Two Roads?: Endogeneity of Credit, Expectations, and Fed Activism

Like gold, credit is subject to laws of supply and demand. Since it doubles as money, its quantity can adjust to alleviate an excess demand for money assuming that expansion is not limited by elevated credit risk. We can expect credit markets to conform more closely to the classical model if policy uncertainty is reduced (Koppl 2002, 184-194).[1] A consistent rule like nominal income targeting would help limit some of this risk by stabilizing expectations about monetary policy. Not only does the base money supply become responsive to demand under a nominal income target regime; credit markets become more flexible too. In what follows, I will outline the operation of credit markets as would occur absent outside interference. I will also analyze the effects of central bank activism and of regulation of credit on the responsiveness of credit markets to demand for money.

The relationship of credit and an endogenous money stock has long been recognized (Thornton 1939; Wicksell 1936; Hawtrey 1919). The response of credit to an increased demand for money is not only an empirical observation. As Glasner aptly points out, “nominal balances [of banks] fluctuated with ‘the needs of trade.’ . . . The law of reflux, in fact, is equivalent to Say’s Identity (1985, 47).” Much like the response of the gold production to an increase in the price of gold, an increased demand for money is concomitant with a rise in demand for money-like substitutes. Financial intermediaries respond to this demand by lowering reserve ratios and expanding their balance sheets (Leijonhufvud 1979; Gorton and Pennacchi 1990; Selgin and White 1994; White 1999).

For clarification, we can imagine a scenario where credit creation helps overcome a shortfall in aggregate demand. Consider an economy that is at the bottom of an economic depression. Prices are still falling, but production and employment have finally begun to increase. Sensing a rise in optimism, entrepreneurs begin to attract investment into new projects.[2] During the depression, banks had to increase their reserve levels in order to maintain solvency. Now that the outlook has improved, banks that survived the spike in defaults begin to increase net investment. They provide the money necessary for entrepreneurs to employ inputs left idle by the depression. Once economic volatility subsides enough to allow the expectations of investors and entrepreneurs to converge to a great enough extent, the former will extend credit to the latter. As realistic plans for a new ordering of resources emerge, output begins to increase and relieve the shortfall in demand.

In recent years, the Federal Reserve, under the chairmanship of Ben Bernanke, has failed to lead the economy into a robust recovery. Instead, the Bernanke Fed has taken on unprecedented roles as a financial regulator and credit allocator (Hummel 2012). Furthermore, the payment of interest on excess reserves has served to incentivize the persistence of low market rates of interest. Increased uncertainty is evidenced increased demand for liquidity as near zero returns on U.S. treasury bills and an elevated spread between these and treasury bonds reflect (U.S. Treasury). Due in part to policy uncertainty and in part to perverse incentives from risk free returns, creditors are more risk averse than usual. Since the start of the crisis in 2008, there has been drop in both the level and rate of growth of bank credit at all commercial banks (see FRED). This is true even as the recession ended 5 years ago. Given an increase in Fed activism under Bernanke, banks were better off lending only to the highest quality borrowers, investing in treasury bills, or leaving excess reserves on account at the Federal Reserve to collect interest.[3]

This pattern of policy activism has increased uncertainty.[4] Every time the officials at the Federal Reserve adopt an unexpected policy, market actors must recoordinate their actions to match these new circumstances. If these actors begin to expect numerous changes in policy within a certain time period but are unsure of what those policies will be, they will limit risky activity and the length of investment. In the case of banks, intermediaries will refuse to offer loans to borrowers to whom they would otherwise lend. As banking activity slows due to uncertainty, credit markets are less able to relieve an excess demand for money. Anemic economic growth results.

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[1] Roger Koppl argues, “Fed activism did induce instability in money demand. The Fed should not abandon money supply targets, but should pursue them according to a fixed rule.”

[2] This story is consistent with the “stylized facts” of the business cycle. SeeSnowden and Vane (2005).

[3] During the crisis, inflation hedging waned as liquidity preference increased (Gurnayaka, Sack, and Wright 2010, 89).

[4] Ironically, Bernanke cited the importance of a “clear and credible commitments about future policy actions [author’s emphasis].” Cited in Espinosa (2012).