On Tuesday September 18, US central bank policy makers surprised financial market players by cutting the federal funds rate target by 0.5% to 4.75%.
The key motivating factor behind the hefty cut in the federal funds rate target was an economic model that Fed Chairman Ben Bernanke developed while in academia.
Bernanke is of the view that changes in financial and credit conditions are important in the propagation of the business cycle through a mechanism that he dubbed the "financial accelerator."1
In his view, it is by means of the "financial accelerator" that a sudden short-lived disruption in financial markets can set in motion a prolonged disruptive and amplified effect on the real economy.
Bernanke suggests that the financial accelerator works through two channels: a credit channel, and a balance sheet channel.
With respect to the credit channel, Bernanke believes that banks and other intermediaries develop informational capital (expertise in gathering relevant information regarding potential borrowers), which allows the efficient allocation of loanable funds. Various shocks, however, can curtail banks' use of their information capital. This in turn forces banks to keep their balance sheets as liquid as possible and curtails lending activities. Consequently, this inhibits consumer spending and capital investment, thereby setting in motion an economic downturn.
The second channel — the balance sheet channel — is about the credit worthiness of borrowers: the availability of collateral facilitates credit extension. According to Bernanke, during a severe economic crisis declining output and falling prices, which raise the real debt burden, lead to widespread financial distress among borrowers, lessening their capacity to pledge collateral. In short, the decline in the financial health of potential borrowers during a severe economic crisis impedes the efficient allocation of credit.
A key concept in Bernanke's model is the external premium, which activates the "financial accelerator." The premium is defined as the difference between the cost to a borrower of borrowing money in financial markets and the opportunity cost of internal funds. On this Bernanke says,
External finance (raising funds from lenders) is virtually always more expensive than internal finance (using internally generated cash flows), because of the costs that outside lenders bear of evaluating borrowers' prospects and monitoring their actions.2
Hence the external finance premium is generally positive. The external finance premium that a borrower must pay depends inversely on the strength of the borrower's financial position. According to the Fed chairman a borrower with a healthier financial position (measured in terms of net worth, liquidity, and current and expected cash flows) relative to other borrowers is going to pay a lower premium.
The inverse relationship of the external finance premium and financial conditions of potential borrowers creates a situation when otherwise short-lived economic shocks may have long-lasting effects.
For instance, as a result of a sudden disruption in the supply of credit, the finance premium tends to increase and this sets in motion a disruptive amplified effect on the real economy. As a result of higher premium borrowers, cash flows come under pressure and this puts pressure on their financial health. Consequently, this exerts further upward pressure on the premium, which in turn puts more financial pressure on borrowers.
In response to this, banks are likely to curtail their supply of lending to counter the increase in bad loans and this in turn further lifts the interest rate premium. From this one can see that a disruption in the credit markets, which can occur for various reasons, can set in motion a financial accelerator that amplifies the damage to the real economy from the initial disruption.
According to Bernanke, once financial disruptions occur it is the role of the central bank to act swiftly by aggressively pushing money to prevent the financial accelerator from damaging the economy.
In his testimony to the House Financial Services Committee on September 20, the Fed chairman provided the rationale for the hefty cut of 0.5% in the federal funds rate target on September 18:
We took the action to try to get out ahead of the situation and try to forestall potential effects of tighter credit conditions on the broader economy.
Now, in Bernanke's model the effect of shocks on the real economy is assessed with respect to real gross domestic product (GDP). Elsewhere we have shown that the GDP is the amount of money spent on various final goods and services; its rate of growth is not determined by the strength of its various components as such but by the strength of the money supply's rate of growth. (For instance, if on account of some shocks the housing sector comes under pressure while the money supply continues to expand, then more money will be spent in other sectors and less on housing.) In short, the overall monetary expenditure rate of growth, i.e., the GDP rate of growth, varies in accordance with the rate of growth of money.3
If on account of shocks a disruption in credit markets occurs then a fall in credit expansion ensues. This in turn is likely to slow down the rate of growth of money, and the rate of growth of real GDP will follow. So from this perspective it would appear that Bernanke was correct to aggressively lower interest rates on September 18 in order to prevent an economic recession.
In Bernanke's view a typical financial disruption is associated with,
A weak banking system grappling with non-performing loans and insufficient capital or firms whose creditworthiness has eroded because of high leverage or declining asset values are examples of financial conditions that could undermine growth.4
The question that must be asked is what gives rise to the emergence of such conditions? Disruptions in financial markets do not emerge out of the blue.
We suggest that the major cause that sets these disruptions in motion is likely to be the central bank itself.
Whenever the Fed loosens its stance, it sets in motion rising growth in the money supply. Conversely, whenever the Fed tightens its stance it sets the foundation for declining growth in money. It is this that drives the GDP rate of growth and sets in motion the so-called boom-bust cycles.
For instance, between December 2000 and June 2004 the Fed was pursuing an aggressive lowering of interest rates: the federal funds rate fell from 6.5% to 1%. As a result of this loose stance, a visible increase in the growth of our monetary measure AMS had taken place. Between Q3 2001 to Q4 2004 the average yearly rate of growth of AMS stood at 7.5%. This should be contrasted with the rate of growth of 2% in Q2 2001 and 0.8% in Q4 2000. On the back of the loose-interest stance and the subsequent increase in the growth of money supply, the yearly rate of growth of real GDP jumped from 0.2% in Q4 2001 to 4.1% by Q1 2004.
In June 2004 the Fed reversed its stance: the federal funds rate target was raised from 1% to 5.25% in July 2006 and kept at this level until September this year. In response to the tighter stance the growth of our monetary measure AMS has been in a visible downtrend since Q4 2004. The yearly rate of growth fell from 7.9% in Q2 2004 to 1% in Q1 2007 before bouncing to 1.7% in Q3 2007. As a result, the yearly rate of growth of real GDP fell from 3.3% in Q1 2006 to 1.5% in Q1 2007 before a slight bounce to 1.9% in Q2 2007.
So what can be inferred once we observe that the central bank loosens its monetary stance and sets the platform for a rising rate of growth in money supply? We can derive from this information that it is likely to cause a shift of real savings towards nonproductive activities at the expense of productive, wealth-generating activities. In short, this leads to a weakening of real wealth formation, the source of real savings — the key for economic growth.
Note that the so-called economic boom comes in terms of stronger monetary expenditure — i.e., GDP — on account of a strong money supply rate of growth. (The underlying real economy is in fact bleeding because loose monetary policy undermines wealth generators.)
Once the percentage of activities that sprang up on the back of a loose money policy increases it is not surprising that the level of debt in relation to real wealth follows suit. (The ratio of nonproductive to productive debt increases. The productive debt refers to borrowed funds employed in the production of wealth. Conversely, a nonproductive debt refers to borrowed funds that are not employed in the production of wealth.)
Contrary to Bernanke, it is not the high level of debt that leads to a crisis but rather the loose monetary policy of the central bank. It is loose monetary policy that gives rise to nonproductive activities and hence to an increase in nonproductive debt. As a rule, the crisis is set in motion once the central bank reverses its loose stance — the money supply rate of growth starts to decline. A tighter stance undermines various nonproductive activities and in turn weakens their ability to serve the debt they have incurred — a financial crisis emerges.
Observe that a tighter stance slows down the shift of real savings from wealth generators to nonproductive activities — it is this that puts pressure on nonproductive activities. Hence a policy that aims at countering the emerging financial crisis in fact only further weakens wealth generators and thereby poses more problems for the economy.
As long as the wealth generators are still large enough as a percentage of all acting individuals, Fed policy makers can get away with the policy of "rescuing financial markets." However, if this percentage falls to below 50%, then there will not be a sufficient amount of real savings to carry all the activities in the economy; a deep economic crisis emerges.
We can thus conclude that if the pool of real savings is in bad shape, Bernanke's policy to counter the so-called "financial accelerator" could in fact worsen general economic conditions.
Conclusion
We suspect that a key factor behind the large cut of 0.5% in the federal funds rate target on September 18 by the Fed was Bernanke's view that financial-market shocks can produce a severe economic recession.
According to the model that Bernanke follows a sudden disruption in financial markets can set in motion a disruptive amplified effect on the real economy. Hence, to counter this, the Fed chairman is of the view that the central bank must always be on guard to pump enough money to neutralize the negative effect from various shocks. We suggest that by attempting to counter various shocks that are predominantly the product of Fed's own policies, Bernanke's Fed has likely made things much worse as far as real economic fundamentals are concerned.
- 1Ben S. Bernanke, "The Financial Accelerator and the Credit Channel."
- 2Ben S. Bernanke, "The Financial Accelerator and the Credit Channel."
- 3Frank Shostak, "Have We Outgrown Recessions?"
- 4Ben S. Bernanke, "The Financial Accelerator and the Credit Channel."
