Once again, the European press is trumpeting the triumph of the prodigals after a week in which both the Spanish and the French were accorded more time to get their budgetary house in order – a move which, given the downward economic trajectory of the pair, has something of a whiff of force majeure about it – and the German Finance Minister Schaeuble acknowledged that, yes, the fiscal pact around which he and his boss have built so much of their electoral credibility did in fact encompass a ‘certain flexibility’.
In the wake of a mass demonstration on the streets of Paris at which the Left Front’s heavily-defeated presidential candidate Melenchon fulminated that “We do not want the world of finance in power!” – an expostulation delivered to the strains of ‘Ca ira!’, one supposes – Schaeuble’s Gallic counterpart Moscovici was hardly in a position to soft-pedal the German concession, instead vaunting grandiosely in his turn that, “We are witnessing the end of the dogma of austerity… we are at a decisive turning point in the history of the European Project”.
Brave words, indeed, but Frau Merkel, for one, begged to disagree – or, at least, to dissemble for the benefit of her domestic audience. “If one regularly spends more than one earns, something must be awry,” she opined, while one of her party’s spokesmen, Steffen Seibert declared that, “Our contention is that the… crisis has its roots in the overindebtedness of many member states… in to low a degree of competitiveness.” No prizes for guessing to whom he was referring.
Last week’s supposed poster boy for the new laxity, Commissar – sorry, Commissioner – Barroso, was also out on the circuit, denying that he had endorsed any such slippage by telling Welt am Sonntag that he had been “deliberately misinterpreted”, that – au contraire, mes amis – “growth which depends upon debt is unsustainable” and that the blame for the ‘Project’s’ woes should not be pinned on German policy but rather on “excessive outlays, lack of competitiveness” – that word again – “and irresponsible finance.” “Each nation,” he went on, “should look to clean up the mess on its own doorstep.”
Amid all this posturing, it does strike your author as a touch ironic that while the commentariat treats Europe’s persistence with its failed experiment in ‘fauxterity’ as a clear and undeniable symptom of the mental inadequacy of its ruling elite, the members of that same consensus themselves retain what is, if anything, an even more delusional faith in the combined evils of inflation and Big Government as the magical means with which to conjure away all our present woes.
In case you hadn’t noticed, fellas, we have been reinforcing monetary-fiscal failure for the past five years, by continuing to ply the patient with ever stronger doses of what it was that made him ill in the first place. Just multiply the DAX by the youth unemployment rate if you want a snapshot of where your approach has gone horribly wrong – of where you have let the GINI out of the bottle, as it were – and you might realise that if there is anyone who needs to reconsider their attachment to a discredited dogma, it is you!
Whisper it, but even your hero seems to be getting the drift. For witness that, in his latest speech in Rome, Mario Draghi was happy to say that “Fiscal policies must follow a sustainable path, separate and distinct from cyclical fluctuations. Without this prerequisite, lasting growth is not possible… Particularly for countries with structurally high levels of public debt…”, before going on to assert far more boldly that – as we have said since Day One of the crisis – “…to mitigate the inevitable recessionary effects of fiscal consolidation, the composition of such measures must favour the reduction of current public spending and of taxes, particularly in a context such as in Europe where taxation is already high by international standards….” [our emphasis].
Though we must be careful not to read too much into the man’s words, it is hard not to hope that this might reflect the first fragile flowering of a genuinely new approach – of the inauguration of a policy of REAL austerity, this time of the invigorating kind which incorporates a partial lifting of the deadening hand of the state, rather than the enervating, bastardized version of slower spending growth and rapidly rising taxes with which we have been so far afflicted and which has only served to compound the financial shock delivered by the collapse of the last bubble.
All this remains to be seen but, in the here-and-now, the temptation to use this effusion of political hot-air as an excuse to buy yet more stocks, more ailing sovereign debt, and more junk credit has become well-nigh irresistible, especially since Super-Mario not only overrode what he hinted was some internal opposition to an official rate cut at the latest ECB meeting, but also managed to leave dangling before a slavering crowd of stimulus junkies a tantalising hint that he might soon push the level below zero. In case we were too obtuse to get the point, he underlined his intentions with another of his famously portentous, almost Delphic pronouncements: that even though the ECB council was still scrambling to divine whether anything could possibly go wrong with such step into the unknown, he, Draghi, stood ‘ready to act’.
It was not the first time in recent days, of course, that the marbled halls of Mount Olympus had echoed to the sonorous baritone of the Gods as they sought to reassure us poor mortals that they had matters well in hand: that they had taken time off from their weighty contemplation of the sublime, the eternal, and the infinite to tend instead to our petty concerns. Had not the Bernanke Fed subtly quashed all thoughts that it might soon ‘taper’ its own open-handed distribution of milk and honey with that one, equally Pythian phrase: “the Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation”?
How can a man NOT want to buy the market in the face of the solicitous stance being taken by the venerated possessors of such unchallenged omniscience?
For all this, the imposition of the near-mythical, negative deposit rate might seem to entail more problems than advantages, not least because it would effectively act as a tax, a drain upon the earnings, of the very same banks that the last five year’s ruinous policies have been attempting to bolster. Bear in mind that, even after the recent redemptions, European banks have a hefty €628 billion parked with the ECB and so a 50bp levy on this could amount annually to perhaps 15% of industry-wide profits.
Nor can banks simply avoid this by withdrawing their funds: outside money – the kind created by the central bank – is, after all – outside. This means that its supply can only be altered with the complicity of the bank of issue itself which must therefore allow its myrmidons to pay back more of their LTROs, covered bond repos, and so forth – a reduction of liquidity which one might think would run counter to the original intention. Thus, one supposes, the idea will be that the banks will enact the Gesellian wet dream of passing on the cost to their own depositors, of taxing their money instead.
Here we must consider the fact that while the individual can easily seek to disembarrass himself of what he now considers an excess proportion of money among his holdings, collectively the public can only have their aggregate stock of inside (bank-created) monies diminished in one of three ways: they must repay their loans (deleverage further); the banks themselves must call in said loans (intensify the crunch); or people who hold a demand account must swap it for a term deposit (which does not constitute money-proper), or invest in a long-term security issued by the bank itself (we specify this last because a moment’s thought will reveal that the purchase of non-bank paper simply passes the parcel to the seller or issuer of said obligations who must then rid himself of them in his turn).
While that latter condition might seem an ideal juncture at which the banks could seek to boost their levels of capital (albeit at an average price:book of significantly less than one), the truth is that what the authorities seem most keen to provoke is a what is technically called a ‘monetary disequilibrium’ – that is, the situation where the public’s demand to hold money is thrown out of kilter. Under such conditions – and given the nominal inflexibility discussed above – the money stock can only be effectively reduced if its real value falls; if prices rise and so reduce its worth; i.e., if there is an inflation.
In that regard, the impulse to buy stocks on what is no more than a vague expression of intent might not seem so wholly irrational, after all. To see this in what is admittedly a toy example, suppose that half the population holds only cash and no equities (call these sticks-in-the-mud Group A), while the remainder has a reverse proportion of all equities, no cash to an equal overall nominal value held in their portfolios (call the ‘Nothing but Blue Skies’ crowd, Group B). The aggregate cash ratio from which we start is therefore 50% (albeit thanks to a not-to-be-exceeded and somewhat unrealistic divergence of preferences between our two cohorts).
Now suppose the members of Group A change their outlook on life and seek to acquire equities from Group B, paying successively higher prices for ever smaller increments in order to tempt their counterparts into the trade. Under some fairly crude assumptions, after four rounds of such bidding, with one third of the stock of equities having exchanged against two-thirds the stock of money, equity prices will have tripled, the cash ratio of both groups will have converged on 25%, and aggregate net worth will have doubled (to the relative advantage of the initial equity holders, but to the outright, if decidedly notional, benefit of all).
Note, however, that none of this says that the equities are worth three times as much for even if the monetary disturbance has somehow meant that earnings have also tripled (and this is far from being guaranteed even should revenues rise in proportion), this may represent no material gain whatsoever, but only register the inflation of a wider range of prices which here has not been consequent upon an increase in the stock of money per se but solely upon a diminution in its societal valuation.
Herein lies the great gaping hole at the centre of official policy. Yes, the central banks can increase the stock of outside money almost without limit. Yes, they can make it as unattractive as possible for anyone to hold this (though when we come to think about the impact of negative rates, let us not forget that people are generally happy to pay to have their other valuables safely stored, or that bank charges used to be a routine imposition upon the short-term depositor). And yes, to some extent they can assume that their actions will enhance the relative appeal of things other than money or its partial substitutes.
But what they cannot ever gauge is how much influence they can exert, nor how quickly their will may be done, nor even upon what specific mix of goods, services, or claims their policy will have most impact. As the great Richard Cantillon pointed out three centuries since, the whole question is highly path dependent and the path actually followed will be the result of an incredible cascade of interactions between individual, subjective choices, each one altering the quantum field in which the next has to be taken. As we Austrians have been saying for the past one hundred years, this affects relative prices much more profoundly than it does average ones. Crucially, it is in that matrix of relative prices that you find the motivations for all economic actions and the justification or otherwise for both the composition of the capital stock and the distribution and employment of labour. If entrepreneurial uncertainty and personal bewilderment have been major contributors to our ongoing malaise, as many of us have been arguing, it should be clear that we seek to introduce further sources of instability and potential disruption only at our peril.
Nor can our Sorcerer’s Apprentices be entirely sure that, as the demons they have summoned out of the vasty deep continue to chip away at the foundations of trust in the very currency which they, the necromancers, are charged with upholding, they do not unleash a catastrophic collapse of the whole superstructure of values and contractual chains which towers above them, reducing the whole economic system to chaos in the process.
If you can convince me that any mortal can hold such a complex tangle of possible outcomes within their comprehension, I will allow that our monetary heretics may be right to do away with the combined practical experience and theoretical understanding of all those who have gone before them over the ages. Until you do, I shall be forced to withhold my endorsement and to mutter darkly about the unexpiable sin of hubris instead.
According to a European Central Bank Governing Council member Ewald Nowotny, Federal Reserve Chairman Ben Bernanke sees no risk to inflation in the United States. According to Nowotny, Bernanke had given a “very optimistic” portrayal of the U.S. outlook.
“They see absolutely no danger of an expansion in inflation,” Nowotny said. Bernanke had said U.S. inflation should be 1.3 percent this year.
Fed forecasts put inflation by the end of this year in a range of 1.3 to 1.7 percent. The yearly rate of growth of the consumer price index (CPI) stood at 1.5% in March against 2% in February and 2.7% in March last year.
Also the growth momentum of the core CPI (the CPI less food and energy) has eased in March from the month before. Year-on-year the rate of growth has softened to 1.9% from 2% in February and 2.3% in March last year.
For Bernanke and most experts the key factor that sets the foundation for healthy economic fundamentals is a stable price level as depicted by the consumer price index.
On this way of thinking a stable price level doesn’t obscure the visibility of the relative changes in the prices of goods and services.
Consequently, it is held, this leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals.
A stable price level enables businesses to see clearly market signals that are conveyed by the relative changes in the prices of goods and services.
For instance, let us say that a relative strengthening in people’s demand for potatoes versus tomatoes took place. This relative strengthening, it is held, is going to be depicted by the relative increase in the prices of potatoes versus tomatoes.
Now in a free market businesses pay attention to consumer wishes as manifested by changes in the relative prices of goods and services. Failing to abide by consumer wishes will lead to the wrong production mix of goods and services and will lead to losses.
Hence in our case businesses, by paying attention to relative changes in prices, are likely to increase the production of potatoes versus tomatoes.
On this way of thinking if the price level is not stable then the visibility of the relative price changes becomes blurred and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.
This leads to a misallocation of resources and to the weakening of economic fundamentals. In short, unstable changes in the price level obscure changes in the relative prices of goods and services.
Consequently, businesses will find it difficult to recognize a change in relative prices when the price level is unstable.
Based on this way of thinking it is not surprising that the mandate of the central bank is to pursue policies that will bring price stability i.e. a stable price level.
By means of various quantitative methods the Fed’s economists have established that at present policy makers must aim at keeping price inflation at 2%. Any significant deviation from this figure constitutes deviation from the growth path of price stability.
Observe that Fed policy makers are telling us that they have to stabilize the price level in order to allow the efficient functioning of the market economy.
Obviously this is a contradiction in terms since any attempt to manipulate the so called price level implies interference with markets and hence leads to false signals as conveyed by changes in relative prices.
By means of setting targets to interest rates and by means of monetary pumping it is not possible to strengthen economic fundamentals, but on the contrary it only makes things much worse. Here is why.
Policy of price stability leads to more instability
Let us say that the so called price level is starting to exhibit a visible decline in growth momentum. To prevent this decline the Fed starts to aggressively push money into the banking system.
As a result of this policy, after a time lag, the price level has stabilized. Should we regard this as a successful monetary policy action? The answer is categorically no.
Given that monetary pumping sets in motion the diversion of wealth from wealth generating activities to non-wealth generating activities obviously this leads to the weakening of the wealth generation process and to economic impoverishment.
Note that the economic impoverishment has taken place despite price level stability. Also, note that in order to achieve price stability the Fed had to allow an increase in the growth momentum of its balance sheet and consequently in the growth momentum of the money supply.
It is the fluctuations in the balance sheet and the subsequent fluctuations in the growth momentum of money supply that matter here. It is this that sets in motion the menace of the boom bust cycle regardless of whether the price level is stable or not.
While increases in money supply are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors.
Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place.
In other words, while money growth is buoyant prices might display low increases.
Clearly, if we were to pay attention to the so called price level and disregard increases in the money supply, we would reach misleading conclusions regarding the state of the economy.
On this, Rothbard wrote,
“The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware”
(America’s Great Depression, Mises Institute, 2001 , p. 153).
During the 1926 to 1929 the alleged stability of the price level caused most economic experts including the famous American economist Irving Fisher to conclude that US economic fundamentals were doing fine and that there was no threat of an economic bust.
The yearly rate of growth of the CPI displayed stability during 1926 to 1929 (see chart). Most experts have ignored the fact that the yearly rate of growth of the US central bank balance sheet jumped to 42% by June 1928 from minus 14% in February 1927.
The sharp fall in the growth momentum of the Fed’s balance sheet after June 1928 (see chart) set in motion an economic bust and the Great Depression.
At present the Fed continues to push money aggressively into the banking system with its balance sheet standing at $3.3 trillion as at the end of April against $0.9 trillion in January 2008. We suggest however that a fall in the growth momentum of AMS since October 2011 raises the likelihood of a bust in the months ahead.
If one adds to all this the possibility that the process of real wealth generation has been badly damaged by the Fed’s loose policies it shouldn’t surprise us that we could enter a severe slump in the months ahead.
Summary and conclusion
For most economists the key to healthy economic fundamentals is price stability. A stable price level, it is held, leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals. It is not surprising that the mandate of the Federal Reserve is to pursue policies that will generate price stability. We suggest that by means of monetary policies that aim at stabilizing the price level the Fed actually undermines economic fundamentals.
On Thursday April 4 the Federal Reserve Vice Chairman Janet Yellen said in Washington the Federal Open Market Committee (FOMC) should be prepared to alter its $85 billion monthly pace of bond buying based on changes in the economic outlook.
Yellen’s comments support a proposal by St. Louis Fed President James Bullard to reduce the pace of purchases as the economy improves, or expand it if the economy weakens.
Also, the Fed Chairman Ben Bernanke said last month the FOMC is considering this strategy to “appropriately calibrate” its policy.
The view that the Fed should calibrate its monetary policy in line with the likely state of the economy stems from the popular way of thinking that the role of the central bank is to make sure that the economy stays on a path of balanced economic growth.
According to this way of thinking the economy is seen as some kind of space ship that has deviated from its trajectory.
To bring it back onto the correct path, policy makers must give it an external push. So if the push in terms of loose monetary policy doesn’t produce the required results then policy makers must become more aggressive until the space ship is brought onto the desired path.
Conversely, if the economy, for whatever reason, is pushed onto the path of high inflation, then the central bank by means of a tighter monetary stance must bring the space ship onto the “correct” path.
Within this way of thinking, given that the economy is currently way below its right growth path there are plentiful of unemployed resources. Consequently, this permits policy makers to adopt a very aggressive loose stance without igniting inflation.
We suggest that this way of thinking is erroneous. An economy is about human beings and not about a space ship that follows along a growth path.
A policy that attempts to bring the economy onto the “correct” trajectory leads to a diversion of wealth from wealth generators to non–wealth-generating activities, thereby weakening the process of the wealth generation, i.e. it leads to an economic impoverishment.
In the meantime, the latest economic data seems to support the view that the Fed is unlikely to reverse its loose monetary stance soon.
The ISM manufacturing activity index fell to 51.3 in March from 54.2 in the previous month – whilst the ISM services index eased to 54.4 last month from 56 in the month before.
Non farm employment increased in March by 88,000 against the median forecast of economists for an increase of 190,000. Year-on-year employment increased by 1.91 million after rising by 2.027 million in February and an increase by 2.03 million in January. Additionally the diffusion index of employment in the private sector fell to 54.3 last month from 59.6 in February and 65.2 in December last year.
Elsewhere we have suggested that fluctuations in economic data are set in motion by fluctuations in the growth momentum of money supply as depicted by our monetary measure AMS.
After closing at 2.2% in June 2010 the yearly rate of growth of AMS climbed to 14.8% by October 2011.
Afterwards the yearly rate of growth has been following a declining path closing at 7.3% in March this year. (A change in the money supply rate of growth doesn’t affect all activities instantly – there is a time lag. For some activities the time lag is short while for others it is much longer).
We suggest that the fact that the growth momentum of AMS has been declining since October 2011 implies that downward pressure on economic activity has already been set in motion.
As time goes by the supporting effect on economic activity from the rising growth momentum of AMS during June 2010 to October 2011 is likely to weaken whilst the fall in growth momentum since October 2011 onward is likely to start to dominate the economic scene.
Based on the lagged growth momentum of real AMS (AMS adjusted for CPI) we suggest that the growth momentum of industrial production could come under strong pressure from the second half of this year. This is likely to undermine the growth momentum of employment (see chart).
We hold that massive monetary pumping by the Fed not only didn’t provide support to the economy but on the contrary has severely damaged the process of wealth generation. Elsewhere we have shown that it is the formation of real wealth that funds and thereby supports underlying economic growth.
This runs contrary to the popular way of thinking that loose monetary policy can somehow fund and grow an economy. All that loose monetary policy can do is to give rise to various non-productive bubble activities and thereby undermine underlying economic growth.
As long as the pool of real wealth is expanding loose monetary policies can give the impression that they grow the economy. Once however the pool becomes stagnant, or starts to decline, the economy follows suit.
In this case if central bank policy makers try to enforce aggressive monetary pumping this weakens the wealth generation process and weakens the pool of funding further. There are signs that this might be already happening. As a rule when the central bank pushes money into the banking system banks lend this money out thus boosting the money supply rate of growth and after a time lag this boosts the economic activity.
At present this mechanism is not working. Despite a massive increase in the Fed’s pumping as depicted by its balance sheet, banks so far have chosen to sit on the pumped cash rather than lend it out. In early April the Fed’s balance sheet stood at $3.2 trillion against $0.9 trillion in January 2008. Banks surplus cash jumped to $1.726 trillion in early April from $1.578 trillion in January. In January 2008 surplus cash stood at around $2.4 billion.
As the pool of real wealth comes under pressure banks find it much harder to acquire good quality borrowers, hence the supply of lending is slowing down. Now if the Fed were to attempt to force banks to increase lending this is not going to help real economic growth if the pool of funding is under pressure. The best thing the Fed could do to help the economy is to do nothing as soon as possible. This will strengthen wealth generators and in turn the wealth generation process.
Summary and conclusion
Some Fed officials have suggested that once the US economy gains strength it will be appropriate to reduce monetary pumping. The latest economic data seems to support the view that the US central bank is unlikely to reverse its loose monetary stance soon. The ISM manufacturing and services indexes have weakened last month whilst employment increased in March well below economists’ expectations. We suggest that the fact that the growth momentum of AMS has been declining since October 2011 implies that downward pressure on economic activity has already been set in motion. We also hold that the process of wealth generation was badly damaged by loose monetary policies of the Fed. This runs the risk of a prolonged economic slump. The best thing the Fed could do to help the economy is to do as soon as possible nothing.
The purpose of this essay is to put the latest crisis in the context of longer-term debt trends in the US and to attempt some predictions in respect to the US economy and financial markets.
Statistics are records of past events. Analyzing statistics means interpreting history, and this can only be done on the basis of theory. We must first have some theoretical notions to be able to render past events intelligible. Of course, historic data cannot be in conflict with the theory used, as that would put the validity of the latter in doubt. But we can neither use statistics to prove the correctness of a theory nor directly discover new theories (although history may give us ideas about potential theories). Before we look at the data I should give a brief outline of my theory, which readers of my book Paper Money Collapse will be familiar with.
The theory – short version
Paper Money Collapse challenges the prevailing consensus on money. This consensus holds that it is good to have something called ‘monetary policy’. Most mainstream economists today, while accepting the superiority of markets when it comes to allocating scarce resources to their most urgent uses, also maintain that in the field of money state involvement is desirable, and that a smoothly functioning economy requires a constantly expanding supply of state paper money and the guidance (manipulation) of certain market prices (interest rates) by a central bureaucracy, i.e. the central bank. More precisely, this bureaucracy should keep expanding the supply of money in such a way that money’s purchasing power declines continuously (moderate, controlled inflation) and that, whenever the economy is weak, it should use its powers to ‘stimulate’ the economy towards faster growth, usually through accelerated base money production and administratively lowered interest rates.
Paper Money Collapse argues that all these notions are erroneous and dangerous. Constant monetary expansion is not needed (not even in a growing economy) and is always highly disruptive. The continuous expansion of fiat money, naturally via financial markets, systematically distorts interest rates, which must lead to capital misallocations and other economic imbalances that will make recessionary corrections at a later stage inevitable. The recessions that ‘easy’ monetary policy is then supposed to shorten or ease are thus nothing but the result of previous monetary expansion.
Recessions can only be avoided by avoiding artificial booms through credit expansion. Once monetary expansion has led to sizable economic distortions the recession becomes unavoidable – and even necessary to cleanse the economy of dislocations. But to make matters worse, in our present system of unconstrained fiat money creation, recessions are – whenever they occur – countered by accelerated money creation (usually via new bank reserves from the central bank) and further cuts in interest rates. Imbalances are thus not being purged from the economy. Instead they accumulate over time making the financial system and the economy overall progressively more unstable. The system is moving towards a point of catharsis: either a complete purge is finally allowed to unfold (painful) or ever more fiat money is created until the public loses confidence in fiat money itself and a hyperinflationary currency collapse occurs (more painful).
I maintain that this theory is logically consistent and not in conflict with past events.
Clearly identifying, let alone quantifying, imbalances is exceedingly difficult if not impossible. It is usually during crises that imbalances become visible as such. Consequently, analyzing data requires a considerable degree of judgement. In the following I look at ‘excessive indebtedness’ as a major dislocation caused by fiat money expansion.
The present monetary system naturally encourages the excessive accumulation of debt, and discourages deleveraging and disinflation, although at certain points in time these may be difficult to avoid altogether. During the financial crisis deflationary and recessionary forces briefly gained the upper hand. To what extent have they purged the system of money-induced imbalances? Has a meaningful ‘cleansing’ of imbalances taken place? If so, has the economy ‘healed’?
I had a look at the Federal Reserve’s Flow of Funds data and the following picture emerges.
Over the 31 years from 1981 to the end of 2012, total debt outstanding in the US economy grew from $5,255 billion to $56,280 billion. The debt load has increased continuously from year to year – with only one single exception: 2009, when total debt declined by just 0.2%. Debt has grown faster than nominal GDP in 27 out of 31 years. The average growth rate in total debt was 8% per annum, compared to 5.4% for nominal GDP. In 1981, total debt outstanding was 168% of GDP, today it is 359% of GDP.
In 1981, total debt broke down as follows: household debt was about 48% of GDP; business debt was about 53% of GDP; the public sector owed about 38% of GDP and the financial sector 29% of GDP. Note that of the four major sectors, the public sector and the financial sector were the two smaller ones. Debt of the financial sector was only slightly more than half of corporate debt.
Things looked very different by the end of 2012: Household debt had ballooned to 82% of GDP and corporate debt to 81%. Public sector debt now stood at 93% of GDP and financial sector debt at 103% of GDP. The public and financial sector had become the largest debtors.
While corporate debt was about 7.5 times larger in absolute terms at the end of 2012 than at the end of 1981, financial sector debt was 17 times larger. Over the 26 years from 1981 to the eve of the current financial crisis in 2007, financial sector debt grew at an average clip of more than 12% per annum compared to about 6% for nominal GDP over the same period. When we entered the present financial crisis in 2007, financial sector debt stood at an all-time high for any sector in US financial history, at 131% of GDP.
I maintain that such a dramatic growth in overall indebtedness, as well as the specific breakdown of that growth by sector, is symptomatic of our unconstrained fiat money system with its constant money growth and lender-of-last-resort central banks that encourage debt accumulation and promote high-leverage strategies in the financial sector. That this has led to substantial economic instability is now self-evident.
Has the US economy deleveraged since 2007?
The two sectors that were most exposed in 2007 were households (via the residential mortgage market) and the financial sector. Both sectors have shed debt since 2007. Both have deleveraged. Households reduced their debt from a record $13,712 billion in 2007 to $12,831 billion at the end of 2012. These $881 billion mean a reduction of 6.4%. The financial sector was forced to cut debt even more: From 2007 to 2012, total outstanding debt of the financial sector was reduced by more than $2,100 billion, a reduction of 12%.
Such reductions in debt were unprecedented in the 31-year history we are looking at here. At no point before had household debt and financial sector debt declined on a year-over-year basis. In this respect, the events of the recent crisis were indeed unique. ‘Cleansing’ has occurred. But how meaningful are these reductions? In absolute terms – total amounts of debt outstanding – both sectors are roughly back to where they were …..in Q3 of 2006, barely a year before the crisis started! Not much has happened in absolute terms. However, in recent years, the economy has continued to grow moderately, so as a percentage of GDP, household debt is today roughly where it was in 2002/3, and financial sector debt is about where it was in 2001/2. In relative terms, a decade of excess has thus been unwound.
Nevertheless, as mentioned above, the total debt load has continued to grow and stands at an all-time record today. The reason for this is mainly the explosion in public sector debt. While households and financial firms have cut debt by $3 trillion since 2007, the state has taken on an additional $6.6 trillion in new debt over the same period– almost all of it at the federal level! In fact, outstanding debt of the federal government has more than doubled since 2007!
The trend of ever-rising overall debt has thus continued. The deleveraging in the household and financial sector has, however, resulted in a reduced pace of debt accumulation overall, despite heavy borrowing from the federal government. In 2010, for the first time since 1992, the economy has grown faster than total debt, and this has continued in 2011 and in 2012, if at a slowing pace. Consequently, total debt stands at 359% of GDP today, slightly down from its peak of 381% in 2009. At 359% debt-to-GDP is back to where it was at in early 2007. Again, not much deleveraging has occurred in total.
Conclusion and outlook
I cannot see that the recent crisis has already brought about some kind of fundamental healing of the US economy, some much needed purge of monetary excesses. Yes, households and the financial industry have trimmed back and are now probably in better shape than a few years ago. Household debt numbers now seem to be stabilizing, meaning deleveraging could be coming to an end, while there is no sign yet that financial deleveraging has concluded. Of course, given the prevailing belief system, those who control the levers of the fiat money system are doing what they can to discourage further deleveraging. Zero interest rates and open-ended QE are hardly conducive to debt reduction.
Here are my present forecasts, and they are necessarily highly speculative:
- Super-easy monetary policy will continue as far as I can see. The Fed has declared that it wants to use monetary policy to boost employment (the hubris of the bureaucrat!). But deleveraging in the financial sector, if it persists, would be a problem for the Fed’s strategy. The financial sector is crucial in transmitting easy policy. The Fed can thus reasonably be expected to continue leaning against deleveraging with all its might. And if and when deleveraging turns into re-leveraging, the Fed will probably nurture it for some time.
- Public sector profligacy is not a crisis phenomenon but has been in full bloom since 2002 and is now in large part structural. A political solution looks unlikely any time soon. The state will thus continue to be the main driver behind the overall growth in debt. Funding this debt accumulation is not a problem with the Fed now the biggest marginal buyer of Treasury securities and the Fed unlikely to abandon super-easy policy anytime soon.
- The corporate sector has not been a major driver in this story so far. Recently, corporate debt has begun to expand again. It is not unreasonable to assume that this will continue.
- In aggregate, the picture could be the following: outstanding debt of the public sector will continue to grow rapidly, corporate debt mildly to maybe strongly; household indebtedness might stagnate. The wild card remains the financial sector. My guess is that what little overall deleveraging we experienced – measured as a modest decline in total debt in relation to the economy’s capacity for income-generation, i.e. GDP – is in the process of being reversed. The interventionists (i.e. the mainstream) will hail this as a success of policy. ‘Debt-deflation’ has been avoided – for now. A more realistic assessment is that the economy is as much on financial steroids as a few years ago, and – in aggregate – as fragile. Expanding debt levels further from here will require interest rates that are continuously depressed through policy and an even more activist and interventionist central bank. The Fed is fully on board with this.
- Deflation is very unlikely from here. The debasement of paper money continues. Inflation rates should begin to move higher.
Debt-GDP-ratios of 359% (now) or 381% (2009) are unusual historically. The ratio was below 200% at the start of the Great Depression and it peaked at a touch above 300% in 1933, when nominal GDP collapsed. The current debt load is unprecedented. But then, countries such as Japan and the UK have total debt in excess of 500 percent of GDP. Disaster still looks inevitable but maybe not imminent.
…a final word on the bond market.
It so happens that the start year of the above analysis – 1981 – also marked the peak in bond yields in the US. 10-year Treasury notes reached 15% back in 1981 and went on a downward path from there that lasts to this day. We have had an almost uninterrupted, 31-year bull market in bonds. Not only Treasuries but also corporate and mortgage debt are presently trading at or near historic lows in yield. Although the US economy never had to carry more debt – certainly never more in absolute terms and almost never more relative to GDP – the compensation that investors get for holding all this debt has never been lower!
Sure, inflation was still high in the early 1980s but the structural drop in inflation was over by 1992. CPI inflation has broadly moved sideways in a stable range since the early 1990s without any additional disinflationary momentum.
It seems that over the past three decades the debtors were encouraged to take out ever more debt because the lenders – the bond buyers – were happy to hold ever more debt at ever lower yields. A market in which demand for assets keeps rising at persistently rising prices (persistently falling yields) has all the ingredients of a bubble. I think the US bond market – and by extension, international bond markets – could be the greatest bubble in history.
The big question is when will this bubble pop?
This article was previously published at DetlevSchlichter.com.
On rare occasions I make specific, near-term market predictions, most recently in Q3 last year, when I called for a modest equity market correction. As it happened, only a tiny correction occurred, followed by a large subsequent rally taking the S&P500 index to 1,550 this week. Now I am making a similar if bolder prediction: A larger correction, possibly a crash (20%+), appears imminent. There are various fundamental and market technical reasons for this view but these all follow from the same ultimate cause: policymaker activism. The Fed and other major central banks ‘own’ this rally. If a crash occurs, and takes the global economy down with it, let’s place blame where it belongs.
The road to record highs
The old adage, “Don’t fight the Fed,” is one that many investors learn first-hand by taking losses. The printing press can be a powerful thing. But like most if not all powerful things, it has its limits. Think of a chess player able to choose which piece goes where. That might seem quite a power until faced with checkmate, when no further moves are possible.
Having stimulated a large increase in money and credit growth through QE in the second half of last year, the Fed now faces checkmate. Why is this so? Because the surge has now reversed as velocity has plummeted. Year to date, both broad money and private sector credit growth are zero even through the monetary base is growing at nearly a 70% annualised rate . The Fed is, therefore, pushing as hard as ever, but still pushing on a string. Moreover, following on by far the largest amount of artificial fiscal and monetary stimulus ever thrown at the US economy, including during the Great Depression, the string is far longer than that which existed back in 2008.
THE MONETARY BASE HAS SURGED OF LATE…
…BUT BROAD MONEY AND CREDIT GROWTH HAVE SUDDENLY SLOWED TO ZERO
Although they will not admit this, the Fed is now essentially out of options. Recent talk about negative interest rates is just that: talk. As the NY Fed research staff have already noted, they could not work in practice . Some will argue that there remains an arrow in the quiver, namely the power to outright monetise debt, public and private, and pro-actively debase the dollar. But this would end the dollar’s reserve currency status, something that would greatly reduce the Fed’s power in any case, and it would most probably lead quickly back to some form of global gold standard . (While I and many other sound money advocates would endorse such a policy, I am well aware that the current Fed leadership abhors the thought of wearing a monetary straightjacket.)
It would not be accurate to claim, however, that the previous surge in money and credit growth did not impact the economy. Most probably it prevented the H2 2012 global growth slowdown from being larger than it was. More obvious is that strong growth in money and credit balances changed investors’ risk preferences, such that they decided to hold proportionately more equities than bonds. This has pushed up valuations for the former. Rotation out of bonds has had relatively little impact on prices, however, as the Fed has been buying large amounts of Treasuries and, importantly, primarily in longer maturities, where their buying activities have a much greater price impact as this compresses term premia. (Short-maturity bond prices are primarily a function of short-term interest rates, which are set by the Fed and which have been essentially zero since 2008.)
Celebration on Liberty Street?
So notwithstanding the slowing economy, the Fed has engineered a large stock market rally. No doubt Fed officials are celebrating. Some investors might also be pleased, but it primarily benefits those who want to cash out at high valuations. Corporate insiders, for example, are selling at the fastest rate in years. Many companies are raising capital through either initial or secondary offerings. Such activity is a sign of a market top, however, and should concern the far larger ‘buy-and-hold’ crowd seeking to increase their wealth through a sustained rally.
There are several other reasons to be seriously concerned. First, consider valuations. Naturally a crash is more likely from elevated valuations than from depressed ones. Where are we now? Well, at 1,550, the S&P500 index is valued at around 14x forward earnings. That is not far above the post-1980 average, so may not appear lofty to some, but consider: This historical period includes many years of bubble-like valuations, including 1987, 1997-2000 and 2005-07. Depressed years, such as 1981-82 are less well represented in this sample.
Second, relying on forward earnings may be problematic as they are notoriously overstated relative to realised reality. In the present instance, forward earnings growth estimates are in the double-digits, even though profit margins are already at record highs. If history is a guide, profit margins are highly unlikely to remain this wide for long .
ELEVATED PROFIT MARGINS UNSUSTAINABLE
Third, the current rally has been characterised by steadily declining volumes. In other words, a relatively small number of transactions have been responsible for pushing up prices. This is in sharp contrast to some research suggesting that a ‘wall of cash’ has been pushing the market higher. (In any case, cash cannot directly push prices higher as for every cash buyer there is also a seller.)
Finally, let’s return to our starting point: Money and credit growth were strong in H2 2012 but this got little traction in actual economic activity. So what has this money and credit been used for? There is much evidence that it has been used as leverage to purchase shares. For example, margin interest on the NYSE is unusually high, at a level associated with previous market crashes.
What credit giveth, it can take away
Applying a little logic, if it is true that, courtesy of activist central bankers, the money and credit growth surge last year is behind the ongoing if increasingly low-volume rally in equities, then a sharp slowing or contraction of money and credit growth should trigger a sharp reversal. If accompanied by corporate profit warnings or other negative headlines, it could precipitate a crash.
As discussed, profit warnings are highly likely to continue in the current environment. Given that there has been nearly zero US household disposable income growth over the past year—in part due to the recent increase in payroll+Obamacare taxes—it is difficult to see how forward earnings expectations of 10%+ can possibly be met. Yes, the foreign sector might be doing better but recent dollar strength will depress those profits when accounted for in dollar terms. Slowing or contracting money and credit plus profit warnings could crash the market. Soon.
The bulls counter these arguments in various ways. Perhaps the most common bullish argument at present is that interest rates are low and will stay low as long as US unemployment remains elevated. After all, this is explicit Fed policy and I began this edition with “Don’t fight the Fed”. But if I’m right and the Fed and other central banks now face checkmate, it makes no difference. The Fed may try to stop a crash but short of trashing the dollar I doubt it can succeed. Of course, if the Fed does intervene and the dollar falls sharply, equity investors will still lose wealth in real if not nominal terms. Checkmate is checkmate.
At this point, the risk/reward for owning equities is tilted in favour of cash. Better still, if you believe that the Fed would at least try to arrest or reverse a crash with additional stimulus measures, would be to acquire safe haven real assets and liquid commodities that cannot be arbitrarily devalued by desperate central banks, including of course gold.
Speaking of gold, it has performed poorly of late. In my view the decline in the gold price is the mirror image of the decline in the equity risk premium. Once risk preferences shifted in favour of equities, yet money and credit growth slowed abruptly, it was absolutely necessary that certain other prices would decline. Not only gold, but copper, crude oil and most agricultural products have also fallen in price. By contrast, the Fed has directly prevented a material decline in bond prices through increased intervention.
Central banks probably have continued buying gold however, just as they were buying at a record pace last year. But as with all things, just because one sector of the market is buying doesn’t mean that prices can’t decline. For example, there are numerous recent reports of commodity hedge fund redemptions, implying forced liquidations of commodity positions. While some commodity hedge funds purport to be ‘market-neutral’, in my experience advising and working with such funds, I can assure you that most retain a long bias. Fund liquidations therefore imply net selling, not net buying.
I don’t disparage holding a commodity long bias, however. Regular readers of the Amphora Report know why: A long position in commodities is in effect a short position in currencies at risk of devaluation: Not just the dollar, but the euro, yen, sterling … you name it. Excessive debts and currency devaluation go hand in hand historically and I see no reason why this time should be different, other than devaluations will be more global than at any time since the 1930s. Indeed, there are reasons to believe they may be larger. Poor demographics and large public sectors in the developed economies imply unusually low productivity growth. This does not bode well for these economies’ abilities to service their vast accumulated debts without resort to large devaluations .
In closing, whether or not I am proven right by events, I would encourage my readers to ponder what, exactly, a rising stock market implies when it decouples from the real economy. In my view it is yet more evidence that resource misallocations are widespread; that investment decisions are being heavily distorted via manipulated interest rates and bond markets; that fundamental, value-driven investment is being ‘crowded out’ by raw, undisciplined speculation . This is not the way to grow a healthy economy, although it can, and clearly has, provided short-term stimulus from time to time.
Investors think longer-term than speculators. They also think longer-term than politicians. What is happening now is that the short-termism for which politicians are frequently and rightly criticised has come to dominate the financial markets, the economy and, quite possibly, society generally. History is not kind to societies that operate in an arbitrary, risk-it-all and get-rich-quick way. Long-term investment, savings, thrift and the rule of law tend to result in better outcomes. Central banks are doing far, far greater damage than they realise.
 To see just how dramatic these money and credit developments are please see the relevant charts from the St Louis Fed’s weekly US financial data publication here.
 For a thorough discussion of the NY Fed paper on negative interest rates please see PAR FOR THE PATHOLOGICAL COURSE, Amphora Report vol. 3 (September 2012). The link is here.
 This is, in fact, the central thesis of my 2012 book, THE GOLDEN REVOLUTION, available on Amazon here.
 For an excellent discussion of the dangers of relying on forward earnings estimates please see this article by John Hussman here.
 The US devalued the dollar vs gold by some 60% in 1934.
 This topic was explored at length in a previous Amphora Report, THE ASSET PRICING IMPLICATIONS OF THE GREAT BAILOUT, linked here.
This article was previously published in The Amphora Report, Vol 4, 13 March 2013.
According to Ben Bernanke, the Chairman of the Federal Reserve Board, the pulling back on aggressive policy measures too soon would pose a real risk of damaging a still-fragile recovery.
The Fed Chief is of the view that for the purposes of financial stability a continuation of the central bank’s aggressive stimulus conducted through purchases of Treasury and mortgage securities remains the optimal approach.
In response to the financial crisis and the deep recession of 2007-9, the Fed not only lowered official rates to effectively zero, but also bought more than $2.5 trillion in assets in an effort to keep long-term rates low.
But is it true that a loose monetary stance provides support to economic activity? Furthermore, if this is the case then why after such an aggressive lowering of interest rates and massive expansion of the Fed’s balance sheet does the economic recovery remain fragile?
Surely if loose monetary policy could revive economic activity then a very loose policy should produce very strong so called economic growth – so why hasn’t it happen this way?
Contrary to popular thinking, loose monetary policy, which leads to a misallocation of resources, weakens the economy’s ability to generate final goods and services, i.e. real wealth.
This means that loose monetary policy not only cannot provide support to the economy but on the contrary undermines the foundations for economic growth.
The so-called recovery that Bernanke and most commentators are referring to is nothing more than the revival of various non-productive or bubble activities, which in a true free market environment wouldn’t emerge in the first place.
These bubble activities are funded by means of loose monetary policies, which divert real wealth from wealth generating activities thereby weakening the process of wealth generation.
From this we can infer that a still fragile economic recovery, i.e. a fragile revival of bubble activities, despite the very loose Fed monetary stance could mean that the wealth formation process must have been badly hurt. (Note that notwithstanding very loose monetary policies, without the expanding pool of real wealth it is not possible to stage a strong recovery of bubble activities).
If our assessment is valid then obviously the sooner the loose stance is reversed the better it is going to be for the economy.
Needless to say, bubble activities are not going to like this since the diversion of real wealth to them from wealth generators will slow down or cease all together.
A fall in economic activity in this case is in fact the demise of various bubble activities.
Contrary to Bernanke, we can conclude that the continuation of loose monetary policies could only lead to financial instability and prolong the economic crisis.
Some commentators, among them Bernanke himself, blame the fragile economic recovery on banks’ reluctance to aggressively lend out the money pumped by the Fed. Without the cooperation of banks, the Fed’s aggressive pumping is not translated into a strong expansion in the money supply.
On this the growth momentum of commercial banks lending shows softening. Year-on-year the rate of growth of real estate loans fell to 0.1% in February from 2.3% in the month before.
The yearly rate of growth of business loans eased to 11.3% last month from 13.5% in January.
Also the growth momentum of commercial banks consumer loans has eased last month. The yearly rate of growth softened to 3.8% from 3.9% in January.
The pace of overall commercial bank lending, which includes lending to government, has eased visibly last month. Year-on-year the rate of growth fell to 3.7% from 6.2% in January.
The growth momentum of inflationary lending remains in a visible decline with the yearly rate of growth closing at 6.2% in February from 11.3% in January.
The banks’ reluctance to lend is also seen in the strong increase in their holdings of surplus cash. In the week ending March 6 excess cash reserves stood at $1.648 trillion against $1.546 trillion in March last year and $0.8 trillion in January 2009. Also note that in the week ending March 6 the yearly rate of growth of Fed’s balance sheet jumped to 7.6% from 4.7% in February.
Once the pool of real wealth comes under pressure, the number of good quality borrowers tends to decline. Obviously this tends to reduce the supply of lending. We suggest that if the pool of real wealth is stagnant or worse declining then regardless of whether banks will start lending or not, no meaningful economic expansion can emerge.
Summary and conclusion
According to the Fed Chairman Ben Bernanke pulling back on aggressive policy measures too soon would pose a threat to economic recovery. Our analysis indicates, however, that the sooner the Fed reverses its loose stance the better it is going to be for the underlying fundamentals of the US economy. A reversal in the current loose stance, whilst good news for wealth generators, is going to undermine various non-productive wealth consuming activities. Meanwhile the growth momentum of US commercial bank lending displays a visible weakening.
We recently looked at the Federal Reserve’s 2012 results. In particular, we pointed to some positive and negative developments. On a positive note, the Fed managed to shrink down the size of its balance sheet by approximately one-third of a percent. (Hey, it’s a start.) On a negative note, this decrease occurred because banks shifted their holdings of reserves into cash, thus forcing the Fed to sell off some of its assets. I explained that this is a potentially negative result, as the shift into cash brings with it inflationary pressure on prices.
In this article I want to point out who has benefited from the Fed’s operations over the past year.
There has been a lot of discussion about the large increase in reserves, and especially excess reserves, held by the banking system. Mostly this discussion is couched in terms of the increase in the money supply. While the increase in excess reserves—less than $2bn in August 2008 to almost $1.5 trillion at the end of 2012—does represent an increase in the money supply, some rule changes accompanying the crisis also signify that they are part of a bailout. One aspect of the Fed’s crisis response was to commence paying interest on required and excess reserve balances. (The required reserve is the amount of money banks must hold to meet the minimum reserve requirement on deposits, and excess reserves are any amount held in excess of this minimum.)
Interest on reserves is set at 0.25 percent, and is paid from the Fed’s operating revenues to its member banks. As we can see in Figure 1 below, the Fed has paid the banking system nearly $4bn each month for the last two years to hold on to their reserves.
Figure 1: Interest paid on reserve balances (monthly, $bn) Source: Federal Reserve Bank of St. Louis
One way to think of this payment is as a sort of bailout. Since the payments on reserves are paid out from the Fed’s operating revenues, it reduces its end of year profits by the same amount. Since these profits would normally be remitted to the Treasury, the policy of paying interest on reserves has been, in effect, a fiscal policy involving a transfer from the Treasury to the banking sector. Interest on reserves redirects taxpayer money to the banking system, over $45bn during 2012. This transfer from the Fed to the banking system is larger than any single year transfer from the Fed to the Treasury prior to 2009.
The Fed estimates that it will remit to the Treasury $88.9bn from its 2012 operations, a record-breaking year. As we can see in Figure 2, there has been a steady increase in the amounts of remittances to the Treasury over the past decade, and especially since 2009.
Figure 2: Federal Reserve annual remittances to U.S. Treasury ($bn)
The sharp increase after 2008 was the result of the quantitative easing policies. By increasing the money supply, the Fed had to purchase assets from the banking system. Some of these assets were U.S. Treasuries, some were riskier mortgage-backed securities, and some were guaranteed Federal agency debt. All of these newly purchased assets paid an interest rate, which contributed to the increase in Fed operating revenues and profits as it increased the money supply.
The $91bn of net income came almost wholly from interest earned on the securities the Fed holds ($80.5bn).
The U.S. Treasury issues bonds which are bought by the Federal Reserve. (We should note that the Fed doesn’t buy these bonds directly from the Treasury, but only on the secondary market from favored dealers.) Interest paid on these bonds accumulates at the Fed as income, and at the end of the year the Fed distributes it back to the Treasury, less its operating expenses. Since the Fed held, give or take, about $1.6 trillion of U.S. Treasury securities over 2012, the government was essentially able to get a free lunch—any interest paid on these securities was an accounting fiction, as it was remitted back at the end of the year (less expenses).
Normally the Fed only operates at the short end of the yield curve. This means that as a general rule the Fed only purchases short-term U.S. Treasury debt. Since short-term debt is also the lowest yielding, some might say that the Fed is not really providing much of a free lunch.
The big news during 2012 for Fed watchers was the expansion of its “Operation Twist.” With an increased focus on the long end of the yield curve, the Fed started purchasing bonds of longer maturity to keep long-term borrowing costs low. This was a savvy move that would help shield the Treasury from the effects of some of the Fed’s own policies. The Fed has the potential to increase inflationary pressures on prices through its monetary expansion. Since this inflation is not occurring now, but almost certainly will at some future date, only longer-dated securities will see their yields rise to account for their lost purchasing power. This would spell disaster for a Treasury that finances itself in part with longer-dated securities. By pledging to buy longer-term bonds, the Fed will artificially reduce their yields and thus mask the inflation premium building on their yields.
||Jan. 1, 2012
||Jan. 1, 2013
|Within 15 days
|16 to 90 days
|91 days to 1 year
|1 to 5 years
|5 to 10 years
Table 1: Maturity distribution of U.S. Treasury holdings of the Fed ($m)
While the Fed has slightly decreased the total amount of Treasuries held, Operation Twist has increased the average maturity of these holdings. The Fed currently holds almost no Treasuries with maturities under 1 year and has increased its holdings dated longer than 5 years by over $200bn. Even though the total amount of Treasury debt held has decreased, the total distribution to the Treasury has increased because of this maturity shift. By holding higher interest rate bonds of longer maturities, the Fed earns more interest, which results in more profit to remit to the Treasury at year end.
As we review the Fed’s operations in 2012 we see the usual outcomes. The banking sector has benefited from its operations (unusually so, thanks to the continued interest on reserve policy) and the government has received a free lunch by having a ready buyer for its ever-increasing debt, especially long-term debt, which might otherwise be susceptible to inflationary pressures increasing its interest yield. Let’s see what surprises the Fed has in store for us in 2013.
Under President Obama the debt of the United States government has grown by about 50%, and now stands at close to $16 trillion. Every year, the US government spends between $1.2 and $1.5 trillion more than it takes in. Every day that financial markets are open the US government has to borrow an additional $4 billion.
The pathetic fiscal cliff ‘compromise’ of last week has proved the most cynical students of the political elite correct in that there is not a snowball’s chance in hell that Washington will ever get this under control.
Can this go on forever? No, it cannot — although adherents of the Church of Modern Monetary Theory now proclaim that its holiness, the State, is not restricted by earthly matters, and that no limits apply to it. “It simply prints the money!” Back on earth, however, such recklessness has consequences, and these consequences will ultimately put a very nasty end to proceedings. But politics will not fix this. This much is certain.
One of the annoying little things that stand in the way of more debt is the dreaded debt ceiling debate, a quaint congressional tradition according to which the politicians in Washington have to periodically pretend that they can indeed exercise self-constraint and that they would even obey self-imposed limits. After the usual self-serving theatrics, both parties agree that the debt ceiling should be lifted, that spending must continue, and that more debt should be accumulated – in the interest of the American people, the US and the global economy, social peace, and because the show must go on.
Since March 1962, the debt ceiling has been raised 74 times.
Enter The Coin!
In order to make this farce a tad easier next time, the following plan has been concocted. It has recently made the headlines. You can read about it here and here:
The U.S. treasury is to issue a platinum coin with a notional value (that is, a value that is fixed entirely arbitrarily by the government) of $1 trillion, and this coin is deposited with the Federal Reserve. In fact, the coin is used to pay down $1 trillion of US government bonds held presently by the Fed (The Fed holds more than $2 trillion in government bonds). Thus, tradable government debt that counts against the debt ceiling is swapped for a ‘commemorative’ coin that does not count against the debt ceiling. $1 trillion of government debt thus magically disappears.
The US government has its fans who believe that anything, legally or illegally, should be done to keep it living beyond its means for as long as possible. These fans are supporting the plan. Among them is, not surprisingly, Paul Krugman, who fears nothing more than a congressionally enforced coitus interruptus before the protracted orgy of money-printing and deficit-spending has a chance to climax – as he keeps promising us – in a wonderful return of self-sustaining growth.
But the plan has many critics. Their criticism strikes me, however, as rather naïve and faint, and also missing the true significance of it all.
The critics make the following points:
1) This is just a trick and may not be legal.
2) It eases the pressure on politics to reduce the deficit meaningfully.
3) This could lead us onto the dangerous road toward debt monetization and could be inflationary.
Let me address each of these points before I come to what I consider the most important aspect of this.
Ad 1): Oh pleeeeze! Is it a trick? Is it a gimmick? Could it be illegal? – Are you stuck in the 1980s? – Of course, it is a trick and probably illegal! But who cares? Please get real. We have long passed the point at which any of the major governments feel constrained by such things as constitutions, laws, contracts or past promises. We live in a time of ‘anything goes’. Remember: “We will do whatever it takes!”
Look at Europe: From the start of the European debt crisis to today, EVERY rule that was set up at the start of EMU in order to govern it and to discipline its members, has been violated, ignored or shamelessly re-interpreted. The political class is making up its own rules as it goes along. Parliaments are rubber-stamping everything, and if they hesitate they are told that they could be held responsible for the ‘next Lehman’. Sign here, or else….
As I explained here, the US government has already abandoned habeas corpus, has arbitrarily annulled private contracts and will force Americans into commercial transactions. You think they will stop at the laws governing the issuance of commemorative coins? Do you really think that the army of lawyers that works for Washington cannot come up with a reasonably acceptable explanation (read: this side of totally laughable) for whatever the government wants to do that will sufficiently appease the folks at Harvard Law Review?
We may not get this specific version of the plan but something similar will certainly be implemented in the near future. You can bet on it. It is simply in line with current modes of thinking and the present political culture – or lack thereof.
Ad 2) The politicians will feel less pressure to enact real budget reform. – Oh come off it! There is neither real desire nor ability nor the required character and decency among the political elite to fix this self-inflicted budget mess. If you needed a reminder of the spinelessness and stupidity ruling Washington you only have to look at the great fiscal cliff compromise that was reached last week and that the equity market, evidently still on a drug-high from snorting unlimited lines of free central bank money, has been celebrating deliriously ever since. Let me say this in reference to a great quote by the incomparable P.J. O’Rourke: To expect Washington to reform itself and rein in spending is akin to giving your car keys, your credit card and a bottle of Jack Daniels to your 17-year old son and expect him to act responsibly.
Ad 3) Could this be the start of debt monetization?
Debt monetization has been going on for years, is alive and kicking, and gets bigger by the day. In the US and Britain, the central banks are the largest holders of their respective governments’ debt and the largest marginal buyers. The Bank of England has monetized about 30 percent of outstanding debt and now has more UK Gilts (government bonds) on its balance sheet than the entire UK pension and insurance industry combined. Under its current program of ‘open-ended’ QE3 (or QE4, or QEwhatever) the Fed buys $85 billion worth of new Treasuries and other securities every month.
Let’s get this straight: The whole raison d’etre of central banks is that they print money to fund the state. The Bank of England – the mother of all central banks – was set up specifically for this purpose in 1694. Since then a whole list of elaborate excuses has been drawn up for why central banks are needed and useful, a list that looks more ridiculous by the day: Central banks control inflation and guarantee monetary and economic stability? The exact opposite is true: Central banks create inflation and cause monetary and economic instability. There is no escaping the conclusion that they are organs of state planning and systematic market manipulation and thus fundamentally incompatible with the free market. But one true purpose remains: funding government. Increasingly, it is the dominant function of the ECB, the Bank of Japan, the Bank of England, and the US Federal Reserve to secure cheap credit for their respective governments and their out-of-control spending programs.
There is nothing new, surprising, or shocking about the $1 trillion coin proposal. It is perfectly in tune with the zeitgeist and with established trends in politics.
Bernanke will need a new script
So, what is significant about it? – Only one thing in my view: It exposes Bernanke as a liar.
Remember that Bernanke, and also his other central bank chums, such as Mervyn King and Mario Draghi, have tried to maintain the myth that they could one day – if markets allowed it or required it – reduce their bloated balance sheets. During the financial crisis, the Fed has ballooned its balance sheet from $800 billion to close to $3 trillion. We are supposed to believe that this is all temporary. Just to provide a stimulus. Nobody calls this debt monetization or ‘funding the government’. Same in Europe: Mervyn calls it ‘unlocking the credit markets’, Mario calls it ‘making sure the monetary transmission mechanism works’. The idea is that when the economy is finally mended the central banks can ‘normalize’ their balance sheets. More importantly, should inflation concerns arise, the central banks would quickly mop up all the excess bank reserves that they provided through ‘quantitative easing’ and sell the very assets they accumulated during the easing cycle. That would mean liquidating the central bank’s holdings of – among other things – government bonds.
But once the government has replaced liquid government bonds on the central bank’s balance sheet with illiquid coins the central bank’s maneuverability is severely restricted. When the public gets nervous about inflation, the central bank would have to reverse its crisis-policies and sell assets. There is (still) a market for US Treasury debt. However, there is no market for $1 trillion coins.
While the central bankers try to convince the public that their buying of government debt is a special case, an exception, a temporary policy measure, and that they could still defend the value of paper money if circumstances require, the politicians have other plans. They already consider central bank buying a permanent source of funding – unlimited and ever-lasting. I have long maintained that the central banks have no ‘exit strategy’, that they will simply not be allowed to reverse course. This is now becoming part of the official narrative, and central bankers who maintain otherwise are either hopelessly deluded or simply lying.
The deficits are here to stay and they will be funded by the printing press. No limit, no end, no exit.
Will this lead to inflation? _ Well, unless you are a fully signed-up member of the Church of Modern Monetary Theory, you know the answer.
This will end badly.
This article was previously published at DetlevSchlichter.com.
Finally, the great day has come and gone when the Fed would once again ride to the action, not daring to be left behind by the ECB’s perverse vaunting of its new ‘unlimited’ programme of bond purchases and too impatient to attend the continually postponed policy shifts so long expected from both the PBOC and the BOJ. A few months of less-than-stellar macro numbers, coupled with a lull in the rise of the price indices which was helped along by the last cyclical downturn of commodity prices (alas, for the ordinary American housewife, long since reversed) and the Mighty Oz was free to rummage deep into his carpetbag of gewgaws and conjuror’s props, once more.
The rationale for this latest enormity is, frankly, hard to determine lest it be Bernanke’s eagerness to present whoever might replace him under an incoming Republican administration with a fait accompli and so to ensure his legacy as the worst economic ‘experimenter’ to be empowered since the dark days of Roosevelt himself (he of the breakfast egg gold price fixing; the alphabet soup price and wage dictatorship; and the enforced famine of mandated crop and livestock destruction).
So, when we received a little insight into the fevered mind of the Chairman – coming in the form of what he told an interlocutor from Reuters, when asked to explain how exactly he envisaged that his new, open-ended, $45-billion a month QE programme would work – our first urge was to utter the obsecration: ‘Spare us, Lord, from the scheming of idiot savants!”
Apart from the fact that Blackhawk Ben here seemed to hew to a particularly crude version of the Phillips curve largely disavowed by even the most unreconstructed mainstreamers (one which imagines that extra jobs can be bought if only prices can be made to rise fast enough), after five years of ever more desperate flailing to restore false, boom-time levels of activity, he appeared to have staked his all on bursting the piñata of the labour market by smacking it with the rough-hewn pole of the so-called ‘wealth effect.’
As he told the journalist in Thursdays’ post-FOMC Q&A:
The tools we have involve affecting financial asset prices… Those are the tools of monetary policy. There are a number of different channels. Mortgage rates, other interest rates, corporate bond rates. Also the prices of various assets….
For example, the prices of homes. To the extent that the prices of homes begin to rise, consumers will feel wealthier, they’ll begin to feel more disposed to spend. If home prices are rising they may feel more may be more willing to buy home because they think they’ll make a better return on that purchase. So house prices is [sic] one vehicle…
Stock prices – many people own stocks directly or indirectly. The issue here is whether improving asset prices will make people more willing to spend…
One of the main concerns that firms have is that there is not enough demand… if people feel their financial position is better… they’ll be more likely to spend, and that’s going to provide the demand firms need in order to be willing to hire and to invest…
These few, brief sentences contain such a miasma of error that it is hard to know where to begin if we are to restore a fresh breeze of economic rationale to this swamp of non sequiturs and wilful misunderstandings. It is not enough that crude, Krugmanite Keynesianism clings to the cheap parlour trick of using money illusion to fool unemployed wage-earners into lowering the reservation price of their labour, but now we must battle against banal, Bernankite Bubble-blowing – the hope that money illusion will fool cash-constrained asset owners instead.
To show what we mean, indulge us while we parse the Chairman’s words:
If we can artificially suppress interest rates to a low enough level, lots of people will forget that they got themselves into the current mess by borrowing too much the last time we did this and so they will begin to do so again – especially the would-be home-owners and condo-flippers.
If the price of homes begins to rise, those who have already borrowed to buy one will feel better off even though: (a) they will earn not one red cent in extra income because of that appreciation and (b) if they do manage to register a one-off capital gain, it can only come at the expense of the purchaser, whose acquisition of a durable store of shelter services will therefore involve a much greater, zero-sum call on his resources than otherwise would have been the case.
The stock market should also rise just because there’s more easy money chasing after a parking place. Naturally, we at the Fed could care less about the quaint notion that equities should represent a sensibly valued claim on a company’s estimated stream of residual earnings, or that capital markets need genuine prices if they are to serve any useful social function by allocating scarce savings to the prospectively best investment projects.
To the contrary, from our perspective, if Joe Soap wants to splash out to celebrate the entirely notional, potentially only nominal, and probably ephemeral gains on his 401k which we can bring about – without wondering whether the increase represents any lasting contribution to the aimed-for security of his retirement – well, in the long run, we’re all dead, aren’t we?
Companies don’t have enough ‘demand’, don’t you know, so if we can only get people to wave their cheque books at them, they will be so sure of being able to profit from this that they will offer every one of their new customers a job, on the spot!
Incidentally, we Keynesians are big on portraying consumer demand as being the driver of the economy, even though we’ve never quite been able to explain why it is that the ‘demand’ inherent in the existence of millions of hungry people in the world – all pathetically eager for an extra morsel of food – has not automatically brought about the necessary increase in agricultural output, investment, and employment in precisely the same manner that we are now presuming will be the case for, say, WalMart once we start buying in its customers’ mortgages.
Like most macromancers, what our esteemed Chairman is missing here is any concept of how a business actually functions, of how it and its peers interrelate in the overall structure of the economy, and of the critical role played by capital and time in the division of labour and the provision of goods. He is also prey to the superficial fallacy – a kind of inverted Say’s Law – that consumption somehow dictates the amount (rather than merely the composition) of production, something that has not been the case ever since Adam was condemned to earn his daily bread in the sweat of his brow and to till the ground from when he was taken.
Thus, rather than being fooled by the mantra that ‘(personal) consumption is two-thirds of the economy’, one should be clear about the distinction that its (imputation-boosted) count is actually only two-thirds of the highly-subjective statistical shorthand which is GDP – and that this is not the same thing at all! Gloves may well comprise 100% of the clothing I put on my hands in winter, but if they are all I don when I go out snow-shoeing, I’m not likely to get very far before some Good Samaritan of the Alps finds my half-frozen form and has to send forthwith for the nearest brandy-carrying St. Bernard so as to revive me.
This is a matter to which we have already devoted a great deal of time, but a brief synopsis here is probably in order.
Take, for example, the four years from 2006-9 inclusive which saw US GDP average just under $14 trillion while cash PCE came in at a mean $8.5 trillion (ergo, validating the shibboleth that the latter number equates to 60% or so of the first). Mainstream thinking may stop short here, smugly satisfied with this trivial – and circular – QED, but this is not even half the story.
We say this because, over the period in question, aggregate business revenues – i.e., the best representation of the overall circulation of goods and services throughout the economy – amounted to no less than $33 trillion a year (the vast bulk of which receipts were subsequently disbursed again, whether as above-the-line costs, below-the-line outlays, interest, dividends, or taxes).
Thus, not only was the ‘economy’ almost 2 ½ times as large as the GDP count, but every $1 of that supposedly crucial personal outlay was matched by $3 of business-to-business spending.
So, if Mr, Bernanke really wants to get ‘demand’ going, the foregoing drops a heavy hint that he would be three times as effective as he has been if he and his masters in Washington could manage to do something (or, conversely, to stop doing much of what they counterproductively have been doing) which ends up promoting greater managerial/entrepreneurial belief that not only can profits be made, but that, once made, more of them will be retained by their rightful owners.
It should also be recognised that the vast bulk of that $25 trillion in B2B expenditures is every bit as discretionary as the outlays of the most finicky of shoppers: no businessman can be compelled to keep his store open, or his factory running, if he finds the game not worth the candle, even though mundane economic analysis tends to assume without question that, far from being an adaptive, calculating, he is an unthinking automaton who can very much be relied upon to do just that, irrespective of his estimated remuneration.
More fundamentally still, it is the relationship (strictly, the ratio) between his receipts and his disbursements wherein the lies the difference between our hero’s commercial success – and so, his role in hiring, commissioning and the onward generation of orders for his suppliers – and his failure – hence, his sad duty to undertake lay-offs, cut-backs, and cancellations. Even absent net, new investment to improve and deepen the capital stocks and so raise real incomes, the overwhelming preponderance of that $25 trillion (in fact, all of it less an average $1.5 trillion before – and only $250 billion after – depreciation) represents a voluntary sacrifice of the enjoyment of present goods, undertaken merely to keep things running as they are.
The idea that such a delicate network of relative prices and differential cash-flows can be not only maintained, but enhanced, by the clumsy process of artificially forcing arbitrary quantities of money and credit into the system is at best naïve and at worst astrological in its pseudo-rationality. At root, such gross interventions as these, no matter how greatly they excite the raptures of the mainstream inflationists, ensure nothing more than the confusion of those critical accounting algorithms which help ensure that capital and labour are not being squandered. This is so because, not having the noble pedigree of the free, unhampered market, the infusions – being nothing more than the bastard offspring of the central planners’ hubristic conception – bear no definitive relationship to the generation and subsequent movement of the real goods and services whose value-giving exchange it is the sole purpose of these media to facilitate, both across space and through time.
To see this, take the simple – if extreme – example of the post-Lehman crisis itself. The Fed, we are told, by the newly-respectable brotherhood of NGDP targeters, ‘only’ had to ensure that the gross flow of money out of the funnel at the end of the economy (the $14 trillion per annum, principally in the form of final, exhaustive spending) remained unaltered and all would have been well. [We shall here ignore the fact that this would have been an impossible task to have undertaken in real time even if all the various rivalrous sects and sub-sects of NGDPers had managed to agree upon what means should have been employed, upon whether levels or growth rates of the aggregate should have been controlled, and over what horizon this was to be brought about].
But look at the facts of what did happen that year as the economy swirled around the ragged edges of a maelstrom of total collapse. Total domestic, non-MFI credit rose a modest 2.9% as the private component of this fell 2.5% while Leviathan’s appetite grew by a monster 13.7% (counting GSEs in with government itself). Meanwhile, M1 jumped 18.1%, ‘Austrian’ Money Supply (M1+, if you will) rose 25%, and M2 added a more modest 9.1%. Confusion confounded, you might say, since we are being exhorted to act to control one or more of these aggregates, depending upon which particular ‘new’ monetary school you choose to believe. But the difficulties do not end there, for worse was to come in the ‘real’ economy.
Here, the hallowed NGDP measure fell 3.7%, implying the Fed should have added X, or maybe Y, or Z in order to offset the switch in emphasis from credit to money and the concurrent slowdown in the immediate use or ‘velocity’ of that money.
But this was not the end of it, for private-sector NGDP (the important bit) fell a greater 5.7%, while the total business revenue measure which we have argued above is the real key variable, slumped to a crushing 11.5% loss. Within this the disparities were even more marked. Revenues among the extractive industries plunged 50.6% at one end of the spectrum as those accruing to health & social care rose 4.4% at the other. For profits – and hence, for both the means and the incentive to expand output and employment – the spread was even more extreme for the trailing four quarters to our two end-dates, ranging from a 73% contraction for the extractive sector to a 68% gain for the utilities (which, in part, benefited from the formers’ woes in the shape of cheaper energy inputs, again underlining the point that it is relative costs and prices which count, not absolute ones).
Again, we have to ask the targeters and reflationists: how, where, and when was the central authority supposed to have intervened in order to lessen the economic pain; and how do we know that same pain was not either intensified or prolonged, rather than mitigated, by the actions which were taken since these could not have done other than to have interfered with the market’s attempts to find proper clearing prices, to excise dead capital stock, and to marshal its combined entrepreneurial abilities for the task of laying down new capital where the evaporation of the prior bubble had revealed it to be truly useful (and, by extension, profitable) to do so?
If the Bernanke Fed had any answers then – or, indeed if it has since achieved sufficient enlightenment to justify its present burst of activism – we should be delighted to hear them. Our breath is not being held.
As a practical matter, it should be noted that the final data which we use to plot these changes have only just begun to be made available on a delayed quarterly basis and, even then, a full check on their validity awaits the glacial progress of the statisticians at the IRS, whose findings can be up to four years in arrears!
Though we must always exercise caution regarding any use of aggregates, a reasonable proxy is therefore what we need if we are to monitor developments, albeit using the broadest of brushes. For us the widely-ignored business sales data fits the bill for overall activity, while the ratio of its sub-components—retail sales versus those made in the manufacturing and wholesale sectors gives us an idea of gross saving/investment v end-consumption. Another way of showing this is to plot the monthly personal consumption estimates against those for business revenues. As the plot shows, this latter is highly variable and has been in decline ever since the financialization of the economy began in earnest in the early-1980s.
A falling ratio implies, to an Austrian, that a greater degree of time preference appears to be developing and hence, a higher natural rate of interest (the ratio of intertemporal prices) has come to prevail.
In contrast, an examination of the path of BAA bond yields shows that market rates (after subtracting consumer price changes) have been steadily falling over time, due to a toxic mix of loose money and abundant speculative leverage. The gap between what should be and what is, is therefore a widening one, suggesting that a mix of overconsumption and malinvestment, fuelled by increased non-productive indebtedness, is to be expected.
Chronic and often highly elevated current account deficits (not to mention the dire fiscal situation) testify to the overconsumption element, while the series of ever-more violent booms and busts, coupled with lacklustre real net investment and stagnant real wages, are symptomatic of the second, while the level of debt itself should itself need no further comment.
Given this malign constellation of factors, the Fed’s eagerness to suppress all interest returns for at least the next three years and for as far out the curve as its tainted grasp can extend is not likely to do anything to restore a much-needed touch of balance to the world’s largest (and formerly most vibrant) economy.
Bond yields have already been forced far too low, making stocks seem relatively well-valued, even as the underlying conditions deteriorate and the fatal dependency on the sweet neurotoxin of stimulus deepens its grip on the patient. By progressively suppressing the economy’s intrinsically-generated price signals in this fashion, a wholesale paralysis of the system may one day result.
What Bernanke’s intellect cannot seem to encompass is the thought that if a man has lost weight through an illness related to his previously poor dietary regime, it will simply not do to try to fill out his now-baggy suit by tempting him back into over-indulgence. Some glimmerings of this idea do surface in the occasional expression of doubt about just how large such shadowy entities as the ‘output gap’ or the ‘structural growth rate’ may still be in the aftermath of 2008’s debacle, but none of these misgivings ever seem to penetrate the cranium of a man who thinks he can meaningfully reduce unemployment by stimulating junk finance in all its many forms.
It is not only that Bernanke’s policies will inevitably assist the zombie companies and the obsolescent industries to absorb scarce resources (not least on bank balance sheets) to a much greater degree than is justified, thereby denying greater returns both to their better-positioned rivals and to those nascent endeavours which could better reflect unalloyed consumer preferences and whose growth could come to replace yesterday’s failures as tomorrows’ providers of income. There is also the danger that lax money misleads even today’s supramarginal businesses into over-estimating the depth and duration of demand for their products, ultimately undermining many otherwise sound undertakings and reducing these, too, when the cycle next turns, to the ranks of the Living Dead.
Gather ye rosebuds will ye may, for the bloom on this Fed rally, too, will eventually wither and fall.