Thursday, March 2, 2017

Capital Strengthening, the Fed's Balance Sheet and More

In a "perfect" world, the Fed would not need a large balance sheet, to begin with. Alas, that's not the circumstance presently, given the lack of economic dynamism and investment opportunity in spite of Wall Street gains. Which is why I agree with those who remain concerned about unwinding the Fed's balance sheet, too soon. A few weeks earlier, David Andolfatto also reasoned there could be fiscal advantages in maintaining the balance, for now. Larry White at Alt-M argued otherwise, and here's Andolfatto's response. Larry White sums up in his post:
The principal cases for normalizing the Fed's balance sheet are (1) the Fed should not distort the allocation of credit by holding trillions in MBS and (2) normalizing the size of the balance sheet would allow the Fed to normalize the conduct of monetary policy by making bank reserves scarce again. There is no fiscal-free-lunch case for holding off on normalization.
While I agree with Larry White that the balance sheet isn't really conducive for fiscal "opportunities", the bigger issue is maintaining economic stability and the overall valuation of general equilibrium conditions. What's concerning is that hawks and doves alike are anxious for normalization (whatever that may be), even though many recent monetary policy responses stemmed from economic problems which have yet to be addressed, according to their structural underpinnings.

Caught up in today's normalization "wishful thinking" is an even bigger issue. Is monetary history"as we know it", in jeopardy? As Nick Rowe writes, "all that remains is the boring technical work of bringing central banks implementation of that policy closer and closer to perfection." He continues:
How will the end of The End of Monetary Policy History affect investment? I think it would cause investment to fall. And that fall in investment (as a percentage of GDP) would cause the long run GDP growth rate to fall. And this fall in the growth rate would happen even if the growth rate of employment were unaffected by the end of The End of Monetary Policy History...We need a regime change. But instead all I see is that the demand for a monetary policy regime change is slowly sliding down the agenda as the world's economies slowly "recover". This is not what "recovery" is supposed to look like. 
Suppose that good fortune eventually prevails, and the monetary policy history that matters, doesn't fall away. In that case, we might also have occasion to ask: What took place (structurally) which made a large balance sheet appear necessary in the first place? Central bankers need a bit more patience. One can only hope that policy makers aren't anxious to unwind because no one believes substantial capital strengthening is possible. After all - if this is the case - deflation could indeed occur, should policy makers act too quickly.

What could be done? One way to think about what's involved, is the continuous interplay of fixed and circulating capital, as described centuries earlier by Adam Smith (he also considered education investment a form of fixed capital). In our time, much of the dynamism and velocity of circulating capital, has gradually been captured as fixed capital. While much of fixed capital over the centuries has been associated with growth and output, today's fixed capital often is expected (instead) to generate specific revenue flows. This is one reason why general equilibrium valuation, now in delicate balance via Fed balance sheets, has become such an important factor.

For instance, too much nominal income is expressed as fixed human capital in the guise of formal education and mortgage activity - in relation to other market activities. Nevertheless, the fact nominal income has become narrowly defined, is all the more reason to protect a large Fed balance sheet until this circumstance has a chance to change. It's important not to destabilize the asset values of general equilibrium in the meantime, in part because governments rely on these valuations for their own circulating capital.

Meanwhile, the process of capital strengthening can begin. Once all individuals play a greater role in circulating (human) capital, more nominal income can be expressed in active terms. Even though this new velocity would take the form of local knowledge use and services participation, it would gradually help restore the kinds of monetary normalcy which really count. Indeed, circulating capital in the form of human capital, would ensure an economic normalcy which I suspect might be an improvement over the "normalization" processes which policy makers want to achieve on our behalf.

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