What's the Cost of an Inflation-Free Bank Bailout?

Includes: KBE, KRE, XLF
by: Josh Dowlut

The banks got two types of bailouts, one fiscal-basically anything involving Treasury [TARP, TALF, AIG, Fannie/Freddie (FNM/FRE)], the other monetary-basically anything involving the Fed (0% interest rates, TAF, quantitative easing, MBS/Treasuries purchases, and an expanded balance sheet/monetary base). The general consensus for fiscal policy's trade-off cost was increased deficits, debt and presumably higher taxes or reduced spending in the future. The general consensus of the monetary policy's trade-off cost was inflation. At this point there is a real possibility of avoiding inflation, and achieving an inflation free bailout of the banking system in spite of unprecedented expansionary monetary policy.

How is this possible? The quantity theory of money states that money supply affects prices. More money chasing the same amount of stuff leads to inflation. Most are familiar with MV=PQ where money supply times velocity=price times quantity. But you also have to remember how banks create money in our fractional reserve banking system. M0 (monetary base) times bank lending=M2 (broad money supply) and it is the M2 broad money supply that affects price levels. In other words, if all the money the Fed created through various quantitative easing and debt monetization stays locked up as M0, it won't affect prices, and this leads us to the Fed's crafty exit strategy.

The Fed's exit strategy (see here) can be summarized as paying banks not to lend. Through increasing the excess reserve rate (the interest rate paid to banks with excess reserves-normally banks have to make loans to earn interest, but not anymore), offering term deposits-essentially CDs that pay interest on excess reserves, and reverse repos that trade banks excess reserves created by the Fed for interest bearing securities the Fed is engineering an environment where banks can make interest revenue without lending to anyone. It offers the real possibility of keeping a lid on M2 regardless of what happened to M0 over the least year or so.

Now for the big question: if we achieve an inflation free monetary bailout, is there a trade-off cost and if so what is it? The first rule of economics is "there is no free lunch" so logically there must be a cost, but what is it?

The first step to answering that question is to ask what would have happened had there been no bailout? The most likely scenario is a wholesale collapse of the banking system, a huge contraction of M2, and a deflationary spiral. Cleary the banks are losers in that scenario, but there are winners. For one, savers. For two consumers. If you can't qualify for a car loan or a mortgage but want to buy a house or a car, aren't you much better off if they cost less? The 3rd group that wins are workers. While it is true nominal wages fall in deflation, analyzing price and wage volatility from 1899-1933 show the ratchet effect works both ways, wages are far more stable than price levels, and that in periods of deflation, for example the Great Depression, REAL WAGES INCREASED (from The Relationship Between Wage Rates and Inflation by Emmett H. Welch, 1933). Examining history from 1820-1913 reveals US real per capita income increased by nearly a factor of 5 and when ranked against other developed nations went from middle of the pack to #1 (see here - pdf) during the exact same time the general price level fell almost 50% (Deflation Determinants, Risks and Policy Options published by the IMF in 2003, pg 9). The historical record shows you can have deflation and strong growth. It also shows that deflation rebalances income distribution in favor of the average worker.

To that end, what was the cost? The monetary bailouts used central planning to override the free market forces that would have lowered the Gini coefficient and benefited savers, consumers, and workers at the expense of banks, shareholders, and investors. While the monetary bailouts may not appreciably expand M2, they will serve to appreciably zero sum game the division of it into the hands of bankers and out of the hands of everyone else.

Disclosure: No positions