Lehman, PSI and the consequences of credit policy: The third lever of macroeconomics
May 2nd 2013, 19:20 by G.I. | WASHINGTON, D.C.
By credit policy (or banking policy or financial policy) I mean anything that affects how the financial system influences aggregate demand. Of course, we’ve always known aggregate demand depends on both the central bank’s policy rate and the spread over that rate paid by households and firms. But before the cirisis the relationship between the policy rate and what borrowers paid was assumed to be either constant, or endogenous to monetary policy or the business cycle.
That this is not always true is the greatest lesson macroeconomists have learned from the crisis. The role of credit policy is critical to understanding the current state of Europe’s economy. My colleague’s Free Exchange column in this week’s issue and accompanyingleader explore why businesses in Spain and Italy pay so much more to borrow than businesses in Germany even though they share a common currency and monetary policy. The column notes how Mark Gertler and Ben Bernanke identified the “bank lending channel” as a critical variable in the transmission of monetary policy. Put simply, low interest rates won’t boost demand if the financial system is unable or unwilling to pass those low rates on to customers.
Why is Europe now in recession? Some, like my colleague R.A., blame excessively tight monetary policy by the ECB. Some, like Paul Krugman, blame excessively tight fiscal policy; Mr Krugman regularly lambastes former ECB president Jean-Claude Trichet for praising the confidence-restoring effects of austerity, with a chart of euro-area unemployment chart that looks like the one I’ve posted here.
Both, of course, might be at work. But credit policy may be more important than either. The credit crunch now suffocating peripheral Europe is not just the endogenous consequence of weak growth or the Greek crisis; it is also rooted in deliberate policy choices. In October of 2010, Nicholas Sarkozy and Angela Merkel had their famous walk on the beach in Deauville, France and decided that Greece, and sovereign debt more generally, would no longer be sacrosanct: investors in such debt could be subject to default. In July, 2011, such “private sector involvement” (PSI) became official euro zone policy: holders of sovereign debt would have to accept haircuts as a condition of future bailouts. At the same time, the European Banking Authority began its “capital exercise”: European banks would undergo a second round of stress tests, and those found wanting would have to boost capital ratios. But since weak banks couldn’t turn to weak sovereigns or some pan-European fund for new capital, they would have to reduce loans instead.
Mario Draghi, the ECB’s president, later called the PSI decisions Europe’s Lehman. When America let Lehman Brothers fail in September, 2008, it shattered an assumption that had, little noticed, long underpinned America’s capital markets: that a large, systemically important intermediary would not be allowed to fail. That assumption should not have been allowed to take hold in the first place, but once it did, its sudden nullification triggered panic and a credit crunch out of proportion to the actual extent of impaired loans. In Europe, regulators had long assigned a zero risk weight to sovereign debt, which, as a result, comprised a major part of banks’ capital, and collateral for funding. Moreover, European banks depended either implicitly or explicitly on the presence of a solvent sovereign to bail them out. Declaring that sovereigns would be allowed to fail meant declaring their banks would be allowed to fail, too. As with Lehman, one can argue that Europe’s sovereigns and banks should never have been perceived as risk free. But by removing that perception, the decisions in October of 2010 and July, 2011 caused sovereign spreads to blow out, deposits to flee peripheral banks, and, coupled with the capital exercise, a devastating credit crunch and recession. In 2011, before the worst of these impacts were felt, the ECB reckoned tightened credit conditions stripped two percentage points off the region’s growth. The effect must undoubtedly have grown since, and probably exceeds that of austerity.
Mr Trichet may have been wrong to praise austerity but he was almost certainly right to warn that changing the status of sovereign debt was potentially catastrophic. Indeed, the ECB wanted austerity less for its alleged confidence-inducing effects than as a quid pro quo for backstopping sovereign debt and thereby maintaining its risk-free status. Political leaders spoiled that effort; they later, reluctantly, backed away from PSI but raised the specter again by bailing in Cyprus’ depositors. The ECB has nonetheless done what it can; its announcement last fall of unlimited support for the sovereign debt of countries that accept budget oversight has brought spreads back down. Today Mr Draghi said the ECB is consulting with other European institutions on using asset-backed securities to kick start lending to small and medium sized enterprises. One way might be for the European Investment Bank to borrow from the ECB to buy such securities.
Events of the last few years should leave no doubt about the influence of credit policy on growth. But how should that contribution be modeled? While the policy rate and the size of the monetary base, the traditional metrics of monetary policy, are easily measured, credit policy is more diverse and often not even seen as policy (as the Lehman and PSI decisions attest). Examples of credit policy tightening in recent years include the new Basel 3 capital and liquidity rules and in America, Fannie Mae and Freddie Mac clawing back losses on mortgages originated during the boom; stringent new underwriting standards; the Dodd-Frank prohibition on bailouts; and various other state and federal level rules governing the supply of credit. In other countries, authorities have imposed higher down payment requirements on houses, and introduced capital controls to slow the inflow of foreign capital. Examples of eased credit policy include Britain’s Funding for Lending and America’s various foreclosure mitigation schemes. Some of these policies manifest themselves in the credit spread; some are harder to detect, showing up in the supply of, or demand for, credit.
In principle, though, all credit developments can be incorporated into a model of the macroeconomy. David Romer offers a good place to start. On page 128 of this article, Chapter 5 “Credit Market Disruptions” he equates the presence of credit disruptions to an interest rate spread that raises or lowers aggregate demand at a every given level of the policy rate.
Separately, Brad DeLong in his essay, “Understanding our adversaries,” quotes Olivier Blanchard:
When teaching the IS-LM, we have the same interest rate on the IS and the same interest rate on the LM. Basically, the policy rate that the central bank chooses by the LM curve goes into the IS curve when corrected for expected inflation. I think what we have learned is that these [two interest rates] can be incredibly different. So I would have an r and an rb, and have a machine in the middle–the banking system which would, depending on its health, determine the spread.
Mr DeLong takes a stab at just that:
Start with a simple quantity theory of money. There is this particular class of assets out there that are called “money”. Money demand is a function of the price level P times the level of real spending Y divided by the velocity of money V, and the velocity of money depends positively on the short-term safe nominal interest rate i:
M = PY/V(i)
By itself the quantity theory of money is a two-commodity model: money, and spending on currently-produced goods and services. But what is this price i? Where does it come from? It is the opportunity cost of holding spendable money in your portfolio rather than bonds–short-term safe nominal bonds. So we need to add a bond market: the flow of money into the bond market from savers S(Y) has to equal net bond issues from the government G-T plus private bond savings vehicles backed by real investment I(r), where r is the long-term risky real interest rate:
S(Y) = (G-T) + I(r)
And the gap between the long-term risky real rate r and the short-term nominal rate i is (a) inflation π, (b) expected changes in the short-term safe nominal rate EΔi, and (c) the quotient of the riskiness of the economy ρ and the risk tolerance τ: ρ/τ
r = i + EΔi + ρ/τ – π
Let me translate:
The spread between the central bank’s policy rate and what households and firms actually pay rises when the expected path of that policy rate, and the overall riskiness of the economy, go up or when inflation, or people’s appetite for risk, go down.
What I would like to see is a more explicit reference to the role of policy in determining that spread. There isn’t much we can do about the impact of terrorist attacks, earthquakes and even asset price busts on risk appetites. But we can do something about policy. Or at least, we should try.
The original article is linked here.