With monetary transmission impaired we may be in a perpetual “Sword of Damocles” moment

It may be that the monetary transmission mechanism is impaired through the structural imbalances that have developed within global economies over the last 20 years (+/-). If the transmission mechanism is impaired then we are in a perpetual “Sword of Damocles moment.”

The recent IMF blog, “The New Global Imbalance: Too Much Financial Risk-Taking, Not Enough Economic-Risk Taking” introduces a well known pre existing dynamic as “a new global imbalance”:

Policymakers are facing a new global imbalance: not enough economic risk-taking in support of growth, but increasing excesses in financial risk-taking posing stability challenges

We have been in a declining capital and human investment scenario for some time (discussed in many a recent blog), in many key developed economies, and we have been in a paradigm of increased financial leverage/asset focussed money supply growth.  This is not new and is the primary reason why we are pinned to the economic floor with the proverbial boot pressed to our throats.  I discussed this also in a recent blog…  

The IMF rightly points to the risks posed by the shadow banking financial system:


Banks are safer but may not be strong enough to vigorously support the recovery. And risks are shifting to the shadow banking system in the form of rising market and liquidity risks. If left unaddressed, these risks could compromise global financial stability

But I feel that the shadow banking system, in terms of its size and its risks, is also a function of excess asset focused money supply growth and a declining focus of money supply dynamics on real economic activity.  A recent OFR report on Shadow Banking makes a similar statement.

The global macro drivers behind the secular rise of cash pools and leveraged portfolio managers in the asset management complex are identical with the real economy drivers behind the idea of secular stagnation

The fact that the Shadow Banking system has been growing strongly since the late 1990s confirms that the “new imbalance” has likewise been developing for some time. The increased asset focus of money supply growth and the increased rate of growth of excess asset focussed money supply growth has gone hand in hand with low interest rates…

Excess MS, low IRs..low capital expenditures and a focus on financial leverage has also shifted monetary demand to the shadow side. 

One shadow banking issue is financial leverage and the value of assets attached to that leverage with respect to the potential growth in output needed to support that leverage.  This is a portfolio risk and a consumption risk in that many of the assets directed via the shadow banking system may be identified in holders minds as close to or near money.

The other issue is the withdrawal of liquidity from the financial assets that shadow banking has been supporting, in a risk event.  Traditional banking both intermediates and manages its balance sheet, but shadow banking really has no risk management role….those who decide when and how to pull supply of finance are the investors, not the banks..time frames and liability management demands are different.

It is not a question of the money tied up in the Shadow banking system because the money supply is not actually tied up in it, it cannot hold deposits..but it does mediate money supply transfers and it does mediate markets for shadow banking financed assets. 

The blog then goes onto address one further important issue:

In order to address this new global imbalance, we must promote economic risk-taking by improving the transmission of monetary policy to the real economy. And we must address financial excesses through better micro- and macroprudential policies. 

I refer to the emboldened part.   We have missed many an opportunity to reset the financial system, to bring leverage and asset prices into balance with economic growth potential: in 1997/1998, 2001/2004, 2008/20?? we supported leverage and asset price imbalances. 

I feel that one of the problems behind the failure of asset prices to transmit demand to the real economy is the increasing income and wealth inequality globally.  But I also feel that a key developing transmission point was cut dead in its tracks in the way asset markets, in particular the housing market, corrected during the onset of the current and continuing financial crisis.  If everything is in balance, high asset prices should eventually transmit demand to the real economy by increasing the demand for money within expenditure portfolios and away from asset portfolios and in so doing limit asset prices and raise activity/prices in the production/consumption side of the economy. 

It may be that the transmission mechanism is impaired through the structural imbalances that have developed within global economies over the last 20 years (+/- ?).  If the transmission mechanism is impaired then we are in a perpetual “Sword of Damocles moment.” 

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