Still think tight money helps the banks?

This blog title is a response to thousands of comments I’ve received over the past two years.  I would often reply that banks did very poorly when the Fed drove NGDP lower in 2009.  I wonder whether recent events call into question the widely held view that tight money helps banks.

And how about gold?  Still think that high gold prices mean high inflation ahead?


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46 Responses to “Still think tight money helps the banks?”

  1. Gravatar of David Pearson David Pearson
    10. August 2011 at 08:14

    Scott,

    You ask an understandable question about gold given the deflationary European banking crisis.

    For purposes of investment, Gold is a hedge against high and volatile inflation, period. For any other investment purpose, currency is a more attractive alternative.

    Now think: in 1932-3, with deflation raging and banks collapsing, was the probability of high and volatile inflation rising or falling? Of course it was rising as the U.S. was preparing to leave the gold standard. We are at a similar juncture today. Repeated attempts by the Fed to rescue the financial system while maintaining a ceiling of 2% inflation have met with failure. Either the Fed will accept deflation risk, or it will have to try to change behavior by promising much higher inflation. This is essentially your proposal. So every time the gold price rises on bad news, it is the market signalling, “the worse things get, the more chance the Fed will listen to Scott Sumner.”

    That is the good news. The bad news is that markets are unlikely to agree with you that high inflation can be fine-tuned as you suggest. Once we start down that road, gold protects investors from having it be a one-way street.

  2. Gravatar of David Pearson David Pearson
    10. August 2011 at 08:20

    BTW, the real source of high and volatile inflation is the fear of central bank monetization of chronic high (and rising) fiscal deficits. Again, is the risk of that eventuality higher or lower on the news of a potential European bank run? I would say much higher.

  3. Gravatar of RB RB
    10. August 2011 at 08:23

    Eddy Elfenbein had an interesting post showing that gold empirically appears to be a highly leveraged short position in T-bills.
    http://www.crossingwallstreet.com/archives/2011/03/gold-hits-all-time-high.html
    It seems to have held over more than 50 years.
    http://www.crossingwallstreet.com/archives/2010/10/more-on-the-gold-model.html

  4. Gravatar of Morgan Warstler Morgan Warstler
    10. August 2011 at 08:32

    “I would often reply that banks did very poorly when the Fed drove NGDP lower in 2009.”

    You were wrong. The big banks were STILL OPEN. Until they are driven insolvent, you will be wrong.

    Since you are wrong about banks let’s look at gold.

    Gold is a commodity, plus these days it is an indicator against ALL currency.

    Scott (and others), let me ask you these “think like a trader” question:

    Say the US announced that it was going to sell ALL Federal lands and use pay down deficit…

    Say they announced an end to the EPA…

    Say they said they’d stop providing Medicare to anyone over the age of 90….

    What happens to the price of gold?

  5. Gravatar of John John
    10. August 2011 at 08:33

    In 2009 banks were capital constrained and the Fed did what they have the power to do which is inject liquidity. The monetary base has exploded since then. Providing more liquidity does not address the underlying problems so money may still appear tight as measured by NGDP. Regardless of the Fed’s policy stance, it’s impossible for the economy not to suffer in terms of NGDP when banks make loans to projects that end up being losers. Real resources get directed in ways that aren’t in line with consumer preferences and no amount of action by the government or central bank can hit some sort of reset button.

  6. Gravatar of John John
    10. August 2011 at 08:37

    Morgan,

    Imagine what would have happened to the price of gold if the Fed had announced that they were going to allow their assets to mature and cease any further open market operations yesterday. That might have been all it would take to drive gold down significantly.

  7. Gravatar of dwb dwb
    10. August 2011 at 08:39

    IMHO, the people who say tight money helps the banks have never worked at a bank.

    1. IMO its a common misperception that banks make money on “the spread”. untrue. first, you have to adjust the spread for the expected default and loss given default, and once you do, the spread is pretty fair. Yes, sometimes the EMH is somewhat violated, but if the price is too good to be true you’ve mismodeled it and Goldman will eat you as a lite afternoon snack.

    2. Banks make money on flow and originating deals. They place deals between people who need money and people who have money, and earn a fee for a pretty 52-page powerpoint deck that tells you the investor all about what a great deal and you the issuer what a great deal this is and how its the perfect time to issue debt or borrow money. See #1, both cannot be true yet somehow they always are (this is from vast experience dissecting deals)! Given that they earn money on flow and fees, tight money means low loan supply, which means low fees and income. In the current environment, it may not be supply but also low loan demand.

    3. banks “make” money by holding assets on the balance sheet for one reason or another (credit cards, mbs etc). As a long term strategic use of the balance sheet and capital, I am skeptical that they make money that way. risk models are inherently backward looking, and risk managers are inherently backward looking. forecasting long term credit losses is tricky and has a high forecast error. So at the top they underpredict losses and and the bottom overpredict losses…Every bank I’ve worked at or come in contact with thinks they are “the best” at predicting losses….

    which gets me back to my original comment, people who think tight money helps the banks usually have no clue how they work.

    and on gold, deflation helps gold cause its a safe haven. inflation helps gold cause its a hedge. if the fed prints money, it helps gold because “central banks cannot determine its price.” whatever seems to be going on is an argument to buy gold. gold and silver are the ultimate bubble assets.

  8. Gravatar of RB RB
    10. August 2011 at 08:42

    If you see Eddy’s post above which draws on work by Summers/Barsky, gold price empirically appears to be related to interest rates and not inflation.

  9. Gravatar of Benjamin Cole Benjamin Cole
    10. August 2011 at 08:45

    Good commentary.

    Yes, absolutely the United States can inflate. Sheesh, if we ran five percent inflation for five years, the value of the debt outstanding would be reduced in value by a little more than 25 percent.

    Oh shocking, you mean the rates of inflation we had when Reagan was president? Oh, the horrors!

    BTW, check out the CPI. From July of 2008 to June of 2011, the CPI-U rose from 219.964 to 225.722, or a 2.62 percent increase in three years.

    And this July is likely deflation, due to oil prices.

    Why all the hysteria about minute rates of inflation in the right-wing? It speaks to a type of dementia.

    Ironically (and sadly) it was Milton Friedman who advocated aggressive and sustained use of QE in situations like we face today. He flat out told Japan to inflate.

    There are times when inflation is good, and now is one of those times.

    All the whimpering and pettifogging about debasing the currency comes from people with an unhealthy attachment to the symbols of money (gold or cash), as opposed to true wealth-building.

  10. Gravatar of David Pearson David Pearson
    10. August 2011 at 08:58

    RB,

    I agree with that analysis: real interest rates are the primary driver of the gold price. Expectations of negative real rates over time are normally associated with the risk of high and volatile inflation. The reason gold/inflation correlations break down is because they include the periods where inflation is rising (modestly) for cyclical reasons. These periods typically occur when the Fed is actively raising the real interest rate.

    Persistent negative real rates, when they coincide with high, chronic fiscal deficits, are evidence that the central bank is (directly or indirectly) monetizing deficits. If the expectation sets in that this will persist more or less permanently, then high inflation will follow as actors seek to hedge with assets other than gold.

  11. Gravatar of StatsGuy StatsGuy
    10. August 2011 at 09:00

    @John:

    “Imagine what would have happened to the price of gold if the Fed had announced that they were going to allow their assets to mature and cease any further open market operations yesterday. That might have been all it would take to drive gold down significantly.”

    No John, that is exactly wrong. If you observed over the past few days, gold has been acting as a risk-alternative asset. It has moved inversely with stock prices. I guarantee you that if the Fed had announced more tightening (not repurchasing assets as they mature), stock prices would have gone down, and gold would have shot up 5% or more. it’s moving up again today. It’s acting as a hedge on future sovereign and bank default risk. Govts are destroying the future power of their currency (which is dependent on their national production) in order to preserve the current power of their currency and their debt. That is all.

    Most gold bugs have no idea what gold is really doing, although they’ve earned better returns than I have. (I avoid gold because, quite simply, I’m a contrarian – most gold bugs right now are hardly contrarians.) That said, at 1800 an ounce, the total value of world gold reserves is about 10 trillion dollars, and gold is reversing its 20 year production decline. In 2012, it will exceed 2009 production due to new capacity online, and more capacity (and new technology) is projected through 2016, so who knows what will happen long term. Gold bugs say otherwise, but technology disagrees. Peak oil folks said oil had entered terminal decline, but US oil production increased massively last year, and is projected to continue rising (at current technology levels) for another 8-10 years, meanwhile US oil consumption may be seeing a downward technological shift at some point in the future. Anyway, it’s quite clear to me there is something about the Fed’s real objective function that I truly do not understand.

    However, it is quite clear you’ve gotten your linkage of Fed to gold backwards. Just like so many people got their linkage of Fed to T-bill rates backwards…

  12. Gravatar of Bryan Willman Bryan Willman
    10. August 2011 at 09:04

    Conjecture:

    After a financial crises as bad as the one we are trying to stumble away from, one of two events are required to return to normal.

    a. Deflation, default, related disorder -> reallocation.

    b. Inflation, default, related disorder -> reallocation.

    In other words, I conjecture that it *is not possible* to escape the current circumstance without either serious inflation (high enough to be painful and matter) or large scale write-downs and work offs. And that the space or throat between these things is very narrow and provides no accleration to the economy.

    Climb, or dive if you must, but do not try to float. Japan has been floating…

    (Uh, I think Scott and the late M. Friedman arrive at a pretty similar conclusion…)

  13. Gravatar of JTapp JTapp
    10. August 2011 at 09:17

    Gold is about default risk. The ECB has basically shown itself incompetent, CDS on French debt are as pricey as CDS on Spanish debt was a couple months ago. This is an invisible bank run.
    Brazil, Turkey, and other developing countries who have been growing very strongly the past year or so are now experiencing what appears to be capital flight as their stock markets are taking a hit (Turkey’s central bank lost some credibility with a decision about a week ago, triggering a big sell-off).

    Where does the money fleeing these places go? Gold. Right now it stands the best chance of holding up as the other currencies depreciate. That’s my 10 cents.

  14. Gravatar of StatsGuy StatsGuy
    10. August 2011 at 09:44

    “Every bank I’ve worked at or come in contact with thinks they are “the best” at predicting losses….”

    This is true of actuarial depts. at insurance companies too… Funny.

  15. Gravatar of David Pearson David Pearson
    10. August 2011 at 10:02

    Stats Guy and Jtapp,

    “Govts are destroying the future power of their currency (which is dependent on their national production) in order to preserve the current power of their currency and their debt. That is all.”

    “Right now it stands the best chance of holding up as the other currencies depreciate. ”

    In other words, gold is protection against high and volatile inflation (in other words, the risk of unexpected losses in currency purchasing power). Forget about “alternative risk assets” and “safe havens”. These are meaningless constructions.

  16. Gravatar of Luis H Arroyo Luis H Arroyo
    10. August 2011 at 10:25

    Quite interesting the various analysis on gold rush.
    But no one takes account that:
    It is a global fenomenon
    China is buying gold.
    So I think is not so easy to relate with US only.

  17. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    10. August 2011 at 10:34

    Maybe Eric Falkenstein is wrong, it isn’t Treasuries that are the Giffen Good, it’s gold.

  18. Gravatar of David Pearson David Pearson
    10. August 2011 at 10:35

    Luis,

    China’s gold buying is related to the U.S.. In an effort to peg its exchange rate, China has to hold down real interest rates or face enormous capital inflows. The result is negative Yuan deposit rates. Chinese savers have a choice of avoiding these by either buying dollars, gold or risk assets. The latter choice is complicated by the fact that the Chinese equity market has been in a bear market for years.

    BTW, Latins were not gold buyers during their high inflation era. Instead, they held dollars in off shore deposit or currency form. This means they believed in the stable purchasing power of the dollar and therefore did not need gold as a “safe haven” during times of instability. The Chinese seem to believe otherwise.

  19. Gravatar of Morgan Warstler Morgan Warstler
    10. August 2011 at 10:42

    ATTENTION!

    Matty is now supporting my three year effort to foreclose on deadbeats and sell their homes for pennies on the dollar to private citizens.

    http://thinkprogress.org/yglesias/2011/08/10/292969/fannie-and-freddie-can-provide-unilateral-stimulus/

    And he is calling it stimulus!

    Maybe he’ll do the same thing with Federal land and privatizing the post office!

    It is checkmate! Progress ARE BENDING. To all you fools who spent the last three years screaming for more inflation, behold – we’re gonna do it my way.

  20. Gravatar of JimP JimP
    10. August 2011 at 10:55

    http://www.nytimes.com/2011/08/10/opinion/half-measures-from-the-fed.html

    The Times calls for charging interest on reserves.

  21. Gravatar of JTapp JTapp
    10. August 2011 at 10:56

    Just saw a report that money market fund assets increased $61.28 billion over the last week. I’d say that’s a big increase in demand for money and decrease in velocity.

  22. Gravatar of dwb dwb
    10. August 2011 at 11:00

    *sigh* whenever you scratch the surface on these gold arguments you find a lot of bugs and invariably a jedi mind trick.

    There is no guarantee that gold will be hedge against inflation (it was not for 30 years!) except the belief that that someone else will buy it at a higher price. If there is any correlation at all with inflation IMO it is through the wealth effect: the bulk of gold demand comes from jewelry, when people feel richer they buy jewelry. Ultimately, the proportion of income devoted to gold cannot be ever-increasing, so ultimately the price of gold should not go up much more than world NGDP (industrial demand is pretty limited). Most jewelry demand comes from india and china… so the price of gold should be tied to NGDP of those countries (back of the envelope, gold demand share of GDP for india is 3%). At some point, the price chokes off this demand because, umm, you have to eat and sleep somewhere.

    So if you believe the inflation story, you are betting china and india wont choke off inflation, and ironcally, should be selling gold every time the Yuan appreciates and the dollar depreciates since its one more bullet against chinese inflation.

    but if you think its a safe haven, well, there is no guarantee of principal return.

    but alas… most arguments for gold are one sentence deep. Presented with evidence all you get back is the jedi mind trick (look over there the central bank of south korea is buying!). Investment demand is driving the gold price, at the margin, which is driven in turn by the upward trend. when the music stops and investment demand dries up there is plenty of supply to meet demand. Investment demand cannot continue to rise for the same reason jewelry demand cannot continue to rise: income share cannot forever increase.

  23. Gravatar of Benjamin Cole Benjamin Cole
    10. August 2011 at 11:04

    CNN calls Bernanke a quitter—

    Bernanke has thrown in towel on economy

    By Paul R. La Monica @CNNMoney August 10, 2011: 1:43 PM ET

    NEW YORK (CNNMoney) — Is the Federal Reserve waving the white surrender flag? It sure looks that way.
    The Fed made the unusual (and unprecedented) move on Tuesday to tell the market in plain English that it intends to keep rates near zero for the next two years!

    That is disappointing on many levels. First and foremost, it is a crystal clear sign from Ben Bernanke and other Fed members that they think the economic recovery (if one could still call it that) will remain tepid for a long time.
    That is probably one of the reasons that the post-Fed euphoria on Tuesday afternoon on Wall Street quickly gave way to despair again on Wednesday.
    This is not good. The Great Recession may have technically ended in June 2009. But for many Americans, this current malaise is just an extension of the problems that first began to surface in 2007. Lost Decade anyone?
    Yes, that’s a Japan reference. And it’s sadly apt. The Fed, by pledging to leave short-term rates “exceptionally low” for what will eventually amount to a four-and-a-half-year stretch, is essentially guaranteeing that long-term bond rates will remain persistently low — just like in Japan.

  24. Gravatar of Morgan Warstler Morgan Warstler
    10. August 2011 at 11:18

    JimP, the NYT going after Fed to end IOR is another win for Tea Party.

    It means they are have given up on anything that directly benefits ANY Democrat constituency.

    It means banks having to loan to Tea Party SMBs. If we’re going to have inflation let the new money in the market flow through the good guys.

    —–

    And BTW guys wasn’t Wisconsin GENUIS!

  25. Gravatar of effem effem
    10. August 2011 at 11:32

    I realize this is off topic but wanted to ask the group what the think of the following:

    The tremendous drop in 10yr bond yield has come almost entirely at the expense of the real yield component. The real 10yr yield is now negative while inflation expectations are hanging in at 2.25%.

    It’s hard to avoid thinking that the market is screaming at us – we have a growth problem that is separate from inflation (which is fine at 2%+).

  26. Gravatar of Gabe Gabe
    10. August 2011 at 11:36

    Tight money is good for whoever knows the Fed is going to do tight money first. In this economy, all it takes is a little indication of tight money or a tip that the fed will not do easy money and you can place your bets accordingly and make billions…ont he other side you jsut need a littl bit or warning and clarification for when the Fed is about to undergo a new QE and you can make money again on the bubble up phase.

    Not all the banks benefit from this cycle, not all the banks are high enough up the food chain to get the inside info. However, the money printing power circle is a nice club to be in and it is really not difficult to understand why. If you honestly think the Fed is trying to construct policy for the benefit of the masses then you are not very smart.

  27. Gravatar of Oliver Oliver
    10. August 2011 at 11:42

    Can you explain why high gold doesn’t mean high inflation ahead? I can’t figure out the gold price at all – and most of the people who comment on it are crazy.

    A year ago I thought of putting on the following trade: short gold, and short the ten-year bond. They had both gone up a lot, and if we had hyperinflation the bond would go down, and if we had deflation gold would go down.

    That was my reasoning. I still don’t know why it’s wrong. But thank the Lord I didn’t put it on…

  28. Gravatar of StatsGuy StatsGuy
    10. August 2011 at 12:53

    @Morgan

    So, are you just a republican shill then? You are correct that we may “do it your way”, not because it’s the best way, but because your people won the political debate. They effectively shorted the dollar, and by preventing any tax increases (to, say, the 18% of GDP level that Reagan and Bush 1 had), they prevented any budget cuts as well, and so they have destroyed the economy – thinking it will win them the next election. Which, it may. And, they’ve benefited economically, and socioeconomically (keep those black folks where they belong, after all).

    Only funny thing is that those who shorted treasuries got their hinds handed to them, badly.

  29. Gravatar of StatsGuy StatsGuy
    10. August 2011 at 12:59

    @ David P

    “In other words, gold is protection against high and volatile inflation (in other words, the risk of unexpected losses in currency purchasing power).”

    That simplistic view is blatantly wrong. Many things are protection against high and volatile inflation. Oil is a better protection against inflation than gold, but it has dropped. Stocks are a better protection against future inflation, especially highly leveraged stocks. They’ve plummeted. Tbills are a LOUSY protection against future inflation. They’ve spiked.

    Your opinion is utterly obliterated by fact. In the past few weeks, Tbill and gold prices have been highly correlated. How is this consistent with your inflation hypothesis? It isn’t. But this childish narrative seems to be winning the public debate.

    Gold is the only protection against risk whose demand is not dependent on future consumption, and indeed is inversely correlated with future consumption. All asset demand is relative to other assets, which as a whole are relative to future expected consumption streams.

    We’re doomed, because our national (and international) conversation is being dominated by children in suits.

  30. Gravatar of StatsGuy StatsGuy
    10. August 2011 at 13:07

    @Gabe

    You may be right. The Fed seems to do exactly the opposite of what everyone expects. Even the most cynical gold bugs (ZeroHedge) were certain QE3 was coming 3 days ago.

    Not a conspiracy theorist? Check this out:

    http://ftalphaville.ft.com/blog/2011/08/08/646276/

    Efficient markets? Only if there is a market. There is no market, however. Prices can be whatever they are set at.

  31. Gravatar of TheNumeraire TheNumeraire
    10. August 2011 at 13:44

    Effem is right. TIPS have had a huge run these last two weeks. Short-term NGDP/inflation expectations are declining, medium and long-term expectations are not. That likely means that the markets smell recession, not deflationary monetary policy.

    Prof. Sumner has been emphasizing the recent plunge in nominal bond yields, but nominal yields can prove to be a misleading distraction. In the Oct 2008 financial crash, nominal 5&10 yr. bonds were trendless — TIPS however were crashing in price alongside stocks, gold, commodities and forex.

    At present, TIPS are in such demand that for the first time ever the 10 yr. TIP has a negative yield (the 5 yr. TIP was briefly negative in the spring of 2008). Gold is not trending as it did in 2H 2008, nor is the dollar. On balance, market conditions are nowhere near where they were in Oct 2008 — we know for a fact that monetary policy was deflationary back then and every market-sensitive indicator told us so.

  32. Gravatar of StatsGuy StatsGuy
    10. August 2011 at 13:57

    Numeraire, maybe – but 10 yr tips is a risk hedge, and the premium may represent tail risk, not baseline scenario expectation. Certainly, the plummet in the nominal 10 yr suggests this – the question is whether the drop to 2.2% on the 10 year from 3% is more or less than the drop in inflation expectations. This is not 2008 yet, no liquidity freeze or LIBOR spike of that magnitude. The banking system is OK so far, which is why the Fed may not act. Here’s the problem with the long term inflationistas:

    http://www.indexmundi.com/g/g.aspx?c=ja&v=71

    Japanese inflation last 10 years. During that time, gold prices in Yen have done what? 30 year Japanese bond rate is now 2%. Gold price didn’t seem to be a good predictor of inflation in the Yen…

  33. Gravatar of Matt Waters Matt Waters
    10. August 2011 at 14:48

    “Can you explain why high gold doesn’t mean high inflation ahead?”

    Because gold prices, like any other asset, cannot be easily shorted by investors to bring gold prices down to more fundamental levels. The short-sellers on stocks in the late-90′s mostly lost their shirts because they didn’t generally didn’t have the money to meet margin calls. Their investors generally didn’t have the patience either to ride out the short while the bubble went ever higher.

    Like housing, gold over the long-term merely tracks inflation. But in the last few years, gold has had annualized return far in excess of inflation or any other asset for that matter. Oil has also risen much faster than inflation, but that is for fundamental supply and demand reasons. More people are fundamentally using less oil.

    Most gold buyers, however, are buying it as an extreme inflation hedge. They are not end users who have actual utility for gold. They are essentially speculators who really do not have a fundamental use for gold, unlike jewelers or drivers using gasoline.

    Prices sometimes do not “reflect all available public information” because of the issues with shorting stocks and the money to be made speculating. In a bubble, only the last buyers will actually lose money and many people in the market will become more rich than if they bought only on fundamentals. Gold is in that cycle now and it will crash. Just because it’s impossible to predict when it will crash and make money on shorting it does not mean it’s not overpriced.

  34. Gravatar of Scott Sumner Scott Sumner
    10. August 2011 at 17:30

    David (and Morgan), Then why are nominal interest rates plunging? Why is T-bond “paper” getting more valuable?

    RB, Good find. He didn’t mention that I also did a paper of gold and the Gibson Paradox.

    John, You said;

    “Regardless of the Fed’s policy stance, it’s impossible for the economy not to suffer in terms of NGDP when banks make loans to projects that end up being losers.”

    Have you checked out NGDP growth in Zimbabwe in recent years?

    dwb, Very good comment.

    Statsguy, Good point about gold.

    JTapp, I agree.

    David Pearson. Perhaps a loss of purchasing power in southern Europe, but not the US.

    Patrick, Maybe, but consider that the newly rich Chinese and Indians are also buying lots of gold.

    Luis, Very good point.

    Bryan, We need some inflation, but not necessarily a high rate.

    JimP, Thanks, that’s worth a post.

    Ben, Thanks–that’s a good CNN article.

    effem, We have a AD problem and an AS problem. Fixing the AD problem will improve AS.

    Oliver, I suggest you avoid those sorts of gambles.

    The Numeraire, You said;

    “Effem is right. TIPS have had a huge run these last two weeks. Short-term NGDP/inflation expectations are declining, medium and long-term expectations are not. That likely means that the markets smell recession, not deflationary monetary policy.”

    I pay no attention to inflation; falling NGDP expectations implies a deflationary monetary policy is my view. I agree 2008 was different—perhaps people wanted liquid assets, and TIPS are less liquid than T-bonds.

    Also remember that the SRAS is pretty flat right now.

  35. Gravatar of Morgan Warstler Morgan Warstler
    10. August 2011 at 18:19

    T-Bonds aren’t getting more “valuable” it simply reflects investors thinking that “the Fed isn’t going to print so much $, my $ loses value.”

    If investors thought the Fed was going to nuts, they’d run from T-Bills.

    They’d do the same thing if they thought Obama was going to pull an FDR – they’d think default was likely.

  36. Gravatar of cassander cassander
    10. August 2011 at 20:40

    Inflation benefits those who get the money first, and our system gives the banks the first crack at new money. Therefore, the banks must benefit from inflation.

    Deflation benefits those who lend long, and banks are in the business of borrowing short and lending long. Therefore, the banks must benefit from deflation.

    Am I missing something here, or are the guys in the tin foil hats right that the banks can’t lose?

  37. Gravatar of StatsGuy StatsGuy
    11. August 2011 at 03:45

    @Cassander

    No, not really. Deflation benefits those who lend long and borrow short (banks, finance) ONLY to the extent that default risk does not increase, and to the extent that collateral backing loans (like mortgages) does not suffer an asset value collapse.

    Oops.

    In addition, deflation has reduced new loan volume, which reduces future profit. Banks want high spreads, high loan volume, and low default risk. They face tradeoffs across these. The super low long rates right now are dangerous for banks and pension funds, if short rates rise in a few years. That’s why I’m getting very nervous the longer this thing goes on. The longer we go, the more finance companies become exposed to massive risk if long rates rise, and the more we see political pressure mirroring that in Japan to never let the long rate go up (aka, to seek deflation).

  38. Gravatar of Ryan Ryan
    11. August 2011 at 07:05

    Prof. Sumner, why do you keep straw-manning your critics in such a way?

    People who disagree with you aren’t looking for “tight money,” they’re looking for “money whose value isn’t dictated by a central authority.” See the difference?

    Granted, you may in response to this comment come up with some quotation by some conservative pundit who is not a serious economist, but that doesn’t count.

    I reiterate: Your critics want neither tight money nor loose money. They want to end the Fed.

  39. Gravatar of Morgan Warstler Morgan Warstler
    11. August 2011 at 08:26

    Its a very good question Ryan. Scott has no answer other than status quo.

  40. Gravatar of TheNumeraire TheNumeraire
    11. August 2011 at 11:44

    “Numeraire, maybe – but 10 yr tips is a risk hedge, and the premium may represent tail risk, not baseline scenario expectation.”

    I doubt that it is a credible explanation, Statsguy. Tail risk is by definition heavily unexpected and does not attract a huge hedge premium. Especially considering that I am referring to medium-longterm expectations (5&10 yr. TIPS)– the stock market equivalent would be a surge in put protection on S&P 500 contracts for 2016 or 2021 or some such outlier.

    “This is not 2008 yet, no liquidity freeze or LIBOR spike of that magnitude.”

    That was my point. It’s not Q4 2008, I was countering some of the discussion that was speculating otherwise. There likely will be not be a severe liquidity crunch and interbank freeze anyway because the system has less leverage today and is not governed by the foolishness of mark-to-market practices which caused leveraged portfolios to mark down their collateral and face margin calls.

    “Here’s the problem with the long term inflationistas:”

    Pointing out that long-term inflation expectations have not declined is not the same as expecting a surge in inflation. I pointed out the difference between obvious deflationary expectations (Oct 2008) and the situation today. The difference between a recession and a bear market compared with a depression and a financial crash will show up in changes in long-term NGDP expectations — if the inflation component of NGDP expectations does not change then the only way a financial crash and depression could occur would be because of a supply-side problem.

    “Japanese inflation last 10 years. During that time, gold prices in Yen have done what? 30 year Japanese bond rate is now 2%. Gold price didn’t seem to be a good predictor of inflation in the Yen…”

    I specifically made mention of the trend of gold prices, not the absolute level which can be influenced by changes in real gold values. In Oct 2008, the trend was sharply down despite the fact most people would say gold is a ‘safe haven’ from financial calamity.

    If you don’t think the gold price trend can be telling of the stance of monetary policy, why don’t you plot the yen/gold from the late 1980′s to the present and see if you can spot when the brunt of Japan’s deflationary policy took place as well as when the BOJ practiced quantitative easing.

  41. Gravatar of TheNumeraire TheNumeraire
    11. August 2011 at 11:55

    “I pay no attention to inflation; falling NGDP expectations implies a deflationary monetary policy is my view.”

    You can’t guess at medium/long-term NGDP expectations without some measure of inflation expectations.

    Short-term is obviously different, but my initial point was aimed at observing medium/long-term. NGDP expectations are far more stable farther out, which means the markets believe the current recession/bear market is not part of a greater depression/financial crash. I would not say current monetary policy is deflationary; i would say it is benign, leaning in neither direction.

  42. Gravatar of Scott Sumner Scott Sumner
    11. August 2011 at 18:45

    Cassander, You said;

    “Inflation benefits those who get the money first, and our system gives the banks the first crack at new money. Therefore, the banks must benefit from inflation.”

    I don’t see why banks have first crack.

    Ryan, This post is aimed at people who oppose tight money, not conservatives per se.

    TheNumeraire, It is deflationary relative to sensible policy targets, such as 5% NGDP growth.

  43. Gravatar of cassander cassander
    11. August 2011 at 21:28

    Scott> They get to borrow money straight from the fed via repo agreements.

  44. Gravatar of ssumner ssumner
    12. August 2011 at 06:06

    Cassander, During normal times 99.9% of new money is injected through OMPs. Recently the discount window has been more active–but that’s not normal.

  45. Gravatar of cassander cassander
    12. August 2011 at 10:34

    Scott> But even with open market operations, the fed prints money, then buys assets from banks. The money supply is thus increased, and prices go down. And yes, I realize that the real world isn’t so linear, but still, the banks are the first people to get the money (unless you count the fed). Besides, you’ve pointed out before that disinflation causes banking panics/failures. Doesn’t that imply that inflation is generally good for banks?

    Statsguy> I don’t think we’re actually disagreeing here. Since banks borrow at close to 0, and lend at whatever they can get, it seems almost tautological that, all else being equal, they benefit from deflation. You just pointed out that all else is never equal, which is true, but not the point of my question.

  46. Gravatar of ssumner ssumner
    14. August 2011 at 08:05

    Cassander, I thought they bought assets from bondholders. Why assume they are banks? Would anything be different if the Fed exclusively bought bonds from non-banks? Money is fungible.

    No it doesn’t imply inflation is good for banks, just as deflation and high inflation are both bad for the economy.

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