Maturity Transformation and Duration Mismatch

Paul Krugman conveys an idea in words better than anyone else regarding the topic that is at the heart of modern banking: maturity transformation. In simple terms, individual savers deposit their money with the banks. These funds should be available on demand, because the savers can withdraw these on demand [hence the term demand deposit]. But the banks are allowed to loan these funds to borrowers for a specified amount of duration agreeable between the bank and the borrower. In this post, Krugman writes clearly:

Like a lot of people, my insights draw heavily on Diamond-Dybvig (pdf), one of those papers that just opens your mind to a wider reality. What DD argue is that there is a tension between the needs of individual savers — who want ready access to their funds in case a sudden need arises — and the requirements of productive investment, which requires sustained commitment of resources.

Prof. Krugman is talking about a dilemma, similar to Triffin Dilemma, but at a much more basic level. Triffin Dilemma deals with the consequences of using a single country's currency as the world reserve currency (which gives the single country an exorbitant privilege). Prof. Krugman recognizes that the same medium used by both the individual savers and the people requiring funds for productive investment leads to a conflict between both parties. If they both have different goals, why not use a different medium? [For the interested readers about a monetary system thesis where medium of exchange is decoupled from store of value, please consider this link.]

Prof. Krugman doesn't get to that part though, in his discussion. Note also that how he refers to requirements of productive investment but ignores borrowing for non-productive needs (such as for e.g., buying a house because prices and rising).  Not all borrowing is of high quality and not all borrowing is done for the feasible term structure. A borrower wants to borrow at the maximum duration with the lowest interest rate possible, but a saver whose funds get lent may not accept the same terms. There is a yield spread in this case (bid and an offer, there is no such thing as a monolithic price) and market dynamics help figure out the duration/interest rate details. But if a central bank mucks with this market signal, what happens as a consequence? The market will eventually run out of qualified borrowers. There happens a disco-ordination of natural social interaction when the key signal of interest rate is messed up.

What if we do listen to what hard money advocates want? As Prof. Krugman rightly points out, there will be more panic crashes. The times when US and the world was on a fixed gold standard was very painful for a number of reasons. When credit expands beyond what can be meaningfully serviced by the economy, the credit levels naturally will contract. But under a fixed gold standard, credit is denominated in gold which causes the contraction to be extremely severe. There will be too much collateral damage. Even businesses that were operating under a reasonable profit margin and less debt would fail. This is what happened during Great Depression I. 

America had no major financial panics other than in 1873, 1884, 1890, 1893, 1907, 1930, 1931, 1932, and 1933. Oh, wait. The truth is that returning to gold is an almost comically (and cosmically) bad idea.

In the same post on outlawing banks, Krugman talks about a task that banks engage in a normal fashion, borrowing short to lend long. He writes:

Any arrangement that borrows short and lends long, that offers investors claims that are liquid while using their funds to make illiquid investments is a bank in an economic sense — and is potentially subject to bank runs.

But there is another operation which is mostly unnoticed in mainstream economic circles and which essentially renders quantitative easing as a fuel added to the fire of deflation. The Fed could be unwittingly contributing to more deflation while engaging in an attempt to devalue the dollar. Professor Fekete has written several articles on risk free bond speculation, where the speculators are engaging in the same activity of borrowing short to lend long. It is clear that borrowing short to lend long is at least a dubious idea which can have negative long-term consequences.

Let's take an example and understand the duration mismatch problem in a concrete fashion. I want to borrow $250,000 for a 30 year loan. Assuming that the banks cannot create deposits to fulfill a loan without any reserves, will any one even lend me that sum for such a long duration? Even if I cannot find a willing lender who can accept the duration and the sum, will the interest rate be acceptable to me (the borrower) so that the deal can actually happen? Probably not, the interest rate charged may be exorbitant depending on available credit conditions (when there is a natural limit on credit creation). If a central bank mucks with the interest rates and keeps them artificially low for too long, may be I could borrow (but I shouldn't under normal circumstances). This has created a mispricing of risk which goes undetected initially but a fault nevertheless in the overall system.

Through this discussion one aspect becomes very clear: a person depositing funds at the bank should get to choose their time preference on those funds (and the fraction that should be available upon demand). Secondly, a honorable bank should match this duration for a qualified borrower. Vetting the borrower and matching the duration is the bank's job. Even prior to deciding the time preference of the saver's portion of loanable funds, the saver gets to make an arbitrage: what fraction to save and what fraction to leave as time deposits. What if the medium to save was completely different from the medium to transact/invest/loan etc.? Does that resolve this conflict which gets created between creditors and borrowers?

Analyzing quantitative easing

I am using this post as a vehicle to document the different views on quantitative easing and their relative merits/demerits. The conventional view point is as follows:

GDP = C + I + GS + Net exports

C= Consumption  (private sector)

I = Investment (private sector)

GS= Government Spending (public sector)

Net exports = the difference between total exports and total imports

In order to boost GDP, one should be able to increase any of the 4 factors. It is a well-known fact that households and the private sector are saturated with debt and the deleveraging process has just begun. Therefore consumption cannot be easily boosted if debt levels are elevated.  Even though interest rates remain repressed through QE, the lower interest rates cannot immediately spur further borrowing because this borrowed money cannot be easily serviced when wages are stagnant. Although the Fed's reasoning is that lower interest rates will encourage more consumer spending, it cannot sustain itself because of saturated debt levels.

Investment can be boosted by reducing effective corporate tax rates, but there should be consumption capacity for the investment to take place. When consumption capacity is low, then regardless of the tax rates -- new investments cannot happen. It is a vicious cycle.

The political appetite for government spending determines whether it can be increased. Clearly since 2011, the debate on the US political spectrum has shifted towards the debt ceiling and therefore the political appetite for increasing spending is waning.

This leaves us with net exports. Exports can be increased either by exporting more goods and services or by exporting the same goods and services but devalue the currency. Devaluing the currency has negative consequences as well. US imports are much higher than US exports, therefore the cost increase in imports (since a devalued dollar means US pays more for imports)  could overwhelm the gain in exports and net effect can still continue to be negative. There's quite a bit of non-linearity in all this discussion, so it is important to bear this in mind. Cost of imports may not immediately increase, for example because the dollar inflation is not immediately detected (dollar being the world reserve currency).

James G Rickards, a renowned financial expert explains the above as the Fed's rationale for QE2 and further QE, in his popular book Currency Wars.

There are two other alternative views which I would like to highlight. Professor Fekete writes about the risk-free bond speculation in his article There is no Business like Bond Business, Still. Here's his 2010 article on the same subject. The professor makes a valid point that the primary dealers can front-run the Fed (since the Fed announces when it is going to buy and how much before market opens) and then flip the bonds back to the Fed at a higher price and pocket risk-free profits.

This means that interest rates keep going lower and lower until this game cannot continue.As interest rates keep going lower and lower, it is harder to service the previously acquired debt because the income stream keeps reducing. It is a perverse effect since the Fed is trying to fight deflation, but actually making the pain worse. He compares the current paradigm to an economic resonance with a built-in runaway vibration that can snap the whole system(similar to Tacoma Bridge collapse of 1940). Here's an excerpt from his article titled 'Premature Obituaries (for the dollar)'.

When the energy level of the self-boosting system overwhelms centripetal forces, the system snaps like a broken chain, releasing the surplus energy most destructively. This is the substance of every crack-up boom. Like Mises, I also object to the use of the word hyperinflation, albeit for a different reason. It suggests that the phenomenon is linear and follows the laws of the Quantity Theory of Money. The more money is printed, the higher do prices go. However, we are here facing highly non-linear phenomena. Our economy is torn to pieces by runaway vibration. We are victimized by the self-destruction of the monetary system subjected to oscillating money-flows boosted by the resonance of fluctuating interest rates resonating with fluctuating prices.

The other alternative view that I want to highlight is that of a popular blogger, FOFOA who writes on two topics: a) dollar hyperinflation and b) Freegold monetary theory. In his post Inflation or Hyperinflation, he details how QE is all about managing the unstoppable flow of Treasuries.

The USG today is spending $3.6B more than it is taking in, each and every day. That's a big mess of dollars flooding out of the USG. $1.5B per day is flooding outside of our zone while $2.1B is staying right here on our front lawn. This is all flow. It is ongoing and unstoppable. And it all must be mopped up by someone. And by someone, I mean either the foreign sector, the domestic private sector or the Fed buying up US Treasuries. $3.6B per day, an unstoppable, unending broken water main gushing out dollars. Marginal flow!

Don't be fooled by the misdirection. QE, twist, whatever; it's not about interest rates or helping the economy recover. It's 100% about disguising and managing this uncontrollable, unstoppable mess. It's more like a broken sewer line than a water main now that I think about it.

Sure, the Fed needs to keep interest rates from rising. Because what happens when interest rates rise? The value of the entire $35T bond market starts to collapse and bond holders panic. The Fed doesn't want that, so don't bet on them letting interest rates rise. But as I said, I'm not worried about the stock of dollars. I'm worried about this broken sewer line we call the federal budget deficit which means no one has to sell a single bond. In fact, someone has to continuously buy $3.6B more each and every day, including weekends and holidays.

In another post titled Moneyness, FOFOA writes:

The USG thinks (and truly believes) that the key to rejuvenating the US economy is trashing the dollar as a short cut to increasing exports (reducing the trade deficit). But what it can't see (nor anyone that focuses solely on the monetary plane for adjustment) is that the huge trade deficit the USG wants to quit is actually its own heroin fix. This is a deadly combo for the US dollar.

The key point to take away is that Budget Deficit and Trade deficit are inter-related in the sense that government spending towards goods and services increases our imports, therefore worsening the trade deficit.

To summarize, following are the stated or unstated effects of quantitative easing:

1. Lower interest rates to boost consumer borrowing and spending (Fed's take, but not true in the real world because the transmission mechanism is broken when debt levels are saturated)

2. Increase exports through cheaper dollar, which causes global inflation and boosts US GDP (Rickards's take in his book -- this is supported with some empirical data and real world evidence)

3. Risk-free bond speculation reinforces a feedback loop of lower and lower interest rates leading to capital destruction until the system cannot handle this anymore (Fekete's take -- interest rates are heading lower even though they take a wibbly wobbly path)

4. Manage US Government budget deficit and sustain the US trade deficit amidst political gridlock and unwillingness to raise taxes or cut spending (FOFOA's take -- plausible explanation)

But one aspect is quite clear. QE is a grand experiment where consequences are unknown and there are several negative effects (because of the fact that it is implemented on a complex system with non-linear effects) which are hardly discussed by the Fed.