June 21, 2012
The Global Financial Crisis is in its fourth or fifth year. Global economic indicators point to a world economy where there is stagnate growth, unacceptably high unemployment and seemingly no end in sight. In the United States unemployment is hovering around just above 8%, PMI is just above 50 and declining, GDP growth is slowing, and personal income and spending are flat or falling. Because of such news of deterioration, the Federal Reserve has announced that it will continue Operation Twist-- the selling of short-term securities and the simultaneous purchase of long-term securities. However, like the second wave of quantitative easing, Operation Twist may have little effect on the economy.
At the onset of the financial crisis, in addition to the bank bail-outs which provided loans and gurantees of up to $29 trillion to troubled banks (which is described in great detail here: http://www.levyinstitute.org/pubs/wp_698.pdf), the Federal Reserve began a program of what is known as quantitative easing. Essentially, the Federal Reserve purchased mortgage-backed securities, short-term Treasury notes and other forms of debt from banks. Subsequently, short-term rates were driven down to near zero and banks no longer had as many risky assets on their balance sheets. As debts matured, interest rates began to rise and the Federal Reserve began a second wave of quantitative easing, purchasing even more Treasury notes in order to hold down short-term interest rates at near zero.
The logic behind Operation Twist is similar to that of quantitative easing. By selling short-term debt and simultaneously buying long-term debt, the Federal Reserve is lowering long-term rates relative to short-term rates and vice. The reasoning behind targeting lower short-term interest rates is that lower short-term rates brings about short-term borrowing and subsequent investment, which brings about increased economic activity in the short run. Increased economic activity in the short run can improve economic confidence and lead to more borrowing and investment, which has the potential to lead to further economic activity and growth in the long run. Similarly, targeting lower long-term interest rates is supposed to bring about an increase in long-term borrowing and investment as well as allow individuals to refinance long-term debt and mortgage debt at lower rates. But, it can be argued that the Federal Reserve has run out of bullets in this regard.
The current recession can be classified as what is referred to as a balance sheet recession. Broadly speaking, there are three types of financing that a firm in a modern capitalist economy utilizes: hedge finance, speculative finance and Ponzi finance. A firm that utilizes hedge financing is able to service its current debts out of current and future income flows. In speculative finance, a firm may be able to meet its debt obligations most of the time but, due to seasonal fluctuations in business or otherwise, must refinance a portion of its debts-- that is it services a portion of its debts by taking on more debt. Then there are firms that use Ponzi finance, where in order to service its debts the firm must continually refinance. Naturally, Ponzi finance cannot go on indefinitely. The type of finance a firm utilizes can change at any moment and is subject to changes in the business cycle and prevailing market conditions. For example, an unexpected drop in revenue can force a firm which is utilizing hedge finance to begin assuming characteristics of a firm utilizing speculative finance. Similarly, revenue and interest rate fluctuations can force a firm that is speculatively financed to become a firm that is utilizing Ponzi finance.
In the period immediately following a recession, investors and entrepreneurs are extremely cautious and less likely to borrow or invest because of the trauma induced by recession. As the economy picks up, businessmen and investors become more confident and more willing to incurr debt to invest. The further out from recession an economy is, and the more robust an economy becomes, the more exuberant investors and businessmen become and firms which have previously used hedge financing begin to use speculative financing. This exuberance can lead to an irrational exuberance, bubbles and an increase in borrowing or Ponzi finance. Once a firm, or multiple firms, using Ponzi finance defaults on its debts, because such financing cannot go on indefinitely, panic quickly sets in. Once panic sets in, other firms utilizing speculative or Ponzi finance begin to sell off assets to pay down their debts and investment subsequently falls. The subsequent fall in investment and the downward pressure on prices an asset sell off induces has a negative effect on demand and on the prices of the goods firms produce. Such a decline in demand and prices affects the income and profitablity of firms and their ability to service their debts, which can result in hedge finance becoming speculative finance and speculative finance becoming Ponzi finance. Of course, this deflation has a negative effect on employment as well and a corresponding effect on demand, which can lead to a virtuous downward cycle. This process can continue until either debts are repaid, there is a boom-inducing market innovation or some form of government intervention.
In the years leading up to the 2007-2008 financial crisis, there was a tremendous amount of debt-financed speculation in various asset markets, such as the stock market, but with houses and mortgages (and their financial derivatives) being the preferred assets of speculation. The build-up of such debt was massive and accelerated at such a rate that it contributed significantly to demand and the appearance of ever expanding wealth in the form of rising asset prices. The process became self-reenforcing. However, once the rate of default on mortgage debt started to increase, markets panicked. Suddenly the assets that investors were speculating on weren't perceived to be as valuable as was once believed during more exuberant times. This led, of course, to panicked selling and falling asset prices. On top of all the debt which accumulated during more speculative, exuberant times, there was of course an accumulation of consumer debt in the form of credit cards, student loans and mortgages taken out for non-speculative purposes to purchase homes in a market where speculation was driving house prices ever upward.
What culminated in 2007-2008 is a situation where the private sector is over indebted and upside-down on their mortgages. Currently, the private sector is in the process of deleveraging, or paying down its debts. Consequently, there isn't much room for spending on consumption and what results is a fall in aggregate demand. The process of deleveraging and the resulting fall in aggregate demand leads to a recession which is referred to as a balance sheet recession. Because the United States, as well as the rest of the world, is currently in the midst of a balance sheet recession, programs such as quantitative easing and it's cousin Operation Twist have little desired effect. If quantitative easing and Operation Twist are supposed to work through the chanel of lowering interest rates to increase private sector borrowing, it is not evident that such a strategy will be effective in an environment where the private sector is already massively in debt and in the process of paying down those debts.
For more information on balance sheet recessions, debt deflation and financial instability, see the works of Hyman P. Minsky (http://digitalcommons.bard.edu/hm_archive/) and Steve Keen (http://www.debtdeflation.com/blogs/) .