The macroeconomics of a ‘negative carry universe’
The debate around banking is once more dominating the news. I’ve long argued there are three primary issues that banking reform must aim to address (making banks safer, making banks serve the rest of the economy and dealing with the remuneration issues). But yesterday a very important post on the FT’s Alphaville blog (which also includes an excellent Game of Thrones reference) got me thinking – maybe the issue is actually even deeper than I thought.
(As warning this is a somewhat esoteric blog post that may not interest everyone or, quite possibly, anyone.)
Alphaville’s Izabella Kaminska, building on a long series of posts of the changing nature of the monetary system and the economics of being beyond scarcity, believes we may now be in a ‘negative carry universe’.
The notion of ‘positive carry’ is central to banking as we know it. Simply put, the positive carry is the difference between the rewards received from holding one asset over the costs of funding that position. This is the core business of banking – borrowing short and lending long. A textbook bank takes deposits from the public (short term borrowing) and transforms this into long term lending at a higher interest rate. This is the old 3-6-3 rule of banking– pay depositors 3%, charge borrowers 6% and be on the golf course by 3pm.
Of course financial innovation has transformed banking. Banks no longer need deposits to fund lending – instead they can themselves borrow from wholesale markets. But the principles of positive carry and borrowing short to lend long remain the same.
Kaminska though has been asking, what if the positive carry world no longer exists? As she writes:
The battle is no longer about liquidity but about preventing the negative carry universe from impairing bank profitability forever. Indeed, unless a positive carry is re-established banks will never be able to support themselves, for they will never be able to make money according to the old model.
That’s because the old model rewards banks for encouraging investment — for the purpose of avoiding scarcity of goods in the future — by extending credit today. It rewards them for taking a risk on investments that might fail to overcome scarcity in the future. It does not, however, reward them for taking the opposite risk: that investments may lead to the production of too many goods.
This is why negative net interest income is now the primary problem of the system.
As Kaminska counter-intuitively asks:
Thus what if the banking crisis is less about bad lending decisions and more about overly successful investment?
To some extent that plays into the long-running theme of a dearth of investment opportunities that Chris Dillow has been writing about:
there is still – as Ben Bernanke said back in 2005 – a “death of domestic investment opportunities” in western economies. Quite why this should be so is not clear. Possible explanations include: a slowdown in the rate of technical progress; an inability to profit from what technical progress there is; and the migration of low wage-dependent business to the far east.
Two things, though, are clear. First, we know now that demand for investment good is price-inelastic. Lows prices of goods themselves, and low risk-free interest rates, are not enough to get firms spending.
Secondly, neither investors nor government nor the general public seem to be prepared for a world of few investment opportunities and weak growth.
The large output gaps in Western economies (and at a global level) and the ever growing corporate cash piles do suggest that something is different about the current crisis.
As Kaminska writes:
this could be because in a negative carry universe — one in which goods, collateral and assets are expected to permanently outnumber money in the future — bank profits can only be achieved through pariah practices rather than lending. Banks are ironically encouraged to destroy capacity, disincentivse investment, borrow money from the economy rather than lend it, and hoard wealth. All phenomenons we are currently seeing. All phenomenons which are economically destructive.
Now, I’m not entirely convinced that this is the case but it is at least worth considering seriously, because if this is the world we are living in, everything just got a lot more complicated.
Three years ago Brad DeLong wrote an excellent post entitled ‘Is Macroeconomics Hard?’. Looking back (primarily) to nineteenth century economists he concluded the answer was a resounding ‘no’. A depression (or ‘general glut’), by this framework, is the result of excess supply of labour, goods and services balanced by an excess demand for some form of financial asset.
DeLong identified three different schools of thought as to where this excess lay:
- Fisher-Friedman: monetarism: a depression is the result of an excess demand for money–for those liquid assets generally accepted as means of payment that people hold in their portfolios to grease their market transactions. You fix a depression by having the central bank boost the money stock. Eliminating the excess demand for money also brings the goods and labor markets into balance and out of excess supply.
- Wicksell-Keynes (Keynes of the Treatise on Money, that is): a depression happens when there is an excess demand for bonds–for ways of moving purchasing power from the present into the future. The workings of the banking system lead the market rate of interest to be above the natural rate of interest which balances the supply of funds saved and the demand for funds to finance business investment. You fix a depression by either reducing the market rate of interest (via expansionary monetary policy) or raising the natural rate of interest (via expansionary fiscal policy) in order to bring them back into equality. Then, with no more excess demand for bonds, the goods and labor markets will also be back in balance and out of excess supply.
- Bagehot-Minsky-Kindleberger: a depression happens because of a panic and a flight to quality, as everybody tries to sell their risky assets and cuts back on their spending in order to try to shift their portfolio in the direction of safe, high-quality assets–which, of course, everybody cannot all do at the same time. The excess demand is an excess demand for high-quality AAA assets in particular, not of money (although outside money and some inside money are AAA assets) and not of bonds (some of which are AAA assets, but not all). You fix a depression by restoring market confidence and so shrinking demand for AAA assets and by increasing the supply of AAA assets. Eliminating the excess demand for high-quality assets is eliminated will bring the goods and labor markets out of excess supply and back into balance.
Whilst there remains disagreement amongst these eminent thinkers as to the cause of the glut, there is at least something the government can do:
Nevertheless, in this Malthus-Say-Mill framework it seems as if there is always or almost always something that the government can do to affect asset supplies and demands that promises a welfare improvement over, say, waiting for prolonged nominal deflation to raise the real stock of liquid money, of bonds, or of high-quality AAA assets. Monetary policy open market operations swap AAA bonds for money. Quantitative easing that raises expected inflation diminishes demand for money and for AAA assets by taxing them. Non-standard monetary policy interventions swap risky bonds for AAA bonds or money. Fiscal policy affects both demand for goods and labor and the supply of AAA assets–as long as fiscal policy does not crack the status of government debt as AAA and diminish rather than increasing the supply of AAA assets. Government guarantees transform risky bonds into AAA assets. Et cetera…
And here we get to the problem, for, as Kaminska writes, whilst this may be the case in a positive carry world, it is not necessary the case in a negative carry world.
For now, unfortunately, it seems that most central banks are still pre-occupied with re-engineering bank profitability from a positive carry perspective. In fact they are doing everything they can to fight off the threat of negative carry. Interest on excess reserves being perhaps one of their most significant tools in this battle.
What they perhaps don’t appreciate is that even if they can induce short-term positive interest rates for the official banking industry, there’s an entire universe of shadow banks which are already suffering the effects of negative net interest income
In a ‘negative carry universe’, if that is indeed what we are now in, the imbalance between the goods markets and the money markets is much more difficult to fix than is suggested by DeLong’s Malthus-Say-Mill framework. If we are in such a universe than maybe macroeconomics is a lot harder than we originally thought.