In the fall of 2008, when the government took extreme steps to avoid a financial collapse, it created, what might be described as a partial liquidity trap. At the time, this was not a problem. The policymakers were not trying to assist the economy. They were attempting to restore confidence in the banking system. This was achieved by creating a massive pool of funds that served as assurance that the debts of the banking system would be covered. When depositors and lenders understood that this money was available, the runs on the banking system stopped. The program succeeded.
The Federal Reserve is now embarking on a new program to increase financial resources. This time the goal is not to assure the safety of the banking system. This time the Federal Reserve has clear economic goals. It wants to stimulate economic growth, increase employment, and maintain inflation at an undefined rate. Therefore, if a new liquidity trap develops the Fed’s actions will have failed.
So begins the latest missive from Rochdale Securities Dick Bove, "Without Bank Support QE2 is Liquidity Trap". What caught my eye here was Bove’s eye for detail on the objective of QE1 versus QE2. The first QE was couched as a ‘liquidity’ problem. Remember all the talk about markets seizing up and so on? Now the Fed’s money printing is couched as – how did Bernanke put it – "supporting the recovery and sustaining price stability." See the difference?
Now, the right thing for the Fed to have done in 2008 and 2009 was to take on its role as lender of last resort in providing liquidity when markets seize up at a penalty rate. But that’s it. All of the other stuff – including permanent zero (PZ) Fed Funds rates – is where the problem was. The key here is the penalty because it helps one to discern liquidity problems from solvency problems.
But now in 2010, QE and PZ equals queasy. It is not geared to the central bank’s narrow function. Rather it represents an expansion of the Fed’s role into the quasi-fiscal.
For Bove, this isn’t his concern because he is a bank analyst. And when he sees PZ and QE, he’s not queasy in the least. He continues:
If this problem is to be avoided, the banks must distribute the funds being deposited in the banks, domestically. They will not be able to do this if the banking regulators tighten capital rules. This is because any new funds the banks receive as a consequence of QE2 will be redeposited in the Federal Reserve creating a new massive pool of funds that will neither lower interest rates nor create economic growth.
Assuming the Federal Reserve policymakers understand this, the outlook for banks has improved meaningfully. There is hope that the regulators will ease banking restrictions. One clear sign that this may happen is the growing likelihood that banks will be allowed to increase their dividends as soon as the first quarter of 2011. Bank stocks are very appealing at this juncture because if bank strictures are eased, bank earnings will soar.
Now, I am not convinced bank earnings will soar regardless of capital rules since the demand for additional credit is weak. Bove’s analysis is a supply-side analysis which is in direct contradiction to how the market for credit actually works i.e. demand for loans create reserves as at the micro level, bank credit is dispensed independent of reserves. See Marshall’s latest piece for a discussion of this.
But Bove makes for interesting reading. In typical, bank-bullish fashion, he says:
There are two obvious questions that arise at this point:
- Will the regulators understand that they need a growing banking system if they want a growing economy and back away from bank bashing?
- If the regulators give the banks some ability to expand; can they generate a higher level of earnings?
I think that the answers are Yes and Yes.
Here’s the macro part from Bove’s piece that Tracy Alloway picked up on. He rejects Bernanke’s explanations for why he is doing QE and comes to an alternate conclusion.
There may be another explanation as to why the Federal Reserve has embarked on its new policy. My view is that the United States is in a financial war with China. This war is being fought in two arenas. They are the budget deficit and the trade deficit. The United States is losing both wars and, therefore, may be taking some relatively dramatic action to adjust the battlefield…
All efforts by the United States to have free market forces set the value of currencies have failed. China, in specific, has rejected all initiatives by this country to let the Renminbi float. The Chinese argument is that letting the Renminbi float would create significant problems in that country. Implicit in this argument is that it is better for the Chinese to have the United States suffer due to an overvalued Chinese currency than have the Chinese suffer by fairly valuing this currency.
The Federal Reserve’s new policy goes directly to this dilemma. By issuing new currency to buy Treasuries, the Fed is reducing the value of the dollar. The impact of this is similar to getting an increase in the value of the Renminbi. It changes price levels in both countries impacting the trade deficit.
As mentioned above, by attempting to weaken the dollar against the Renminbi, pressure is placed on China to buy dollars to offset the Fed’s moves. This can be accomplished if the Chinese buy Treasuries, which obviously creates a dilemma for the Chinese.
Bove finishes his thinking here by saying:
The conclusions to this point are as follows:
- While the growth of the economy is slow, it is faster than the annual growth of the economy over the past decade.
- Inflation is not declining at an ominous rate and it has yet to be explained why this would be bad if it did happen.
- Job loss is a severe problem but there is no proof that monetary policy creates new jobs.
- By purchasing Treasuries, the Federal Reserve aids the United States in paying for its deficit.
- By debasing the dollar, the United States begins to deal with its trade deficit problem.
The real thrust behind QE2 may be the latter and not the former issues.
There you go. Do you buy it? I don’t.