US Bank Behaviour since the Lehman Collapse, Bailout Uncertainty, and the Timing of Exit Strategies

            This paper documents a dramatic post-Lehman slowdown in the rate of growth of US banking credit in spite of a huge accumulation of banks’ reserves at the Fed. Appealing to results in a theoretical background paper the banking credit arrest in the immediate aftermath of Lehman’s collapse is explained in terms of an increase in bailout uncertainty triggered by the Lehman event. The strong persistence of this phenomenon is explained in terms of a crisis induced toughening of banking regulation along with a persistent increase in probabilistic awareness to low bailout probabilities (or, equivalently an increase in uncertainty aversion) within a multiple priors framework. The paper also documents a dramatic decrease in total net new (non treasury) bond issues due mainly to the disappearance of mortgage related bonds along with an increase in net new issues of corporate bonds. Those phenomena explain why, in spite of a huge expansion of the monetary base, inflation has been subdued since Lehman’s collapse.

            Since the Lehman’s event cumulative base money in the US expanded at a rate similar to the cumulative rate of increase of base money through more than half of the post WWI German hyperinflation. During the six years between September 2008 and September 2014 cumulative inflation in the US has been a bit over twelve percent while the cumulative rate of inflation following the same base money expansion in Germany led to a twenty four-fold cumulative increase in the price level. An important reason for this dramatic difference is that in the US today the Fed’s high powered monetary expansion is not translated into credit and new purchases. By contrast in post WWI Germany the monetary expansion was immediately used by government to purchase goods and services. One lesson from this comparison is that the current risks of inflation are very small. The penultimate section of the paper discusses alternative exit strategies as well as various tapering triggers.