-- John Kemp is a Reuters columnist. The views expressed are his own --
By John Kemp
LONDON, Nov 25 (Reuters) - The original function of central banks in the eighteenth and nineteenth centuries was to help manage a government's debt issue. Lender of last resort and macro management functions were later additions in the late nineteenth and early twentieth centuries respectively.
As late as the 1950s (for the United States) and the 1990s (for the United Kingdom) debt management remained a key function but it has faded from view as independent central banks have increasing focused on monetary policy. Fiscal consolidation and six decades of macro stability has reduced the pressure from the fiscal side. All that is about to change radically.
MONEY BUT NO CREDIT
The quantity theory of money (beloved of generations of monetarist economists) is both a profound insight and a trivial accounting identity. In its naïve form, quantity theory (MV=PT) holds that the stock of money (M) multiplied by the rate at which it changes hands (velocity of circulation, V) equals the number of transactions in the economy (T) multiplied by the average price level at which they occur (P).
Assuming velocity is constant (V) an increase in the money stock (M) must stimulate the number of transactions (T) or raise the average price at which they occur (P). The Fed's quantitative easing strategy is designed to increase the money supply (M) in order to force an increase in output (T), prices (P) or some combination of the two, averting both a slump and a deflationary decline in prices.
The is that quantity theory assumes velocity (V, the demand for cash and bank deposits) is constant or at least determined by outside factors that have nothing to do with the stock of money, prices or output. In practice, money demand depends on a combination of structural factors (banking technology, payment cycles) and cyclical ones (such as willingness to take on debt and precautionary savings). It is not constant at all.
Cyclical factors have become dominant since the banking crisis intensified in September. Precautionary demand has surged (velocity has fallen) as consumers and businesses want to hold much more money (bank deposits and cash) for any given level of output and prices "just in case".
The Fed's attempt to boost the money supply (M) has been entirely offset by the increased demand for cash and deposits.
The problem is actually worse than this simple account suggests. While the Fed can create money in the "narrow" sense by increasing the level of reserves within the banking system, it cannot create money in the "broader" sense of credit extensions from banks to one another, households and corporations.
But it is broad money (credit) is rather than narrow money (cash and reserves) that is more relevant for stimulating changes in output and prices. While the Fed has managed to boost narrow money in the last two months by expanding its balance sheet, broad money has been flat or falling.
The Fed's efforts have been frustrated because commercial banks have been changing the composition of their balance sheets to include more reserves (narrow money) and fewer loans and leases (broad money). Over the last month, the increase in commercial bank assets in recent weeks has all been in reserves with the Fed and holdings of Treasury bills. Interbank lending has continued to shrink, while loans and leases to the rest of the economy are flat.
SOLVENCY AND UNCERTAINTY
The problem with broad money is that credit is a function of having solvent and liquid banks willing and able to lend, and solvent borrowers willing and able to take on debt and perhaps put up sound collateral. But falling house prices, deteriorating collateral values, and pervasive uncertainty about employment, income and corporate cash flows have combined to create widespread questions about solvency and destroy the credit creation process.
The monetary transmission mechanism is now broken. The Fed's narrow money creation is being offset by risk-averse changes in bank balance sheets and a rise in cash demand by households and firms. While the Fed is busy creating reserves, and there is no stimulus to output or prices.
The task for policymakers is to restore credit creation and stabilise, then reduce, the demand for cash balances. Since it is pervasive uncertainty about the economy which is limiting credit creation and boosting cash demand, the solution is to find some way to limit that uncertainty. The answer obviously has to come from outside monetary policy (since it is the failure of the monetary transmission mechanism that is the root of the problem).
The only option left is fiscal policy. The federal government needs to announce a big enough fiscal stimulus (in effect an "insurance policy") that households become less fearful and start to spend again, while businesses worry less about sales and are prepared to invest and keep more employees on payroll.
FLOATING THE COLOSSAL DEBT
Fiscal stimulus is needed to make monetary policy effective again. But stimulus on the scale envisaged will be ruinously expensive and push up the government's borrowing costs sharply unless investors can be convinced to continue buying Treasury securities at very low yields.
Demand for low-yielding Treasuries depends on convincing investors that (i) inflation will remain under control, but more importantly (ii) interest rates will remain low for a very long time. Monetary policy has to support the government's borrowing programme. This is exactly what happened in the United States and the United Kingdom throughout the late 1930s and through the Second World War until 1951.
In fact monetary policy went much further than this. Throughout the late 1930s and during the war, the Fed mandated a maximum yield for various types of government debt at various maturities, and committed to buy securities on the open market if the yield breached those ceilings. Monetary policy guaranteed the effectiveness of fiscal policy, which in turn helped make monetary policy more effective.
INTEGRATED FINANCIAL POLICY
In the last 50 years, analysts have become used to thinking of "fiscal" and "monetary" policy as two separate items run by separate institutions (the Treasury and the Fed in the United States, the finance ministry and the central bank in other countries). Institutional and policy separation has been reinforced by the trend over the last two decades to central bank "independence".
But faced with the crippling cost of rescuing the banking system, and a massive bill for tax cuts and government spending, fiscal and monetary policy are now essentially one and the same. Instead of thinking about separate fiscal and monetary policies, for the next few years analysts will have to get used to thinking about "financial" policy in a combined sense (much as their predecessors did before 1945).
The Fed and the Treasury will be forced to act jointly. For the time being, the Fed is unlikely to go as far as announcing ceilings on Treasury yields (though several respected commentators have called on the central bank to consider conducted open market operations in a wider range of collateral types and at longer maturities, which amounts to the same thing, with the Fed buying longer dated Treasuries and other securities to bring down yields).
The Fed is, however, virtually certain to keep U.S. interest rates on the floor for an extended period. It needs to convince the market there will be no "normalisation" of interest rates for at least 3-4 years if the Treasury is to have any hope of placing the expected $3-4 trillion worth of new debt in fiscal 2009 and another substantial tranche in fiscal 2010.
Fed Vice-Chairman Don Kohn hinted at this when he spoke last week about the Fed operating in recent times on the fuzzy border between fiscal and monetary policy. Chairman Ben Bernanke was even more explicit in his 2004 speech on quantitative easing, where he noted quantitative measures might be a more credible way to commit to keep monetary policy loose in the medium term than an interest rate target; and noted that one of the key transmission mechanisms was the ability to hold down long-dated bond yields, making borrowing cheaper for the government as well as the private sector.