Sunday, March 23, 2008


Bear with me, while I try and make some sense of this. Just because it happens to be bothering me. You can skip it if you like, without missing any particular Iraq news.

With yields on short-term US Treasury bills approaching zero, Paul Krugman (and the less-comprehensible Brad DeLong) have started talking about a dead-end for orthodox monetary policy.

(The Federal Reserve buys and sells Treasury bills to and from commercial banks as its way of manipulating the rates banks charge each other for unsecured loans, mostly overnight. This is supposed to in turn influence the economy via the banks' setting of their lending rates and lending volumes. Since the "main tool" can't be brought any lower than zero, the effectiveness of that "tool" as a way of lowering the interest-rate structure and stimulating the economy, is at a dead-end. That's their argument).

And what happens then, they ask in mock-perplexity, failing to point out something very important, which they themselves know: Namely that there was something of a dress-rehearsal for this in Japan starting in 1998 when Japanese short-term rates dropped to close to zero. (At about the same time, in Japan, the consumer price index also turned negative, but the policy-interest-rate "conundrum" was the same). Moreover, at that time there was considerable pressure from the US (and Krugman himself weighed in in support of that pressure) for the Bank of Japan to adopt "unorthodox" monetary policies, partly, the Japanese financial press thought, by way of using Japan as a guinea pig for what might some day happen in the US.

This pressure was ultimately successful, and Bank of Japan policies between 1998 and 2006 included a range of "unorthodox" approaches, including: Acquisition from financial institutions of a gradually-expanding range of assets that ultimately included: Commercial Paper; long-term Japanese Government Bonds; and even, for a brief period of time, stocks. The policy-target was explicitly shifted from targeting short-term interest rates, to targeting the size of cash reserves held by the commercial banks at the Central Bank (so-called "quantitative easing"). Since the bank-reserves at the Central Bank are non-interest-bearing, obviously the Bank of Japan needed to make it attractive for banks to swap interest-bearing assets for more reserves than they legally were required to hold, and this it did via a range of obscure tactics, including making sure the banks made spread-profits on buying stuff and reselling it to the Central Bank. The arcane aspects of this were mainly kept out of sight (partly because a lot of it made banking look a lot like shooting fish in a barrel), and the focus was instead on the headline figure, namely the level of reserves held by the commercial banks at the Central Bank. But even after the process had been going on for some time, a debate continued: This was keeping the banks afloat, but exactly what the heck was this supposed to accomplish in terms of stimulating the real economy?

The first answer was that this was supposed to make the banks more confident about lending to real-world customers, thereby helping lift the economy out of stagnation. But it soon became clear this wasn't happening. Banks were non-lenders for a variety of reasons, the main one being that they weren't really risk-assessment people at all, having only ever lent on the security of real estate, so once real estate values started to sag, they stopped lending period). In the absence of a bank-lending recovery, the policy-justification shifted to the Central Bank's "management of expectations", in the sense of negating people's expectation that a tightening would be just around the corner should the economy show the first signs of recovery. (Because these reserves would take a long time to draw down smoothly, and until they were drawn down, there couldn't be any interest-rate tightening).

But this was mostly talk. The real nub of quantitative easing was that it allowed the Central Bank to artificially prop up their decrepit colleagues in the commercial banking system, under the pretext of coaxing public opinion out of its deflationary mind-set. Deflation-fighting became the fig-leaf for a system-wide bank-bailout, where, as it was pointed out at the time including in the financial press, a much simpler solution would have been the more "structural" approach of sending one or two bank CEOs to the slammer. (Krugman, for one, argued that the problem was not "structural," but rather, amenable to this kind of unorthodox monetary policy).

So when Krugman now starts writing about the dead-end of traditional monetary-policy effectiveness in the US, one would naturally expect that the discussion will soon turn to the question of "unorthodox" monetary-policy measures. Of course the difference here is that (1) the CPI in the US isn't yet negative; and (2) the Central Bank has already started buying strange assets from financial institutions, so in Japanese terms they have decided not to bother waiting for the deflation-fighting excuse, and just go ahead and support the system anyway, without the deflation-fighting fig-leaf.

So what's the problem? Why not just follow through with the Japanese example (which itself followed in basic outline the recommendations of Krugman and others anyway)?

The problem right now is that for big and complicated policy shifts like this, you need a big and un-complicated propaganda pitch to support it. Without that, it would be like trying to invade Iraq without the "WMD" argument, or like continuing the occupation without the "War on Terror" of the "risk of civil war" arguments. You need those kinds of arguments to sell people on major policy moves.

That's the problem here. They've got the program without any special propaganda to go with it. What to do?

In the Japanese case, the pitch was that "deflation is unprecedented, so there is a need for drastic policy-responses even if they are unprecedented and untested". What will be the PR pitch for this in the US, in the current case?

So far, in the current US case, it appears the pitch is going to be merely to ratchet up the sense of public anxiety: These financial losses are really, really, really unprecedented, so there is a need for a policy response that is really, really, really unprecedented. That way people will just say: Thank goodness they are doing something about this; look how worse-than-1929 horrible it would be if they did nothing.

You will see the opening rhetorical fanfare for this in the New York Times piece today bearing the hysterical title "What Created this Monster?" There is a reference to "complex instruments that lurk in the financial shadows"; "a potential epidemic"; "Wall Street's version of nitroglycerin"; and so on. You get the idea. And yet for all this lurking epidemic in the shadows, there isn't any attempt to explain any of it, almost as if touching it might cause something to detonate. And yes, in another NYT story today there is a reference to 9/11 and the idea that extraordinary times demand extraordinary measures.

We are back with the "known unknowns" and the "unknown unknowns" (Rumsfeld), where the past incompetence of the authorities serves to bolster an atmosphere of panic that can be used to dis-enable public scrutiny and the taking of responsibility, and let these same authorities adopt even more drastic and unexamined policies. In contrast to the sophistication of the Japanese case, where deflation-fighting served as a pretext for the systematic bailout of the banking system, in the current US case, all they have for advertising and promotion is fear, and plenty of it.

This is like the post-9/11 War on Terror in another way too. Because if you dig down another layer in the propaganda, you will see that there must be some kind of underlying popular support for the bizarre assertions about Saddam=AlQaeda, Palestinians=terrorists, and so on, in the sense that this reflects a blanket lack of confidence in the people of that region, which you could probably call anti-Arab racism. The current financial crisis is calling up an equally ugly feature of our system, and it is the mirror opposite: The reason Americans will presumably let the same people who trashed the financial system work on fixing it, is that there is supposedly a blanket sense of confidence in them. The idea that the financial system works on finely differentiated levels of confidence or lack of confidence only goes so far. At some level, the elite sticks together in a very undifferentiated way, and hopes that in the Japanese way everyone will stick with them.

So here's the problem. In order to gain public acquiescence for a Japanese-type sustained bank-bailout, the powers that be are going to have to talk up the whole deflation/catastrophe theme. Japan was already in a deflationary condition when the policy-shift occurred, so harping on that issue wasn't damaging in itself. But US isn't currently in a deflationary condition, so by talking this up, they are helping bring it about. But that's what the "logic" of the situation calls for: fear and lots of it. Otherwise people might not agree to the kind of knee-jerk bailouts the elite is looking for. And there is the recent experience of fear-promotion to support extraordinary measures after 9/11. In other words, this is coming to be seen as the way you do things in public policy. The 9/11 policy fallout was damaging in a lot of ways, some of which were indirect and which some people didn't understand until it was too late. Adopting this same basic approach to the financial crisis could end up being much more directly destructive, and not just for other people this time.

During much of the period referred to above, I published a daily summary/commentary based on the Japanese financial press for the Wall Street crowd, so these things have been on my mind.


Anonymous Anonymous said...

Right. Deflation is nowhere in sight. Nor is it likely to appear. According to Mankiw:

...most economists believe that the mistakes that led to the Great Depression are unlikely to be repeated. The Fed seems unlikely to allow the money supply to fall by one-fourth. Many economists believe that the deflation of the early 1930s was responsible for the depth and length of the Depression. And it seems likely that such a prolonged deflation was possible only in the presence of a falling money supply.

8:46 PM  
Anonymous Anonymous said...

Sorry, forgot to mention that the above was taken from

8:48 PM  
Anonymous b. said...

One should also keep in mind that the "deflation scare" was already successfully used in 2002/2003 and was Greenspan's excuse to go to 1% interest rate in the first place.

2:14 AM  
Blogger badger said...

its all this American stuff I can't get my head around. What a culture! Who can understand it?? Stock is $30 last week, then $2, now its $10... One day they're all waving the flag together, next day they're at each others throats. Who are these people? What makes them tick...I don't get it

1:30 PM  

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