“Has anyone else noticed that the current crisis sheds light on one of the great controversies of economic history?” Paul Krugman asked his readers back in Novermber last year. In fact on reading this I felt immediately filled with the urge to stand on my chair and shout out loud across the Atlantic to him “Hi Prof, yes me”, since – to plagiarise a phrase from Robert Lucas – scarcely a day has passed since the 9 August 2007 (the day PNB Paribas found themselves short of $2 billion dollars to “close” their books) when I have not been thinking about this. In fact, despite the many bad things that can obviously be said about the present crisis, it does have one saving virtue – it enables many of us economists to get “close up and personal” and take a ringside seat and really see for ourselves, and at first hand, just how things may actually have worked back then. In this sense I would like to extend my profound thanks and deep gratitude to each and everyone of the 45 million Spanish men and women and the 140 million odd Russians who are idling away their time at the moment running round and round the treadmill, all in the cause of helping me triangulate, and sort out a few nagging questions that have been haunting me ever since my late adolesence.

Monetary Policy On The Zero Bound

The controversy to which Krugman refers relates to the role of monetary policy in what we could call “extreme situations”. For present purposes we could describe an extreme situation as one in which either (or both) a severe credit crunch and a liquidity trap are present. The liquidity trap would normally be associated with the presence of general consumer price deflation, while former may (or may not) be, but if it is, then this certainly complicates things a lot. But before I go any further, what do we really mean by a credit crunch, and what is a liquidity trap?

Crunch, Crunch, Crunch

One of the things which central bankers have historically spent most time lying awake at night thinking about (since it tends to produce a severe loss of effectiveness in conventional monetary policy) is the arrival of what we nowadays call a “credit crunch”. Such a credit crunch normally consists of a sharp contraction in the supply of bank credit as a result of a massive loss of inter-bank trust which is produced by the accumulation of a large quantity of nonperforming loans and semi-worthless assets inside the financial system.

There will be close to no growth in lending by Spanish banks in 2009 as the economy contracts, the head of Spanish bank Sabadell said on Tuesday. “Credit this year is going to grow by zero or nearly zero due to the steep adjustment in the economy as it undergoes deleveraging,” Sabadell’s Chief Executive Officer Jaime Guardiola told a press breakfast.

Such a crunch would normally have two components; a) a decline in bank capital due to the accumulation of bad loans held by the banking sector with a resulting fall in the capital asset ratio large financial institutions. The banks normally respond to such a situation by reducing the amount of loans they are prepared to supply and; b) the emergence of a cautious lending attitude on the part of banks following their experience with a combination of bankruptcies, nonperforming loans, and recession. Such circumstances make firms and households less desirable potential borrowers than they used to be, and they also have the self-reinforcing effect of tightening credit conditions and worsening the developing recession, which is, of course, itself partly a by-product of the initial credit crunch. Thus when the thing locks tight, you need more than some 3 in 1 rapid-ease to unlock it.

Credit crunches are thus normally characterised by the fact that – despite the presence of a low interest rate environment – a sharp tightening of credit conditions occurs. The “lending attitudes” of financial institutions, at least from the borrower’s perspective, suddenly become much more stringent.

A credit crunch implies that injections of liquidity (expansions in base and narrow money) do not increase private credit and aggregate lending. This is exactly what we have seen happening in Japan from the mid 1990s onwards. Base and narrow money increased at a robust pace, but the broader money aggregates most directly related to corporate investment and consumer spending only grew modestly, as can be seen in the chart below, which comes from Gauti Eggertsson and Jonathan D. Ostry, Does Excess Liquidity Pose a Threat in Japan? (IMF Working Paper, April 2005 – please click on image for better viewing).

At the same time aggregate bank lending to the private sector decreased sharply, directly producing a tightening of credit conditions as faced by Japanese enterprises, while government borrowing increased substantially, in a pattern we are now getting used to seeing in the United States and Western Europe.

In addition Krugman has now drawn our attention to some of the growing evidence that this pattern may well be repeating itself in the United States at the present time. As he says, the Federal Reserve has been spectacularly aggressive about expanding the monetary base (see chart below), yet bank lending has remained pretty much stationary.

Running On Empty Aka The Liquidity Trap

The other type of extreme situation which needs to be kept in mind is danger of a liquidity trap. Discussion of liquidity traps (or the danger they represent) came back into vogue in the late 1990s following a renewed focus on the problem by Krugman himself in the Japanese context.

In fact most of recent discussion of the liquidity trap problem has been focused on Japan, for the simple reason that Japan was the first major industrial economy to face serious and ongoing price deflation since the 1930s episodes. It was, of course, during the 1930s that Keynes first drew serious attention to the liquidity trap explanation for why monetary policy might be ineffective when interest rates come up against what we now call the “zero bound”.

Basically the risk of entering a liquidity trap is heightened when interest rates are at or near zero, and domestic demand contracts with sufficient force to produce a substantial and ongoing fall in prices, since the implicit rate of return on simply holding cash is not that different from that obtained by holding short term government bonds, especially when transaction costs are taken into account. (If prices drop at a 2% annual rate, for example, this gives you an implicit rate of return of 2% on bank notes).

Now we need to be careful here, since while monetary policy in one economy after another is gradually coming to rest around the zero bound, by and large price inflation has not (yet) fallen below zero (or not for a sufficient length of time), and while it is evident that a number of countries face the imminent risk of this happening (Germany, Spain, Ireland, the UK, Japan and the United States most notably) we are not there yet, and the central banks are working furiously (well I’m not too sure about the ECB) to unblock the credit crunch before the associated contraction in economic activity produces the sort of price deflation which increases the risk of one country after another getting stuck in some kind of liquidity trap.

The simplest explanation for why it is that an increase in the monetary base may have only limited effects on inflationary expectations and real macroeconomic variables goes back to Keynes. Keynes argued that monetary policy ran the risk of becoming impotent in stimulating demand and raising spending since interest rates were already at their lowest possible level. Essentially he argued that increasing the monetary base by buying short-term government bonds is irrelevant at zero interest rates since money and short-term government bonds become effectively perfect substitutes.

This (monetary policy impotence) argument has been challenged to some extent of late, most notably by Ben Bernanke, who argues that while the central bank may lose policy leverage over short term interest rates, by buying longer term instruments (10 or 30 year bonds) the bank may influence rates further up the yield curve.

But there was another dimension to Keynes thinking here, and this was associated with the causal chain between the monetary base (which the central bank evidently controls) and the level of output and prices (which it apparently doesn’t). Keynes suggested that the relation between monetary base and the level of output was not a linear one, and indeed in a credit driven economy the causal chain might just as easily run from sentiment to credit availability to the output level to broad money (rather than the other way round), meaning the central bank was certainly free to move the level of base money around at will, but remained effectively impotent when it came to influencing the level of bank lending and output. This seems very plausible as it sounds horribly reminiscent of the actual situation we are seeing around us at the present time.

This is why the name of Keynes has become so closely associated with the idea of government spending, since given that the central bank has only limited ability to regulate the output level by using monetary policy, he considered direct demand management by via fiscal injections to be much more effective. Indeed in one of his last interviews Milton Freidman himself implicitly conceded the point, declaring that “The use of the quantity of money as a target has not been a success”.

The core of Krugman’s analysis is the idea that the equilibrium real interest rate – that is, the real rate that would match saving and investment – and thus bring output back up towards its capacity level – turns negative in a liquidity trap. Thus we can have an economy which is struggling to find its equilibrium point but which is unable to do so since it effectively cannot generate the rate of interest which would make this possible.

But how can the equilibrium real interest rate be and remain negative? Because, argues Krugman, poor long-run growth prospects (a debt deflationary environment) make investment demand so low that a negative short-term real interest rate would be needed to match saving and investment. Given a nominal interest rate floor of zero a positive expected rate of inflation becomes necessary to generate negative real interest rates, which will stimulate aggregate demand and restore full employment.

Equally importantly, injections of liquidity by the central bank which raise base money (or bank reserves) turn out to be pretty ineffective in raising the growth rate of broader money aggregates. Krugman shows that Japan’s monetary base grew 25% from 1994 to 1997, but that the broader monetary aggregate (M2 + Certificates of Deposit) grew only 11%, and bank credit didn’t grow at all. And more recent statistics indicated that “money hoarding” continued to be evident in 1998-1999, as an expansion of the monetary base in the range of 8% to 10% resulted in only about a 3% growth in M2 + CDs. Posterior Bank of Japan data show that between March 2001 and May 2004 while Japanese bank reserves grew by 800% the monetary base (which is bank reserves plus cash in circulation) only increased by 67%.

Now, as I say, there little evidence at the present time that we are already in a liquidity trap, but the danger that some countries (including Japan, yet one more time) may fall into one, is certainly real, and non-negligible.

Economics Is Giving Me A Depression

So what has all this got to do with the Great Depression debate? Well quite a lot actually.

As Krugman argues, a central theme of Keynes’s General Theory was the impotence of monetary policy in depression-type conditions. But Milton Friedman and Anna Schwartz, in their seminal monetary history of the United States, claimed that the Federal Reserve could have prevented the Great Depression — a claim that in later, popular writings, including those of Friedman himself, was transmuted into the claim that the Federal Reserve “caused” the Depression.

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
Ben Bernanke, On Milton Friedman’s Ninetieth Birthday

(As we have seen, what the Fed really controlled was the monetary base — currency plus bank reserves. As the chart displayed below – which comes from Krugman – shows, the base actually rose during the great slump, which is why it’s hard to make the case that the Fed caused the Depression. Although arguably had the Fed acted more aggressively earlier – eg if it had expanded the monetary base faster and done more to rescue banks in trouble – the blow might have been softened, even though as we are seeing at the present time, there are no guarantees, this will always and forever have to remain a huge “what if”).

Underlying the whole Friedman & Schwartz view of The Great Depression is the assumption that (in both the short and the long term) the “velocity” of money reflects the “money holding propensities of the community” (p679). Under the normal ceteris paribus convention, tastes are taken to remain unchanged. Thus, the authors feel themselves authorised to write as though a movement in the monetary aggregate in and of itself exerted a simple and direct influence on real output. This idea that velocity remains constant has been repeatedly question by critics of the Monetary History, citing most notably Irving Fisher who argued in a now famous Econometrica paper that debt liquidation leads to distress selling, which in turn leads to a contraction in current deposits plus currency as bank loans are paid off, and thus to a slowing down of velocity of circulation. This contraction of deposits and of the slowdown in the velocity of circulation, aggravated by distress selling, causes a general fall in the level of prices. Sound familiar?

Friedman & Schwartz for the most part take a pretty simple view of the cause of the monetary contraction in The Great Depression:

the monetary authorities could have prevented the decline in the stock of money – indeed could have produced almost any desired increase in the stock of money. (P.301: note the almost]. The monetary decline from 1929 to 1933 was not an inevitable consequence of what had gone before. It was the result of policies followed during those years (p.699).

On the question of how the authorities could have controlled the money stock, they answer, in words quite evocative of things we have been hearing of late, by conducting “extensive open market purchases” to increase bank reserves: What they say of the first year of the depression expresses their view reasonably clearly:

It has been contended with respect to later years (particularly during the years after 1934….) that increases in high-powered money, through expansion of Federal Reserve credit or other means, would simply have added to bank reserves and would not have been used to increase the money stock…. we shall argue later that the contention is invalid, even for the later period. It is clearly not relevant to the period from August 1929 to October 1930. During that period, additional reserves would almost certainly have been put to use promptly. Hence the decline in the stock of money is not only arithmetically attributable to the decline in federal Reserve credit outstanding: it is economically a direct result of that decline. (pp341-2)

Basically Friedman & Schwartz never really seriously consider the possibility that bank lending was held back by factors other than their reserve position. This is because they seem to pay practically no attention to the asset side of banks’ balance sheets. Their (then) view of the world would seem to allow a limited space for the banks’ role as financial intermediaries who live by striking a balance between the needs of two types of client: depositors (the public as asset owners) and borrowers (the public as investors and debtors). Nor does it allow for the fact that banks as intermediaries operate in a world of uncertainty, that banks’ assessment of their client’s creditworthiness varies, and that in the short term their lending determines the size of the money stock.

If these effects are accepted as important, the stock of money has to be seen as determined at least in large part by the business situation, and this is exactly what we are seeing now. It thus becomes more and more plausible that the scale of bank lending during the Great Depression was significantly restrained by the state of the bank loan book, and by their increased caution in lending to customers whose profit expectations had deteriorated drastically, as well as by the capital adequacy position and it was these considerations, and not the size of their reserves, that imposed a limit on the size of the money stock.

The government is losing its patience with the banks,” Spanish Industry Ministry Miguel Sebastian said just hours after the labour ministry said the number of people out of work in Spain rose to over 3.3 million as of the end of January, a 12-year high, “I will tell them, with all my power and conviction, that this is not the time for large profits. It’s the time to support credit and financing for families and companies in this country,”

Spain’s largest union, the CCOO, went a step further and said banks had to start dolling out credit, or face state efforts to control lending. The demands, and word the Bank of Spain Governor and other bank sector leaders would address Congress in coming weeks, raised talk the government could create a state bank or take stakes in private banks to influence their credit policy. “We shouldn’t rule out the government taking a stake (in a private bank) and, in an extreme case, creating a public bank,” said Paloma Lopez, CCOO employment secretary general. “If they don’t free up financing, if the banks keep putting up objections, the government has to go a step further.”

The point is that one must believe that the fall in income had a major effect on personal consumption, and the great fall in output a major influence on business investment, and the interaction of the two (once the process started) a dominating influence. At most, then, monetary influences could have initiated the depression, or worsened it when it started, but they could not have been the sole dominating influence through its course. The parallel fall in the money stock cannot then be taken as evidence of the latter’s causal significance.

Banco Popular followed the lead of other Spanish banks on Friday, opting to sacrifice 2008 profits to increase provisions against bad loans amid the deepening economic slowdown. Popular posted a 16.8 percent drop in net profit for 2008 on to 1.05 billion euros ($1.4 billion), below analysts’ forecasts, as loan loss provisions increased. Popular has one of the highest exposures to Spain’s property sector, currently in a steep downturn after a decade-long boom. Many property developers are defaulting.

Popular is expected to post an around 8 percent rise in net interest revenue in 2009. Loans grew 6.1 percent, with 44 percent to small and medium-sized businesses, and client deposits grew 21.1 percent. Higueras said he sees, at best, low digit loan growth in 2009, but stressed that Popular would continue to lend money to businesses and private individuals. “We are not giving up on lending …. We will come through this crisis however long it lasts,” he said.

Conclusions

Finally, (below) some more charts on Japan, prepared by the Japanese economist Richard Koo. In the first chart the thick blue line (please click over chart if you can’t see adequately) shows the perception of large businesses of the willingness of banks to lend to them, as surveyed by the Bank of Japan for the Tankan index. You will note the line plunges twice, and it is the second plunge, or “credit crunch”, which interests me at the moment. This was the crunch that finally drove Japan decisively off into deflation, and produced that now famed “liquidity trap”. Basically the first credit crunch was resolved via large scale government contruction spending, the guaranteeing of bank deposits, and the swallowing by the banks of a large number of non-performing loans. Does all this sound familiar? It should. But then Japan reached a point were the financial system could struggle forward no further. So the crunch broke out again, and this time the only way to resolve the problem was with two massive injections of capital into the banking system.

The problem is that these injections – as can be seen below – served to push the Japan government debt to GDP ratio sharply upwards, and it is this part of the story that I feel we will see repeating itself now in countries like the United States and Spain.

The problem is that the US economy became, as I am sure everyone is now only too aware, very highly leveraged with total (private and public) debt to GDP ratios of around 350% of GDP. This is now unsustainable. The government is basically – via the various bailout processes – trying to reduce the part of this ratio which is held by the private sector and hence reduce the degree of leveraging to within a range that will allow bank lending to function again.

The problem is that as these bailouts take effect US GDP is itself contracting, and at the same time prices are pushing the frontier between price increases and price decreases. It is really very important to not allow systematic price falls to set in, and doubly important not to allow expectations for inflation to turn negative.