Tuesday, January 25, 2011

Monetary Policy and Bank Profits

Axel Leijonhufvud had a tremendous impact on my understanding of macroeconomics.   Admittedly, I was first exposed to him by Yeager, and I still have a "Keynesian Diversion" take on "Keynesian Economics and the Economics of Keynes."    Still, I am probably one of the more "Keynesian" of the quasi-monetarists.   Interest rates play a much larger role in my version of monetary disequilibrium than that of Scott Sumner, or Yeager, for that matter.

So, what to make of Leijonhuvud's rant about the social injustice of the low short term interest rates?    He argues that banks are borrowing at very low rates, approximately 1 percent.  They are holding government bonds that are paying 3 or 4 percent.    They are making a large margin, and this is unjust, I guess to the depositors who are only earning 1%.

 At first pass, I was a bit horrified.    So, the Fed should do some open market sales, worsen the existing excess demand for money, and hope that a liquidity effect raises short term interest rates?   Banks will have to raise deposit rates to compete, and their excess profits from investing in government bonds will shrink?    What a disaster.  Worsen the recession to make sure that depositors earn high interest rates.   (I hate to admit it, but I worry sometimes about special pleading by great, retired economists whose late stage of life asset portfolios may be earning very low yields.)

The Fed's job should be to keep money expenditures on a stable growth path.   If short term interest rates fall to very low levels, then so be it.  If bank lending rates fall by less, so that bank margins rise, that should be no concern of the Fed.

I suppose it might be a concern for anti-trust policy, but to me, the key issue would be entry.   If banking currently is providing excessively high profits, and there are people who want to organize banks, then let them.  As they bid for deposits and invest the funds, then the margin that banks earn will fall.  If regulators are blocking new entry into banking until existing banks make up for losses from lending against overpriced houses, I will complain as well.

Of course, Leijonhufvud then claims that this situation of banks paying low rates on deposits and purchasing higher yield government bonds is risky and could lead to a future banking crises.  Why?   If interest rates on government bonds should rise, then the banks will suffer capital losses on their portfolios of government bonds.  

To me, this argument contradicts the claim that banks are making excessive profits.    Once the risk of capital loss is taken into account, perhaps the gap between the interest rates banks pay and what they earn is reasonable.   In other words, the banks may be very competitive, and if they expected the current rates on longer tem government bonds to persist, then they would bid up the yields on deposits and/or bid up the prices of long term government bonds and lower their yields.   Perhaps the risk adjusted yield on bank asset portfolios isn't that much higher than what banks pay on deposits.

However, there are two ways in which government policy could reduce the gap between bank deposit rates and the interest rates on government bonds.   In the debate about QE2, some, like Robert Barro, have argued that with low yield T-bills being more or less a perfect substitute for base money, open market operations with T-bills have no effect.   When the Fed purchases long term bonds, on the other hand, this does have an effect, because long term government bonds with 3 to 4 percent yields are not perfect substitutes for base money.    Some have pointed out that this implies that having the Treasury refinance the national debt by selling more T-bills and using the proceeds to pay off longer term bonds as they come due, or even purchasing the longer term bonds on the market would have the same effect as QE2.

This argument seems sound.  When Barro and others express disbelief that the composition of the national debt could possibly have much effect on money expenditures, it seems to me they just failed to understand their own argument.    If T-bills are the same as base money, then a shift in the composition of the national debt is the same thing as creating more money.

Anyway, if the Treasury did refinance the national debt by selling more T-bills and paying off longer term government bonds, the result (ceteris paribus) should be a higher yield on T-bills and lower yields on the long term government bonds.   Banks would have to raise deposit rates to match the higher yields on T-bills, and their earnings on long term government bonds would fall.   The "excess" profits earned by banks would fall.    Presumably, banks would either shrink both sides of their balance sheet or shift from holding government bonds to making more commercial loans.  

Why doesn't the Treasury follow this policy?   Presumably because they want to lock in relatively low long term interest rates.    If they borrow with T-bills, when short term rates (and expected long term rates) rise, they will have to pay more right away.    In other words, by having the Fed and banks purchase long term government bonds, this risk is shifted to them.   Of course, treating the Fed as independent of the rest of the government is a complete illusion, and with deposit insurance, much of the commercial banking system is little different.

A second issue is more narrowly focused on Fed policy.   Following neo-Keynesian precepts, the Fed's solution to the lower bound on its target interest rate was first and foremost to promise that short term interest rates will stay low for an extended period.    This policy does seem like it will leave banks with low borrowing rates for this extended period.    The policy of QE2, on the other hand, involves purchasing long term government bonds.   As I have explained before, it could actually raise interest rates on long term bonds, but to the degree expectations of future growth in money expenditures remain depressed, it would lower long term rates on government bonds.   This would reduce the gap that so concerns Leijonhufvud.

My view is that the Fed should cease targeting interest rates altogether.    It should instead target a growth path for money expenditures and commit to expand the quantity of money enough to reach that target.   Interest rates should depend on market forces (and I would like monetary institutions that make negative nominal interest rates on short term government debt possible.)    If expectations of recovery result in higher long term interest rates and lower demands for short term government bonds and other safe financial assets, then it would be a mistake for the Fed to have made some kind of promise to keep short term interest rates low.

In other words, if expansionary Fed policy raises short term rates, and so what bank depositors earn, then great!  On the other hand, if expansionary Fed policy lowers those rates, then so be it.   Fed policy should be aimed at keeping money expenditures on a target growth path, and short term interest rates and bank profits should not be its concern.

6 comments:

  1. This is a very interesting comment. If we leave the link between low interest rates and bank profits aside - even though that is the gist of the discussion, frankly, I doubt the Fed is intentionally leaving int. rates low with the primary goal of making bankers rich - the comment raises issues as to exactly how the Fed is conducting monetary policy to which I would like to comment. And by the way, I am in full agreement with you that the world is suffering from a humungous excess demand for money.
    "The Fed's job should be to keep money expenditures on a stable growth path" - absolutely agree, but should they do that by encouraging people to borrow more and pile even more household debt? Because that is what low interest rates incentivize.
    " Some have pointed out that this implies that having the Treasury refinance the national debt by selling more T-bills and using the proceeds to pay off longer term bonds as they come due, or even purchasing the longer term bonds on the market would have the same effect as QE2." - it exactly does - substitute US Treasury for the Fed and substitute T-Bills for interest on excess deposits - that is the whole idea of the Fed - they are steriizing QE2, in effect making sure that the excess reserves stay with the Fed, the money supply does not increase for all intends and purposes, and all QE2 does is flatten the yield curve (in theory as you point out).
    " If T-bills are the same as base money, then a shift in the composition of the national debt is the same thing as creating more money." - not really, at least not really in practice, even though in theory I may agree with you. Creating more debt (issuing T-Bills for example) is not the same thing as creating more money - again we have the same issue as before - the Fed's idea of increasing the money supply has inevitably involved the creation of more debt - there is no other way - it is simple accounting - the Fed - a private bank cannot create money (asset) out of thin air (The US Treasury can see below ) -as for every asset it needs to have a corresponding liability.
    "My view is that the Fed should cease targeting interest rates altogether" - yes absolutely, but if it is (solely) involved with conducting the right level of the money supply and it does this by the means described above, isn't the Fed inherently targeting interest rates as well? What do you think will happen if instead of the Fed expanding the money supply in the normal way they have done so far, the US Bureau of Engraving and Printing(US Treasury) starts increasing the money supply the old fashioned way - by actually printing money - maybe not at all old-fashioned as Bernanke even alluded to it (the helicopter drop)? What if that is accompanied with a gradual rise in the short term interest rate by the Fed? In other words, if we both agree that the problem we are facing is excess demand for money why don't we give the people the money instead of deluding ourselves that by encouraging them to borrow they are getting the money? And let's not forget that money , especially the USD being the reserve currency of the word, is not some sacred, magical thing, but it is nothing more and nothing else than a medium of exchange (and its accompanying half brother -"store of account"). The store of value is just a mirage...

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  2. "In the debate about QE2, some, like Robert Barro, have argued that with low yield T-bills being more or less a perfect substitute for base money, open market operations with T-bills have no effect." If one assumes that low yield T-bills constitute a perfect substitute for base money, no *argument* is needed. Note, however, that Barro merely assumes that low yield T-bills are such a perfect substitute; he offers no argument for that.

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  4. I have argued before that if the yield on T-bills fall so low that currency is a better store of wealth than T-bills, then regardless of whether or not they are perfect substitutes in all ways, increases in the quantity of T-bills (whether due to deficits or changes in the finance of the national debt) will reduce an excess demand for money, and open market operations with T-bills (purchasing T-bills with newly created base money) will not help.

    I think deficits have undesirable real effects. I don't think that monetary institutions should depend on refinancing the national debt. I also grant that permanent changes in the quantity of base money will have effects that permanent changes in the quantity of T-bills will not. But I don't favor permanent changes in the quantity of base money and I am not very interested in making committments to a higher price level.

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  5. "So, what to make of Leijonhuvud's rant about the social injustice of the low short term interest rates?"

    The main social effect is smaller transfer payments from borrowers to lenders. Personally I like the idea of the fair rate of interest as proposed by Pasinetti (1981) where the fed funds rate is set equal to the trend rate of growth of labor productivity. With such a fair rate of interest, the earnings of one hour of labor, when they are saved, allow its owner to obtain a purchasing power which is equivalent to that obtained with the earnings of one hour of labor in the future.

    "He argues that banks are borrowing at very low rates, approximately 1 percent. They are holding government bonds that are paying 3 or 4 percent."

    Banks need to follow GAAP rules and set aside capital to ensure that if interest rates rise they don't take losses that could make them insolvent. It limits how much long term govt debt they buy. For the major banks I've read their main source of profit derives from fees, not the spread between the cost of funds and the rate they charge on loans.

    " If T-bills are the same as base money, then a shift in the composition of the national debt is the same thing as creating more money."

    T-bills are close substitutes for base money. As you know banks have reserve requirements they need to meet, and open market operations drain reserves from the banking system. When t-bills aren't perfect substitutes than it means all the reserves have been drained. A shift in the composition is not a creation of more money. All that would happen is a shift in the term structure of government debt, no new net financial assets are created.

    "My view is that the Fed should cease targeting interest rates altogether. It should instead target a growth path for money expenditures and commit to expand the quantity of money enough to reach that target. "

    Not possible. In the UK and US they tried monetary aggregate targets in the the early 1980's and economists including Milton Friedman concluded it's impossible to do in the real world (B. Friedman 1988). In practice CBs have no choice but to set interest rates and accommodate demand for reserves at that target rate, the fact that we have a stable overnight rate (and the demand for reserves is highly inelastic) is evidence central banks do accommodate demand for reserves at their target interest rate.

    " Interest rates should depend on market forces (and I would like monetary institutions that make negative nominal interest rates on short term government debt possible.)"
    You'd have to bring us on the gold standard or some other fixed fx to achieve this again. The Fed is the monopoly creator of reserves and no longer are required to devote policy to defending a currency peg. As such, to set interest rates, or to not set interest rates are both pure policy decisions.

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  6. It will be interesting to see where the interest rate goes, but with recent rise, it will be very interesting with how things go, so we need to be very careful. I always trade with simple approach; it’s helped by OctaFX broker and their epic setting from having lowest possible spread at 0.1 pips to cash back where I get 50% back on all trades which is on losing trades too. They also have daily market updates too, so I like it all so much.

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