Why Monetary Expansion Is Not Enough

If banks don’t give credit, then the amount of deposits decreases regarding the monetary base (issued by the central bank). That is, the speed of money circulation is reduced, so any sort of “monetary boost” by means of extending the central bank’s assets becomes sterilised in banks or is invested in public debt so as to obtain profitability without risk.

That’s exactly what we see now in Spain, where credit to households and corporations kept falling in Januar while credit to the public administrations kept increasing (at a lower rate, though: only 8%). Meanwhile in Europe we don’t see much enthusiasm in filling the banks’ safes by the ECB. It won’t become credit but it could help to re-structure their balances and liquidity. But let’s see Samuelson’s explanation:

But here’s Paul Samuelson, from pages 353-4 of his 1948 textbook:

Today few economists regard Federal Reserve monetary policy as a panacea for controlling the business cycle. Purely monetary factors are considered to be as much symptoms as causes, albeit symptoms with aggravating effects that should not be completely neglected.

By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, “no nothing,” simply a substitution on the bank’s balance sheet of idle cash for old government bonds. If banks and the public are quite indifferent between gilt-edged bonds — whose yields are already very low — and idle cash, then the Reserve authorities may not even succeed in bidding up the price of old government bonds; or what is the same thing, in bidding down the interest rate.

Even if the authorities should succeed in forcing down short-term interest rates, they may find it impossible to convince investors that long-term rates will stay low. If by superhuman efforts, they do get interest rates down on high-grade gilt-edged government and private securities, the interest rates charged on more risky new investments financed by mortgage or commercial loans or stock-market flotations may remain sticky. In other words, an expansionary monetary policy may not lower effective interest rates very much but may simply spend itself in making everybody more liquid.

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In terms of the quantity theory of money, we may say that the velocity of circulation of money does not remain constant. “You can lead a horse to water, but you can’t make him drink.” You can force money on the system in exchange for government bonds, its close money substitute; but you can’t make the money circulate against new goods and new jobs. You can get some interest rates down, but not all to the same degree. You can tempt businessmen with cheap rates of borrowing, but you can’t make them borrow and spend on new investment goods.

Brilliant!