Another “Operation Twist” will cause more damage to the economy

Last week the US central bank has announced that it will expand its “Operation Twist” program to extend the maturities of assets on its balance sheet and also said it stands ready to take further action to put unemployed Americans back to work. The US central bank will prolong the program through the end of the year, selling $267 billion of shorter-term securities and buying the same amount of longer-term debt. The action should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative, so it is held.

The idea behind the move, nicknamed “Operation Twist” after a similar policy in the 1960’s, is to push down long-term borrowing costs to encourage the housing market and other forms of economic activities. But why should a lowering of interest rates do all this?

For instance the data between 2007 to present indicates that a decline in interest rates did nothing to lift visibly housing starts. There is in fact a positive correlation between interest rates and housing starts since 2007. (A fall in interest rates is now associated with a downtrend in housing activity). Note that prior to 2007 there was negative correlation between housing starts and interest rates – so why is there a sudden break in the correlation?

Now, a fall in interest rates cannot grow the economy. All that it can produce is a misallocation of real savings. As a rule an artificial lowering of interest rates (which is accompanied by the central bank monetary pumping – increases commercial banks reserves) boosts the demand for lending and this as a rule causes banks to expand credit out of “thin air”.

This in turn sets in motion the diversion of real savings, or real funding from wealth generating activities to non-wealth generating activities.

Since so called economic activity is measured in terms of money obviously the more money is created the greater the so-called economic activity is going to be, which is misleadingly interpreted as a strengthening in real economic growth. (Note that employing price deflators doesn’t fix the problem of measuring real economic growth).

As long as the pool of real savings is still expanding the illusory policy of the central bank appears to be “working”.

Trouble emerges when the pool of real savings is coming under pressure (when it is either stagnating or falling). Then monetary pumping by the Central bank cannot lift the rate of growth of money supply since banks don’t employ the pumped money in boosting the expansion of lending.

Note that banks are just intermediaries, once the pool of real savings is not there any expansion of lending out of “thin air” runs the risk that this will end up as non performing assets.  (Remember it is the expanding pool of real savings that makes real economic growth, i.e. real wealth expansion possible).

Obviously banks will not be interested in this. Observe that when the pool of real savings is expanding banks “can afford” to engage in inflationary lending without incurring too much risk.

However, as the pool comes under pressure the chances that banks will end up holding a large percentage of non-performing (i.e. bad) assets increases. Under this situation the Fed cannot do much since the banks will not expand lending out of “thin air”. In short if the pool of real savings is in trouble, the Fed’s ability to create illusions is coming to an end.

Obviously the Fed can bypass the banks and lend money directly to the non-banking sector, thereby boosting the growth momentum of the money supply – so-called “helicopter money”. We suggest that if the pool of real savings is in trouble such pumping will not “work”, in fact it will run the risk of destroying the market economy.

For those commentators who hold that an artificial lowering of interest rates could grow the economy we must reiterate that an interest rate is just an indicator. In a free market it would mirror consumer preferences regarding the consumption of present goods versus future goods. For instance, when consumers raise their preferences towards future goods relative to present goods this is manifested by a decline in interest rates.

Conversely, an increase in the relative preference towards present goods leads to the increase in interest rates.

As a rule, all other things being equal, an increase in the pool of real funding tends to be associated with an increase in the preference towards future goods i.e. a decline in interest rates. Note however that movement in interest rates has nothing to do with the generation of real wealth as such. The key for that is the increase in the capital goods. What makes this increase in turn possible is the expanding pool of real savings.

In a market economy interest rates instruct entrepreneurs (in accordance with consumer time preferences) where to channel their capital. A policy that artificially lowers interest rates only sends misleading signals to businesses thereby resulting in the misallocation of real funding.

If a lowering of interest rates could have created economic growth as the popular thinking has it, then it makes sense to keep interest rates at zero level for a long time.

The fact that we have already had such an experiment, which so far failed, should alert various supporters of low interest rate policies that something is completely wrong with the idea that central banks can grow an economy.

By now it should be realized that the artificial lowering of interest rates can only divert real funding from wealth generating activities towards non-productive activities, thereby diminishing the ability of wealth generators to grow the economy.

From this we can conclude that the latest policy of the Fed not only is not going to help the economy but on the contrary it is going to make things much worse. What is needed now is the curtailment of the Fed’s ability to pursue loose monetary policies. The less the Fed does the better it is going to be for the economy.

The Fed however, is unlikely to stop with its policies to “revive” the economy. In fact the Fed Chairman Ben Bernanke said, “If we don’t see continued improvement in the labor market, we will be prepared to take additional steps if appropriate”. The Fed Chairman added, “Additional asset purchases would be among the things that we would certainly consider”.

But then why should it work if it has failed so far? Even if the Fed were to boost its pace of pumping by introducing QE3 i.e. buying assets and expanding aggressively its balance sheet, it will not work if the banks will sit on the new cash and will not lend it out.

So far, in June, banks excess cash reserves stood at $1.490 trillion against $1.461 trillion in May. This means that if the pool of real savings is in trouble, which is quite likely, the Fed will have difficulties to stimulate economic activity, i.e. to generate an illusory economic growth.

Summary and conclusion

The US central bank announced that it will expand its “Operation Twist” program by extending the maturities of assets on its balance sheet. So far this policy seems to have been ineffective in significantly reviving the economy. We suggest that this policy in fact only further distorts the economy. Hence we suggest that the latest extension of the “Operation Twist” is going to make things much worse. On account of still-subdued bank lending it is questionable whether the Fed can artificially stimulate the economy without the cooperation of commercial banks. We are doubtful that banks will agree to cooperate if the pool of real savings is in trouble.

5 Comments

  • Paul Marks says:

    To an English ear the word “twist”, in “Operation Twist”, says it all – as to “twist” things means being dishonest (corrupt). To corrupt and pervert something – in this case the financial system (as if was not corrupt and debased enough already).

    This is yet another effort to lend out “money” that no one really saved – the fool’s gold of “cheap money”, “low interest rates” and the whole monetary crank fallacy that “modern economics” is based upon.

    The system is in a terrible hole and the response of the leftist elite (and their establishment “conservative” hangers on) is to carry on digging. Indeed to dig at emergency speed – seemingly unaware that their digging is undermining the foundations of everything.

    It is has been clear for some time that it is no longer a question of “if” the present financial system is going to collapse – the question now is “when” it will collapse.

    And when the “cheap money” fairy castle in the air finally goes, it will take the Western Welfare States with it.

  • Janis Klumel says:

    Pointing out that banks do not expand lending although central bank keeps low interest rates and expands money supply can mean different things:
    a) banks are aware of Austrian business cycle theory and without increase in real savings shall not pursue credit expansion,
    b) entrepreneurs are aware of Austrian business cycle theory and without increase in real savings (which is manifestation of consumer preferences regarding the consumption of present goods versus future goods) do not demand credits from banks in order to pursue new business activities,
    c) it is not a question of macroeconomics but is an issue of microeconomics, ie simple financial asset risk management.

    And pointing out that banks do not expand lending although central bank keeps low interest rates and expands money supply does not reveal broader picture, because banks are also aware that inflationary money benefits the first receiver at the expense of those who receive the money toward the end of the chain of economic activity, therefore inflationary money shall be used anyway and will be transferred to other economy where pool of real savings increases or is greater. Or inflationary money stays in the economy and will be used for asset financing instead for credit financing, and will be exploited for purchase of financial assets: stocks, bonds. In this case credit expansion is transformed into different form of fiat credit money expansion.

    And it can be affirmed that in such a way central bank distorts price relations of production goods and causes misallocation of production goods.

    • Robert Sadler says:

      Speaking for European banks I can tell you why lowering interest rates does not motivate banks to expand lending. European banks have a lot of long dated interest rate swaps based on much higher interest rates from six years ago. Some of these swaps go out another 10 years. Reducing the interest rate increases both the value of the swap to the bank and consequently the credit risk of the position. The borrower cannot afford to pay back the loan and the swap thus the bank cannot exit the position without taking a significant loss.

      Given the increase in risk caused by the low interest environment and the fact that the bank has funds tied up in a high risk position they cannot make new loans. They are also motivated to de-risk their balance sheet. Holding funds as reserves at the central bank is one way to achieve this.

  • While I fully agree that doing The Twist can do nothing to promote employment in the national economy, I cannot see it doing any harm either, really.

    Only exception there being to the reputation and confidence of the public in the private central bank.
    What reputation and what confidence, you ask?

    Yes.
    Exactly.

    • Robert Sadler says:

      While I fully agree that doing The Twist can do nothing to promote employment in the national economy, I cannot see it doing any harm either, really.

      Other than prolonging the current depression or starting a new bubble you mean?

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