Category 1) A pure liquidity crunch — traditionally a bank run — when, by any measure, the bank remains entirely solvent and cash-flow positive;

Category 2) A liquidity crunch and insolvent (assets minus liabilities excluding shareholder equity is negative) according to market prices, but solvent according to hold-to-maturity modeling and cash-flow positive;

Category 3) A liquidity crunch and insolvent according to both market prices and hold-to-maturity modeling, but still cash-flow positive;

Category 4) A liquidity crunch, insolvent and cash-flow negative, but likely to be cash-flow positive in the near future and remain so thereafter; and, finally,

Category 5) A liquidity crunch, insolvent and permanently cash-flow negative.

A category 1 failure is easily contained by a lender of last resort and should be contained: the bank, after all, remains solvent and profitable. Furthermore, a pure liquidity crunch, left unchecked, will eventually push a bank through each category in turn and, more broadly, can spill over to other banks. There need be no cost to society of bailing out a category 1 failure. Indeed, the lender of last resort can make a profit by offering that liquidity at Bagehot‘s famous penalty rate.

A category 2 failure occurs when the market is panicking and prices are not reflecting fundamentals. A calm head and temporarily deep pockets should be enough to save the day. A bank suffering a category 2 failure should probably be bailed out and that bailout should again be profitable for whoever is providing it, but the authority doing to bailing needs be very, very careful about that modeling.

For category 1 and 2 failures, the ideal would be for a calm-headed and deep-pocketed private individual or institution to do the bailing out. In principle, they ought to want to anyway as there is profit to be made and a private-sector bailout is a strong signal of confidence in the bank (recall Warren Buffett’s assistance to Goldman Sachs and Bank of America), but there are not many Buffetts in the world.

Categories 3, 4 and 5 are zombie banks. Absent government support, the private sector would kill them, swallow the juicy bits and let the junior creditors cry. If the bank is small enough and isolated enough, the social optimum is still to have an authority step in, but only to coordinate the feast so the scavengers don’t hurt each other in the scramble. On the other hand, if the bank is sufficiently important to the economy as a whole, it may be socially optimal to keep them up and running.

Holding up a zombie bank should optimally involve hosing the bank’s stakeholders, the shareholders and the recipients of big bonuses. Whether you hose them a little (by restricting dividends and limiting bonuses) or a lot (by nationalising the bank and demonising the bonus recipients) will depend on your politics and how long the bank is likely to need the support.

For a category 3 failure, assuming that you hold them up, it’s just a matter of time before they can stand on their own feet again. Being cash-flow positive, they can service all their debts and still increase their assets. Eventually, those assets will grow back above their liabilities and they’ll be fine.

For a category 4 failure, holding them up is taking a real risk, because you don’t know for certain that they’ll be cash-flow positive in the future, you’re only assuming it. At first, it’s going to look and feel like you’re throwing good money after bad.

A category 5 failure is beyond redemption, even by the most optimistic of central authorities. Propping this bank up really *is* throwing good money after bad, but it may theoretically be necessary for a short period while you organise a replacement if they are truly indispensable to the economy.

Note that a steep yield curve (surface) will improve the cash-flow position of all banks in the economy, potentially pushing a category 5 bank failure to a category 4 or a 4 back to a 3, and lowering the time a bank suffering a category 3 failure will take to recover to category 2.

Zero hedge [that's this site] commentary suggests the fed manipulates our very life blood, as ordered by the lizard men, in order to create infinite debt and establish a soviet central planning regime.

So true …

A friend sent me to this opinion piece by Alan Kohler, a journalist at the ABC (that’s the Australian Broadcasting Corporation, for any Americans in the audience).  He’s terribly worried about HFT in general and front-running in particular.  I can’t be bothered quoting him — you can click through and read it for yourself if you like.  Go on, I’ll wait.

At first, I couldn’t see how anybody could legally front-run me.  I wrote this in reply to my friend:

Suppose that I’m a buyer.  My order is:

* I want to buy up to W shares

* The last transaction price was X per share

* I will pay no more than Y per share

* If there are any shares on offer for a price lower than or equal to Y, the following applies:

* Take the lowest asking price that is less than Y.  If the quantity available for sale at that price is greater than X, I’m done.  If the quantity available at that price is less than W, then look for the next-lowest asking price that is less than or equal to Y.  Repeat as necessary.

* If I end up buying everything on offer for asking prices less than Y and I still haven’t filled my order, the remainder is left as a bid at price Y.

So the “normal” way of buying shares — walking up to your broker and saying “10 shares, please”, is just a way of saying “W=10, Y=infinity”. It’ll get you 10 shares at the current prevailing price.

I can see how my broker could front-run me:  After getting my order, they could buy up everything with an asking price lower than my Y and then sell it to me at Y.  But (a) it’s illegal for brokers to do this; and (b) the whole point of my saying that I’m happy to buy them at price Y is that I’m happy to buy them at price Y.

I cannot see how an entirely separate company can front-run me.

Then a second friend pointed out that the front-running is really against institutional players in the market.  In reply to him, I described it like this:

1) I’m an institutional buyer (presumably an institutional seller would just have everything in reverse). The current price of the stock (i.e. the last transaction price) is X. I think that it’s worth at least Y now and that it will, over time, eventually be worth Z, with Z > Y > X. I want to buy 1 million shares at as low a price as possible but no higher than Y. There are more than a million shares available in existing quotes with asking prices between X and Y.

2) Rather than spook the market, I send in a stream of buy orders. Say, 100 orders for 10,000 shares, with the bid price for each gradually rising with whatever ask quotes are available.

3) The HFT dude is sitting right next to (or even inside) the exchange and sees this stream of orders coming in and being filled sooner than regular market players.

4) He doesn’t know it’s me sending them in and he doesn’t know my cut-off quantity or my cut-off price, but simple logic says if I’ve just sent in 9 orders for 10,000 shares each, I’m probably going to send in a 10th, too.

5) Making an intelligent guess that I will, he (very) quickly throws an order into the exchange to buy (say) 10,000 shares at the current asking prices and then once he’s got them, puts them up for sale again a fraction of a cent per share higher. He can do this offer to buy, complete the transaction and offer to sell before I get around to submitting my 10th order precisely because he’s so close to the exchange.

6) My 10th order comes in and since the (new, higher) asking price is still below my cut-off price, I happily buy them off the HFT dude.

7) Repeat until I finish buying 1 million shares or the price rises to Y, in which case I stop early.

I might still have that wrong (and if anybody with actual knowledge sees any mistakes, please do correct me), but for the moment I’ll suppose that I’ve got the basics down.  Here are my thoughts, in handy bullet-point form:

• Recognising the presence of the HFT dude, the rational thing for the institutional buyer to do would be to randomise the size and timing of each order they send in to mimic a bunch of smaller players. I assume this happens.

• To the HFT dude, a sequence of buy orders from a single purchaser and a sequence of buy orders from a collection of different purchasers would therefore be observationally equivalent. The HFT dude is therefore just a momentum trader.

• At worst, the HFT dude is unmasking the institutional buyer’s desire to stay hidden.

• Let’s say that the institutional buyer’s current valuation of Y is correct. Absent the HFT dude, the original sellers lose (because they sold at prices below Y) and the buyer gains (because they bought at prices below Y). With the HFT dude, the original sellers lose the same amount for the same reason and the buyer is forced to split their gain with the HFT dude.

• But if the true value of the stock really is Y, the presence of the HFT dude simply moves the price towards Y more quickly. The market is indeed made more efficient.

• If the institutional buyer was looking to buy for the long term, I see no problem here. Their primary goal was always to profit from the Z-Y margin and if they managed to purchase at something less than Y, that was just gravy.

• If they were only intending to hold on to the shares for a couple of seconds anyway because they were trying to do exactly the same thing to even slower and larger buyers up the food chain (i.e. they are only interested in the Y-X margin), then frankly, they had it coming and the world should not feel sorry for them.

• On the face of it, it seems to me that institutional players complaining about HFT outfits doing front-running amounts to complaining that they’re being forced to do their real job (of actually analysing the long-term profitability of a business) instead of just day trading.

• Other aspects of HFT, like quote stuffing, may still be harmful; I don’t know.

• I can see why regular, retail day traders (i.e. guys sitting in their bedrooms) would hate HFT frontrunning: they’re the slowest form of momentum traders. I do not see why I should care about them.

From his latest letter to shareholders in Berkshire Hathaway, the Sage of Omaha‘s opinion on gold as an investment:

The second major category of investments involves assets that will never produce anything, but that are purchased in the buyer’s hope that someone else – who also knows that the assets will be forever unproductive – will pay more for them in the future. Tulips, of all things, briefly became a favorite of such buyers in the 17th century.

This type of investment requires an expanding pool of buyers, who, in turn, are enticed because they believe the buying pool will expand still further. Owners are not inspired by what the asset itself can produce – it will remain lifeless forever – but rather by the belief that others will desire it even more avidly in the future.

The major asset in this category is gold, currently a huge favorite of investors who fear almost all other assets, especially paper money (of whose value, as noted, they are right to be fearful). Gold, however, has two significant shortcomings, being neither of much use nor procreative. True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production. Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.

What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct. Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As “bandwagon” investors join any party, they create their own truth – for a while.

Over the past 15 years, both Internet stocks and houses have demonstrated the extraordinary excesses that can be created by combining an initially sensible thesis with well-publicized rising prices. In these bubbles, an army of originally skeptical investors succumbed to the “proof” delivered by the market, and the pool of buyers – for a time – expanded sufficiently to keep the bandwagon rolling. But bubbles blown large enough inevitably pop. And then the old proverb is confirmed once again: “What the wise man does in the beginning, the fool does in the end.”

Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce – gold’s price as I write this – its value would be $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?

Beyond the staggering valuation given the existing stock of gold, current prices make today’s annual production of gold command about $160 billion. Buyers – whether jewelry and industrial users, frightened individuals, or speculators – must continually absorb this additional supply to merely maintain an equilibrium at present prices.

A century from now the 400 million acres of farmland will have produced staggering amounts of corn, wheat, cotton, and other crops – and will continue to produce that valuable bounty, whatever the currency may be. Exxon Mobil will probably have delivered trillions of dollars in dividends to its owners and will also hold assets worth many more trillions (and, remember, you get 16 Exxons). The 170,000 tons of gold will be unchanged in size and still incapable of producing anything. You can fondle the cube, but it will not respond.

Admittedly, when people a century from now are fearful, it’s likely many will still rush to gold. I’m confident, however, that the $9.6 trillion current valuation of pile A will compound over the century at a rate far inferior to that achieved by pile B.

Brilliant stuff.

James Bullard, of the St. Louis Fed, gave a speech in which (I believe) he argued that wealth effects meant that potential output was discretely lower now after the crash of 2006-2008.  David Andolfato and Tyler Cowen both liked his argument.

Scott Sumner, Noah Smith, Paul Krugman, Matt Yglesias, Mark Thoma and Tim Duy (apologies if I missed anyone) all disagreed with it for largely the same reason:  A bubble is a price movement and prices don’t affect potential output, if for no other reason then because potential output is defined as the output that would occur if prices didn’t matter.

Brad DeLong also disagreed on the same grounds, but was willing to grant that a second-order effect through labour-force participation may be occurring, although that was not the argument that Bullard appeared to be making.

In response, Bullard wrote a letter to Tim Duy, in which he revised his argument slightly, saying that it’s not that potential output suddenly fell, but that it was never so high to start with.  We were overestimating potential output during the bubble period and are now estimating it more accurately.

The standard reply to this, as provided by by Scott Sumner, Tim Duy, Mark Thoma and Paul Krugman, takes the form of:  If actual output was above potential during the bubble, then where was the resulting inflation?  What is so wrong with the CBO’s estimate of potential output (which shows very little output gap during the bubble period)?

Putting to one side discussions of what the output gap really is and how to properly estimate it (see, for example, Menzie Chinn here, here and here), I’ve always felt a sympathy with the idea that Bullard is advocating here.  Although I do not have a formal model to back it up, here is how I’ve generally thought of it:

• Positive output gaps (i.e. actual output above potential) do not directly cause final-good inflation.  Instead, they cause wage inflation, which raises firms’ marginal costs, which causes final-good inflation.
• Globalisation in general, and the rise of China in particular, meant that there was — and remains — strong, competition-induced downward pressure on the price of internationally tradable goods.
• That competition would induce domestic producers of tradable goods to either refuse wage increases or go out of business.
• Labour is not (or at least is very poorly) substitutable.  Somebody trained as a mechanic cannot do the work of an accountant.
• Therefore, the wages of workers in industries producing tradable goods stayed down, while the wages of workers in industries producing non-tradable goods were able to rise.
• Indeed, we see in the data that both price and wage inflation in non-tradable industries have been consistently higher than those in tradable sectors over the last decade and, in some cases, very much higher.

The inflation was there.  It was just limited to a subset of industries … like the financial sector.

(Note that I’m implicitly assuming fixed, or at least sticky, exchange rates)

As it happens, I also — like Tyler Cowen — have a sneaking suspicion that temporary (nominal) demand shocks can indeed have effects that are observationally equivalent to (highly) persistent (real) supply shocks.  That’s a fairly controversial statement, but backing it up will have to wait for another post …

The question was asked if it made sense for Treasury to permit bids and awards at negative interest rates in marketable Treasury bill auctions. DAS Rutherford noted that there were operational issues associated with such a rule change, but that the hurdles were not insurmountable. It was the unanimous view of the committee that Treasury should modify auction regulations to permit negative rate bidding and awards in Treasury bill auctions as soon as feasible. Rutherford noted that any decision on this policy change would likely be made at the May refunding.

Fun times.

It’s an incredible result; stunning, really. I just wish it didn’t make me so depressed.

I salute the innovation and cheer on the profits. That is capitalism at its finest and we need more of it.

It’s that f***king mountain of cash (now up to $100 billion) that concerns me, because it’s symptomatic of what is holding America (and Britain) in the economic doldrums.

The return Apple will be getting on that cash will be miniscule, if it’s positive at all, and conceivably negative.  Standing next to that, their return on assets excluding cash is phenomenal.

Why aren’t they doing something with the cash? Are they not able to expand profits still further by expanding quantities sold, even in new markets? Are there no new internal projects to fund? No competitors to buy out? Why not return it to shareholders via dividends or share buybacks?

Logically, a company holds cash for some combination of three reasons: (a) they use it to manage cash flow; (b) they can imagine buying an outside asset (a competitor or some other company that might complement them) in the near future and they want to be able to move quickly (and there’s no M&A deal that’s agreed upon faster than an all cash deal); or (c) they want to demonstrate a degree of security to offset any market perceived risk with their debt.

Apple long ago surpassed all of these benefits.  The net marginal value of Apple holding an extra dollar of cash is negative because it returns nothing and incurs a lost opportunity cost.  So why aren’t their shareholders screaming at them for wasting the opportunity?

The answer, so far as I can see, is because a significant majority of AAPL’s shareholders are idiots with a short-term focus. They have no goddamn clue where else the money should be and they’re just happy to see such a bright spot in their portfolio.  Alternatively, maybe the shareholders aren’t complete idiots — Apple’s P/E ratio has been falling for a while now – but the fundamental point is that they have a mountain of cash that they’re not using.

In 2005 that wouldn’t have been as much of a problem because the shadow banking system was in full swing, doing the risk/liquidity/maturity transformation thing that the financial industry is meant to do and so getting that money out to the rest of the economy.[*] Now, the transformation channel is broken, or at least greatly impaired, and so nobody makes any use of Apple’s billions. They just sit there, useless as f***, while profitable SMEs can’t raise funds to expand and 15% of all Americans are on food stamps.

Don’t believe me?  Here’s a graph from the Bank of England showing year-over-year changes in lending to small- and medium-sized enterprises in the UK.  I can’t be bothered looking for the equivalent data for the USA, but you can rest assured it looks similar.  The report it’s from can be found here (it was published only a few days ago).  The Economist’s Free Exchange has some commentary on it here (summary:  we’re still in trouble).

So what is happening to all that money?  Well, Apple can’t exactly stick it in a bank account, so they repo it, which is a fancy way of saying that they lend it to a bank (or somebody else in the financial industry) and temporarily take some high quality asset like a US government bond to hold as collateral.  They repo it because that’s all they can do now — there are no AAA-rated, actually safe, CDO tranches being created by the shadow banking system any more, they’re too big to make use the FDIC’s guarantee (that’s an excellent paper, btw … highly recommended) and so repo is all they have left.

But the financial industry is stuck in a disgusting mess like some kid’s hair with chewing gum rubbed through it. They’re all just as scared as the next guy (especially of the Euro problems) and so they’re parking it in their own accounts at the Fed and the BoE.  As a result, “excess” reserves remain at astronomical levels and the real economy makes no use of Apple’s billions.

That’s a tragedy.

[*] Yes, the shadow banking industry screwed up. They got caught up in real estate fever and sent (relatively) too much money towards property and too little towards more sustainable investments. They structured things in too opaque a manner, failed to have public price discovery and operated under distorted incentives. But they operated. Otherwise useless cash was transformed into real investment and real jobs. Unless that comes back, America and the UK will stay in their slow, painful household deleveraging cycle for another frickin’ decade.

A veto stops a thing from happening (think of the UN Security Council).  The fiscal compact is going to go ahead, just without Britain.  Therefore, Britain did not veto it; they declined to take part.

That is all.

Update:

Okay, that isn’t quite all.  Just to be clear, I think that Cameron did the wrong thing.  I believe that, at a minimum, he should have committed to bringing the proposal to the UK parliament.  It may well have been voted down at that point, but nevertheless it should have happened.  Parliament is sovereign in the UK.  This was a serious proposal with potentially significant consequences from either agreeing to it or walking away from it; the people of Britain deserved to have their elected representatives decide.

I am undecided on whether signing up to the pact would be in the best interests of the UK.

• Immediately establish a single, Euro area-wide bank deposit guarantee scheme.  A single currency must absolutely ensure that a Euro held as money in Greece be the same as a Euro held as money in Germany.  That means that retail and commercial deposits in each should be backed by the same guarantee.  I have no firm opinion on how it should be funded.  The classic manner is through a fee on banks proportional to their deposits, but if Euro area countries ultimately prefer to use a Tobin-style tax on transactions, that’s up to them.  Just get the thing up and running.  Of course, a unified deposit guarantee also requires a unified resolution authority in the event of an insolvent bank collapsing.  There are many and varied forms that fiscal union can take; this is the most urgent of them all.  I am shocked that this does not already exist.

• The ECB should switch from targetting current inflation to expected future inflation.  The Bank of England already does this.  Accepting that any effect of monetary policy on inflation will come through with a lag (or at least acknowledging that current inflation is backward looking), they “look through” current inflation to what they expect it to be over the coming few years.  This is important.  Current inflation in the Euro area — i.e. the rate of change over the last 12 months — is at 3%.  On the face of it, that might make an ECB policymaker nervous, but looking ahead, market forecasts for average inflation over the coming five years are as low as 0.85% per year in Germany.  They will be much lower for the rest of the Euro area.  Monetary policy in the Euro area is much, much too tight at the moment.  At the very least, (a) interest rates should be lowered; and (b) the ECB should announce their shift in focus toward forward inflation.

• The ECB should start to speak more, publicly, about forms of current inflation that most affect future inflation.  This follows on from my previous point, but is still logically distinct.  The Fed likes to focus on “core” inflation, stripped of items with particularly volatile price movements.  I don’t much care whether it is non-volatile prices or nominal wages, or even nominal GDP.  I just want the ECB to be speaking more about something other than headline CPI, because it is those other things that feed into future headlines.

• The ECB’s provision of liquidity to the banking system, while currently large, is not nearly large enough.  The fact that “German Bunds trade below the deposit facility rate at the ECB and well below the Overnight Rate” is clear evidence of this.  I currently have no opinion on whether this ought to be in the form of increasing the duration of loans to Euro area banks, relaxing the collateral requirements for loans or working with member countries’ treasuries to increase the provision of collateral.  I certainly believe (see my second point above) that interest rates should be lowered.  The point, as far as is possible, is to make replacing lost market funding with ECB funding more attractive to banks than deleveraging.

• A great deal of Euro area sovereign debt is unsustainable; hair-cuts are inevitable and they should be imposed as soon as possible (but, really, this requires that a unified bank resolution authority be established first).  The argument for delaying relies on banks’ ability to first build up a cushion of capital through ongoing profitability.  When banks are instead deleveraging, the problem is made worse by waiting.

• Credit Default Swaps must be permitted to trigger.  The crisis may have its origins in the the profligacy of wayward sovereigns (frankly, I think the origins lie in the Euro framers not appreciating the power of incentives), but the fundamental aspect of the crisis itself is that various financial assets, previously regarded as safe, are coming to be thought of as risky.  By denying market participants the opportunity to obtain insurance, Euro area policymakers are making the problem worse, not better.  Market willingness to lend to Greece in 2025 will in no way depend on how we label the decisions made in 2011 and 2012.

• Every member of the Euro periphery should be in an IMF programme.  Yes, I’m looking at you, Italy.  If the IMF does not have sufficient funds to work with, the ECB should lend to it.  All politicians in Euro periphery countries should be speaking to their electorates about multi-decade efforts to improve productivity.  These things cannot be fixed in two or three years.  They can, at best, be put on the right path.

• For every country in an IMF programme, all sovereign debt held by the ECB should be written down to the price at which they purchase it.   If the ECB buys a Greek government bond at, say, a 20% discount to face value, then that bond should be written down by 20%.  The ECB should not be in a position to make a profit from their trading if Europe finds its way through the overall crisis.  Similarly, the ECB should not be in a position to take a loss, either — they should not be required to take a hair-cut below the price they pay for Euro area sovereign debt.

Note that I have not yet used the phrase “Euro bond” anywhere.  Note, too, that a central bank is only meant to be a lender of last resort to banks.  The lender of last resort to governments is the IMF.

If Euro area policymakers really want to engage in a fiscal union (a.k.a. transfers) beyond the absolutely essential creation of a unified bank deposit guarantee scheme, it is perfectly possible to do so in a minimal fashion that does not lessen the sovereignty of any member nation:  Have a newly created European Fiscal Authority (with voluntary membership) provide the minimum universally agreed-on level of unemployment benefits across the entire area, funded with a flat VAT.  Any member country would retain the ability to provide benefits above and beyond the minimum.  This will have several benefits:

• Since its membership would be voluntary and it would provide only the minimum universally agreed level, it cannot, by definition, constitute a practical infraction on sovereignty;
• It will help provide pan-European automatic stabilisers in fiscal policy;
• It will provide crucial intra-European stabilisation;
• It will increase the supply of long-dated AAA-rated securities at a time when demand for them is incredibly high; and
• It will decrease the ability of Euro member countries to argue that they should be able to violate the terms of the Maastricht Treaty at times of economic hardship as at least some of the heavy lifting in counter-cyclical policy will be done for them.

———————-

Update 30 Nov 2011, 13:05 (25 minutes after first publishing the post):

It would appear that the world’s major central banks have announced a coordinated improvement in the provision of liquidity to banks.  This is a good thing. Press releases:

• Bank of England
• Bank of Canada
• ECB
• Bank of Japan
• Swiss National Bank
• Federal Reserve

The crisis of 2007/2008 and the present Euro-area difficulties may both be interpreted, from a policymaker’s viewpoint, as a combination of two related events: an exogenous change in the relative supplies of high- and low-risk assets and, subsequently, a classic liquidity crisis. A group of assets that had hitherto been considered low risk suddenly became viewed as high risk. The increased supply of high-risk assets pushed down their price, while the opposite occurred in the market for low-risk assets. Unsure of their counterparties’ exposure to newly-risky assets, the suppliers of liquidity then withdrew their funding. Note that we do not require any change in financial intermediaries’ risk-aversion (their risk appetite) in this story. Tightening credit standards, common to any downturn, serve only to amplify the underlying shock.

Central banks responded admirably to the liquidity crises, supplying unlimited quantities of the stuff and generally at Bagehot’s recommended “penalty rate”. In response to the first problem, and being concerned primarily with effects on the real economy, central banks initially lowered overnight interest rates, trusting markets to correspondingly reduce low-risk and, in turn, high-risk rates. When overnight rates approached zero and central banks were unwilling to permit them to become negative, they turned to QE, mostly focusing on forcing down low-risk rates (out of a concern for distorting the allocation of capital across the economy) and allowing markets to bring down high-risk rates.

Consequently, QE tightens spreads over overnight interest rates and since spreads over blew out during the crisis, this is commonly seen as a positive outcome and even a sign that the overall problem is being resolved. However, such an interpretation misses the possibility, if not the fact, that broader spreads are rational market reactions to an underlying shift in the distribution of supply. In such a case, QE cannot help but distort otherwise efficient markets, no matter what assets are purchased.

Indeed, limiting purchases to low-risk assets may serve to further distort any “mismatch” between the distributions of supply and demand. Many intermediaries operate under strict, and slow moving, institutional mandates that limit their exposure to long-term, high-risk assets. Such market participants are simply unable, even in the medium term, to participate in the portfolio rebalancing that CBs seek. The efficacy of such a strategy may therefore decline as those agents that are able to participate become increasingly saturated in their purchases of high-risk debt (and in so doing are seen as risky themselves and so unable to raise funds from the constrained agents).

Furthermore, QE in the form of open market purchases of bonds, no matter whether they are public or private, automatically implies a bias towards large corporates and away from households and small businesses that rely exclusively on bank lending for credit. Bond purchases directly lower interest rates faced by large corporates (through portfolio rebalancing), but only indirectly stimulate small businesses or households via bank funding costs. In an environment with reduced competition in banking and perceived fragility in the financial industry as a whole, funding costs may not decline in response to QE and even if they do, the decline may not be passed on to borrowers.

In any event, a direct consequence of QE at the ZLB must be a reduction in the expected profitability of the financial industry as a whole and with it, a corresponding decline in the industry’s ability to withstand negative shocks. Given this trade-off, optimal policy at the ZLB should expressly consider financial system fragility in addition to inflation and the output gap, and when the probability of a negative shock rises, the weight given to such consideration must correspondingly increase.

How, then, to stimulate the real economy? Options to mitigate such a trade-off might include permitting negative nominal interest rates, at least for institutional investors; engaging in QE but simultaneously acting to improve financial industry resilience by, for example, mandating industry-wide constraints on dividends or bonuses; or, perhaps most importantly, acting to “correct” the risk distribution of long-term assets. The first of these is not without its risks, but falls squarely within the existing remit of most central banks. The second would require coordination between monetary and regulatory policy, a task eminently suited to the Bank of England’s new role. The third requires addressing the supply shock at its source and so its implementation would presumably be legislative and regulatory.

If further QE is deemed wise, it may also be necessary to grit one’s teeth and shift purchases out to (bundles of) riskier assets, if only maximise their effect. Given the distortions that already occur with low-risk purchases, this may not be as bad as it first seems.

Active monetary research can help inform all of these options, but more broadly, should perhaps focus not just on identifying the mechanisms of monetary transmission but also consider their resilience.