What Is The Yield Curve? Why Is It Important? 6
Which takes us to the second form of real money, bank loans.
We already know that an inverted yield curve signals that liquidity conditions are tight in the near term relative to the long, meaning that demand for short term borrowing is high.
In other words, a shortage of money.
As was the case with fiscal stimulus, the quicker real money gets injected into the economy, the better. This means that contrary to how they’ve behaved in the past, and continue to behave, banks need to be making more loans precisely when they least want to.
Obviously, this is a massive contradiction and conflict of interest. On one hand we have banks, private enterprises which exist solely to ensure that they remain solvent and able to do business.
On the other, we have the economy as a whole, which is dependent on banks to create money when it is needed most (during recessions). Failing which, businesses who need short term financing to tide them through the economic contraction will fail, sparking a chain reaction of loss jobs, income, and spending.
Needless to say, banks simply won’t lend during a recession, at least nowhere near as freely as they did when times were good.
From their perspective, recessions greatly increase the probability of existing loans running into default, much less new ones. Remember that banks are inherently short convexity, that is, a small number of big defaults can send them under.
As such, it makes very little business sense for them to be taking on increased risk during a period of time which demands more risk-taking prudence.
Unfortunately for the rest of us, this means that the shortage of money in the broader economy doesn’t get alleviated.
As with other problems of a systemic nature, developed economies (and populations) turn to the government for a solution. In the case of recessions, this means central banks – if private banks won’t inject money into the economy, surely the central bank will!
To their credit, central banks, especially in developed economies, have really stepped up to try to do so.
The means through which they have tried to pump money into the economy has, over the years, expanded to the point where what was once deemed unorthodox is now common practice.
Their toolkit now ranges from the humble interest rate cut to ultra low interest rates, negative interest rates, and of course the biggest monetary bazooka of them all, QE.
To their discredit, none of it has really worked. While they, and others, will point to improving data and economies rebounding from recession as proof that their policies have worked, it is quite easy to see that they really don’t.
To be continued…
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