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Debt Overhang Impeding Normal Bank Activity.

  • Written by Syndicated Publisher 66 Comments66 Comments Comments
    September 14, 2011

    Dan Aronoff responds to Tim Congdon’s article, Theories look flimsy if they are misunderstood, published in The Financial Times of London on September 1st. Tim Congdon (pictured above) is the founder of the macroeconomic forecasting consultancy Lombard Street ResearchDan’s response, below, was published in FT on September 6 2011. Dan Aronoff is a regular contributor to The Sceptical Market Observer.

    Sir,

    Tim Congdon et al point out, with considerable justification, that the omission of a commercial banking sector from mainstream macroeconomic models – such as the canonical model developed by Michael Woodford – is a serious shortcoming that, inter alia, obscures the role of banks in the transmission channels of monetary policy (Letters, September 1). But Prof Congdon’s assertion that “when the quantity of bank deposits rises significantly in a short period, strong forces to boost national income and wealth come into play”, which certainly applies in normal times, misses an important feature of our current economic predicament.

    The debt overhang on bank balance sheets weakens the link connecting deposit increases – which are generated by monetary expansion – and growth in bank lending. In normal times, when banks are well capitalised and desire to increase lending, an increase in deposit liabilities will induce them to raise the required additional capital to meet the reserve requirements enabling an increase in lending. But when banks are undercapitalised, capital is scarce and markets are saturated in fear, an increase in deposits will often lead banks to engage in offsetting reductions in other liabilities or, if available, to increase deposits in interest-bearing central bank accounts.

    In western economies today, near zero nominal interest rates and crippling debt overhang on banks have caused the traditional channels of monetary transmission to seize up: the interest rate channel of monetary transmission has melted into a “liquidity trap” and the bank lending channel has broken. Monetary policy has become irrelevant.

    Images: Flickr (licence attribution)

    About The Author – Luc Vallée

    Currently President of The Independent Market Observer. Chief Economist and Vice-President at the Caisse de dépôt from 2001 to 2008. Chief Financial Officer and Vice-President, Corporate Strategy for Mediagrif Interactive Technologies from 1999 to 2001 – MDF.TO. Deputy Treasurer at Canadian National Railways, 1997-1999. Associate Professor of Applied Economics at l’École des Hautes Études Commerciales (HEC) in Montréal, 1989-96. Consultant for the World Bank, the Canadian government, the Quebec government and the City of Montreal. Deputy director of the Center for International Studies, 1993-1996. Adviser to the investment banking division of Société Générale in Canada, 1996. President of ASDEQ in 2005-06. Member of the National Statistics Council of Statistics Canada, 2008-now. Ph.D. (1989) in economics from the Massachusetts Institute of Technology.
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