Wednesday, December 17, 2008

Lessons [not] learned

The Federal Reserve yesterday lowered the target-rate for overnight loans in the interbank market to between one-quarter percent and zero percent, and the standard comments are to the effect that the authorities are "out of ammo" in terms of trying to further lower interbank rates to spur bank-lending; and they they have thus embarked on a policy of targeting not the rate on such transactions, but something called "quantity". This is described as "unorthodox" but also in imitation of what the Japanese authorities did starting in 2001. But there are several important differences, suggesting Bernanke and the others are merely repeating shibboleths from the Japanese case, and in fact have learned less than we are being led to believe:

(1) Greater untransparency in the American case. The Japanese authorities spelled out what "quantity" they were talking about, and it was the size of the commercial banks' liquid reserve accounts with the Bank of Japan over and above what they were required to hold to satisfy their regulatory liquidity-reserve requirements. Moreover there were target amounts set for this, and the liquidity reserves were the headline number on a periodic basis in the financial press, so people could see how the BOJ was doing in meeting these targets. The Fed, by contrast, has not said what "quantity" exactly it is targeting, making this a particularly untransparent move, enabling the Fed to provide the Banks with money in ways that can't be accurately kept track of.

(2) In the American case, the household sector is being kept entirely out of sight in the monetary policy debate. The institutional politics in Japan was as follows: The Finance Ministry (the most important single power-center in the Japanese establishment) was anxious to fend off pressure for additional fiscal spending, their institutional aim being to keep state-borrowing as cheap as possible, and keep the fiscal deficit as small as possible. Via the business press, politicians in the ruling Liberal Democratic Party (LDP), and foreign spokespeople including Krugman and others who were unaware they were taking sides in a domestic institutional struggle, all weighed in on the side of pressuring BOJ to be more and more progressive and proactive, and this is the situation that culminated in the move to quantative easing. Whether or how this finance-ministry (Treasury Dept) versus central-bank rivalry will be played out in the American case remains to be seen, but when the US pundits talk about the "lessons learned" from the Japanese case it appears all they are doing is repeating what they and others were saying in the Japanese case: Make the central bank be the aggressive lead agency in this, and spare the fiscal authorities.

What this means is that the policy debate is made even more untransparent, in the following sense: Providing liquidity to banks is supposed to spur lending, and thus stimulate economic activity. But the whole point about quantative easing was that lowering borrowing rates for banks didn't have that effect, and it was for that reason that they decided to go ahead and load the banks up with more and more liquidity even though their borrowing rates were already zero. This meant that the "temporary patience" that the household sector was supposed to show vis-a-vis near-zero deposit rates for their savings deposits was turned into a much more permanent thing. BOJ governors would occasionally apologize for this and ask for renewed patience, but the point is that the pressure for the monetary authorities to take an aggressive policy lead really meant shelving the whole question of the household sector. They were too busy pursuing the unsuccessful attempt to pump liquidity through the banks and into the real world in more and more novel ways.

(3) Risk of the dollar becoming the world's funding currency.The Japanese low-rate policy made the yen the world's so-called "funding-currency", in the sense that big money was able to borrow yen at low rates, convert to other currencies for investment at higher rates, and continue rolling these positions over (the so-called "carry trade"). The first thing that the Japanese financial press noted about yesterday's Fed move is that this makes the American target rate lower than the comparable Japanese target rate (currently 0.3%). No one is trumpeting this, but the point is that this risks turning the US dollar into the world's funding currency, feeding the dollar's drop generally against all currencies. Whether or not this turns out to be an important factor in a future controlled or uncontrolled dollar-drop remains to be seen, but it is worth noting that this isn't one of the points in the standard commentary.

So while the commentary talks about alleged lessons learned from the Japanese experience, this seems more a case of lessons not learned and risks not adequately taken into account.

(I was in Japan and reading the Japanese financial papers during much of this recent period, and I hope to be able to post from time to time summaries from the Japanese press reflecting on these issues, possibly in ways similar to the views expressed in the US press, possibly in different ways).