Managing Inflation Expectations and Motivating Economic Growth

A Rising Tide Lifts All Boats (that can Float) Economists are still vexed by liquidity traps. The reason is that it is easy to see frictions in resolving bad assets, but difficult to see a way out. Right now, banks can’t afford to write off their full exposures to bad assets without additional capital, but banks also can’t afford to keep the assets on the balance sheet without even more capital because, without explicit recognition they are unable to credibly commit their exposure to the bad assets. Hence, banks don’t lend and economic growth stagnates.

The problem, however, is not just the banks but also what can be called the “unwitting” investors in the bad assets. In the Great Depression, regular bank depositors turned into unwitting long-term creditors overnight when banks failed without deposit insurance. Today, myriad banks and funds are prohibiting withdrawals (even against contractual terms) or paying out only “in-kind” in order to stem debilitating losses in a manner similar to the Great Depression. Even bank shareholders who thought they had blue-chip investments are finding out they held junk.

To wake up one day and find you had intended to invest in blue-chips but had really invested in junk is systemically problematic when you can’t withdraw your funds. When redemptions or sales are impossible because the market is flooded with junk, investors are stuck with maturities and risk grades they did not desire and are unable to reallocate their portfolios to their preferred characteristics, particularly investments issued by value-producing firms.

Government funds to take the assets off investors’ hands don’t help, either, only replacing the personal tax with an equivalent public fiscal burden. No matter how we distribute the loss, the aggregate amount of loss to the economy remains the same: the resulting liquidity trap substantially drags down economic growth.

The trap, however, is endemic in the “wait until tomorrow” approach that is so attractive in crises. Values slid from historic highs to today’s levels. The central bank has stepped in with accommodative measures, bringing rates to historic lows. Economic growth is right around the corner. So investors wait… and wait… and wait. But growth never comes. Why?

The answer proposed in my own research[1] is that the cost of waiting has been reduced by the central bank to almost zero. Without a traditional market cost of waiting, investors’ money remains tied up in bad assets. With zero interest rates and no economic growth, deflationary expectations arise and begin to be priced into financial contracts. The liquidity trap does not respond to traditional interest rate cuts because investors’ behavior is working for them. Hence, exit from the liquidity trap requires changing investors’ incentives.

The goal should be to put bad assets to investors willing and able to make use of them, particularly deep pockets investors (with a lot of long-term cash) that know how to extract value out of the assets. The sentiment is similar to that espoused by Ben Bernanke in his famous “Non-monetary Effects…” paper: Bernanke (1983, p. 272) surmised that as “…a matter of theory, the duration of the credit effects … depends on the amount of time it takes to (1) establish new or revive old channels of credit flow after a major disruption and (2) rehabilitate insolvent debtors.” In practice, Bernanke seems to be attempting to “establish new channels,” but the only attempt at “rehabilitation” seems to be mortgage modification. In my opinion, “establishing new and reviving old credit channels,” will follow “rehabilitation” if “rehabilitation” is carried out completely and targeted at the right group of debtors.

So how do we get the assets from the current “unwitting” investors to the vulture investors who know how to remediate credit and rehabilitate borrowers? The government could buy the assets and subsidize the reallocation but that is bound to be horribly inefficient. Furthermore, if investors thought they could get a better price later – from the government or the market –they still face the zero cost of waiting.

Perhaps it is better to raise the cost of waiting by reflating interest rates. That means credibly committing to an inflationary bias in order to get investments out of the hands of “unwitting” investors and into the hands of vulture specialists that have the means and capability of managing bad assets. With the cash received, previously “unwitting” investors can reallocate their portfolios to value-producing firms rather than facing the potential for further value-destruction in their present portfolios. When value-destroying firms lock up markets, they drag the economy down with them. When value-producing firms raise funds, they exert a powerful force for economic growth.[2]

The new administration has a unique opportunity support value-producing firms by promoting reflation now. Timothy Geithner, having spent considerable time inside the Federal Reserve System and having worked directly with Bernanke already, may have the ability to creatively pursue coordinated Treasury and Federal Reserve actions not seen since the Fed-Treasury Accord of 1951, which affirmed the Fed’s staunch independence from Treasury.[3] While I would not normally suggest the breakdown of central bank independence and the strategy carries with it risks of whether the Fed can effectively de-politicize itself on the other side of the crisis, the strategy allows the Fed to maintain short-term rates at their current low levels while the Treasury swaps out or repurchases TIPs and assembles its financing for the higher inflation to follow. By generating inflationary expectations in such a manner, the Fed avoids further embedding the zero-rate liquidity trap problem in longer-term markets through the proposed purchase of longer maturity paper and can stop overextending their balance sheet to fund troubled asset liquidity programs that, themselves, threaten not just the central bank’s independence, but continued viability.

In summary dealing effectively with liquidity traps vexes even the best economists. Agencies like Treasury do not maintain significant staffs of economists devoted to understanding and dealing with today’s crisis, but they do possess policy tools that can be used to fight the crisis. The Federal Reserve, on the other hand, possesses vast economic knowledge and creative thought about the crisis, but its tools for dealing with financial exigencies such as this are limited. Coordination between Treasury and the Federal Reserve can therefore augment the Federal Reserve’s very limited toolbox for affecting inflation expectations. We need to incentivize the shift of bad assets from general investors to specialists by increasing inflation expectations. Treasury policies like a TIPs buyback or swap could be a powerful means of shaping expectations in the near term, incentivizing Bernanke’s resuscitation of “…channels of credit flow after a major disruption and …rehabilitat[ion of] insolvent debtors.”

[1] “A Real Options Approach to Bankruptcy Costs: Evidence from Failed Commercial Banks during the 1990s.” Journal of Business, July 2005 (79:3), pp. 1523-53. “Bank Asset Liquidation and the Propagation of the Great Depression,” (with Ali Anari and James Kolari). Journal of Money, Credit, and Banking, August 2005 (37:4), pp. 753-773.
[2] Indeed, Japan’s economic growth only began to take off when it pursued a reflation program, albeit nearly a decade after their crisis began.
[3] Prior to that time, the Fed agreed with Treasury that the primary emphasis, for funding WWI, the Great Depression programs, and WWII, was to keep Treasury borrowing rates low.