For the Twenty-First Century - By Doug Noland

By Doug Noland
June 15, 2007
Source

Today, Chairman Bernanke presented a paper, The Financial Accelerator and the Credit Channel, at the Federal Reserve of Atlanta’s conference on The Credit Channel of Monetary Policy in the Twenty-First Century. It is a technical discussion of issues near and dear to my analytical heart – and worth plodding through. I’ll excerpt and attempt an argument against conventional doctrine.

From Dr. Bernanke:

“Economic growth and prosperity are created primarily by what economists call ‘real’ factors--the productivity of the workforce, the quantity and quality of the capital stock, the availability of land and natural resources, the state of technical knowledge, and the creativity and skills of entrepreneurs and managers. But extensive practical experience as well as much formal research highlights the crucial supporting role that financial factors play in the economy… In the United States, a deep and liquid financial system has promoted growth by effectively allocating capital and has increased economic resilience by increasing our ability to share and diversify risks both domestically and globally.”

My comment: The dilemma today is that current forces supporting “economic growth and prosperity” are primarily of a financial nature. Credit growth and resulting asset inflation and financial flows dictate the nature of economic activity to a greater degree each passing year. The pricing mechanism and incentive structure have been debauched. To be sure, financial “profits” have come to command system behavior. Yet as long as sufficient system Credit creation is maintained – readily providing ample new purchasing power throughout – the “services”-based U.S. economy plows right along, emboldening the New Era crowd and aggressive risk-takers in the process. Traditional frameworks and conventional thinking are in large part worthless, at best.

And it is certainly not, as Greenspan and Bernanke insist, a case of “effectively allocating capital.” Instead, today’s (global) prosperity is the upshot of an unrelenting boom in new Credit powering myriad Bubble processes and dynamics. As such, Dr. Bernanke’s analysis is hopelessly archaic. Today, new Credit is so readily available that the “effectiveness” of its allocation is beside the point. Contemporary Credit systems have so far proved remarkably resilient. This dynamic is misinterpreted as economic “resiliency,” when in fact economic systems have become precariously dependent upon (addicted to) uninterrupted rampant Credit creation and flows of speculative-based liquidity. We delude ourselves with fanciful notions of our newfound “ability to share and diversity risks,” when the issue is actually the postponement of the day of reckoning through ever greater risk-taking.

It is curious how Dr. Bernanke can offer an extensive discussion - where he highlights academic work related to “financial accelerators” and “Credit channels” – without addressing Wall Street firms, hedge funds, private equity, securitizations, “repos,” derivatives and foreign financial flows (certainly including the central banks). His approach remains little tweaks to the traditional bank centric analytical approach, conveniently chucking the heart of contemporary finance into the nondescript category “non-banks.” Old paradigm frameworks won’t suffice for the New Credit Paradigm.

"Just as a healthy financial system promotes growth, adverse financial conditions may prevent an economy from reaching its potential. A weak banking system grappling with nonperforming loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth. Japan faced just this kind of challenge when the financial problems of banks and corporations contributed substantially to sub-par growth during the so-called ‘lost decade.’"

The critical flaws in Dr. Bernanke’s framework at times shine through in this presentation. He instinctively sees the boom period as sound and, apparently with astute policymaking, sustainable. There is no recognition that a so-called “healthy financial system” may over time sow the seeds of boom/bust dynamics and inevitable financial and economic impairment. The primary role of activist policymaking revolves around rectifying “adverse financial conditions” that occasionally hold prosperity at bay. He believes “weak banking system” can and should be avoided by manipulating the inflationary process. Post-Bubble policy errors were to blame for Japan’s “lost decade” - not spectacular inflationary Bubble excesses. More grievous policy blunders – and not a more reckless boom – were to blame for the Great Depression.

"Putting the issue in the context of U.S. economic history, I laid out, in a 1983 article, two channels by which the financial problems of the 1930s may have worsened the Great Depression).

The first channel worked through the banking system. As emphasized by the information-theoretic approach to finance, a central function of banks is to screen and monitor borrowers, thereby overcoming information and incentive problems. By developing expertise in gathering relevant information, as well as by maintaining ongoing relationships with customers, banks and similar intermediaries develop ‘informational capital.’ The widespread banking panics of the 1930s caused many banks to shut their doors; facing the risk of runs by depositors, even those who remained open were forced to constrain lending to keep their balance sheets as liquid as possible. Banks were thus prevented from making use of their informational capital in normal lending activities. The resulting reduction in the availability of bank credit inhibited consumer spending and capital investment, worsening the contraction."

My comment: Banks were “prevented from making use of their informational capital” because the “marketplace” had lost faith in their (deposits) and others’ liabilities. Boom-time Credit and speculative excess and resulting Monetary Disorder had precariously distorted asset prices, earnings, incomes and the flow of finance throughout the U.S. and global economies. The scope of the preceding Bubble excesses ensured Credit system impairment, “runs” from risky assets, and rather deep-seated disillusionment. The inflationary boom had severely corrupted the financial intermediation process.

“The second channel through which financial crises affected the real economy in the 1930s operated through the creditworthiness of borrowers. In general, the availability of collateral facilitates credit extension. The ability of a financially healthy borrower to post collateral reduces the lender's risks and aligns the borrower's incentives with those of the lender. However, in the 1930s, declining output and falling prices (which increased real debt burdens) led to widespread financial distress among borrowers, lessening their capacity to pledge collateral or to otherwise retain significant equity interests in their proposed investments. Borrowers’ cash flows and liquidity were also impaired, which likewise increased the risks to lenders. Overall, the decline in the financial health of potential borrowers during the Depression decade further impeded the efficient allocation of credit. Incidentally, this information-based explanation of how the sharp deflation in prices in the 1930s may have had real effects was closely related to, and provided a formal rationale for, the idea of ‘debt-deflation,’ advanced by Irving Fisher in the early 1930s (Fisher, 1933).”

It is fundamental Macro Credit Theory that “the availability of collateral facilitates Credit extension.” Surely, an increase in Credit Availability and the flow of marketplace liquidity will tend to support asset inflation. Higher asset (“collateral”) prices, then, foster further augmented Credit expansion and, almost certainly, greater speculative activity. “Collateral” can actually be a bigger issue during the boom, and I disagree with Dr. Bernanke’s contention that “The ability of a financially healthy borrower to post collateral reduces the lender’s risks and aligns the borrower's incentives with those of the lender.”

In reality, Credit booms inherently inflate asset prices, incomes and business “cash flows”, in the process creating a steady flow of so-called “healthy borrowers” willing to perpetuate an increasingly unwieldy Bubble – surreptitiously increasing lender risk throughout the life of the boom. Moreover, it is the nature of Credit “blow-offs” that lender risk grows exponentially as collateral values inflate most spectacularly. Only careful analysis of the underlying Credit process will provide an informed view of the true health of most borrowers. And, as far as the alignment of incentives, the further into Bubble excess the greater the incentive for the financing community to loosen lending standards sufficiently in order to perpetuate the boom (think telecom ’99 or subprime ’06). Seemingly robust “borrowers’ cash flows and liquidity” abruptly turn suspect with the arrival of the inevitable bust.

"The ideas I have been discussing today have also been useful in understanding the nature of the monetary policy transmission process. Some evidence suggests that the influence of monetary policy on real variables is greater than can be explained by the traditional ‘cost-of-capital’ channel, which holds that monetary policy affects borrowing, investment, and spending decisions solely through its effect on the level of market interest rates. This finding has led researchers to look for supplementary channels through which monetary policy may affect the economy. One such supplementary channel, the so-called credit channel, holds that monetary policy has additional effects because interest-rate decisions affect the cost and availability of credit by more than would be implied by the associated movement in risk-free interest rates… The credit channel, in turn, has traditionally been broken down into two components or channels of policy influence: the balance-sheet channel and the bank-lending channel (Bernanke and Gertler, 1995). The balance-sheet channel of monetary policy is closely related to the idea of the financial accelerator that I have already discussed. That theory builds from the premise that changes in interest rates engineered by the central bank affect the values of the assets and the cash flows of potential borrowers and thus their creditworthiness, which in turn affects the external finance premium that borrowers face…

Historically, monetary policy did appear to affect the supply of bank loans… In the 1960s and 1970s, when reserve requirements were higher and more comprehensive than they are today, Federal Reserve open market operations that drained reserves from the banking system tended to force a contraction in deposits. Regulation Q, which capped interest rates payable on deposits, prevented banks from offsetting the decline in deposits by offering higher interest rates. Moreover, banks had limited alternatives to deposits as a funding source. Thus, monetary tightening typically resulted in a shrinking of banks' balance sheets and a diversion of funds away from the banking system… The extension of credit to bank-dependent borrowers, which included many firms as well as households, was consequently reduced, with implications for spending and economic activity.

Of course, much has changed in U.S. banking and financial markets since the 1960s and 1970s. Reserve requirements are lower and apply to a smaller share of deposits than in the past. Regulation Q is gone. And the capital markets have become deep, liquid, and easily accessible, either directly or indirectly, to almost all depository institutions.

This is not to say, however, that financial intermediation no longer matters for monetary policy and the transmission of economic shocks. For example, although banks and other intermediaries no longer depend exclusively on insured deposits for funding, nondeposit sources of funding are likely to be relatively more expensive than deposits, reflecting the credit risks associated with uninsured lending. Moreover, the cost and availability of nondeposit funds for any given bank will depend on the perceived creditworthiness of the institution…

Like banks, nonbank lenders have to raise funds in order to lend, and the cost at which they raise those funds will depend on their financial condition--their net worth, their leverage, and their liquidity, for example. Thus, nonbank lenders also face an external finance premium that presumably can be influenced by economic developments or monetary policy. The level of the premium they pay will in turn affect the rates that they can offer borrowers. Thus, the ideas underlying the bank-lending channel might reasonably extend to all private providers of credit."

In the case of both the Credit system and monetary policy, developments since the 1960s and 1970s have been nothing short of momentous and historic. Today, asset-based lending (as opposed to financing business investment) and sophisticated (market-based) financial intermediation completely dominate the Credit creation process. Myriad intermediaries issue basically unlimited quantities of myriad Credit instruments - in the unbridled extension of new Credit. Bank deposits are today but a sideshow. As for policy, the Federal Reserve has gone to a system of openly transparent fixed short-term interest rates. Credit growth and asset prices are largely disregarded, while a narrow inflationary focus on an index of "core" consumer prices holds sway over policy. The interplay of these two dynamics – marketable securities-based Credit and highly accommodating monetary policy - has created powerful inflationary dynamics that policymakers are ill-equipped to manage. Conventional doctrine is completely oblivious to prevailing inflation.

In reference to today’s financial intermediation, Dr. Bernanke stated that "“nondeposit sources of funding are likely to be relatively more expensive than deposits, reflecting the credit risks associated with uninsured lending. Moreover, the cost and availability of nondeposit funds for any given bank will depend on the perceived creditworthiness of the institution.”

Well, this seemingly innocuous comment approaches the heart of today’s flawed central banking. First of all, it implies that the marketplace accurately assesses and prices risk, an assumption directly at odds with a backdrop of unfettered Credit, marketplace liquidity, and speculation. Importantly, over liquefied and high speculative environments inherently under-price and over-extend risk, and this dynamic tends to only escalate over time. Instead of blind faith in the marketplace’s faculty for accurately pricing and regulating risk, the focus should be on the major systemic risks associated with a Credit apparatus that will by its nature foster reinforcing Credit and speculative excess.

Secondly, today’s securities-based finance juggernaut has evolved into the prevailing source of system Credit and liquidity creation. As such, the creditworthiness of Bernanke’s “borrowing institution” is of minor importance in comparison to the market values (and liquidity) of the securities collateral supporting the borrowing. The booming “repo” market, for example, is dictated by the perceived safety and liquidity of the underlying securities – and not the credit standing of the borrower. And I will suggest that it is a dire predicament when “creditworthiness” for a large part of the Credit system is dependent upon Bubble-induced inflated securities and asset prices, incomes, cash flows and over-liquefied markets generally.

With respect to “financial accelerators” and “Credit channels,” there are some very serious shortcomings inherent in the current regulatory framework. I’ll note a few. First, today’s securities-based Credit knows no bounds (no reserve or capital requirements or natural constraints). Second, the Federal Reserve and global bankers “peg” short-term interest rates and forewarn on policy adjustments. Third, the incentives are simply too enticing for aggressive borrowing at the lower pegged rates (wherever they may be found) to speculate in higher yielding securities and instruments. For one thing, this creates a remarkably powerful inflationary bias in the securities markets overall. And, fourth, the prevailing central banking doctrine disregards asset prices and speculative leveraging.

Dr. Bernanke concludes:

"The critical idea is that the cost of funds to borrowers depends inversely on their creditworthiness, as measured by indicators such as net worth and liquidity. Endogenous changes in creditworthiness may increase the persistence and amplitude of business cycles (the financial accelerator) and strengthen the influence of monetary policy (the credit channel). As I have noted today, what has been called the bank-lending channel--the idea that banks play a special role in the transmission of monetary policy--can be integrated into this same broad logical framework, if we focus on the link between the bank's financial condition and its cost of capital. Nonbank lenders may well be subject to the same forces.”

I’ll conclude by proffering that securitization and asset-based finance have been a radical departure from the traditional Credit mechanism. The proliferation of agency and asset-backed securities, leveraged speculation, derivatives, CDOs and “structured finance” in general has acted as one momentous “financial accelerator.” Developments in monetary policy have aided and abetted the rise of “Wall Street finance” and the empowerment of Credit Bubble dynamics. Monetary “management” has been reduced to telegraphed “baby-step” adjustments to the interest rate “peg.” The Fed allowed itself to become hamstrung by Bubble Fragility and the inoperability of imposing actual system monetary tightening. And when it comes to a working framework for “financial accelerators” and Credit Channels, I suggest that Dr. Bernanke scrap his previous research and have his staff begin anew.

The bottom line is that the Fed is content to let Bubbles run their course, while being ready to implement aggressive “mopping up” strategies. But the potent inherent “financial accelerator” attributes of contemporary asset-based “speculative” finance beckon for a radically different policy approach For the Twenty-First Century.