“Central Bank Balance Sheet Expansion – A Palliative or a Serotonin?”

Sydney M. Williams

Thought of the Day

“Central Bank Balance Sheet Expansion – A Palliative or a Serotonin?”

January 17, 2012

I am far from an expert on the Federal Reserve, but I, like everyone, recognize unusual changes when I see them. And the expansion of the Fed’s balance sheet and, in fact, the Bank of England’s (BOE) and the European Central Bank’s (ECB) over the past three and a half years have been nothing short of extraordinary. It was unsurprising, therefore, that on Friday S & P downgraded France, Austria and seven other European countries. It remains to be seen whether these countries will be as cavalier toward the rating change as was the United States when the same rating agency downgraded our bonds last August.

The reason generally given for the rapid expansion of central banks’ balance sheets was the severity of the global recession and a desire to avoid deflation.

Speculation in stocks had driven valuations to unprecedented highs, in terms of multiples, by early 2000; when prices corrected in 2000-2003 that speculative fever was redirected to home prices. When that game ended, the sharp price declines in both stocks and housing fostered pessimism and a recession. American’s normal optimistic outlook has not yet returned. Millions of people have recognized they were living too much in the present, and were not planning adequately for the future.

Explanations for such speculative behavior on the part of individuals are myriad, but include government policies that encouraged such practices – easy credit and a low cost of borrowing, few incentives to save and an expectation by those working for government and within unions that their financial future was secure. Promises made were considered promises to be honored. But explanations for this profligacy go back further: the proliferation of credit cards in the 1960s and the Community Reinvestment Act of 1977 served to encourage consumption at the expense of investment. Robert Shiller, in Sunday’s New York Times, discussed a new book, Beyond Our Means: Why America Spends While the World Saves. Professor Shiller pointed out that Americans have long exhibited optimism for the future, producing an attitude, combined with government policies that helped breed a measure of personal irresponsibility.

The rise in stock, bond and home prices in the 1990s and early 2000s caused people to become self-indulgent and reckless as regards to borrowing. The image of a pot of gold at the end the rainbow became manifest in the housing industry with prices ever soaring and buyers regularly bidding through the offer price. The New York Times, in a front page article on Saturday, January 14 pointed out that members of the Fed, in their laudatory compliments to outgoing Chairman Alan Greenspan in 2006, appeared not to understand what was happening. Binyamin Applebaum, the author of the article, wrote: “The problem was not a lack of information; it was a lack of comprehension, born in part of their deep confidence in economic forecasting models that turned out to be broken.” It wasn’t just housing, consumption, as a percent of GDP had grown from 61%, in the mid 1950s, to 70% by the mid 2000s.

The last decade’s decline in the consumer’s asset prices – his home and his stockholdings – has impacted his attitudes. At the same time, an aging workforce and growing concerns as to the viability of Social Security and the virtual elimination of defined benefit programs are working their way through the American psyche. When the house of cards began to collapse, the Fed had no choice but to step in.

The consequence for consumers is likely to be a greater focus on savings and a reduced emphasis on consumption. Household and mortgage debt has been modestly reduced. Concomitantly, leverage at financial institutions was mandated to be lowered. The Federal Reserve stepped into the breach to stem what might otherwise have been a perfect storm. Over the past four years, the Fed’s balance sheet has increased three-fold. Similar increases can be seen in the balance sheets of the European Central Bank and the Bank of England. Jonathon Trugman, writing in the New York Post, notes: “In reality, though, the Federal Reserve has just extended essentially unlimited lines of credit, camouflaged as a swap, to the world in U.S. dollars.”

While most people agreed with the Fed’s aggressive actions in 2008 as necessary, the risks of continued monetary expansion are manifold. Inflation is an obvious risk. But there are others. Purchases of longer-dated assets utilizing short term borrowings risk all central banks becoming vulnerable to a rise in interest rates – reducing the value of its assets, while its liabilities remain intact. A Large and on-going purchase of assets by central banks distorts free-flowing capital markets. There is the risk of a cross-border feedback loop. Emerging countries – think China – have increasingly been the buyer of our Treasuries. Interest rates in Europe and the U.S. are no longer a function of normal supply and demand; thus the spread between yields in the developed world and the rest of the world may widen further, raising interest costs for emerging economies, especially those on which our exporters are increasingly dependent.

Actions have consequences. What was palliative in 2008 could become a serotonin in 2012. While I don’t pretend to know the answers, it seems obvious that central banks should begin easing back on monetary expansion, and that fiscal and monetary policy should be directed toward economic growth – less regulation, with a flatter, lower and broader tax system. We need to emphasize exports; to do so requires a healthy global economy, more liberal immigration policies at home, and an education system that is fearless of competition. At the same time, government must recognize the necessity for an aging population to increase savings and investments.

Credit expansion is the easy way out. Professor Joseph Stiglitz of Columbia recently wrote that austerity is not the answer. It “will only exacerbate the economic slowdown.” Nevertheless, the excesses baked into our system must be addressed. The answers will involve some pain; so the focus must be on growth. Despite misgivings of those like Professor Stiglitz, the private sector, time and again, has proven to be the only antidote.