So, why haven’t banks expanded their balance sheets?
“The main problem with fiscal policy is that it is too tempting. Keynes’s idea was to use it as a counter-cyclical tool- on then off. But once governments start using fiscal policy for economic expansion, they just can’t control themselves- fiscal policy is the opiate of the elected.”
Most of the time we think of high interest rates as a problem, but low interest rates are just as problematic. Low interest rates do make money more affordable and can spur growth, affecting all parts of the economy. Housing becomes more attractive for marginal buyers as mortgage rates are reduced. Debt is also easier to service for corporations and governments, taking up less space on the liability side of the ledger. Expanding institutional budgets, not in balance, are easier to rationalize as interest expense becomes a footnote. Even new theories (MMT) gain traction among the investing community. People stay in office. But in an environment where investors buy bonds for capital appreciation, not yield, and others buy equities for yield and not capital appreciation, something seems amiss. If low interest rates are a symptom of monetary tightness in the real economy, then naturally institutions would hoard the safest, most liquid fixed income assets because of liquidity risk. (Recall what happened just recently in the repo market when rates spiked.) This results in lower interest rates because of demand for these assets and the perceived liquidity threat. Low rates also create risk in other parts of the economy via equity valuations and leverage. Discounting mechanisms used for valuations can yield absurd values when below normal rates are used, and low interest rates invite the misallocation of capital by corporate financial officers that only delay the end for firms that existence because of a low cost of debt. So, why haven’t banks expanded their balance sheets, putting more money into the real economy? Reserves are plentiful but money remains tight. The lag effect of monetary policy may be one reason. It does take time for the Fed’s action to play out in the market, maybe as long as a year. Another may be rooted in the regulatory framework of our banking system originating from the crisis of the Great Recession. Regulations today for banks may not be draconian, but they still exert tremendous influence on how banks can and do conduct banking operations. As we are seeing, increasing bank reserves does not guarantee lending will take place. By now it should be clear that changes to how monetary policy gets transmitted throughout our financial system seems warranted. Removing some of the structural and regulatory frictions in the financial system may allow the Fed to distance itself from fiscal policy and the Treasury.
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