Fed to take the slings and arrows.

 

wabuffo

[Spekulatius]

Seems like treating a toddler prone to meltdowns with candy  and Ice cream each time when a tantrum is due.

 

Spek - I may agree with your general comment overall - but as I indicated, the Fed is a side-show.  Its like the Wizard of Oz - its voice booms over the economy, but it is a meek little man behind the curtain who can't even do his basic job sometimes (as in the Sept repo mess).

 

Its unfortunate that the Fed runs its affairs the way it does - with excess reserves and an interest rate on excess reserves.  It is probably the only central bank that does this -- and it is totally unnecessary.  So it draws oohs and ahs when its balance sheet expands.  As I've said before, I think the Fed could run with zero reserves, no problem.

 

It would then retreat into the background, and economic conspiracy theorists would have to find something else to point to...

 

The real heavy hitter to pay attention to is the US Treasury (and Congress).  But they like to avoid the spotlight and push the Fed to take the slings and arrows.

 

wabuffo

 

Yes, thanks for taking the time to explain the Repo issue (again). This does make sense. It seems sort of surprising that Dimon doesn’t exactly know the red line in terms of reserves. One would think that the rule for clearing payments and the reserves  are crystal clear, if that is the most important function of the Fed. Perhaps the Fed bureaucracy likes to keep things a bit muddies to keep everyone on their toes and make sure the Branka never cut ti too close. Seems to have backfired in that incidence.

 

FWIW, we see the correlation of private sector saving and public deficit in this quarter when We saw the headline that the Private savings Rate went to 33%. I guess that happens when you throw of bundles of helicopter money to masses with many of them having no opportunity to spent it. And of course we have the public deficit to match the private savings.

[Cigarbutt]

1) QE should *raise* rates, not lower them.

Huh?  You should tell that to the Fed.  They think they are doing long-term yield curve suppression.  The Fed lowered short-term rates to zero.  The talk now is over yield curve control.

wabuffo

This is what makes monetary policy so confusing...

Now imagine...

If a central bank really wants high inflation they need to...

...target nominal GDP growth instead.

i just want to say that it's difficult to aim for something nominal when a component is inflation.

High inflation (and high nominal GDP numbers) in the 70s and early 80s did wonders for the % of public debt held by the public per GDP but equities had significant yield competition.

Also during that specific inflation period, net national savings went from 10 to 8% of GDP but it stood recently at 2% (and going way down as we speak). Does that matter for future real growth?

In the late 60s and 70s, from an equity perspective, one did not need to wait for a cheery consensus but a dose of eeriness was reasonable against the inflation swindler?

[JimBowerman]

i just want to say that it's difficult to aim for something nominal when a component is inflation.

High inflation (and high nominal GDP numbers) in the 70s and early 80s did wonders for the % of public debt held by the public per GDP but equities had significant yield competition.

Also during that specific inflation period, net national savings went from 10 to 8% of GDP but it stood recently at 2% (and going way down as we speak). Does that matter for future real growth?

In the late 60s and 70s, from an equity perspective, one did not need to wait for a cheery consensus but a dose of eeriness was reasonable against the inflation swindler?

 

Not sure if would be very difficult at all if there were a Nominal GDP futures market.  Make dollars convertible into NGDP futures, in unlimited amounts (by anyone).  Anyone who disagrees with future inflation marktes can make money.  Fed promises to print velocity adjusted dollars when futures imply below 5% NGDP growth and remove dollars when NGDP growth is above 5%

 

NGDP was WAY above trend for 30 years (1960-1992, see below).  It was perfectly obvious, in real time, that monetary policy was entirely too easy for 3 decades.  It is beyond easy to see when monetary policy is too tight/too easy if you have an NGDP futures market.  Fed could set this market up very quickly and very low cost.

 

Though I do agree that targeting inflation can be problematic.  Take the current crisis.  Real GDP understandably will be way below trend for a while. Proper monetary response is to raise inflation to 3-4% to make up for this downfall in real GDP.  Keeping NGDP growth constant does exactly this and is one of the many benefits of NGDP targeting over inflation targeting

 

[wabuffo]

It seems sort of surprising that Dimon doesn’t exactly know the red line in terms of reserves. One would think that the rule for clearing payments and the reserves  are crystal clear,

 

Spek - from what I can tell, I think the rules are pretty clear, but what creates uncertainty is volatility in daily payments.  I think you have some experience working in manufacturing companies - so you can relate to how manufacturers try to set their inventories of finished goods to meet sales orders.  Their supply chain people get demand forecasts from sales, orders on hand plus production schedules and calculate required inventory levels/targets.  But of course, demand forecasts can be wrong and production can sometimes come up short vs the schedule.  So inventories must have an extra level of safety stock to ensure high service levels to customers are always maintained and no sale is missed.

 

I think of reserve levels the same way.  Dimon probably knows that, on average, he needs $60B of reserves to meet daily expected fluctuations, but he feels his bank needs an extra $60B of safety stock.  That leaves him with zero available to lend out.  When JPM was holding $200-$300B, the $60B + $60B of safety stock left him ample reserves to lend.

 

I think the real wild card is the actions of the US Treasury when it comes in with either big spending or big withdrawals (taxes).  Here again, pre-GFC, the Fed and the US Treasury used to have a better system and would coordinate their activities. 

 

For one, the Fed was in the fed funds market in order to maintain its interest rate target and so it had to get information from the US Treasury every week on what it was planning to do with spending, taxes, debt issuance/redemption.  For another, the US Treasury used to keep account balances at not just the Fed - but also in the commercial banking system.  These were called Treasury Tax & Loan Acounts (TTLs).  The Treasury's account at the Fed would hold $4-$5B and the TT&L accounts would also hold maybe $20-$50B in balances.  Thus, if there was a big tax withdrawal day, the cash would stay at the commercial banks and just move deposits from households/corporations to the Treasury's commercial bank accounts - no initial impact to bank reserves at the Fed.  The Fed and the US Treasury would then co-ordinate when the Treasury would withdraw the money from the commercial banking sector so as not to create big ripple effects.

 

Today - the US Treasury holds no commercial banking deposit accounts - the TT&L accounts were phased out after the GFC.  Instead, the US Treasury is holding all of its cash in its account at the Fed and every move swings reserves back and forth from bank reserves.  Frankly, the Fed and US Treasury had a pretty good system to operate monetary policy before the GFC, now they run a clunky and bloated system that is a bureaucratic nightmare for the banks.

 

wabuffo

[mcliu]

@wabuffo, thanks for the detailed posts, really interesting stuff

[wabuffo]

QE can be deflationary if a central bank insists on paying interest on reserves.  I know it's in fashion to say that private banks create most of the money, but this isn't true in a practical sense. The nominal anchor is still the monetary base and that is controlled by the Fed

 

Under normal open market operations (OMOs), the Fed injects 0% yielding reserves in place of say 2% yielding treasuries. This makes a commercial banks balance sheet a bit less risky.  Since reserves are "stuck" in the commercial banking system, the only thing these commercial banks can do (as a whole) is make more loans, etc to bring their balance sheet metrics back in line

 

However, when the Fed insists on paying interest on these reserves, now the open market operations are swapping say 2% treasuries for 2% yielding reserves.  There is no incentive for banks to "rerisk" their balance sheet and hence the banks have very little reason to make more loans.  Of course this will look like "hoarding" of money, etc and result is lower economic (nominal GDP) growth.

 

Jim - interesting take.  I think we both agree that reserves are basically inert.  Where we disagree is that somehow reserves lead to more lending, if only the Fed were more accomodative (ie, lowering interest rates).  I just don't think there's any relationship between the two.  More importantly the data backs it up.  Bank credit is a function of collateral and regulatory capital requirements.

 

Here's a long run chart of the ratio of bank credit to reserves since early 80s.  The chart merely reflects that bank credit grew even as reserves fell during much of the period from the 80s to 2008.  Then the Federal Reserve changed its interest-rate targeting and reserve policy and the ratios since 2008 reflect that.  One (bank credit) has very little to do with the other (reserves).  Its apples-and-rutabagas - no relationship at all.  Indeed, some central banks operate just fine with zero reserves (Bank of Canada).

 

 

Even the traditional reserves-are-10%-of-deposits doesn't show any relationship.  It almost looks like reserve balances are independent and disconnected from deposits or bank credit.

 

We will probably have to agree to disagree on this, but in my view, FWIW - reserve balances at the Federal Reserve serve only two purposes:

1)  Payment settlement.

2)  Meeting reserve requirements (per bank safety and soundness regs).

 

Reserve balances are not used for:

3)  Money creation

4)  Bank Credit extension.

 

Most of the theory about money multipliers and base money just haven't shown any traction in reality and practice.  That's why so much of the expectations of what the Fed can do to stimulate the economy (or slow it down) are bound to fail.  It really is the height of arrogance by the Fed officials that they act as if they do.  If one wants to stimulate the economy, the only lever is fiscal policy through the US Treasury.  Small changes to Fed interest rates have only minor effects.  The rest is risk-appetite/risk aversion by the private sector.

 

So for me, the order of influence on the economy is:

1) Risk Appetite

2) Fiscal Policy

.

.

.

3) Fed Policy

 

 

But I do enjoy reading your stuff (most of the mechanics, I think we agree on).

 

wabuffo

[JimBowerman]

Yes good discussion!

 

I thinks it very hard to discern cause and effect from the data, especially since Central banks usually don't give clear forward guidance.  For example, if a bank is unclear about how much of the currently printed money is permanent, then looking at money multipliers won't be usuful at all.  A prime example of this is 2008.  The Fed printed a bunch of money, but signaled at the same time that they would unwind relatively soon (and paid IOER). But that doesn't mean money printing is ineffective.  It just means they shot themselves in the foot by signaling contractionary forward guidance (which turned out to be true - market called Feds bluff and won). 

 

Would also point out that I should say its reserves PLUS currency that matters (ie MB).  In theory you could have a system with 0 reserves...Or another system with 0 currency.  But you can't have a system with zero MB.  You need a nominal anchor.  in the last few decades, reserves have gone down. But if you look at MB, you can see a large increase (4-5x i believe) which largely coincides with NGDP growth (if you remove IOER factor of late)

 

I think that you're right as far the current system...as it stands, reserves largely for settlement balance, etc.  But I'm saying if the Fed acted appropriately, they could use reserves more as a money creation function to increase NGDP.

 

Fiscal policy is a whole other discussion.  I'd actually don't think fiscal can drive much growth on its own.  The monetary authorities must cooperate, and the monetary authorities can snuff out any fiscal stimulus if they want (see monetary offset -> https://www.econlib.org/archives/2016/08/monetary_offset_1.html)

 

Macro musings has a lot of good stuff.  Have you read much from Scott Sumner or George Selgin?  Pretty much 95% of my views here are just parroting original stuff from those two that I read over the years.

 

btw, if you're on twitter, a few of us tend to have some good discussions on there if you're interested in joining in (example:

)

[wabuffo]

Have you read much from Scott Sumner or George Selgin?

 

Scott Sumner - no

George Selgin - yes, I have his book Floored!  His main point seems to be that the Fed should abandon the floor system with all these excess reserves and go back to old corridor system with minimal reserves.  I basically agree with him on that.  I really like his critiques of current Fed policy and monetary management.

 

wabuffo

 

[vinod1]

The U.S. government literally ran out of cash dollar lenders for their Treasury securities; both domestic and foreign. In reality, the root cause was that the U.S. government ran out of lenders. Foreigners, pensions, insurance companies, retail investors, and finally large banks and hedge funds, simply weren't buying enough Treasuries at that point compared to how many Treasuries the government was issuing, at over $1 trillion annualized. They had no excess dollars from which to lend to the U.S. government at those rates.

 

Vinod - her explanation of the Sept repo crisis is just goofy....and wrong.  I don't think she totally understands how any of this works.

 

In order to understand the Sept repo "crisis' - you have to understand that this was the Federal Reserve causing a self-inflicted wound to itself by not keeping its eye on the ball when it comes to its most important function - running the US payment clearing system between banks. 

 

US PAYMENT CLEARING SYSTEM:

The Federal Reserve manages the US payment clearing, netting and settlement process between federally-chartered banks and thrifts (also includes a few other financial firms but also the US Treasury, of course).  Banks have checking accounts at the Fed and those balances (reserves) are used to make sure all inter-bank payments clear and no bank overdraws its account during daylight hours.  Despite all the focus on FOMC meetings, etc - this is the single most important reason why the Federal Reserve system exists.

 

So what is the sum total of financial transactions processed in a day, a week, a year?  The Fed provides this data for the two major payment clearing systems (Fedwire - which is run by the Fed) and (CHiPS - which is run by ~50 big US banks and the US subs of foreign banks but does the final settlement with the Fed).  Here are their transaction volume summaries:

 

FEDWIRE:

https://www.frbservices.org/resources/financial-services/wires/volume-value-stats/monthly-stats.html

 

CHIPS:

https://www.theclearinghouse.org/-/media/new/tch/documents/payment-systems/chips-volume-and-value.pdf

 

In 2019, Fedwire processed $696t in US payments while CHIPS processed $417t in US payments. That's a total of $1.13 quadrillion in annual financial payments cleared (vs $21t US GDP)  There are also a small amount of transactions settled in cash but we can ignore those.  That's over $3.1t per day.  But I do like to say "$1 Quadrillion Dollars!"

 

ROLE OF BANK RESERVES IN PAYMENT CLEARING:

All inter-bank payment clearing happens at the Fed.  To participate in this activity, banks have "checking accounts" at the Federal Reserve.  The key question is what is the right amount to keep at the Fed given the very high transaction amounts.  What governs the amounts banks have to have there is the Federal Reserve itself (including its regulations and practices).  Let's use our own experience with a checking account and how we would manage our finances - one with overdraft protection and one without.  Since we are all investors, we would prefer to keep the minimum possible in this checking account because there is an opportunity cost to keep large balances vs holding stocks, etc.

 

So on a particular day, we have a large bill payment to make but we are also expecting our bi-weekly pay via direct deposit to come in that day as well. What we don't know is the order in which these transactions will hit our account (plus there could be a surprise outflow we forgot about).  If we keep the balance low and the bill payment goes out before the pay comes in, we'll go into a daylight overdraft and get hit with large overdraft fees by the bank.  But if we have overdraft protection from the bank, we don't care what the order of transactions is, because the bank will cover us for any short-term negative balances.

 

Banks manage their reserves with the same thought process - do they lend out reserves to other banks for some income or do they play it safe.  This is where the Fed, its interest rate management policy and its regulatory rules come in.  Pre-GFC, the Federal Reserve would allow banks to run negative reserve balances intra-day (which the Fed would cover) so long as they ended up at the end of each day with a positive reserve balance.  If some bank looked like it was going to be short, it would try to borrow reserves from banks that would be over.  This might cause interest rates for Fed funds (reserve balances) to increase.  If this was threatening to make the Fed funds rate to rise above the target of the Fed, the Fed would come in with a repo operation - supplying reserves for Treasuries to get the interest rate back to target.  This Fed interest rate targetting is called a corridor system (ie, the interest rate on fed funds stays within a band target set by the Fed and the Fed intervenes when it threatens to break above or below the band - thus the "corridor")

 

But back then, the total excess reserves at the Fed were less than $10B - to clear daily payments of $2-3t per day.  Just like us with overdraft protection at the bank, the banks had daily overdraft protection at the Fed and ran with extremely low reserve balances.

 

After the GFC, the Fed changed the rules for banks.  Daylight overdrafts were no longer permitted (the Fed would cover in an emergency because the Fed must ensure no payment ever fails to clear, but basically the bank CEO would lose his/her job), In addition, there were other rules imposed - there were "living will" requirements that forced banks to hold reserves to cover a certain number of days of payment clearing, etc.. In addition, the Fed expanded its balance sheet to force reserves to expand in size. (remember its the Fed, and not the banks, that control the size of total bank reserves).  Now the Fed changed its interest rate management strategy.  It no longer needed a corridor, since there were more reserves than banks needed - it went to a "floor" system and paid an interest rate on excess reserves.  Fed repo operations basically ceased.  The problem for the Fed is no one really knew where the 'floor' was anymore.  I mean when you have trillions in excess reserves - how can any payments not be cleared?

 

JPM MORGAN CHASE & RESERVES/REPO:

JPMorgan is the biggest and most important bank in the US.  It also has the largest amount of bank reserves since the GFC and thus is, at the margin, the lender of last resort to other banks who need reserves.  Here is a chart that shows quarterly bank reserves for JPM since the GFC (these are from the FFIEC's quarterly bank Call Reports).

So a few things to note about this chart.  Prior to the GFC, JPM managed its payment clearing at the Fed with only $2-4B in reserves.  Payment clearing volumes have not changed much over that time - total payments grow in line with GDP growth.  Then when the Fed started doing all of its QE, JPM's reserves grew to a peak of $450B (over 100x pre-GFC) in March, 2015.  As the Fed began to shrink its balance sheet in 2016-2019, total bank reserves began to shrink (and JPMs reserves shrink too).  But where is the redline?  Especially under the new regulations?  At what point do individual banks like JPM think - I don't feel that I have any excess reserves to lend because of the new rules and regulations?

 

Well - it turns out that point was reached in mid-Sept 2019!  All it took was three days (Sept 13, 16, 17th, 2019) of large tax payments by the US private sector to the US Treasury (in excess of Treasury daily spending) that moved a net $125B from bank reserves to the US Treasury's general account at the Fed (data from the US Treasury Daily Statements for that period).  On Sept. 11, 2019 - total bank reserves per the Fed H.4.1 report stood at $1.458T.  Normally (125/1458 =) a 8.6% short-term reduction of bank reserves shouldn't push the payment system from Defcon 5 to Defcon 1 in the space of a few days.  But unbeknownst to the Federal Reserve, the regulations and rules imposed on the banks limited their ability to deploy their excess reserves to help each other square up at the end of each of those days.  JPM's reserves stood at ~$119b at June 30 and Sep 30, 2019 (which were their lowest levels since the GFC).  The signs were there, though, at previous quarter-ends there were very brief spikes in fed funds rates but nowhere near what happened on Monday and Tuesday Sept 16 and 17.

 

Here's JPM's  Jamie Dimon on his Sept 30 earnings conference call:

..we [JPMorgan Chase] have a checking account at the Fed with a certain amount of cash in it. Last year, we had more cash than we needed for regulatory requirements. ... But now the cash in the account, which is still huge. It's $120 billion in the morning, and it goes down to $60 billion during the course of the day and back to $120 billion at the end of the day. That cash, we believe, is required under resolution and recovery and liquidity stress testing. And therefore, we could not redeploy it into repo market, which we'd have been happy to do."

 

“... we believe the requirement under CLAR and resolution recovery is that we need enough in that account such that if there’s extreme stress, during the course of the day, it doesn’t go below zero.  You go back to before the crisis, you’d go below zero all the time during the day. So the question is, how far is that as a red line? Was the intent to regulate it between CLAR resolution to lock up that much of reserves in account at the Fed.  And that will be up to regulators to decide.  But right now, we have to meet those rules.  And we don’t want to violate anything we told them we’re going to do."

 

So there you have it.  This was a bureaucratic and regulatory FUBAR that forced the Fed to resume its repo operations (and thus go back to a 'corridor' system from a 'floor' system in terms of controlling the fed funds rate).  Nothing more or less than that.  It wasn't because the US Treasury was issuing too much debt -- quite the contrary, the cause was actually the opposite - i.e, the US Treasury running a small 3-day surplus.  I'm not a conspiracy theorist - but as the biggest bank, did JPM force the Fed's hand here?  Was Jamie Dimon chafing at holding too much cash at the Fed and wanted a little loosening of the regulations?  I would never want to accuse Jamie Dimon of anything here, but nor would I want to play poker with him.  But if I had to bet between the bureaucrats at the Fed vs Jamie Dimon, I know who I would bet on. 

 

Once again, sorry for the long-winded response but my wife always jokes that she doesn't want to ask me the time, because I go into explaining how the watch is made.

 

wabuffo

 

This is immensely helpful! Thank you very much.

 

Vinod

[JimBowerman]

Have you read much from Scott Sumner or George Selgin?

 

Scott Sumner - no

George Selgin - yes, I have his book Floored!  His main point seems to be that the Fed should abandon the floor system with all these excess reserves and go back to old corridor system with minimal reserves.  I basically agree with him on that.  I really like his critiques of current Fed policy and monetary management.

 

wabuffo

 

Yes Floored! is a great book.  My youtube post by Selgin earlier in this thread goes into how the Fed can flood the commercial banking system with reserves to get NGDP growth if they want. 

 

Sumner has a great blog that I highly recommend.  Here's one relevant post

 

https://www.themoneyillusion.com/the-real-problem-with-the-money-multiplier/

[Munger_Disciple]

Thanks wabuffo and Cigarbutt for your detailed responses to my question. Also additional thanks to wabuffo for his many educational posts regarding Fed/Treasury operations.

 

[SHDL]

If you follow comments made by Mr. Druckenmiller over the years, he referred to the hot potato effect whereby people in general would then have a lower propensity to hold cash or low yield risk-free debt and reach for yield raising the risk of capital misallocation and resulting in the possibility of asset inflation and subsequent asset deflation once easing was gone or when easing could not mitigate economic deterioration.

 

Right but this argument is something I’m not as convinced about at the moment. For one thing I’m not certain what distortions he is talking about. It’s true that a lot of money has gone into various startups with questionable prospects with regard to future profitability for example but was that really a net loss for society? I’m not so sure, given that consumers have almost certainly benefited, their workers presumably learned useful skills on the job, at least some of technologies that they developed are sure to remain valuable, etc.

[Cigarbutt]

If you follow comments made by Mr. Druckenmiller over the years, he referred to the hot potato effect whereby people in general would then have a lower propensity to hold cash or low yield risk-free debt and reach for yield raising the risk of capital misallocation and resulting in the possibility of asset inflation and subsequent asset deflation once easing was gone or when easing could not mitigate economic deterioration.

Right but this argument is something I’m not as convinced about at the moment. For one thing I’m not certain what distortions he is talking about. It’s true that a lot of money has gone into various startups with questionable prospects with regard to future profitability for example but was that really a net loss for society? I’m not so sure, given that consumers have almost certainly benefited, their workers presumably learned useful skills on the job, at least some of technologies that they developed are sure to remain valuable, etc.

Your perspective makes sense but there is no magical line that determines when productive capital becomes unproductive. It just seems that 'we' (developed nations) appear to require more and more debt to obtain less and less marginal increase in GDP and low and ultra-low interest rates have become a sine qua non.

If interested, Mr. Druckenmiller talked about the productivity of capital in an interview made last year:

https://www.gurufocus.com/news/889851/stanley-druckenmiller-people-have-been-doing-stupid-things

[UK]

https://www.bloomberg.com/opinion/articles/2020-06-02/jpmorgan-s-bond-chief-has-no-time-for-fed-haters

[meiroy]

If you follow comments made by Mr. Druckenmiller over the years, he referred to the hot potato effect whereby people in general would then have a lower propensity to hold cash or low yield risk-free debt and reach for yield raising the risk of capital misallocation and resulting in the possibility of asset inflation and subsequent asset deflation once easing was gone or when easing could not mitigate economic deterioration.

 

Right but this argument is something I’m not as convinced about at the moment. For one thing I’m not certain what distortions he is talking about. It’s true that a lot of money has gone into various startups with questionable prospects with regard to future profitability for example but was that really a net loss for society? I’m not so sure, given that consumers have almost certainly benefited, their workers presumably learned useful skills on the job, at least some of technologies that they developed are sure to remain valuable, etc.

 

Yes, I agree.  A lot of good came out of the 2000 tech bubble and in retrospect, seeing how internet/software/cloud so far has changed the world it had some justification for it.  It wasn't all bad. Same for biopharmaceuticals.

 

It seems that when there's the combination of high liquidity and somewhat low-interest rates, money flows into high-risk sectors as the low hanging fruit is quickly gone.

 

Regarding capital misallocation, yeah it depends where it goes... right now if it goes into infrastructure in the USA it will have great benefit for various reasons.  It's not that higher debt is a necessity for a slight increase in growth in developed countries, but rather it depends on how it used. The USA has been addicted to Ayn Rand and trickle-down wealth which is one of the main causes of the current imbalance.