The sarcasm of the title of my recent post notwithstanding, there are some things economists understand to be true that are. Among those:
- People respond to incentives
As with the Supreme Court, economists extend this principle to organizations, on the (generally correct) idea that organizations are made up of people who act in their own best interest. (It isn’t, pace the old joke, that they wouldn’t pick up a $100 bill lying on the sidewalk; it’s that they would never believe someone would drop one there in the first place.) This is how you get to teach courses in “Organizational Behavior” and the like—it’s not the madness of crowds if they all act “rationally” on an individual basis. (More Skinner than Ballard, but I sidebar.)
In economic models, as I obliquely ,mentioned last post, there is no risk-free arbitrage: if there were, “the market” would eliminate it, because it would mean someone was dropping $100 bills on the sidewalk, and the “the market” would make certain that person (or organization) was bankrupted, or at least suffered enough of a loss to change its behavior.
If you need proof of that:
Note that there were a nominal amount of excess reserves being held by some institutions even before interest was paid. We can treat them basically as rounding errors and systemic inefficiencies; given the skewness of the risk-reward, it has always been safer to put an extra $20,000 or so “in reserve” for late transactions, counterparty failures to deliver, or just plain calculation errors. Think of it as the equivalent of taking $60 out of the ATM when you only expect to need $40; the ability to pay taxes you forgot to calculate, upgrade a shirt from poly to cotton, or buy a bottle of water “on impulse” is more valuable (utile) than the day’s interest on that $20 (currently, just over 1/100,000th of a cent from one of my TBTF financial institutions; half that from the other). And so it goes for reserves.
But in September of 2008, the Fed decides to pay interest on reserves—including Excess Reserves. The banks can now make 25 times what they pay in interest, risk-free, just by holding onto money. The Fed is, essentially, leaving $100 bills on the sidewalk.
Hasty disclaimer: it’s doing so for all the right reasons: the banks need to
rebuild strengthen their balance sheets, and nationalization is off the table. Every little bit helps. Conceptually, economic theory indicates that one should pay “interest,” in some form, for the right to use another’s capital. (That this breaks down in the details is subject for a discussion over tonics.)
I’m using monthly, blended data—nothing so clear as the BarCap analyst examined in the last post—but it’s fairly easy to see what happens even on that trend. Excess Reserves in October are two orders of magnitude higher than they were a few months. They more than double for November, and then stay in a fairly narrow band until around the time the “recovery” began. From August of 2009 until the end of the year, they rise again, just missing the magic $1 Trillion mark in October, breaking it in November and not dropping below again.
It’s free money; why wouldn’t the people who run the banks take it?
And they do. So the number of $100 bills being dropped on the sidewalk would be expected to decline—save that the Fed has no liquidity constraint, even if we’re ignoring a right of seignorage. And the participants come by each night, picking up more.
The externalities of such a situation are obvious. The most direct solutions are two: either (1) stop dropping the bills or (2) show the banks that there are better investment opportunities on a risk-adjusted basis.
Joe Gagnon (h/t Brad DeLong) advocates the former. It is unclear (to me) whether Gagnon is advocating the full cessation of paying 0.25% on reserves or just a temporary cessation until market rates rise, but in either case he recognizes the perils of risk-free arbitrage. (Bruce Bartlett is shriller—and possibly more extreme—than I am on the matter.)
The other option is rather more problematic, not so much because the pump hasn’t been primed as that the water used was rather dirty, with a significant underestimation of the amount of rust that needed to be addressed only compounding the issue.
The result is approximately what one might have reasonably predicted in the goods and non-financial services economy: the Federal G(f) barely compensated for the State –G(s), and only the multiplier effect of that spending actually happening “expanded” anything. (Or, more accurately, some businesses did not fail so rapidly and the cost of some services did not rise so quickly as they would have ex-“stimulus.”) The good news is that there was a barrel of water between the diving board and the ground; the bad news is that the barrel wasn’t full, so the dives had to be better than excellent, with minor injury virtually a best-case scenario.
The non-financial private-sector, in short, has not been able to recover, while the financial sector—propped up by those $100 bills—shows evermore “strength” on the back of dicey assets being held by the Fed, higher fees and lower interest rates for their “customers,” and—of course, $2.5 Billion a year in from the taxpayer.
Sooner or later, we’ll be talking about real money. For now, though, we’re just talking about the real economy. What we have here isn’t (quite) a dead shark—as I said earlier, the private sector has performed amazingly well in the face of opposition to it from the Fed and the banks—but it has a diving tank in its mouth and Tim Geithner et al. taking shots at it will a high-powered rifle. We can only hope that former NYC “financial cop” Geithner isn’t as good a shot as another former NYC cop transplanted to a land he doesn’t like or understand.