Commentary on Political Economy

Monday 7 June 2021


The time to brace in financial markets is coming

Adrian Blundell-Wignall

Central banks have been unable to stop themselves printing money. That means a storm cloud of rising inflation, rising interest rates and rising deficits.

Economist Paul Krugman wrote recently that he couldn’t understand what economic problem bitcoin was trying to solve - a nice point.

Advocates claim it is solving the problem of an alternative to the dollar with inflation on the way. Krugman brushes aside that rationale because money doesn’t cause inflation. Instead, excess printing of money simply causes the ratio of GDP to money (its circulation velocity) to fall.

Krugman is an inflation dove and supporter of US President Joe Biden’s fiscal expansion, because low interest rates are here to stay. But if that were so, then what problem has the US Fed been trying to solve by printing all that money that doesn’t affect nominal GDP and inflation?

With interest paid on reserves at the Fed, a floor is set for the Fed funds rate. This creates an extra instrument (quantitative easing). The Fed can keep printing money to achieve something else without piercing the floor.

But if it’s not to drive nominal GDP, what might that “something” be? And why do we need ever more of it (given the attempt to taper it in 2015 failed)?

In 2008, the Fed was solving the problem of jammed-up liquidity. Velocity dropped vertically as cash assets of banks rose with little effect outside the interbank market. This was to avoid an even bigger crisis.

But the subsequent QE2 and QE3 ratcheting up of cash relative to the economy is a puzzle. It hasn’t affected inflation, as Krugman says, so it must have been to meet some new demand as the crisis receded and trust in banks improved as they were re-regulated.

With low interest rates, large global banks can’t make any money from net interest margins, so they have grown their fee/commissions/spreads businesses through investment banking and prime broking in the non-bank financial sector.

The US Federal Reserve is going to have to solve a problem of its own making.

Enormous risks remain as this involves leverage through derivatives and re-hypothecation chains (the demise of Archegos Capital is a small taste of what can happen).

But the revenue incentives are irresistible for large global banks. As these client services businesses grow, there is a rising demand for cash to meet the liquidity coverage ratio (the ability to withstand 30 days of liquidity stress is a function of the size of these markets) and other precautionary demands. If the Fed doesn’t supply the cash, demand would run ahead of supply and interest rate volatility and risk in the shadow bank sector would grow.

But this will need to change soon. The post-pandemic acceleration of bank reserves and broad money (M2 up 27 per cent in the year to February) is very different and will force things.

The US response to COVID-19 and the Biden fiscal agenda is raising the Fed balance sheet in new ways, such as direct lending to large and small employers (for general support and to protect wages) and to state and municipal governments. This puts money directly into the hands of those that spend it. Similar things are happening in other countries.

This is a legitimate source of inflation concern. Supply chains in the real economy are disrupted at a time when helicopter money for the non-bank sector is boosting spending (unlike QE1, QE2 and QE3).

Inflation will rise further.

The debate now is whether this will be transitory or more long-lasting (with inflation expectations building into wage demands with tightening labour markets). This in turn depends on what the Fed does now. Tricky.

If the Fed begins raising rates and tapering reserves to forestall inflation, it may risk financial sector disruption and that would hurt the economy. Alternatively, it could let inflation rise and hope it’s not too bad.

The latter approach would be a mistake.

Real interest rates are the outcome of bringing saving and investment into equality. While the goal of monetary policy is to provide a nominal anchor, it cannot do this by holding policy rates away from consistency with fundamentals without causing unintended asset price effects.

All across the world budget deficits have moved strongly into deficit in a co-ordinated manner and no more so than in the United States. So government savings is falling everywhere, just as the China savings glut is reversing. As investment simultaneously rises (to reduce dependence on imports for strategic supplies and to build infrastructure), real rates have only one way to go.

It’s little wonder that countries have now found common cause in the COVID-19 crisis to agree on taxing the digital big boys, while in the US Biden plans to get rich people to pay more. These may help reduce the tensions.

The rise in US personal tax for people with incomes more than $400,000, from 37 per cent to 39.6 per cent, is tiny.

The capital gains tax is more significant, but it will rely on people liquidating assets for the pleasure of paying almost half to the government (which is unlikely).

Reversing half of former president Donald Trump’s corporate tax cut could raise 3 per cent of GDP. But we are talking about a general government deficit now around 15 per cent of GDP, and large numbers in all other countries.

Finally, everyone seems pleased about taxing the Apples, Googles and Facebooks. But it is unclear how much will be raised, as non-G7 countries decide what they will do, and when the companies and their accountants and bankers put their heads together.

Real rates are going to rise.

So the Krugman view that all this money printing won’t matter for inflation is less plausible in a world of co-ordinated fiscal expansion, and money being shoved into the hands of spenders - in a world that’s supply-constrained.

I think the economic problem bitcoin is trying to solve is the need by some to transact in the dark economy. It can never be an alternative to the US dollar. The Fed, however, is going to have to solve a problem of its own making. The time to brace in financial markets is coming.

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