Posted by: Dirk | September 9, 2011


The FT has a nice article on ‘Helicopter-Ben’ and the yield curve:

However, in recent weeks, at least in the United States and perhaps soon elsewhere in the Fed dominated global monetary system, the rules have changed. Pilot Bernanke has changed planes from a fixed wing to a rotor-based helicopter by “conditionally” freezing policy rates for at least the next two years. As such the front end of the curve has for all intents and purposes become inert and worst of all flat as opposed to steeply positive. Two-year yields are the same as overnight fund rates allowing for no incremental gain – a return that leveraged banks and lending institutions have based their income and expense budgets on. A bank can no longer borrow short and lend two years longer at a profit.

This, I believe, is the explanation behind Richard Koo’s statement that monetary policy would be damaging (!) in a balance sheet recession (sadly, I cannot find a link for this statement, but I believe that Paul Krugman took it up and discussed this somewhere). By putting the interest rate down to zero, buying up assets and lending at low rates the spreads that banks would earn are falling. This lowers expected profits of banks, which are more or less bankrupt, and causes more financial distress instead of less. This – together with Bernanke’s announcement that low interest rates would be frozen for some time to come – would explain while stocks of financial companies have been hammered in recent weeks.

UPDATE 19/09/2011: with a hat tip to Finn Körner here is an excerpt from Richard Koo’s “Holy Grail“, p. 131-2:

Eggertsson (2003), among others, argued that even if the money supply cannot be increased by inflation targeting, the central bank can still increase the money supply by buying up assets and injecting liquidity directly into the private sector. These authors assert that these purchases would generate a recovery by raising asset prices and at the same time increasing the money supply.

Unfortunately, there are two main problems with this approach. First, with few borrowers left and a marginal money multiplier that is zero or even negative, the central bank would have to make enormous purchases of assets to exert a significant impact on asset prices or the money supply. Second, these purchases would invariably expose the bank to significant risk.

Regarding the first, asset prices do not respond well to central bank purchases during a balance sheet recession. One of the key characteristics of these recessions is that private-sector investors tend to value assets strictly on a discounted future cash-flow (DCF) basis. After all, a bubble becomes a bubble when asset prices reach a level that can no longer be justified by DCF analysis.


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