So Brad has picked up the gauntlet on monetary policy in the Great Depression. As I read him he seems to concede that the argument maybe at least half right, but he still appears to pin his hopes on pumping in enough high powered money to save the day. I would like to make a couple of points at this stage. Firstly that I am deeply indebted for my arguments here to Christopher Dow and his magnum opus on Major Recessions and to my dear brother, the erstwhile anarchist banker. Indeed Dow and Iain Saville seem to have done a good job of keeping the limitations of the Friedman view well in sight even at the height of the monetary mania. As Dow indicates there may well be a good UK post-Keynes tradition of arguing the endogeneity of money, which while it has always been heterodox (we Brits are congenitally heterodox), does at least pass through such distinguished names as John Hicks and Nicholas Kaldor. So not everyone has always been so 'naieve'.
Now going back for a moment to Brad's (and numerous others, many of them currently housed down at the Federal Reserve) faith in the power of high-powered money, it seems to me that one of the issues is how to identify the extent of the problem in advance. It is one of the tenets of the famous Ahearne et al paper that the Japanese reacted by doing too-little too-late. This is fine with the benefit of hindsight, but how do you know in advance? Although we are now well versed in the omnipresence of assymettries - assymetrical shocks, assymetrical risk, assymetrical falsification etc - some symmetries do in fact exist, both in argument and nature. One of these, I would argue, can be found in the boom-crash cycle, and while after recent experience everyone is well clued-up on the difficulties of identifying a bubble in order to 'burst' it, we seem less well tuned into the difficulties of identifying when a downturn might turn into a long and sustained recession. And this is one of the problems I can see in Brad's argument, since, even accepting that flooding the market with money at a key juncture might have some effect (depending on why we were getting the deflation in the first place), identifying when to open the flood gates would seem to be much more difficult. Finally, to back up the difficulty of having so much confidence in monetary instruments with a bit of research, why not try looking at the following paper from Ritschl and Woitek? As their abstract states:
This paper recasts Temin's (1976) question of whether monetary forces caused the Great Depression in a modern time series framework. We adopt a Bayesian estimation and forecasting algorithm to evaluate the effects of monetary policy against nonmonetary alternatives, allowing for time-varying parameters and coefficient updating. We find that the predictive power of monetary policy is very small for the early phase of the depression and breaks down almost entirely after 1931. During the propagation phase of 1930-31, monetary policy is able to forecast correctly at short time horizons but invariably predicts recovery at longer horizons. Confirming Temin (1976), we find that nonmonetary leading indicators, particularly on residential construction and equipment investment, have impressive predictive power. Already in September 1929, they forecast about two thirds of downturn correctly. Our time varying framework also permits us to examine the stability of the dynamic parameter structure of our estimates. We find that the monetary impulse responses exhibit remarkable structural instability and react clearly to changes in the monetary regime that occurred during the depression. We find this phenomenon to be discomforting in the light of the Lucas (1976) critique, as it suggests that the money/income relationship may itself have been endogenous to policy and was not in the set of deep parameters of the U.S. economy. Given the instability and poor predictive power of monetary instruments and the strong showing of leading indicators on real activity, we remainskeptical with regard to a monetary interpretation of the Great Depression in the US.
Did Monetary Forces Cause the Great Depression? A Bayesian VAR Analysis for the U.S. Economy
Albrecht Ritschl and Ulrich Woitek
Now while Brad is busy awaiting the arrival of his troops from the Cardinal, I thought I would also seek a second opinion from my UK back-up, my brother:
My first recollection was of old Mr. Barclay in Lombard Street who in the 1970s was at least 142 years old and still working. He used to start off interviews with any managers who have had bad debts with the question “Why have you lost my money?” In his 128 years of banking old Mr Barclay, bless him, had never had a bad debt!
Why do I use this anecdote? Because I suspect banking has changed since the time of the Depression. This may be important in looking at Mr. De Long’s dichotomy. One way of seeing the difference is as follows.
Targeting outstanding loans may mean that you are emphasising the profitability element of the bank.
Targeting Deposit/Reserves may mean you are looking at the Banks ability to bear losses or to raise more deposits.
The shareholder and the Chief Executive with a profit share scheme are perhaps more interested in A and the Central Bank Control regime in B. Both of course are interested as well in quality of Assets and Maturity Ladder of Deposits. And both are interested in return on Capital. It depends however on the weighting you give to each.
Now my own view is that in old Mr. Barclay’s day we did not have Management by Objectives etc. and all that. And Bankers also used to remember that loans were not only to perform but were also meant to be repaid or at least repayable. Bad Debts, and this may, pace Weber, also have been a moral thing at the time, were to be avoided toute court. Now, today, by contrast, Bad Debts are relegated to an affordable expense and one is playing the percentages. And I would also guess in Mr. Barclays time that one was not operating with such a spread of % spread on loan return as has been the case since the growth of consumer indebtedness from the 1960s onwards. In effect the high interest rates in the consumer market and the interest differential that has grown up between cost of deposits and interest rates in this market is like an insurance premium against Bad Debts (Notwithstanding the other insurance cover products and direct off loading to the insurance sector by means of Securitisation which has taken place, (and for which I was considered a heretic by the Banks chairman when I suggested this would happen in the 1980s!). One further thought in this vein is that when interest rates are low the profitability of interest returns increase since margins become a greater proportion of the total payable by the borrower. Finally there is a split between consumer and corporate lending and this makes a Banker vulnerable to Asset mix. By this I mean if his margin to a AAA Company is 5/16% and his margin to a personal Borrower is 7% then he has to lend a lot more to the corporate borrower than to the Personal Borrower to make up a Bad Debt of £10000. This difference also leads to a spread of risk problem where a Bad Debt in the Corporate Sector leads to much greater loss and thus sometimes the risk /return ratio will affect decision making. This also applies to different Sectors across the board (Classification of Advances Stuff).
Why do I say all this, all of which you know anyway?
What are you doing to the quality of your assets by injecting money into the system. Such effects take time, and by what standard can you estimate this time factor, especially in today’s possible deflationary climate. What are the prior examples? The debate regarding the Fed in the Great Depression shows the lack of example.
Is it going to be throwing good money after bad? My thoughts are than in the Great Depression the mind set had already taken shape (remember the story our father told about his bank going bust in Arkansas and also I think Picasso did not trust his money to banks.) The view was to avoid Bad Debts at all costs. And at that time the Banks were not so subject to the need to perform as regards profit targets then as they are now. (A nice gentleman’s club!) Thus the Banks in the Great Depression saw Bad Debts in 1929 as being directly related to the Stock Market prices and tried to support these by direct purchase rather than by trying to avoid deflation by increased lending. Even if the Fed had injected money I guess the Banks would still have tried to increase the quality of their book in terms of what they believed to be the case rather than what the Fed may have tried to convince them would be the case. (Personally I always went for safety, being prepared to lose business rather than take the risk and the premium. Thus like old Mr. Barclay I did not have Bad Debts. But I was able to sleep at night!).
Such a support operation was the 1970s lifeboat which - thanks to Mr. Cork the Liquidator par excellence - meant that the catastrophe of the Property Boom was manageable rather than disastrous. However, the cost to the Banks was enormous and with the emphasis now being on profit I suspect that the Banks will never willingly enter into such a support operation. When the going gets really tough though the Banks start to look to their Sector Exposure and just bring the shutters down, as we did in the late 1980s when the property sector started overheating. It does not matter who you are, the answer is NO!
What I am saying is that I actually think we may be in a worse situation than in the Great Depression for the following reason. Once the mind set takes hold the Banks will go to improve quality and margins (to cover perceived risk) and sector spread. The situation is NOW, not some hypothetical what if . And if things really get bad with the pressure on profitability more than on social responsibility as it was in the 1970s then any Bank-wide support operation will be much harder to sell.
And if the Fed or the BoE tries to inject money into the system it will not result in new investment or a real rise in spending. The Banks will just try to take the opportunity to offload more risk by way of securitisation against fixed rates at a time of deflation resulting in more of such as the bond bubble.
As I have said to you before the way of trying to manage the impossible situation (if at all) is by trying to look more closely at the Asset side of the Banks Balance sheets, say making certain types of Lending Reserve Assets, and penalising others. This relates control to profitability rather than to Reserves/ Deposit risk which is more in line with the present climate. The A side rather than the B side. In this respect today is different from the days of the Great Depression. But at base, when Bad Debts start to rise the Banks don’t look to the Fed or the Bank of England forecasts of trying to increase liquidity and to avoid deflation. The Banks scramble to secure what they have at present. (And I was always accused of having my customers testicles in jars in the strong room in this connection!)
Once the mind set takes hold the velocity of money slows considerably, and I do not feel any amount of injecting money will alter this. It has to run its course, like a huge ship. As does getting used to permanently lower returns on Capital employed. We have some way to go at present. The last two years have been ones where people have been able to hide behind spectacular bad news, Enron, SARS etc. This has been an excuse for other firms. But now they will not have such an excuse for their lower profitability and the gloom may well deepen. A sort of psychological double dip.