Galway Investment Strategy
By Liam Molloy, Bethany Carlson
August 17, 2012
The Treasury has doled out approximately $10.5 billion on excess bank reserves over the last four years. In our September 2010 newsletter, ‘The QE II is Set to Sail’, we highlighted the emergency Fed policy of paying 25 basis points on excess reserves as an iceberg that could sink the quantitative easing stimulus. This policy tool was enacted on October 6, 2008 to incentivize banks to hold excess reserves in the midst of the financial crisis. It worked. Excess reserves increased by a factor of nearly 300 to a peak of over $1.6Tr. But the policy also introduced another headwind to velocity of money. The Mario Bros. may have beaten the koopas but hadn’t yet raised the flag at the end of the level when Bernanke hit pause. Banks get paid more to hoard than to lend, as the Fed has been paying in a range of up to 15 bps more than LIBOR. Two years ago, we thought that the Fed would unwind this policy, and velocity (and GDP) would improve. Not so.
Looking back over the last two years with the benefit of hindsight, it is conceivable that Ben did not remove the policy because he anticipated the European debt crisis. The ECB under Jean-Claude Trichet made almost uninterrupted missteps since Bear Stearns went under in March of 2008. It’s possible that Bernanke wants to keep US banks’ extra lives on deck until he has sufficient time to see whether Draghi is better suited to the job than his predecessor.
Given the abrupt July 17 reappearance of the conversation about reducing the 0.25% interest paid on excess reserves in testimony before Congress, it may be that Mr. Bernanke shares our perception that Draghi is more credible as ECB Chair than Trichet. Whatever the combination of reasons behind the renewed discussion of the policy move, dropping that quarter percent in the slot could be a major economic stimulus.
While the Fed has done unprecedented work to expand the monetary base since September of 2008, they’ve simultaneously added drag to the velocity of money – which had already slackened as consumers deleverage and repair their personal balance sheets. The money multiplier dropped by half in the fourth quarter of 2008, and it has never recovered. On May 21, 2010, to commemorate Pac-Man’s 30th anniversary, Google changed the logo on its homepage to a playable version of the game. In total, the ‘doodle’ consumed approximately 4.8 million hours of productivity worldwide, or an estimated $120MM, as the world’s most popular video game was enjoyed by its legion of fans. One small change, in just the right place, slowed down the whole system. One small change also contains the power to speed it up again.
One of the ongoing challenges in the current economic recovery is the relatively expensive – if even accessible – financing for smaller businesses. While large cap companies are able to obtain credit at a rate of 2-3%, small caps are lucky to get financing in the 5-10% range, if at all. On the one hand, this financing arbitrage opportunity has spurred some acquisition activity. But over such an extended timeframe, it has also hobbled small business growth, which in turn hindered a traditional engine of job creation. If the essentially risk-free incentive for banks to hoard cash were reduced or removed, there’s $1.5Tr that’s suddenly unlocked to lend. That’s a lot of potential jobs, with the Fed being chased by the specter of 8.3% unemployment. Unleashing Pac-Man Fever would be beautiful music for all (and Jerry Buckner’s and Gary Garcia’s bank accounts).
No Free Life
Whether or not they decide to reduce or remove the interest paid on excess reserves, the Fed still has tools and creativity to deal with the current economic environment (which continues to be subject to deflationary, not inflationary, pressures). However, quantitative easing and other monetary policies have diminishing returns eventually. Like Mario, there’s a big ape out there throwing barrel after barrel at us: bank deleveraging, consumer deleveraging; tepid economic growth; housing and the ongoing mortgage quagmire; the fiscal cliff, tax uncertainty, government-wide lack of compromise; the European debt crisis, European recession; global economic changes, fits, and starts. Ben may have QE and other monetary tools in his pocket, but more than just monetary moves are going to be needed to save the princess.
Thank You, But Our Princess Is In Another Castle
Ultimately, fiscal policy is going to have to catch up to reality, and some certainty is going to be needed for any policy moves to have maximum impact. While it is unlikely that any major legislation on the budget or economic stimulus will take place between now and November, we remain hopeful that the lame duck Congress will take another swing at some Simpson-Bowles inspired budget reform at the end of the year (see August 2011 newsletter, The Death of Common Ground). It’s time for the government to step up and press play.
As always, we are proud to be your partners in saving the princess, and stewardship without compromise.
(c) Galway Investment Strategy