Will Keynesianism work?
Friday, 24 October 2008
Zahid Hussain
It did not take too long for Keynesianism to stage a come-back with the rapid worsening of the ongoing global financial crisis. While we are yet to see a truly Keynesian fiscal policy response (more public works and tax cuts), the monetary policy response in the US, Europe and the emerging markets have followed the true Keynesian dictats.
Policymakers have announced significant rate cuts to lower bank's cost of funds so that they can lend cheaper to others and still maintain a decent profit margin. Policymakers are also injecting liquidity into the banking system hoping that if banks have lots of cash to lend, they will compete for business by lowering the interest rates they charge borrowers.
The question is: Will it work under the present circumstances?
Take the case of rate cut in the U.S. The rate that was cut is known as the Fed Funds rate. This is the interest rate that banks charge one another for overnight loans. It is like our call money rate. Under normal circumstances, the Fed Funds rate is the central bank's primary and most effective tool in influencing interest rates. Unfortunately, the current market situation is anything but normal.
The Fed Funds rate is not an absolute number that anyone actually has to follow. It is a target. The central bank's policymaking arm, the Federal Open Market Committee (FOMC), attempts to influence interest rates throughout the financial system and the economy by targeting the Fed Funds rate.
If the Fed lowers the Fed Funds rate, theoretically the cost of money at which banks lend to one another is lower, too. In theory, then, if all banks have met their reserve requirements, and if they all have cash to lend to each other overnight, and because cash not lent out earns no interest, banks will lower interest rates for borrowers so that their excess reserves are put to use and earn interest.
However, in order for the Fed to actually influence the Fed Funds rate, it has to buy and sell securities by executing open market operations and thereby add cash into the banking system. Normally, the Fed buys Treasuries from dealers and pays cash. The transaction is called a repurchase agreement, or "repo." The Treasury securities the central bank buys becomes part of its balance sheet. When done to the tune of billions of dollars, the result of this transaction is that dealers acquire billions in cash that they deposit into banks. This enables banks to lend more to one another overnight by lowering the overnight rate they charge each other.
The problem currently is that the dealers and banks are likely to be averse to sell any Treasuries. Treasuries are the only security on their balance sheets whose actual worth they know. If the Fed wants to lower the Fed Funds rate, and dealers and banks are not going to sell it any Treasuries, the central bank will have to take in other securities (toxic assets) as collateral against the cash that it wants to inject into the banking system through its repurchase agreements. Just how depleted and how damaged the Fed's balance sheet may become is a major concern. Even that is not the immediate problem.
Flooding banks with cash doesn't mean that banks will increase their lending to each other at the targeted Fed Funds rate, or for that matter at any rate. Banks are all distrustful of each other. The confidence deficit has not yet disappeared. They are hoarding cash as a cushion against their own upcoming losses. They are facing increasing weakness in their inventories of commercial-loan and commercial mortgage-based securities. Banks are also increasingly facing heightened exposure to leveraged loan portfolios on their books that they are unable to off-load. As if these were not enough, they have to contend with a deteriorating credit-card-based securities and portfolios.
If the Federal Reserve is unable to facilitate overnight-bank lending, and is unable to actually lower the Fed Funds rate to its target rate of 1.5 per cent, its credibility will take a hit. It is bad enough that the public have no trust in the banks and banks have no trust on banks. If the public also lose trust in the central-bank's firefighting ability to stem the financial meltdown, what is to come may make the skies in the last three weeks seem only partially cloudy.
Overall the macro policy makers in the developed and emerging economies have done a good job in addressing, publicly, what needs to be done. There had to be some immediate action taken to quell the crisis, a lesson the world has learnt from the policy passivity at the onset of the great depression. The central banks are trying. However, their efforts may just not be enough. While there is absolutely no room for being ideological under a crisis situation, it is important to bear in mind that there may not be any quick fix either. Coordinated policy response is the buzzword now. That is where the hope is. I remain convinced that the great depression would not have been as deep and as long as it actually was had countries not responded each with their own policies attempting to protect demand in their own markets at the expense of others. The result was a race to the bottom. (The author is Senior Economist at the World Bank Dhaka office. The views expressed are the author's own, not that of the World Bank)
It did not take too long for Keynesianism to stage a come-back with the rapid worsening of the ongoing global financial crisis. While we are yet to see a truly Keynesian fiscal policy response (more public works and tax cuts), the monetary policy response in the US, Europe and the emerging markets have followed the true Keynesian dictats.
Policymakers have announced significant rate cuts to lower bank's cost of funds so that they can lend cheaper to others and still maintain a decent profit margin. Policymakers are also injecting liquidity into the banking system hoping that if banks have lots of cash to lend, they will compete for business by lowering the interest rates they charge borrowers.
The question is: Will it work under the present circumstances?
Take the case of rate cut in the U.S. The rate that was cut is known as the Fed Funds rate. This is the interest rate that banks charge one another for overnight loans. It is like our call money rate. Under normal circumstances, the Fed Funds rate is the central bank's primary and most effective tool in influencing interest rates. Unfortunately, the current market situation is anything but normal.
The Fed Funds rate is not an absolute number that anyone actually has to follow. It is a target. The central bank's policymaking arm, the Federal Open Market Committee (FOMC), attempts to influence interest rates throughout the financial system and the economy by targeting the Fed Funds rate.
If the Fed lowers the Fed Funds rate, theoretically the cost of money at which banks lend to one another is lower, too. In theory, then, if all banks have met their reserve requirements, and if they all have cash to lend to each other overnight, and because cash not lent out earns no interest, banks will lower interest rates for borrowers so that their excess reserves are put to use and earn interest.
However, in order for the Fed to actually influence the Fed Funds rate, it has to buy and sell securities by executing open market operations and thereby add cash into the banking system. Normally, the Fed buys Treasuries from dealers and pays cash. The transaction is called a repurchase agreement, or "repo." The Treasury securities the central bank buys becomes part of its balance sheet. When done to the tune of billions of dollars, the result of this transaction is that dealers acquire billions in cash that they deposit into banks. This enables banks to lend more to one another overnight by lowering the overnight rate they charge each other.
The problem currently is that the dealers and banks are likely to be averse to sell any Treasuries. Treasuries are the only security on their balance sheets whose actual worth they know. If the Fed wants to lower the Fed Funds rate, and dealers and banks are not going to sell it any Treasuries, the central bank will have to take in other securities (toxic assets) as collateral against the cash that it wants to inject into the banking system through its repurchase agreements. Just how depleted and how damaged the Fed's balance sheet may become is a major concern. Even that is not the immediate problem.
Flooding banks with cash doesn't mean that banks will increase their lending to each other at the targeted Fed Funds rate, or for that matter at any rate. Banks are all distrustful of each other. The confidence deficit has not yet disappeared. They are hoarding cash as a cushion against their own upcoming losses. They are facing increasing weakness in their inventories of commercial-loan and commercial mortgage-based securities. Banks are also increasingly facing heightened exposure to leveraged loan portfolios on their books that they are unable to off-load. As if these were not enough, they have to contend with a deteriorating credit-card-based securities and portfolios.
If the Federal Reserve is unable to facilitate overnight-bank lending, and is unable to actually lower the Fed Funds rate to its target rate of 1.5 per cent, its credibility will take a hit. It is bad enough that the public have no trust in the banks and banks have no trust on banks. If the public also lose trust in the central-bank's firefighting ability to stem the financial meltdown, what is to come may make the skies in the last three weeks seem only partially cloudy.
Overall the macro policy makers in the developed and emerging economies have done a good job in addressing, publicly, what needs to be done. There had to be some immediate action taken to quell the crisis, a lesson the world has learnt from the policy passivity at the onset of the great depression. The central banks are trying. However, their efforts may just not be enough. While there is absolutely no room for being ideological under a crisis situation, it is important to bear in mind that there may not be any quick fix either. Coordinated policy response is the buzzword now. That is where the hope is. I remain convinced that the great depression would not have been as deep and as long as it actually was had countries not responded each with their own policies attempting to protect demand in their own markets at the expense of others. The result was a race to the bottom. (The author is Senior Economist at the World Bank Dhaka office. The views expressed are the author's own, not that of the World Bank)