Banking: The Finance and the Macro View

A recent post by Tyler Cowen discusses one possible reason why the Fed has refrained from setting a higher inflation target, despite the fact that many economists believe that doing so could boost AD.  The argument is that higher near-term inflation expectations would raise short term nominal rates, and cut into bank profits that are now earned by borrowing short at very low rates and lending long at higher rates.

I can’t say whether Tyler Cowen is correct that worry about bank profits may be a factor discouraging the major central banks from doing additional monetary stimulus.  But I haven’t seen any better explanations for their seemingly perverse behavior.  And I should add that Tyler has mixed feelings about the desirability of such a policy:

I also regard this as a somewhat gruesome hypothesis.  It means that “Main Street” is paying for “Wall Street” (forgive me the use of those awful terms) in at least two ways: high unemployment and inability to earn much on one’s savings.  Risk on the Fed balance sheet is also paying some big part of the bill, since presumably that is helping to maintain the interest rate spread.

I’d say it’s even worse—it isn’t even clear that this strategy would help the banking industry. I believe this “finance view” misses the most important factor influencing bank profits–the state of the macroeconomy.  Earlier this year the IMF lowered its estimate of the worldwide losses to banks from $4 trillion to $3.4 trillion.  The explanation was a slightly better than expected recovery in the world economy after March 2009.  The fact that a modestly better than expected macroeconomic outlook could shave $600 billion off expected banking losses is just one indication of how devastating the worldwide drop in AD was during late 2008 and early 2009.  It sharply reduced all sorts of asset values and severely damaged the financial system.  Indeed the damage was much worse than that from the earlier sub-prime fiasco.

If the sharp drop in AD had not occurred, i.e. if inflation had continued at its normal 2% to 3%, then the banking system would have survived the sub-prime crisis is much better shape.  Yes, banks may gain, ceteris paribus, from lower short-term nominal rates.  But in this case ceteris isn’t paribus.  The very thing that drove nominal rates to near-zero levels is the same thing that caused the bulk of the financial crisis.  And reversing that fall in AD would be a huge boon to the banking industry, even if nominal rates were higher as a result.  Put simply, in most cases when X is bad for an industry, then “opposite of X” is good for that industry.