An important lesson from Jackson Hole 2010

So firstly, he says, it’s important to realise we are in a debt deflation crisis (one of Ben Bernanke’s specalist subjects). Second, that there’s always been a major difference in the Fed’s thinking when it comes to QE1 and QE2.

QE1 was ultimately a defensive move designed to put a floor on a major output collapse. QE2 was, however, was always designed as an offensive manoeuvre.

Under QE1, the Fed expanded its balance sheet by taking in Treasuries, as well as a whole bunch of “other” assets, including a major slice of non-performing mortgage debt.

The balance sheet expansion allowed the Fed to achieve one of two critical support functions to the banking industry. It provided banks with much needed liquidity via an expansion of base money.

Measures like Tarp, meanwhile, helped to recapitalise the banks. And both capitalisation and liquidity were essential to keep banks in the business of lending — and with that the floor on the crisis stable.

The problem was, that despite the recapitalisation and liquidity, banks were still not lending due to a general lack of creditworthy customers. No matter how hard the Fed tried to get the money into the spending stream via the banks, it quickly realised it couldn’t.

via ftalphaville.ft.com