No more liquidity support: Advice from Raghuram Rajan and Viral Acharya

Their paper makes the point that creation of huge amounts of money by a central bank need not necessarily galvanise output.

The Monetary Policy Committee will meet this week. A former governor of the Reserve Bank of India (RBI)--Raghuram Rajan--and a former deputy governor--Viral Acharya--have written a paper (NBER paper number 29680) which ought to give the current governor and his deputy governor for economics a good feeling in case they are feeling like easing up on their liquidity policy. 

The title of the Rajan-Acharya paper is provocative and even poetic: “Liquidity, Liquidity Everywhere, Not a Drop to Use — Why Flooding Banks with Central Bank Reserves May Not Expand Liquidity”. 

But it’s not a paper to be read by the faint hearted. In fact, it came close to giving me a heart attack because the jargon and the logic are both mind-boggling. So, I will not anaesthetise you with the whole paper but stick only to quoting from the abstract.   

I could be wrong but my sense is that Rajan and Acharya are making a political point via some deliberately abstruse economics: that the creation of huge amounts of money by a central bank need not necessarily galvanise the output producing parts of the economy. There can be many situations where this does not happen. 

They give many reasons.

Thus: “Central bank balance sheet expansion…involves not just a substitution of liquid central bank reserves for other assets held by commercial banks, but also a counterpart alteration in commercial bank liabilities, such as in short-term deposits issued to finance reserves and in off-balance-sheet encumbrances pledged against reserves, which are also claims on liquidity.” 

In plain English that means if you press a water balloon in one place, it will bulge in another place but without increasing the total volume of water. Something like that, anyway, I think.

Then they say: “In ordinary times… central bank balance sheet expansion will typically enhance the net availability of liquidity to the system. However, in times of stress, when these offsetting claims on liquidity are exercised, the demand for liquidity can be significantly more.” 

That means when people and firms don’t have enough money to get back to producing, they ask for more than the central bank has created. 

“Furthermore, liquid commercial banks, desiring to maintain unimpeachable balance sheets, may provide only limited re-intermediation of liquidity and contribute significantly to liquidity shortages.”

This means commercial banks will not lend because they want their balance sheets to look pretty. 

“Consequently, central bank balance sheet expansion need not eliminate episodes of stress; it may even exacerbate them. This may also attenuate any positive effects of central bank balance sheet expansion on economic activity.”

This means deficit financing need not work in the way everyone expects it to. They then tell us why this might happen. 

According to them “the financing of reserves on bank balance-sheets leads to the issuance of short-term liabilities that is excessive from a social standpoint and creates claims on future liquidity that offset the reserves” .

I think this means that countries get into a gigantic Ponzi scheme where you borrow more to pay off old debts and thus get more indebted.

And that’s not all: “the encumbrance of reserves due to speculation and regulation, and reserves hoarding by healthy banks in times of liquidity stress, may prevent liquidity flowing to stressed banks.” 

This is like some rivers being in flood and others being parched. The water from one doesn’t flow to the other.

And hence: “Ex ante, these effects may partly explain why central bank balance sheet expansion has less effect on real activity than one might anticipate.”

So what should central banks do? Stop expanding liquidity or wait a bit before stopping? Rajan and Acharya don’t tell us. 

But Rajan has been warning for a long time that “there are no free lunches” for a long time and that national debt has to be paid by the poor of future generations.