Potential growth: even if it’s a friend, it’s still imaginary

A few months ago Federal Reserve Chairmen Ben Bernanke cited five ways in which economic growth in the United States has been hindered by the Great Recession. First, “severe job losses that followed the crisis… may have exacerbated for a time the extent of the mismatch between the jobs available and the skills of and locations of the unemployed.” Second, the epidemic of long-term unemployment has led to hysteresis and moved some of the jobless out of the job market forever. Also, “the rate of unemployment that can be sustained under normal conditions may have been pushed up and the fraction of Americans who are working or looking for work may have been pushed down.” Then, the drop in business may retard future growth in productivity. Finally, “the shock of the worst recession since the Great Depression… may have reduced the willingness of investors and businesses to take risks…” Potential growth is important because it is a crucial element used in the common formulae to set the Fed’s target for what interest rates should be. The most common of these formulae is the Taylor Rule. Central banks either explicitly (Canada, New Zealand) use these rules to set rate targets, or unofficially use them as guidelines (everyone else).

Upon closer review, these seemingly various economic shocks can be, at least partially, alleviated by basic monetary policy. If the Fed could establish the proper incentives, and ensure the publics’ response thereto, an increase in the monetary base could allow the multiple expansion system to increase the money supply. The subsequent ease of access to liquidity would bolster demand, meaning more investment, which means more business endeavors, and ultimately more jobs and economic growth.

This has been, in part, what the Fed was aiming to do with its numerous recent rounds of quantitative easing. By increasing their balance sheet with assets like bonds and CMO purchases, the Fed injects liquid cash into the banking system. Bank reserves are increased, strengthening financial balance sheets and making banks less risk-averse and more willing to lend. As that trickles down the banking system there is more and more money being made available for productive utilization. The Fed’s hypothesis is that the banks would then loan these extra reserves. The loans would provide capital to fund private sector projects, which in turn would pick up the sluggishly growing GDP.

There is one setback keeping the banks’ new reserves from entering the market, however: they are not loaning nearly as much of them as the Fed had anticipated. This is partly due to the cause Mr. Bernanke points out: “the shock of the worst recession since the Great Depression… may have reduced the willingness of investors and businesses to take risks…” Another matter to consider is the discretionary reserve ratio (rd) on part of the banks and currency leakages (c) on part of the public fluctuating at an unprecedented manner. With these two parameters spiraling out of control, the amount of money that is allowed to move through the banks via the multiple expansion system is severely reduced. Thus, the banks show no sign of wanting to follow through with what the Fed is trying to get them to do – make more loans. They remain stubbornly risk-averse despite their burgeoning balance sheets.

In general, a higher rd is indicative of a more defensive banking system. It means they prefer to have more discretionary reserves to hedge against bank runs, loan defaults, and, from the other direction, the Fed’s liquidation of their assets. Likewise, a high c indicates a growing liquidity preference among consumers who suddenly prefer to hold their wealth in cash or liquid reserves as opposed to long term savings or equities, which is common following a recession to ensure faster reactions to sudden economic shifts. Uncertainty is analogous with liquidity, both for banks and people.

An uncertainty index was developed by Stanford economists to chart general public sentiment on economic stability. This index affirms that since 2008, there have been massive shifts in uncertainty. Such figures would explain why the parameters rd and c are difficult for the Fed to project when conducting monetary policy, such as easing. If they do not know how to appropriately manage the monetary base, it is within reason to say that banks are compensating for the lack of knowledge by autonomously conducting themselves apart from the Fed’s arbitrary incentives.

In this regard, the Fed’s attempt at curbing the five problems that emerged from the Great Recession, which Bernanke diagnosed, is moot. The banks are not responding to the incentives, which means the reserves are blocked off to the public. This is due to the Fed’s ineptitude to accurately forecast how much uncertainty is influencing liquidity preference. The Fed may well be able to accurately target both the money supply and interest rates, but they cannot engender certainty in the future. One observer may blame the interest rate that the Fed is paying on reserves, but that interest rate is so low that it cannot account for all of the disconnect between higher bank reserves and not as many funds loaned.

Until the Fed is able to adequately predict rd and c, uncertainty will continue to act as the substitute stabilizer of liquidity preference. Based on this notion, the recent rounds of easing would seem unsuccessful because they are treating the wrong problem. To extend this logic, any future quantitative easing would be equally fruitless. Perhaps banks would be more comfortable loaning their reserves if they had a better idea of what to expect from the Fed, such as what will happen when the Fed calls to sell the assets they have been purchasing. When the incentives they create begin to positively influence rd and c, the monetary base will enable even more expansion of the money supply, and banks will feel better about actually lending that money out.

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