A dove or a hawk?

Janet Yellen, nominated by Obama as the next chairman of the Fed, is more aggressive in her monetary policies than is portrayed in the media

PUBLISHED : Friday, 25 October, 2013, 3:23am
UPDATED : Friday, 25 October, 2013, 3:23am

President Barack Obama has picked Janet Yellen as his nominee to be the next chairman of the United States Federal Reserve.

In the months leading up to this announcement, the press dubbed Yellen the Queen of the Doves, pointing to her reluctance to roll back the Fed's quantitative easing programme.

But when it comes to money supply, she seems downright hawkish.

Traditionally, the dove label has referred to an emphasis on the Fed's mandate to pursue full employment (even at the expense of slightly higher inflation), while the hawk label has referred to a focus on the Fed's price stability mandate.

In practice, however, the dove-hawk distinction typically comes down to a question of the money supply: to increase, or not to increase?

First, we must define what measure of the money supply we are talking about.

While it is true that the Fed has turned on the money pumps in the wake of the 2008 crisis, the Fed only directly controls what is known as the monetary base, or state money, which includes currency in circulation and bank reserves with the Fed.

The vast majority of money supply, properly measured, is known as bank money. This is money produced by the private banking sector through deposit creation, and includes liquid, money-like assets such as demand deposits and savings deposits.

The Fed has been quite loose when it comes to state money, with its share of total money supply increasing from 5 per cent of the total before the crisis, to 20 per cent today.

Given Yellen's support for continuing the Fed's interest rate and easing policies, it would appear that, when it comes to state money, Yellen is indeed a dove.

But, where does she stand on the other 80 per cent of the money supply?

To answer this question, we must look at her stance on financial regulation.

In the aftermath of the financial crisis, politicians, regulators and central bankers around the world (including Yellen) have pointed their accusatory fingers at commercial bankers.

They assert that the keys to preventing future crises are tougher regulations and more aggressive supervision, centred on higher capital requirements for banks.

This would be fine if higher capital requirements were being imposed during an economic boom, because capital increases cause money supply growth to slow, which tends to cool down the economy. But when capital increases are imposed during a slump they become pro-cyclical and actually make things worse.

Indeed, the imposition of higher capital requirements in the wake of the financial crisis has caused banks to shrink their loan books and dramatically increase their cash and government securities positions.

Even the International Monetary Fund and the Organisation for Economic Co-operation and Development quietly acknowledge that this will hamper GDP growth and raise lending rates.

For a bank, its assets (cash, loans and securities) must equal its liabilities (capital, bonds and liabilities which the bank owes to its shareholders and customers). In most countries, the bulk of a bank's liabilities (about 90 per cent) are deposits. Since deposits can be used to make payments, they are "money". Accordingly, most bank liabilities are money.

To increase their capital-asset ratios, banks can either boost capital or shrink risk assets. If banks shrink their risk assets, their deposit liabilities will decline. In consequence, money balances will be destroyed.

The other way to increase a bank's capital-asset ratio is by raising new capital. This, too, destroys money.

If Yellen were truly a dove, she would have been advocating laxity and supervision, not stringency

When an investor buys newly issued bank equity, the investor exchanges funds from a bank account for new shares. This reduces deposit liabilities in the banking system and wipes out money. So, paradoxically, the drive to deleverage banks and to shrink their balance sheets, in the name of making banks safer, destroys money balances.

The US, with Yellen's blessing, has employed a loose state money-tight bank money monetary policy mix.

For all the talk of QE3 and Fed's loose policy, the inconvenient truth is that the overall money supply in the US, broadly measured, is still, on balance, quite tight - thanks in large part to ill-timed bank capital increases.

As a result, the money supply is more than US$1 trillion less than its pre-crisis level. This is bad news for the real economy, particularly the labour market, because money supply growth and unemployment are tightly linked.

If Yellen were truly a dove, she would have been advocating laxity in bank capital requirements and supervision, not stringency.

Despite the massive regulatory burden that has been heaped on the banking system by the Basel III and Dodd-Frank regulatory regimes, and the repeated capital increases that have been imposed on banks by domestic and international regulators, Yellen is not satisfied.

Indeed, she calls this effort "unfinished business".

These are clearly not the words of a dove.

Steve Hanke is a professor of applied economics at Johns Hopkins University