the wrong debate.docx

7/25/2019 The Wrong Debate.docx

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The Wrong Debate: Helicopter Drops vs. Quantative Easing

A central theme of this blog is that the economy is still starved of the monetary

assets needed to restore full employment. That is, the ongoing shortfall ofaggregate demand is at its core caused by a shortage of !"E# and money$li%e

assets relative to the demand for them. The &uestion, then, is 'hat can be done

about this problem.

( have long argued, along 'ith other ar%et onetarists, that the )ed could solve

this problem by adopting a "*D+leveltarget. Why 'ould this help The %ey

reason is that it 'ould create an e-pectation that some portion of the

monetary A/E gro'th from the asset purchases 'ould be permanent 0and non$

sterili1ed by (!E23. That, in turn, 'ould mean a permanently higher price level

and nominal income in the future. /uch %no'ledge 'ould cause current investors

to rebalance their portfolios a'ay from highly li&uid, lo'$yielding assets to'ards

less li&uid, higher yielding assets. The portfolio rebalancing, in turn, 'ould raise

asset prices, lo'er ris% premiums, increase 4nancial intermediation, spur

more ("5E/TE"T spending, and ultimately cataly1e a robust recovery in

aggregate demand. 0!ne could also tell a "e' 6eynesian story 'here the higher

future price level implies a temporary bout of higher$than$normal in7ation that

'ould lo'er real interest rates do'n to their mar%et clearing level.3
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The %ey to the above story is that some portion of the monetary base e-pansion

is e-pected to be permanent. (f the public believes the )ed8s asset purchases are

not going to be permanent and therefore the price level and nominal income 'ill

not be permanently higher, the rebalancing 'ill not ta%e place. ( bring this up

because this same point applies to helicopter dropsor any other %ind of

4scal policy stimulus. #et many of my 4scalist friends miss it. They seem to thin%that helicopter drop 'ill solve the e-cess money demand problem, period. That is

not the case if the )ed continues to hit its in7ation target.

(magine, for e-ample, that 9ongress approved a ;helicopter money?3, one might print ne' base money to 4nance a

transfer to the public, and commit never to retire the ne'ly issued money.

/uppose that in either case, the path of government purchases is the same, andta-es are raised to the e-tent necessary to 4nance those purchases and

to/E25(9E the outstanding government debt, after transfers of the central

ban%?s seignorage income to the Treasury. Assuming the same si1e of permanent

increase in the monetary base, the perfect foresight e&uilibrium is the same in

both cases...

Ho'ever, he notes the t'o approaches 'ould have di=erent e=ects if the public

thought the permanency of the monetary A/E in@ections di=ered:

The e=ects could be di=erent if, in practice, the conse&uences for future policy

'ere not perceived the same 'ay by the public. nder &uantitative easing,people might not e-pect the increase in the monetary A/E to be permanent
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B after all, it 'as not in the case of Capan?s &uantitative easing policy in the period


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+osted by David ec%'orth at ;:LF A

What *eorge ailey 9an Teach s About QE

Quantitative easing 0QE3 is a lot li%e *eorge ailey in the classic )(K It's a

Wonderful Life. *eorge 'as a man 'ho began &uestioning his value to society. A

number of cascading events$$unful4lled life dreams, a run on his ban%, lost ban%

deposits, ban% fraud charges$$made it appear to hm that he 'as on balance a

drag on his community. *eorge decided it 'ould be better for all if he 8tapered8 orended his life. )ortunately, an angel appeared at the last minute and revealed

that despite his immediate problems, *eorge8s overall contributions to society

'ere immense. any lives 'ere/A5ED and changed because of his e=orts. All

that 'as needed to see this fact 'as a broader, longer perspective. *eorge

ailey, in other 'ords, 'as not doing the right counterfactual.

The same is true for s%eptics of QE. any point to the apparent 7a's of the )ed8s

large scale asset purchases 0K/A+s3, but fail to step bac% and consider the

counterfactual of 'hat 'ould have happened in their absence. This point isparticularly poignant to those observers 'ho claim the )ed8s K/A+s of treasuries

are particularly bad because they drain the 4nancial system of safe assets. These

critics note that these safe assets serve as collateral in the shado' ban%ing

system and thus facilitate transactions. Therefore, 'hen the )ed increases its

balance sheet it is actually restricting the funding capabilities of the shado'

ban%ing system and creating a drag on the economy. A gro'ing number of smart

people are ma%ing this point, including (1abella 6amins%i,Tyler 9o'en, +eter

/tella, Arvind 6rishnamurthy and Annette 5issing$Corgensen, and ichael

Woodford. ( contend that 'hile correct on the immediate e=ect of K/A+s, these

critics li%e *eorge ailey are doing the 'rong counterfactual. The right
http://www.blogger.com/profile/04577612979801459194http://macromarketmusings.blogspot.com/2013/12/the-wrong-debate-helicopter-drops-vs.htmlhttp://macromarketmusings.blogspot.com/2013/10/what-george-bailey-can-teach-us-about-qe.htmlhttp://en.wikipedia.org/wiki/It's_a_Wonderful_Lifehttp://en.wikipedia.org/wiki/It's_a_Wonderful_Lifehttp://macromarketmusings.blogspot.com/2013/10/what-george-bailey-can-teach-us-about-qe.htmlhttps://www.google.com/#q=kaminska+collateral+shortagehttp://marginalrevolution.com/marginalrevolution/2013/09/why-michael-woodford-supports-monetary-tapering-kaminska-wins.htmlhttp://www.voxeu.org/article/exit-path-implications-collateral-chainshttp://www.voxeu.org/article/exit-path-implications-collateral-chainshttp://www.kansascityfed.org/publicat/sympos/2013/2013Krishnamurthy.pdfhttp://www.bloomberg.com/news/2013-09-12/why-michael-woodford-thinks-the-fed-should-taper.htmlhttp://www.bloomberg.com/news/2013-09-12/why-michael-woodford-thinks-the-fed-should-taper.htmlhttp://www.blogger.com/profile/04577612979801459194http://macromarketmusings.blogspot.com/2013/12/the-wrong-debate-helicopter-drops-vs.htmlhttp://www.blogger.com/email-post.g?blogID=5713178645208582139&postID=5749651677308729329http://macromarketmusings.blogspot.com/2013/10/what-george-bailey-can-teach-us-about-qe.htmlhttp://en.wikipedia.org/wiki/It's_a_Wonderful_Lifehttp://en.wikipedia.org/wiki/It's_a_Wonderful_Lifehttp://macromarketmusings.blogspot.com/2013/10/what-george-bailey-can-teach-us-about-qe.htmlhttps://www.google.com/#q=kaminska+collateral+shortagehttp://marginalrevolution.com/marginalrevolution/2013/09/why-michael-woodford-supports-monetary-tapering-kaminska-wins.htmlhttp://www.voxeu.org/article/exit-path-implications-collateral-chainshttp://www.voxeu.org/article/exit-path-implications-collateral-chainshttp://www.kansascityfed.org/publicat/sympos/2013/2013Krishnamurthy.pdfhttp://www.bloomberg.com/news/2013-09-12/why-michael-woodford-thinks-the-fed-should-taper.htmlhttp://www.bloomberg.com/news/2013-09-12/why-michael-woodford-thinks-the-fed-should-taper.html


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counterfactual is 'hat 'ould have happened had there been no QE and QEF at

all.

efore delving deeper into this counterfactual, ( 'ant to mention t'o other points

about this criti&ue. )irst, most of the safe asset shortage 'as created by factors

other than the )ed8s K/A+s. !n the supply side, there 'as the destruction and

subse&uent anemic recovery of private$label safe assets as seen in this 4gure. !n

the demand side, the 4nancial crisis and then a spate of subse&uent bad

economic ne's$$Euro1one crisis, 9hina slo'do'n concerns, debt limit tal%s, 4scal

cli= tal%s$$has %ept the demand for safe asset elevated. Also, ne' regulatory

re&uirementsre&uiring ban%s to hold more safe assets is %eeping safe asset

demand elevated.

9onse&uently, forces other than QE and QEF have been driving much of the safe

asset shortage. This can be seen in the 4gure belo' 'hich sho's the treasury

general collateral repo rate and the )ed8s share of mar%etable treasury securities.

"ote that the largest drop in the repo rate 0re7ecting the reduced supply and

increased demand for treasuries collateral3 occurred bet'een late


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for and supply of 4nancial intermediation. )or e-ample, AAA$rated corporations

may issue more bonds to build up productive capacity in e-pectation of higher

future sales gro'th. )inancial 4rms, li%e'ise, may /TA2T providing more loans

as the improved economic outloo% ma%es households and 4rms appear as better

credit ris%s.

There is some evidencethis is happening 'ith QE and QEF. Even if these private

safe assets are not used as collateral in the repo mar%ets they 'ill be used

else'here to satiate li&uidity demand. That, in turn, should )2EE up more

treasuries for use in the repo mar%et. oth of these points are often overloo%ed

by QE critics.

"o' bac% to the counterfactual point. Are QE critics really ma%ing the same

mista%e as *eorge ailey To ans'er that &uestion, let8s thin% through the

counterfactual of no QE and QEF. )irst, assume the )ed8s share of mar%etabletreasuries 'as constant over this period. Also, assume that the shoc%s from the

Euro1one crisis, 9hina slo'do'n, debt limit and 4scal cli= tal%s still bu=eted the

./. economy during this time. What 'ould have happened to the ./. economy

9ould the ./. economy have been as resilient to these shoc%s had the )ed not

been supporting it (f not, then imagine the mess in the 4nancial system and

'hat that 'ould have done to the demand for safe assets. 2epo mar%ets, for

e-ample, 'ould probably be facing an even larger collateral shortage. A

reasonable counterfactual, then, is that the safe asset problem 'ould be greater

'ere it not for the )ed8s QE programs.

( too% this idea to the data. ( estimated a vector autoregression 05A23 over the


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The ne-t 4gure sho's 'hat happens to the /T!96 A26ET . (t declines over

much of the period.

The follo'ing 4gure reports the counterfactual path for employment. Again, not a

pretty picture.
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This ne-t 4gure sho's that core +9E in7ation stays around ;N and never

recovers. /o QE is in7ationary, at least relative to 'here in7ation 'ould be in its

absence.

)inally, this 4gure sho's that the repo rates 'ould have gone negative. "o' this

'ould not happen in practice because of the JK. ut the 5A2 does not %no' theJK and simply forecasts based on estimated relationships. The fact, though, that

it goes signi4cantly negative is instructive. (t indicates the repo mar%ets 'ould

have faced even greater collateral shortages had the )ed not done QE and QEF.


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"o' 'e do not 'ant to read too much into these results. They come from a

forecasting model that is far from perfect. /till, they indicate that a proper

counterfactual of the QE programs re&uires more than @ust narro'ly loo%ing at

the immediate impact of K/A+s on the collateral asset supply. We do not 'ant to

be li%e *eorge ailey and do the 'rong counterfactual. "either should the )ed.

!ther'ise, it too may be tempted to pull the trigger and taper too soon.

y assessment is that QE and QEF has done more to shore up the ./. economy

than many observers reali1e. We do not %no' ho' much 'orse the economy

'ould be in their absence, but the analysis above suggests it could have beenugly. With that said, the QE programs have been 7a'ed because of their ad$hoc,

ma%e$it$up$as$'e$go$along approach that until recently 'as not tied to any

e-plicit target. Tying the K/A+ more 4rmly to conditional outcomes 'ould do

much to improve them. The more rule$li%e and predictable the better. ( thin%

*eorge ailey 'ould agree.

Update:ichael Darda provides some follo'$up comments here.

;The 5A2 'as estimated 'ith the )ed share of mar%et treasuries, the log of

/+L


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contend that K/A+s are more li%ely to be de7ationary than in7ationary. A

recent pieceby Andy 6essler in the W/C typi4es this vie':

/o 'hat8s the problem Well, it turns out, there8s a huge collateral shortage.

*lobal ban%$reserve re&uirements have changed, meaning more safe, highly

li&uid securities li%e Treasurys are demanded instead of, say, *ree% or 9ypriotdebt. And lately, Treasurys have been getting harder to 4nd. Why ecause of the

very &uantitative easing that 'as supposedly stimulating the economy. The ;.

trillion of Treasury bonds sitting out of reach on the boo%s of the )ed is starving

the repo mar%et of safe collateral. With rehypothecation multipliers, this means

that the economy may be shy some L trillion in credit...

OTPthe )ederal 2eserve8s policyto stimulate lending and the economy by buying

Treasurys, and to %eep stimulating until in7ation reaches N or unemployment is

lo'er than .LNis creating a shortage of safe collateral, the very thing needed

to create credit in the shado' ban%ing system for the private economy. The

&uantitative easing policy appears self$defeating, perversely %eeping economic

gro'th slo'er and @obs scarce.

/o is the )ed really Rs&uee1ingR the shado' ban%ing system as 6essler claims

Are the K/A+s actually stalling the recovery rather than supporting it (n a

'ord, no,as this vie' misses the forest for the trees at t'o levels. )irst, by

focusing on the )ed8s K/A+s of safe assets, this understanding overloo%s the more

important contributors to the safe asset shortage. /econd, this vie' ta%es a static

vie'. (t doesn8t consider the dynamic e=ect of K/A+s on the supply of private safe

assets. Ket8s consider each point in turn.

)irst, the main reasons for the safe asset shortage are 0;3 the destruction and

slo' recovery of private label safe assets since the crisis and 03 the elevated

demand for safe assets that has arisen during this time. The importance of the

4rst develpment can be seen in the 4gure belo'. (t sho's the *orton et. al.

0


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This reduction in the supply of safe assets occurred, of course, @ust as the

demand for safe assets 'ere rising in


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provides an estimate of the broad money supply, including shado' ban%ing

money assets but e-cluding treasuries 0the RminusR part3. This measure, then, is

also capturing the supply of private safe assets. The 4gure indicates that under

both QE and QEF, the gro'th rate of private safe assets increased. nli%e QE;

'hich 'as designed to /A5E the 4nancial system, the latter t'o QE programs

'ere e-plicitly geared to'ard shoring up the economy. (n so doing, they alsoappear to have ramped up the production of private safe assets.

QEF is still ongoing and continues to support more private safe asset creation.The recent rise in treasury yields is another sign of this process as it indicates a

rebalancing of portfolios to'ard, among other things, private safe assets. "o'

there is a long 'ays to go before there 'ill be enough private safe assets to

restore full employment "*D+ gro'th. ut 'e are on the 'ay$$the only 'aysince

there is a limit to the amount of safe assets the government can provide 'ithout

@eopardi1ing its ris%$free status$$and this should not be ignored by critics li%e

6essler.

The appropriate criti&ue, then, of the )ed is not that it is s&uee1ing the shado'ban%ing system, but that it has failed to do enough to undo the stranglehold on it

coming from the shortfall of private safe asset creation and the elevated demand

for safe assets.

P.S.Cohn 9ochrane readsAndy 6essler8s piece too. He 'onders if the

monetary A/E is losing its special standing as high$po'ered money since

treasuries have become high$po'ered money for the shado' ban%ing system.

The ans'er is no because the monetary base is still the medium of account, a

huge advantage. Also, though the monetary base and treasuries may be near

perfect substitutes today, they 'on8t be in the future. And investors ma%e their
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decisions based largely on 'hat they thin% 'ill happen in the future. Thus, a

monetary base in@ection today that is e-pected to be permanent and greater than

the demand for the monetary base in the future is li%ely to a=ect spending today,

even though treasuries and the monetary base are no' close substitutes. The

%ey is creating the belief that monetary base in@ection 'ill be permanent, a

point repeatedlymade by ichael Woodford.

;The 4gure sho's that government safe assets have partially o=set the private label shortfall. ( estimate there is still a ./. safe asset

shortfall of about S trillion. This shortfall can be seen in this4gure'hich sho's the amount of safe assets needed to hit full employment

"*D+. The amount of safe assets needed to hit the pre$crisis trend "*D+ path and 9! full$employment "*D+ is calculated as follo'. ( solve

for the!+T(AK amount of money in the e&uation of e-change given an optimal amount of "ominal *D+ 0the pre$crisis trend and 9!

values3 and actual trend money 0safe asset3 velocity as estimated by the Hodric%$+rescott 4lter. That is, ( am solving for in tU

"*D+tV5

t.

+osted by David ec%'orth at ;:; +

Email ThislogThis/hare to T'itter/hare to )aceboo%/hare to +interest

hy is There /till a /hortage of /afe Assets

C+ 6oning 'ants to %no' 'hymany of us continue to tal% about a safe asset

shortage 4ve years after the 4nancial crisis /TA2TED . /houldn8t this problem

corrected itself many years ago He has as%ed this &uestions many times and

most recently framedit this 'ay:

Why do 'e need more safe assets Why don8t 'e @ust let the e-isting ones risein value, thereby providing safety (f 'e 'anted to e-press our desire for safety

by buying 4re e-tinguishers, then (8d agree that 'e need to produce more safe

assets. After all, only some sort of increase in the supply of e-tinguishers 'ill be

able to meet that demand.

ut things are di=erent if 'e e-press our demand for safety by turning to

4nancial mar%ets. The great thing about t$bonds is that unli%e 4re e-tinguishers,

'e don8t need to fabricate more of them to meet our demands for safety... 'e

@ust need a higher real value on the stoc% of e-isting t$bonds. This can be entirely

met by shifts in prices. Where is the problem that needs to be recti4edThis is a great &uestion. Why haven8t 4nancial mar%ets$$the nimblest, most

7e-ible mar%ets of all$$pushed treasury values to levels that 'ould cause the

mar%et for safe assets to clear /houldn8t arbitrage in these mar%ets 4-ed this

problem long ago

Ket me E*(" my ans'er by recalling'hy the ongoing shortage of safe assets

is such a big deal. /afe assets facilitate transactions for ("/T(TT(!"AK

("5E/T!2/ and therefore e=ectively acts as their money. During the crisis,

many of these transaction assets disappeared @ust as the demand for them 'as
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pic%ing up. /ince these institutional money assets often bac%stop retail 4nancial

intermediation, the sudden shortage of them also meant a shortage of retail

money assets. (n other 'ords, the shortage of safe assets matters because it

means there is an e-cess demand for both institutional and retail money assets.

This e-cess money demand, in turn, is %eeping aggregate nominal e-penditure

gro'th belo' 'here it should be.

(t is also important to note that although the crisis began in


15/52

segment from other mar%ets. Where this actually occurs is un%no'n and the 'ay

( have dra'n it is arbitrary. ut hopefully you see the point.

"o' mar%et segmentation is a controversial idea. any observers don8t accept it.

ut it seems li%e a compelling story for the transaction asset mar%et at the JK.

Empirically, it provides an easy e-planation for 'hy AA$AAA corporate yieldspread,@un% bond spread, and other non$transaction asset spreads are getting

closer to historical norms, 'hile theAA yields$;< treasury yield spreadand

the /X+L


16/52

2esolving the /afe Asset /hortage +roblem

!ne of the biggest challenges facing the global economy is the shortage of safe

assets, those assets that are highly li&uid and e-pected to maintain their value.

This shortage matters because safe assets facilitate e-change and e=ectively

function as money. AAA$rated 9D!s, for e-ample, served as collateral forrepurchase agreements 'hich 'ere the e&uivalent of a deposit account

for ("/T(TT(!"AK ("5E/T!2/ in the shado' ban%ing system. Therefore, 'hen

many of these 9D!s disappeared during the 4nancial crisis, a large part of the

shado' ban%ing system8s money disappeared too. This precipitous decline in

institutional money assets declined occurred, of course, @ust as the demand for

them 'ere increasing because of the panic. This problem bled over into retail

ban%ing, since it 'as funded by the shado' ban%ing system, and forced many

retail 4nancial 4rms and households to deleverage. This deleveraging, in turn,

meant fe'er retail money assets @ust as panic 'as %ic%ing in at the retail level. (n

short, the shortage of safe assets is a big deal because it means there is ane-cess demand for both institutional and retail money assets. This

broad e-cessmoneydemand is 'hy aggregate nominal e-penditures in many

countries remain depressed. A full recovery, then, 'ill not happen until there is a

suIcient stoc% of safe assets.;

/o 'hat can be done about this problem atthe' 9. 6lein of The

Economist believesthe solution is for the government to create more safe assets

until this e-cess demand is satiated. He argues that governments 'ho control

their o'n currency are the only producers of safe assets since there isno 9HA"9E they 'ill default. They can al'ays create money to pay o= their

creditors. He sees privately created safe assets, on the other hand, as only

having transitory RsafenessRas evidenced by the history of AAA$9D!s and other

private$label assets that 'ent bust during the 4nancial crisis. +rivate debt

instruments, therefore, cannot solve the safe asset shortage problem according

to 6lein. (nstead, the road to full recovery can only be paved 'ith 4scal policy

creating more safe assets.

( ta%e a di=erent vie': a robust recovery can onlyoccur if there is anincreased con4dence in the safety of private debtinstruments 0i.e. a drop in the

ris% premium3 and, as a result, an increase in demand for them. A full

recovery, therefore,re&uires a restoration of the mar%et for privately$produced

safe assets. 6lein does not believethis is possible, ( do. Here is 'hy ( hold this

vie'.

)irst, there are no truly safe assets, only ones 'ith varying degrees of safeness.

This is true even for governments thatcontrol their o'n 922E"9#

. #es, they 'ill never e-plicitly default since they can create money to

redeem their liabilities, but they can still implicitly default by creating higher$
http://ftalphaville.ft.com/2011/12/05/778301/the-decline-of-safe-assets/http://ftalphaville.ft.com/2011/12/05/778301/the-decline-of-safe-assets/http://macromarketmusings.blogspot.com/2013/01/resolving-safe-asset-shortage-problem.htmlhttp://macromarketmusings.blogspot.com/2012/07/safe-assets-money-and-output-gap.htmlhttp://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://www.economist.com/blogs/freeexchange/2012/12/finance?fsrc=rsshttp://macromarketmusings.blogspot.com/2013/01/resolving-safe-asset-shortage-problem.htmlhttp://www.economist.com/blogs/freeexchange/2012/12/finance?fsrc=rsshttp://macromarketmusings.blogspot.com/2013/01/resolving-safe-asset-shortage-problem.htmlhttp://ftalphaville.ft.com/2011/12/05/778301/the-decline-of-safe-assets/http://ftalphaville.ft.com/2011/12/05/778301/the-decline-of-safe-assets/http://macromarketmusings.blogspot.com/2013/01/resolving-safe-asset-shortage-problem.htmlhttp://macromarketmusings.blogspot.com/2012/07/safe-assets-money-and-output-gap.htmlhttp://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://www.economist.com/blogs/freeexchange/2012/12/finance?fsrc=rsshttp://macromarketmusings.blogspot.com/2013/01/resolving-safe-asset-shortage-problem.htmlhttp://www.economist.com/blogs/freeexchange/2012/12/finance?fsrc=rsshttp://macromarketmusings.blogspot.com/2013/01/resolving-safe-asset-shortage-problem.html


17/52

than$e-pected in7ation. (n other 'ords, investors 'orry about in7ation ris%s too

'hen loo%ing for safe assets. The ./. learned this lesson the hard 'ay in

the ;GM


18/52

9onse&uently, it 'ould be unli%ely that the ./. Treasury could create enough

securities to 4ll the gap created by the shortage of private safe assets 'ithout

undermining the safe asset /TAT/ of treasuries. To be concrete, if 'e follo'

ichael elongia and +eter (reland8s recent paper, 'here they solve for

the !+T(AK amount of money 0or safe assets3 by plugging in potential "ominal

*D+ 0as estimated by the 9!3 and actual trend money velocity 0as estimated by

the Hodric%$+rescott 4lter3 into the e&uation of e-change 0i.e. tU "*D+tV5t3,

the safe asset shortfall for the ./. economy at the end of


19/52

for'ard3 'hile at the same time cataly1e 4nancial 4rms into ma%ing more safe

assets 0because of the improved economic outloo% and the related increased

demand for 4nancial intermediation3. )or e-ample, imagine ho' the public 'ould

respond if the )ed suddenly announced /cott /umner8s proposalof raising their

asset purchase amounts by


20/52

higher nominal spending.

FThis is estimated using a vector autoregression 05A23. The data are &uarterly, in

log levels unless already in gro'th rates, and estimated using L lags. The

generali1ed impulse response function is used here so that ordering of the

variables in the 5A2 does not change the outcome. The sample E*("/ in;G:QS because that is the earliest data point for the e-pected "*D+ gro'th

series. This series comes from the /u rvey of +rofessional )orecasters.

/afe Assets, oney, and the !utput *ap

(n the past, ( madethe case that the shortage of safe assets is really @ust an

e-cess !"E# demand problem. That is, the sharp decline in the stoc% of safe

assets that began in


21/52

the e&uation of e-change 0i.e. tU "*D+tV5t3. ( reproduce their procedure here

using the 9)/8s S divisia money supply;and come up 'ith the follo'ing 4gure:

The 4gure sho's that the &uantity of money assets is currently about MN belo'

'hat is needed to generate full potential "*D+ gro'th. "o' if one ta%es the

percent di=erence bet'een the actual and needed S divisia in the 4gure

above$$the S divisa gap$$and plots it against the the output gap you get the

follo'ing 4gure:

( 4nd this 4gure stri%ing. With a 2of about


22/52

"o' some observers li%eCames ullardsand /tephen Williamsonsbelieve that

the shortage of safe assets or !"E# is the conse&uence of real shoc%s to

4nancial intermediation that have permanently lo'ered the +2!D9T(5E

capacity of the ./. economy. The relationship evident in the 4gure above,

ho'ever, suggests that there is in fact a large output gap given the signi4cant

shortage of money assets. And even if the shortage 'ere caused by a real shoc%,there are still policy options that could close the S gap.

)irst, the government could create more safe assets in the form of treasuries.

This approach, ho'ever, is politically controversial as it re&uires more budget

de4cits. (t is also not clear to me that this approach 'ould be able to create

enough safe assets to completely close the S gap. /econd, the )ed could

create the incentive for the private sector to start producing more safe assets by

adopting a "*D+ level target. /uch a target 'ould raise the e-pected level of

future "*D+ and, in turn, raise the current demand for 4nancial

intermediation /E25(9E/ . That 'ould lead to more privately$produced safe

assets and ultimately a recovery. There are 'ays out of this economic morass.

;( speci4cally use the 9)/8 RS minusR money supply measure. (t had a better 4t

than the regular S.

+osted by David ec%'orth at ;;:L; +

oney /till atters

"ic% 2o'e li%es to remind us that !"E# is the only asset on every mar%et. (f

the supply of or demand for this one asset is disrupted then every mar%et 'ill be

a=ected. This reasoning implies that monetary dise&uilibrium is essential for the

emergence of general gluts. This crisis has reinforced this understanding, but also

has shed some ne' light on 'hat it means. /peci4cally, this crisis has sho'n

that 'hat is used as money is far broader than the standard measures of money.

The 'idely used , for e-ample, is limited to retail money assets li%e cash anddeposits accounts that are used by households and small businesses.

("/T(TT(!"AK ("5E/T!2/ also need assets that facilitate transactions, but the

assets in are inade&uate for them given the si1e and scope of their

transactions. 9onse&uently, institutional investors have found'aysto ma%e

assets li%e treasuries, commercial paper, repos, */Es and other safe assets serve

as their money. These institutional money assets, therefore, should also be

considered part of the money supply. When vie'ed from this broader perspective,

the money supply has been depressed during the crisis in both the nited /tates

and the Euro1one. (t should be no surprise then that both regions are in slumps.
http://research.stlouisfed.org/econ/bullard/Bullard_OMFIF_10July2012_final.pdfhttp://newmonetarism.blogspot.com/2012/07/hp-filters-and-potential-output.htmlhttp://macromarketmusings.blogspot.com/2012/07/safe-assets-money-and-output-gap.htmlhttp://macromarketmusings.blogspot.com/2012/07/safe-assets-money-and-output-gap.htmlhttp://macromarketmusings.blogspot.com/2012/07/safe-assets-money-and-output-gap.htmlhttp://www.blogger.com/profile/04577612979801459194http://macromarketmusings.blogspot.com/2012/07/safe-assets-money-and-output-gap.htmlhttp://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://faculty.unlv.edu/msullivan/Sweeney%20-%20Money%20supply%20and%20inflation.pdfhttp://www.scribd.com/doc/88858143/When-Collateral-is-Kinghttp://research.stlouisfed.org/econ/bullard/Bullard_OMFIF_10July2012_final.pdfhttp://newmonetarism.blogspot.com/2012/07/hp-filters-and-potential-output.htmlhttp://macromarketmusings.blogspot.com/2012/07/safe-assets-money-and-output-gap.htmlhttp://macromarketmusings.blogspot.com/2012/07/safe-assets-money-and-output-gap.htmlhttp://macromarketmusings.blogspot.com/2012/07/safe-assets-money-and-output-gap.htmlhttp://www.blogger.com/profile/04577612979801459194http://macromarketmusings.blogspot.com/2012/07/safe-assets-money-and-output-gap.htmlhttp://www.blogger.com/email-post.g?blogID=5713178645208582139&postID=3529508326158668252http://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://faculty.unlv.edu/msullivan/Sweeney%20-%20Money%20supply%20and%20inflation.pdfhttp://www.scribd.com/doc/88858143/When-Collateral-is-King


23/52

Here are some attempts to measure these broader notions of money. )irst, from

the 9enter for )inancial /tabilityis the S Divisia money supply measure for the

nited /tates:

"o monetary recovery yet in the nited /tates. What about the Euro1one Ket

us 4rst loo% at the Euro1one less *ermany. )or this region 'e use the E98sF

simple sum aggregate. This is not &uite as broad as S, but it does include some

institutional money assets:

Here too there is a 'ide gap bet'een the trend and actual money stoc%. )inally,

here is the same F measure for *ermany:
http://www.centerforfinancialstability.org/amfm_data.php#otherdatahttp://www.ecb.int/stats/money/aggregates/aggr/html/index.en.htmlhttp://www.centerforfinancialstability.org/amfm_data.php#otherdatahttp://www.ecb.int/stats/money/aggregates/aggr/html/index.en.html


24/52

"o surprise here. *ermany8s economy is doing relatively 'ell and thus 'e 'ould

e-pect to see better monetary conditions there. This relative stability of

the !"E# stoc% is another reason 'hy *ermany is no rush to !+E" the E9

monetary spigot to save the Euro1one. Why disrupt stable monetary conditions

in *ermany

/o 'hat are the monetary policy implications The most obvious one is that the

)ed and E9 should create an environment conducive to monetary asset creation

that 'ould support the return of robust aggregate nominal spending. /ince most

of the money assets are created by the credit, maturity, and li&uidity

transformation /E25(9E/ of 4nancial 4rms, policyma%ers should aim to create

an environment conducive to increased 4nancial intermediation. The easiest 'ay

for monetary policy to do this is to raise the e-pected gro'th path of aggregate

nominal e-penditures. This 'ould raise e-pected nominal income gro'th and the

demand for money assets. This, in turn, 'ould cataly1e 4nancial intermediation

and lead to the creation of more money assets. And of course, the 'ay to raisethe e-pected gro'th path of aggregate nominal e-penditures is to adopt a

nominal *D+ level target. (t is time for monetary regime change

P.S. +eter (reland and ichael elognia have an interesting ne' paperthat

sho's money still matters for monetary policy. This is bound to get some "e'

6eynesians 'or%ed up )rom their abstract:

!ver the last t'enty$4ve years, a set of in7uential studies has placed interest

rates at the heart of analyses that interpret and evaluate monetary policies. (n

light of this 'or%, the )ederal 2eserve?s recent policy of Z&uantitative easing,[

'ith its goal of a=ecting the supply of li&uid assets, appears as a radical brea%
http://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://www.nationalreview.com/nrd/articles/300951/monetary-regime-changehttp://irelandp.com/papers/qe.pdfhttp://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://macromarketmusings.blogspot.com/2012/06/money-still-matters.htmlhttp://www.nationalreview.com/nrd/articles/300951/monetary-regime-changehttp://irelandp.com/papers/qe.pdf


25/52

from standard practice. /uperlative 0Divisia3 measures of money, ho'ever, often

help in forecasting movements in %ey macroeconomic variables, and the

statistical 4t of a structural vector autoregression deteriorates signi4cantly if such

measures of money are e-cluded 'hen identifying monetary policy shoc%s.

These results cast doubt on the ade&uacy of conventional models that focus on

interest rates alone. They also highlight that all monetary disturbances have animportant Z&uantitative[ component, 'hich is captured by movements in a

properly measured monetary aggregate.

Why the *lobal /hortage of /afe Assets atters

!ne of the %ey problems facing the 'orld economy right no' is a shortage of

assets that investors 'ould feel comfortable using as a store of value. There is

both a structural and cyclical dimension to this shortage of safe asset problem,

'ith the latter being particularly important no' given the recent spate of

negative economic shoc%s to the global economy. These shoc%s have elevated

the demand for safe assets and, as David Andolfatto argues, is probably the %ey

reason 'hy 'e see such lo' yields on ./. treasuries. !f course, these same

shoc%s have also destroyed many of the once$safe assets 0e.g. European

sovereign bonds3 adding further strain to this asset$shortage problem. This

shrin%ing stoc% of safe assets can seen in the 4gure belo' created by 9redit

/uisse 0ht )T Alphaville3:

This 4gure sho's that if one does not count )rench bonds as safe assets

0a reasonableassumption3, then about half of the safe assets disappeared by


26/52

probably /TA2TED 'ith the collapse of Capaneses assets in the early ;GG


27/52

needed domestically to meet the global demand for it. This, ho'ever, re&uires

running current account de4cits that over time may @eopardi1e the very reserve

currency status driving this dynamic. )rancis Warnoc%summari1esthis parado-

nicely:

To supply the 'orld?s ris%$free asset, the country at the heart of the internationalmonetary system has to run a current account de4cit. (n doing so, it becomes

more indebted to foreigners until the ris%$free asset ceases to be ris%$free.

"o' apply this reasoning to the ./. government that currently seems to be the

preferred producer of safe assets for the 'orld. (f it is to meet the e-cess demand

for safe assets it must run a larger budget de4cit, a point maderecently by David

Andolfatto:

O*Piven the huge 'orld'ide appetite for ./. treasury debt 0as re7ected by

absurdly lo' yields3, this is the time to /TA2T accommodating this demand.

)ailure to do so at this time 'ill only drive real rates lo'er.

ut running larger budget de4cits over time may @eopardi1e the safe$

asset /TAT/ of ./. treasury debt, the very thing currently driving the

insatiable demand for it. The global economy thus faces a TriIn dilemma for the

./. treasury, its go to safe asset.

There is 'ay out of these problems. oth the )ed and the E9 need to return

aggregate nominal incomes in their regions to their pre$crisis trends and do so

using a nominal *D+ level target. eing a level target it 'ould %eep long$runin7ation e-pectations anchored 'hile still allo'ing for an aggressive monetary

stimulus in the short$run 0i.e. until the pre$crisis trends 'ere reached3. (t 'ould

also stabili1e nominal spending e-pectations and add more certainty to long$run

forecasts. ore importantly, it 'ould spur a sharp recovery that 'ould that

'ould lo'er the demand for safe assets and increase the stoc% of safe assets.

oth of these developments 'ould in turn reduce the e-cess !"E# demand

problem and minimi1e the problems 'ith the TriIn dilemma for ./. treasury

debt. nfortunately, 'e are a long 'ay from either central ban% adopting

nominal *D+ level targets.

The 9yclical Dimension of the /afe Asset +roblem

An important problem facing the global economy is the shortage of safe assets,

assets that facilitate transactions at both the retail and institutional level. There

is both a long$term, structural dimension to this problem as 'ell as a short$term,

cyclical one. The structural dimension is that global economic gro'th over the

past fe' decades has outpaced the capacity of the 'orld economy to produce

truly safe assets, a point 4rst notedby 2icardo 9abellero. The cyclical dimension

is that the shortage of safe assets 'as intensi4ed by the *reat 2ecession, a

point stressedby *ary *orton. ( previously madethe case that both the )ed and

the E9 'ere an important part of the cyclical story by failing to restorenominal incomes to their e-pected, pre$crisis paths. (n other 'ords, since


28/52

the )ed and the E9 passively tightenedmonetary policy 'hich caused some of

the safe assets to disappear 'hile at the same time increasing the demand for

them.

( still hold this vie', but after reading some papers on safe assets and tal%ing

'ith Cosh Hendric%son ( have come up 'ith a more general vie' to the cyclical

dimension of the safe asset problem. (t goes as follo's.

*orton, Ke'ellen, and etric% 0


29/52

Bernanke: #ou are more than 'elcome. #ou %no', it has been a real treat for

me to get a'ay from the )ed and bac% into the classroom. /ometimes the stress

of dealing 'ith hard$money congressmen, rogue regional )ed presidents, and

bloggers 'ho cite my Capanese 'or% can be over'helming. /o it really is nice to

escape into the classroom. "o' tell me, is there anything in particular 'e have

tal%ed about that struc% your fancy

Student: Actually, yes. When you e-plainedthat 9hina8s 922E"9# peg to

the dollar means 9hina e=ectively has it monetary policy set by the )ed ( 'as

shoc%ed$$;.F billion 9hinese have their monetary conditions set by a fe'

Americans holed up in a secretive, old building on the other side of the 'orld.

Wo', tal% about fodder for conspiracy theories Anyho', this got me thin%ing:

are there other countries that have their monetary policy determined by the )ed

too /o ( did some research and learnedthat almost half of the W!2KD8/

922E"9(E/ are tied in some 'ay to the dollar. This translates into about a

third of 'orld *D+. That means you guys at the )ed are li%e a monetary ma4a,right

Bernanke: Well, uhm, ( 'ould not phrase it that 'ay but...

Student: ut you do in7uence monetary conditions for about a third of the

global economy, right

Bernanke:#es.

Student: !%ay, let8s say the )ed eased monetary policy for a third of the 'orld

economy. That 'ould imply that the 922E"9(E/ of these dollar$pegging

countries 'ould depreciate relative to the rest of the 'orld. And that, in turn,

'ould ma%e the E9 and the an% of Capan mindful of ./. monetary policy lest

their currencies becomes too e-pensive, right

Bernanke: +robably, but...

Student: /o the )ed, then, is also shaping monetary policy to some e-tent

at the E9 and the an% of Capan. That e-plains 4gures li%e this oneand

this onethat until no' ( did not understand. Wo', you guys really are the

monetary ma4a. /o does this mean the monetary ma4a thin%s about the

implication of the )!98s actions for these other economies 'hen doingmonetary policy

Bernanke:Actually no, 'e have a domestic mandate so 'e don8t really 'orry

too much about them unless they create problems for the ./. economy. And

besides, they don8t have to peg to our 922E"9# . "o one is forcing them to do

so. We may e-ert a lot of in7uence on global monetary conditions, but 'e are not

a monetary ma4a +lease &uit using that name

Student:!%ay, no more monetary ma4a references. ut, if you do e-ert a lot of

in7uence on global monetary conditions, then can8t it e-plain, at least in part,

'hy there 'as a global housing boom The )ed lo'ered global interest rates andspar%ed o= a global housing boom, right
http://blogs.wsj.com/economics/2012/03/20/bernanke-chinas-dollar-peg-like-being-on-gold-standard/http://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.htmlhttp://www.newyorkfed.org/research/staff_reports/sr522.pdfhttp://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.htmlhttp://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.htmlhttp://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.htmlhttp://1.bp.blogspot.com/-817Bbah9b-c/TsCm2ViTUyI/AAAAAAAACPU/WUMlK-Rplbs/s1600/target+rates.jpghttp://1.bp.blogspot.com/-wmpdK-X4Rxk/TsCm29OfCLI/AAAAAAAACPc/SM5Wfe_TDe0/s1600/ngdp.jpghttp://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.htmlhttp://blogs.wsj.com/economics/2012/03/20/bernanke-chinas-dollar-peg-like-being-on-gold-standard/http://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.htmlhttp://www.newyorkfed.org/research/staff_reports/sr522.pdfhttp://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.htmlhttp://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.htmlhttp://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.htmlhttp://1.bp.blogspot.com/-817Bbah9b-c/TsCm2ViTUyI/AAAAAAAACPU/WUMlK-Rplbs/s1600/target+rates.jpghttp://1.bp.blogspot.com/-wmpdK-X4Rxk/TsCm29OfCLI/AAAAAAAACPc/SM5Wfe_TDe0/s1600/ngdp.jpghttp://macromarketmusings.blogspot.com/2012/03/bernanke-student-conversation-you.html


30/52

Bernanke:#ou need to read my papers on the /A5("* glut. They sho' that it

'asn8t ./. monetary policy, but e-cess /A5("*/ from rest of the 'orld that

created the demand for safe assets that in turn drove do'n global interest rates.

This development combined 'ith the securiti1ation of 4nance, poor internal

governance, misaligned creditor incentives, and other private sector failings is

'hat caused the global housing boom.

Student: Doesn8t that sound a bit self$serving, blaming only foreigners and

private sector failings for the housing boom

Bernanke:Koo%, as ( said, read my papers on the saving glut. The ans'ers are

all there.

Student:Well, ( have read your saving glut papers, but ( still have &uestions. (t

seems to me that in those papers you are focusing on the structural component

driving the global demand for safe assets, but ignore the cyclical ones.

Bernanke:What do you mean

Student:The structural component is that global economic gro'th over the past

fe' decades has outpaced the capacity of the 'orld economy to produce truly

safe assets. The cyclical component, on the other hand, is that because of the

)ed8s monetary superpo'er /TAT/ , ./. monetary policy accentuated the

demand for safe assets during the housing boom.

Bernanke: !h really

Student: 2eally. Here is 'hy. )irst, in the early$to$mid


31/52

)or them the promise of lo' short$term interest rates for a Rconsiderable periodR

screamed opportunity. These investors sa' a predictable spread bet'een lo'

funding costs created by the )ed and the return on higher yielding but safe

assets. They too 'anted more AAA$rated assets to invest in so that they could

ta%e advantage of this spread that 'ould be around for a Rconsiderable period.R

Here too, the ./. 4nancial system responded by transforming ris%y assets intosafe assets. /o 'hat do you thin% r. 9hairman

Bernanke:Well, 'hat do you %no', ( am out of time. We 'ill have to continue

this conversation ne-t time after my ne-t lecture on the 4nancial crisis.

Student:/pea%ing of the 4nancial crisis, ( also thin% that since late


32/52

periodR in


33/52

Capan 'ere also responding to ./. monetary policy, they too 'ere ac&uiring

foreign reserves and channeling credit bac% to the ./. economy. Thus, the

easier ./. monetary policy became the greater the demand for safe assets and

the greater the amount of recycled credit coming bac% to the ./. economy. This

is an important but overloo%ed point in most discussion about ho' the )ed8s lo'

interest rates contributed to the housing boom.

Second, the claim that Rall available evidenceR point to a small e=ect ignores

some studies that actually reach the opposite conclusion. )or e-ample, there

are t'ostudiesby 2udiger Ahrend et. al that sho' lo' interest rates, speci4cally

ones lo'er than those prescribed by the Taylor 2ule, in con@unction 'ith rapid

4nancial innovation 'ere very important to the housing boom for most of the

!E9D countries. Here is one graph from the papers that ma%es this point:

Another study that 4nds contrary evidence is Eic%meier and Hofmann0


34/52

other things, it runs a counterfactual e-periment that allo's the authors to see

'hat part of the housing price boom can be attributed to the )ed8s actions, both

shoc%s and systematic policy. Here is 'hat they 4nd:

The blue line is the combined e=ect of shoc%s and systematic policy on housing

prices. The !)HE! house price inde- sho's a large amount of the surge in H!Eprices is because of monetary policy, 'hile the 9ase$/hiller inde- sho's

some'hat smaller but still meaningfully large role for the )ed. (n both cases,

monetary policy only matters for the early$to$mid


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are no' more than < years past the *reat Depression 'ith little end in sight to

the debate surrounding the causes of that do'nturn.

ost economists fall into one of t'o camps 'hen e-plaining 'here the

imbalances originated that led up to the current crisis. Austrian /chool

economists are in the uni&ue position of being able to reconcile these t'o camps,even 'hile favoring the 4rst e-planation to the second.

The 4rst camp, 'hich includes most Austrian /chool economists, loo%s at the

imbalances caused by central ban% interest rate policy being set Ztoo lo' for too

long.[ (n this vie', arti4cially lo' interest rates allo'ed for erroneous capital

investments follo'ing the dot$com bust of


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'ere the recipients of these capital 7o's 'itnessed remar%ably lo' interest rates

and credit booms 'ith a corresponding buildup of debt.

Thus, in the vie' of proponents of the savings glut theory, the )ederal 2eserve

'as not the cause of lo'er interest rates, but rather it 'as a passive observer as

interest rates 'ere lo'ered e-ogenously from these foreign sources.

#et proponents of the global savings glut hypothesis must grapple 'ith one

unans'ered &uestion: What caused citi1ens of Asian countries to increase their

savings rate and destabili1e Western economies 'ith their e-cess capital

out7o's !ne could ta%e the vie' that savings rates are e-ogenously determined

e.g., by animal spirits yet this Ze-planation[ only pushes the problem one

step bac%. What determines these animal spirits

To 4nd a satisfying ans'er 'e must loo% at the role of monetary policy in

determining /A5("* rates.

There is no need to loo% to animal spirits or any ill$de4ned e-ogenous force to

e-plain 'hy developing countries increased their /A5("*/ so much during the

boom andfunneled these /A5("*/ into Western 4nancial mar%ets. The

unsustainable boom propagated by Western central ban%s set this process in

motion by creating a disconnect bet'een the consumption demands 'ith the

domestic +2!D9T(5E capacity of their economies.

oreover, the current ire directed at the loss of manufacturing in the nited

/tates is not the result of Zgreedy outsourcers[ or even Z922E"9#

manipulators[ in Asian countries. The loss of productive capacity in the ./. is the

outcome of a too$lo' interest rate policy by the )ederal 2eserve incentivi1ing

entrepreneurs to move their investments to the higher stages of production

those furthest from 4nal consumption 'hile simultaneously incentivi1ing

consumers to increase their present consumption at the e-pense of savings.

(ote:The vie's e-pressed on ises.org are not necessarily those of the ises

(nstitute.

Glo)al savings glut or glo)al )anking glut*

+,un Song Shin< DE9EE2


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"

/ince ernan%e?s global ban%ing glut? may have been more culpable for the

crisis than the >global savings glut? 0/hin


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Source: () (nternational )inancial /tatistics

Figure #. *overnment budget balance and debt$to$*D+ ratios of (reland, /pain

and *ermany


39/52

To push the analogy 'ith the / further, imagine for a moment that the Euro1one

is a self$contained miniature model of the global 4nancial system. (n thisminiature model, *ermany +KA#/ the role of 9hina, 'hile /pain and (reland play

the /.

According to the analogy, e-cess /A5("*/ in *ermany 4nd their 'ay to /pain

and (reland 'here they in7ate the property bubbles there. The bubbles

subse&uently burst, resulting in the socialisation of private debt through ban%

bailouts and precipitating the sovereign$debt crisis.

Ho'ever, the further 'e push the analogy, the stranger it gets. According to the

>global /A5("*/ glut? hypothesis, 9hinese savers favour / Treasuries because

9hina lac%s deep 4nancial mar%ets that could cater to demands for safe assets. (n

the miniature model of the savings glut for the Euro1one, /panish and (rish ban%

deposits play the role of / Treasuries, since current$account imbalances in the

Euro1one 'ere 4nanced through capital 7o's in the ban%ing sector. To sustain

the analogy, 'e 'ould need to argue someho' that *erman savers shunned

ban% deposits in *ermany to favour ban% deposits in (reland and /pain. Why

'ould *erman savers believe that deposits in /pain and (reland are safer than

those in *ermany At this point, the savings glut analogy strains credulity and

brea%s do'n.
http://www.voxeu.org/article/global-savings-glut-or-global-banking-gluthttp://www.voxeu.org/article/global-savings-glut-or-global-banking-gluthttp://www.voxeu.org/article/global-savings-glut-or-global-banking-gluthttp://www.voxeu.org/article/global-savings-glut-or-global-banking-gluthttp://www.voxeu.org/article/global-savings-glut-or-global-banking-gluthttp://www.voxeu.org/article/global-savings-glut-or-global-banking-glut


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A more plausible narrative is a ban%ing glut associated 'ith the e-plosive gro'th

of cross$border lending in Europe, as illustrated by )igure F 'hich plots the cross$

border domestic 922E"9# lending and borro'ing by EJ ban%s.

Figure '. 9ross$border domestic 922E"9# assets and liabilities of EJ ban%s

Source: (/ Kocational an%ing /tatistics, Table LA

There is a mechanical @ump in the t'o series at the start of ;GGG 'ith the launch

of the euro, as previously foreign$922E"9# lending and borro'ing arereclassi4ed as being in domestic currency 0i.e. euros3. ut from


41/52

'ithin Europe before the formal introduction, as ban%s became more adept at

circumventing the spirit of the initial ;G asel 9apital Accord.

9ompared to other dimensions of economic integration 'ithin the Euro1one,

cross$border mergers in the European ban%ing sector remained the e-ception

rather than the rule. Herein lies one of the parado-es of Euro1one integration.The introduction of the euro meant that RmoneyR 0i.e. ban% liabilities3 'as free$

7o'ing across borders, but the asset side remained stubbornly local and

immobile. As bubbles 'ere local but money 'as 7uid, the European ban%ing

system 'as vulnerable to massive runs once ban%s /TA2TED deleveraging.

urope0s crisis: " )anking crisis 2rst% a sovereign3de)t crisis second

The ban%ing glut hypothesis is a better perspective on the current European

4nancial crisis than the savings glut hypothesis. The crisis in Europe is a ban%ing

crisis 4rst, and a sovereign$debt crisis second. (t carries all the hallmar%s of a

classic Rt'in crisisR that combines a ban%ing crisis 'ith an asset$mar%et declinethat ampli4es ban%ing distress. (n the emerging$mar%et t'in crises of the ;GG


42/52

through the shado' ban%ing system. The role of European global ban%s in

determining / 4nancial conditions highlights the importance of trac%ing gross

capital 7o's in in7uencing credit conditions, as emphasised recently by orio and

Disyatat 0


43/52

/ ban%s in the balance of payments, as the balance$of$payments accounts are

based on residence, not nationality.

uropean )anks: Gross 6ows and US pre3crisis credit conditions

The gross capital 7o's into the / in the form of lending by European ban%s via

the shado' ban%ing system 'ill have +KA#ED a pivotal role in in7uencing credit

conditions in the / in the run$up to the subprime crisis. Ho'ever, since the

Euro1one has a roughly balanced current account 'hile the 6 is actually a de4cit

country, their collective net capital 7o's vis$\$vis the / do not re7ect the

in7uence of their ban%s in setting overall credit conditions in the /.

The distinction bet'een net and gross 7o's is a classic theme in international

4nance, but deserves rene'ed attention given the ne' patterns of international

capital 7o's 0see, e.g., orio and Disyatat


44/52

Debate about the global savings glut hypothesis is mired in confusion, a

fundamental one of 'hich is the seemingly obvious but false claim that a global

savings glut must lead to higher global savings. Here, for e-ample, is a recent

piece by one of my favorite economists, arry Eichengreen:

here is only one problem+ the data show little evidence of a savings glut. Since,/# global savings have *uctuated between 001 and 021 of world 34# with

little tendency to trend up or down.

As surprising as it might sound, global savings gluts do not result in higher global

savings e-cept under speci4c, often unli%ely, conditions.

hat is a savings glut*

There is no formal de4nition, but 'henever mar%et conditions or policy distortions

cause the savings rate in one part of the economy to rise e-cessively 0itself an

ambiguous 'ord3, 'e can spea% of a savings glut. There are at least t'o maincauses of a savings glut.

;. $ rise in income ine5uality. We see this in Europe, the /, 9hina, and

indeed in much of the 'orld. As 'ealthy households increase their share of

total income, and because they tend to save a larger share of their income

than do ordinary households, rising income ine&uality forces up the

savings rate.

. $ decline in the household share of 34. We?ve seen this mainly in 9hina

and *ermany over the past 4fteen years. When countries implement

policies that intentionally or unintentionally force do'n the householdshare of *D+ 0usually to increase their international competitiveness3 they

also automatically force do'n the consumption share of *D+. ecause

savings is de4ned as *D+ minus consumption, forcing do'n the

consumption share forces up the savings share. There are many policies

and conditions that do this, and ( discuss these e-tensively in my boo%,

he reat 6ebalancing, but the main ones are lo' 'age gro'th relative to

productivity, 4nancial repression, and an undervalued currency .

"otice that in both these cases, and completely contrary to the popular narrative

that praises high savings as a conse&uence of household thrift, and so as morallyvirtuous, the rise in the savings rate does not occur because ordinary households

have become thriftier. (n the former case household savings rise simply because

the rich increase their share of total income. (n the latter case national savings

rise 'ithout households in the aggregate increasing their savings.

+ow does the econom, )alance*

An economy?s total production of goods and services 0*D+3 can be de4ned either

from the demand side 0consumption plus investment 3 or from the supply side

0consumption plus savings3. y de4nition, in other 'ords, savings is al'ays

e-actly e&ual to investment.
http://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/http://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/http://www.project-syndicate.org/commentary/barry-eichengreen-examines-competing-explanations-for-three-decades-of-decline-in-real-interest-rateshttp://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/http://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/http://www.amazon.com/The-Great-Rebalancing-Conflict-Perilous/dp/0691158681/ref=pd_bxgy_b_img_yhttp://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/http://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/http://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/http://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/http://www.project-syndicate.org/commentary/barry-eichengreen-examines-competing-explanations-for-three-decades-of-decline-in-real-interest-rateshttp://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/http://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/http://www.amazon.com/The-Great-Rebalancing-Conflict-Perilous/dp/0691158681/ref=pd_bxgy_b_img_yhttp://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/http://blog.mpettis.com/2014/05/why-a-savings-glut-does-not-increase-savings/


45/52

An economy e-periencing a savings glut must maintain this balance. (t is

conse&uently @ust a matter of logic that a savings glut must be accompanied by a

balancing ad@ustment B either by an increase in investment or by a reduction in

savings in another part of the economy B and this ad@ustment must occur

simultaneously. The necessary implication is that 'hatever causes the savings

glut must also cause one or both of these balancing ad@ustments.

There are only t'o 'ays investment can rise and t'o 'ays savings else'here

can drop. This means that a savings glut mustresult in one or more of the

follo'ing, enough fully to o=set the savings glut:

;. (f productive investment has been constrained by the lac% of savings,

productive investment 'ill rise.

. "onproductive investment can also rise. E-cess savings can cause large

speculative 7o's into real estate or other assets, perhaps even setting o=

asset Zbubbles[. When this happens it can create additional investmentoutlets for e-cess saving in the form of pro@ects, including most often real

estate pro@ects, 'hose economic value can only be @usti4ed by rising price

e-pectations.

F. 2ising asset prices can unleash a consumption boom if it causes ordinary

households to feel 'ealthier and so increase their consumption 0the

Z'ealth e=ect[3. This increased consumption creates 'hat ( 'ill call,

perhaps clumsily, a Zconsumption glut[.

S. (f less consumption caused by the savings glut is not matched by higher

investment or by a consumption glut, total demand drops, resulting in

higher unemployment. nemployed 'or%ers stop producing goods and

services but do not stop consuming. ecause savings is simply the gap

bet'een production and consumption, unemployment causes the savings

rate to drop.

Economists almost al'ays miss this point. A global savings glut must be

accompanied by one or more of the four ad@ustments listed above. (t can result in

higher global savings if the economy rebalances in the form of higher productive

or unproductive investment, or it can result in no change in the global savings

rate if the economy rebalances in the form of a consumption glut or a rise inunemployment. "othing else is possible.

The best outcome is if a savings glut is accompanied by higher productive

investment. This is often referred to as Ztric%le do'n economics[ 'hen both the

rich and the poor bene4t from productive investment, 'ith the rich bene4tting

more.

(f there is a savings glut, 'ill productive investment automatically increase (f

productive investment has been constrained by lo' savings it 'ill, but productive

investment tends to be constrained by insuIcient savings mostly in undeveloped

countries. ost e-cess savings, ho'ever, have originated or 7o' into richcountries.


46/52

(n rich countries there are often many productive pro@ects that desperately a'ait

investment, but this failure to invest is driven by other factors, and usually not by

the lac% of savings, so that a savings glut is unli%ely to lead to higher productive

investment. )ormer )ed 9hairman 0;GFS$S3 arriner Eccles even argued that a

savings glut could reduce productive investment. Zy ta%ing purchasing po'er

out of the hands of mass consumers,[ he 'rote, Zthe savers denied tothemselves the %ind of e=ective demand for their products that 'ould @ustify a

reinvestment of their capital accumulations in ne' plants.[

ore commonly 'hen e-cess savings are high they 7o' into real estate and

stoc% mar%ets, perhaps even setting o= bubbles, 'ith overinvestment in real

estate an almost inevitable conse&uence of rapidly rising housing prices 0'e sa'

this most obviously in peripheral Europe, the / and 9hina3. These speculative

7o's have another impact that allo's the economy to balance savings and

investment. The real estate bubble ma%es households feel 'ealthier, 'hich

encourages a consumption glut, so that bet'een the real estate boom and theconsumption glut, the savings glut is fully absorbed.

ut this is temporary. When the asset bubbles burst, the resulting surge in

unemployment brings do'n the savings rate enough again to maintain the

balance bet'een savings and investment.

Savings must )alance

The point here is that a savings glut need not result in an overall rise in savings.

(t can @ust as easily cause a consumption glut else'here 'hose positive impact

on total demand fully mitigates the negative impact of the savings glut. The ideaho'ever that a savings glut can simultaneously create a consumption glut seems

to be one of the most diIcult things for many economists to understand, perhaps

because it seems at 4rst so counterintuitive.

!f course the other 'ay a savings glut need not result in an overall rise in

savings is through higher unemployment. (n fact because neither an asset bubble

nor a consumption glut is sustainable, unless productive investment has been

constrained by a lac% of savings, the only long$term conse&uence of a savings

glut is a rise in unemployment and no rise in total savings.

(n that case there might be only t'o sustainable 'ays to address the resultingunemployment. Either the savings glut is reversed, or governments act to

eliminate 'hatever 'ere the previous constraints on productive investment

0perhaps by liberali1ing constraints to investment or even by initiating a %ind of

Zne' deal[ in infrastructure investment3. The third 'ay, although not sustainable,

is for another asset bubble to be in7ated so as to encourage another

consumption glut, 'hich seems currently to be the preferred 'ay of / and

European governments.

hich wa, is the causalit,*

(t is @ust a matter of logic that unless investment rises substantially, a savingsglut must combine 'ith a consumption glut or 'ith a surge in unemployment so


47/52

that there is no net increase in savings. ut logic only tells us that the t'o must

occur simultaneously. (t implies no obvious direction of causality. Does a savings

glut cause a consumption glut, or does the consumption glut cause the savings

glut To put it in contemporary terms:

;. Did 9hinese policies aimed at forcing up domestic savings 0by forcing do'nthe household income share of *D+3 set o= a consumption glut in the /,

or did pro7igate / consumption re&uire that 9hinese savings rise to

accommodate it

. Did *erman policies aimed at restraining 'or%ers? 'ages force up the

*erman savings rate, 'ith e-cess savings pouring into peripheral Europe,

setting o= real estate bubbles, 'hich then set o= consumption gluts, or did

over$enthusiasm about the euro cause overly con4dent citi1ens of

countries li%e /pain to embar% on a consumption binge, 'hich could only

be balanced by a rise in the *erman savings rate

!ne 'ay of resolving these &uestions might be to e-amine the cost of capital.

+ulling capital from lo'$savings to high savings parts of the economy might seem

to re&uire high interest rates. +ushing capital from high$savings to lo'$savings

parts of the economy might seem to re&uire lo' interest rates.

There is so much misunderstanding about the savings glut hypothesis that much

of the debate has verged on the nonsensical. nless it unleashes a truly heroic

surge in investment B productive or nonproductive, although the latter can only

be temporary B a savings glut must al'ays be accompanied either by a

consumption glut else'here or by a rise in unemployment. "o other option ispossible. This is 'hy savings gluts rarely result in higher overall savings.

This is also 'hy any serious discussion of the savings glut must esche'

morali1ing and must focus instead on the direction of causality. Did distortions

that created a savings glut force the creation of a consumption glut, or did

distortions that created a consumption glut force the creation of a savings glut

Any analysis that does not recogni1e that both must occur simultaneously, and so

must be resolved simultaneously, cannot possibly be correct.

$cademics# 7ournalists# and government and &8 o9cials who want to subscribe

to my newsletter# which sometimes includes portions of this blog and sometimes

:as in this case; does not# should write to me at chin


48/52

although ( cannot prove it, that 'hen income ine&uality is lo', higher savings

associated 'ith further increases in ine&uality can lead to more productive

investment in part because interest rates might be high. (n that case it 'ould

seem that 'hen income ine&uality is high, higher savings associated 'ith further

increases in ine&uality 'ill not lead to more productive investment.

^ Do 'e understand the math behind the +++ calculations

/ome things to consider if /pain leaves the euro _

4$ 8omments

Add your comment

;.

ichael +ettis ay ,


49/52

s paper mone, created ), the world0s central )anks responsi)le 7or

the 9glo)al im)alances that desta)ili;ed the econom,*

y 2ichard Duncan, Culy ;,


50/52

savings of three sources the household sector, the business sector and the

government sector. (nvestment is made up primarily of investments in factories

and e&uipment, as 'ell as residential investment, the building of houses and

apartment buildings.

The rationale for attributing the trade imbalance to the di=erence in nationallevels of savings and investment runs as follo's. (f a country invests more

than it saves, then that country can borro' from abroad to 4nance that gap.

(n that case, that country 'ould have a surplus on its 4nancial account and 0since

the balance of payments must balance3 a de4cit on its current account. (n other

'ords, a country that invests more than it saves 'ill have a current account

de4cit.

nvestment < Savings = 8urrent "ccount >e2cit

9onversely, a country that saves more than it invests, can lend its surplussavings to other countries. (t then 'ill have a 4nancial account de4cit 0money

7o's abroad3 and 0again, since the balance of payments must balance3 a current

account surplus. Thus, a country that saves more than it invests 'ill have a

current account surplus.

Savings < nvestment = 8urrent "ccount Surplus

ernan%e has often used this reasoning to e-plain the nited /tates massive

current account de4cit. /ome countries li%e 9hina, he argues, save more than

they invest, causing them to have a current account surplus and a glut of savings

that they need to lend abroad to savings de4cient countries li%e the nited/tates.

This allo's the nited /tates to borro' from abroad and invest more than it

saves, 'hich produces the ./. current account de4cit.

ernan%e often used this argument to e-plain a'ay the ./. current account

de4cit, even as it gre' to terrifying proportions. (t pea%ed at


51/52

When the +eople?s an% of 9hina 0+!93, 9hina?s central ban%, created S

the wrong debate.docx

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