The debate is on! Are we in a liquidity trap and if so what should we do? Why is the financial system depleted of collateral and what does this mean? Should policy makers and central banks be even more "irresponsible"  and conduct more monitised deficit spending? What does a lack of triple A rated/safe haven securities mean and is it real?
All these questions and more have recently gotten a fascinating treatment in the economics debate courtesy, mainly, of this piece by Credit Suisse. FT Alphaville has been given the question extensive and brilliant coverage and now even the IMF has pitched in. I think the issues raised are not only important, but likely to form a substantial part of the framework for the next decade's research on macroeconomics, monetary policy and financial markets.
So yes my dear reader. This is no time to shy back. Dig in, and dig in hard! In this first post of a series of 3-5 posts, I try to present the building blocks of the argument as I see them and answer the question of why the traditional view on the liquidity trap does not apply in the current situation.
Let me begin with the following key premises for my argument and the state of the global economy and financial system post 2008/09. I will try to develop each of these statements in the posts that follows.
- The crisis of 2008/09 has ushered in what is likely to be a period of severe stress in global sovereign fixed income markets. Sovereign debt distress and defaults are messy and costly affairs and take a long time to deal with. We have now entered a period where the next 10-20 years will see several developed economies default on their sovereign debt. Ageing populations, too low growth and insufficient future income/consumption to push forward mean that the OECD is now at an inflection point. For global financial markets this means that an unprecedented and systemic share of the global fixed income market is likely to be in distress at any given point in time over the next 10-20 years.
- There is an accute shortage of liquid triple A rated government securities. This shortage is structural and capital deepening in emerging economies is too slow and insufficient in size to take up the slack. Pension funds, insurance companies and big real money managagers are now essentially unable to construct their portfolios in such a way to match their future liabilities with a satisfactory (or perhaps even promised) yield. In addition, this leads to mispricings in remaining assets considered the last safe havens. US government bonds, UK Gilts, German Bunds, Danish Mortage Backed Securities etc.
- Central banks are now acting as international clearing houses for the banking system. This is mainly seen in Europe where the ECB has been forced into taking up slack for an interbank market which has essentially been broken. Lowering of collateral standards, ever higher portions of liquidity and extension of maturities of its open market operations are all signs that the ECB is now effectively not only acting as the lender of last resort, it is de-facto the vehicle through which European banks can access liquidity across all maturities. However, whether the central banks buys government bonds outright or funnels demand through the banking system amounts to the same thing.
- The demand for credit is as much a propblem as is the supply. Sifting through the references below, you will find that at least one solution to the problem is that governments must issue even more impaired debt instruments which essentially become assets backed by liabilities created by the central bank. We must understand however that the core of the problem is that there is now a structural lack of solvent sovereign and private credit demand. The argument goes that the higher demand for safe haven triple A rated assets must be met with supply by sovereign debt issuers, but the ability of governments to issue such securities is structurally impaired.
- Central bank monetisation of government liabilities either outright or through open market operations providing liquidity to banks are not costless, even in a liquidity trap. Macroeconomic theory is currently informed by the notion that creating unlimited amount of excess bank reserves in the presence of a liquidity trap (zero velocity environment) has no malicious inflationary side effects. I think the evidence from more than three years of monetary experiment among the major central banks forces us to re-visit this conclusion.
The Liquidity Trap Revisited
In order to start somewhere, I will begin with Izabella's exposé on this paper by Paul McCulley and Zoltan Pozsar. The main points from Monsieurs McCulley and Pozsar's paper, with some slicing and dicing of quotes, are as follows.
At the macro level, deleveraging must be a managed process: for the private sector to deleverage without causing a depression, the public sector has to move in the opposite direction and re-lever by effectively viewing the balance sheets of the monetary and fiscal authorities as a consolidated whole.
... the operational mandate of a central bank operating in a liquidity trap environment should be changed materially.Rather than “policing the government to keep it from borrowing too much” the central bank should help it “to borrow and invest by targeting to keep long-term interest rates low by monetizing debt, with the aim of killing the fat tail risks of deflation and depression. ”The interests of the fiscal authority and the monetary authority rightfully become entwined. What’s more, the loss of the central bank’s independence should not be seen as a concern.
Critics invoke the orthodoxy that printing money is inflationary. But in a liquidity trap it is not. Money is as money does, and judging from the trillions in excess reserves on banks’ balance sheets, money isn’t doing anything. Printed money is unlikely to become inflationary until after the private sector has finished deleveraging and is bidding for funds again.
Generally, I find it difficult to see what new McCulley and Pozsar brings to the table here. This is liquidity trap and deleveraging economics 1.0, but I feel that we need a version 2.0 to understand what is really going on. The liquidity trap argument of old rightly emphasize that government should weigh against a necessary private deleveraging by running large and perhaps even, on the face of it, irresponsible deficits. This line of argument was, in part, inspired by the Japanese experience and the widely held perception that the BOJ was too timid in the initial phases of the Japanese bust.
I largely agree with this line of argumentation, but if the sovereign is an intrinsic part of the problem the argument breaks down. The problem today consequently runs a step deeper than the original liquidity trap argument.
While the initial symptoms of the financial crisis were rightly identified as too much private debt and reckless credit expansion in a key sector (housing and construction) the subsequent crisis in the euro zone has exposed two additional and critical aspects of the crisis.
Firstly, we have seen how governments will ultimately end up assuming private liabilities onto their balance sheet. Secondly, issues of fiscal sustainability in the OECD have been known for ages, but now time has run out. In my opinion, the crisis has provided a catalyst for the unravelling of the obvious mismatch between governments' pension and health care promises to their populations and the inability to meet such promises due to ageing population and low growth environments.
If you accept my premise that sovereign debt sustainability is now a systemic part of global financial markets, you will also see that they role they are supposed to fulfill according to the original views on the liquidity trap becomes very difficult.
Arguing that sovereigns should ramp up the supply of government debt and that central banks should add to the demand for such debt by creating money represents a misinterpretation of the problem. While it may surely mask the underlying issues for a while it cannot hide the fact that we are now at a crucial inflection point in the developed world. OECD governments' business model is broken due to population ageing and future liabilities which they will not be able to pay off.
The financial system's ability to create highly liquid and safe fixed income securities depends on current and future income to service such liabilities and traditional suppliers of such safe assets are simply out of time. Asking governments to act as counterweights against private deleveraging by creating even larger quantities of unserviceable debt cannot work. We see this most forcefully in Europe where sovereigns are being brutally cut out of the market, but there is, in principal, not much difference across the entire OECD spectrum.
It is my view then that for such highly liquid and risk free securities to survive and be continuingly issued, in the current environment, central banks must become permanent supporters of their issuance. We may certainly come to the conclusion that this is a warranted use of central banks' power, but we should be under no illusion that their involvement on this will be, on any plausible definition, temporary. I think this part of the equation has been given far too little credence in the debate so far.
In conclusion, while I agree that LTROs and central bank bank monitisation of sovereign debt liabilities may certainly be warranted from the point of view of battling a severe crisis the way out of this one cannot be mapped exclusively through the lense of ongoing central bank liquidity provision and reserve creation.
Once you accept this part of the argument, we are ready to move on to the issue of what such substantial central bank involvement in our economy means and and also why the collateral crunch is likely to continue and what it means.
Stay tuned ...
 - My readers who are well versed in the research on deleveraging, liquidity traps etc will understand the reference here. In the original literature and thinking about zero nominal interest rate bounds and liquidity traps, the central bank's ability to act irresponsibly is seen as a key prerequisite for turning the corner on debt deflation.