The Next Crisis Is on the Horizon 25 comments
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Even while the Fed and Treasury are fighting deflation and a serious recession, they are laying the groundwork for a new liquidity bubble with the potential for devastatingly high inflation. While the current news is dominated by recessionary GDP, falling consumer confidence, banking rescues, incredible stock market volatility and frozen short term money markets, believe it or not we need to look beyond these once in a lifetime events to the longer-term consequences of current policy.
The Fed and Treasury have made it clear that they will do whatever it takes to save the economy and prevent a depression. I generally agree with what they are doing. I believe that the Fed and Treasury have hard-working, smart and caring leaders and staff who are trying to do the best that they know how for the United States and the rest of the world.
But I am starting to question some key elements of Federal Reserve policy. I don’t understand why, in the face of a liquidity trap, the Fed is increasing money supply at a rapid rate instead of using their regulatory powers to discourage the hoarding of cash and Treasuries by banks. When a liquidity trap exists, interest rates are at or near 0% and monetary policy has little or no effect because individuals and institutions hoard cash. Increasing money supply or cutting the Fed Funds Rate isn’t the cure for a liquidity trap.
Annual GDP is more or less the product of two factors, average money supply and the annual velocity of money (i.e., the turnover rate for money). The Fed attempts to control the amount of money in the economy through monetary policy. However, when banks and other financial intermediaries deleverage, they destroy money supply. When money supply is destroyed (which means it goes down a lot), that has the effect of reducing GDP, reducing inflation (or even causing deflation), increasing the value of the Dollar, depressing commodity prices and causing credit rationing (i.e., not enough money to lend).
In February, 2008, I appeared on FOX Business and predicted that for most of 2008, the destructive effects of uncontrolled deleveraging were the biggest problems that would face the U.S. economy. I said that, as a result of deleveraging, deflation was a much bigger problem than inflation. At the time, no one listened to me because oil prices were skyrocketing and inflation fears were raging. During the summer I started to write in this blog about how real money supply (i.e., money supply adjusted for inflation and growth) was declining at an alarming rate. Sure enough, all of the “textbook” effects of declining money supply that I predicted occurred (including credit rationing, which manifested itself in the failures and near-failures of financial institutions and the freezing of the loan market). And, as predicted, GDP went down in the third quarter. Without increased government spending (i.e., fiscal stimulus), GDP would have crashed.
The risks of money supply destruction haven’t gone away but the Fed and Treasury have worked hard at mitigating these risks with successful programs. As de-leveraging occurs, the Federal Government and the governments of other nations are replacing private leverage and capital with government leverage and capital. As a result, money supply isn’t plunging and unless there is an external shock to the banking system (or a change in policy), I believe that the risk of a catastrophic deleveraging has past.
However, there was the new September/October surprise of liquidity hoarding and falling velocity of money. Lower velocity has the same effect as falling money supply; GDP is destroyed, commodity prices fall, deflation occurs, and credit is rationed.
But the Fed’s effort to increase money supply doesn’t do anything to stop hoarding and maybe makes things worse. A better policy would be increased fiscal stimulus and qualitative adjustments to banking regulations. Qualitative regulatory changes that discourage hoarding include incentives for lending and disincentives for holding cash and Treasuries.
For example, the Fed and Treasury could increase the risk-based capital requirements for banks to hold Treasuries and decrease the risk-based capital requirements to own commercial and consumer loans. Increasing the risk-based capital requirements on Treasuries decreases the profitability of owning Treasury securities, while decreasing the risk-based capital requirements of owning loans increases their profitability. The Treasury can also change tax laws to favor lending over the holding of Treasury securities. Of course, any lending that is encouraged must be accompanied by regulatory enforcement of safety and soundness regulations so that imprudent lending doesn’t occur as a new unintended side effect.
Instead, the Federal Reserve is increasing money supply at an alarming rate. For the week ending October 20, seasonally adjusted M2 increased to $7.9252 trillion which was an increase of $54.3 billion. Since the week ending September 15, the Federal Reserve has increased seasonally adjusted M2 by $256.3 billion which is approximately an annualized 35% rate of increase.
If the Fed continues to increase money supply at the current rate, hyper-inflation will occur sometime in late 2009, 2010 or 2011. There is a risk that suddenly the liquidity trap goes away and velocity accelerates. If money supply continues to rise at its current pace for another 3 to 6 months, when the liquidity trap ends a large monetary bubble will form. If the bubble is large enough (and a 35% annualized increase in money supply is certainly a pace that will create a bubble), asset inflation will be followed by hyper-inflation. Obviously, hyper-inflation is bad and could result in both economic catastrophe and political unrest.
Instead of increasing money supply at an uncontrolled pace, the Fed and Treasury should be working on a coordinated regulatory response to discourage hoarding, and another fiscal stimulus package should be passed by Congress. Pulling these two policy levers will stop hoarding with fewer unintended side effects than continuing to grow money supply at a hyper fast rate.
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This article has 25 comments:
Not quite. Last time I checked Congress wrote the tax laws. The Treasury is part of the Executive Branch and writes no laws.
As for the other suggestions they are true enough taken at face value. If we are to accept as a given that the money supply is increasing "too fast" and we hope to 'fix' our problems via some other approach then the means you suggest is the only 'market' choice left.
What is left out of any discussion of these alternate choices is the fact that the 'rules' for success/failure will now be driven by the FED/USTreasury instead of the marketplace.
Success via "Regulation" is simply another way of saying that the governement will be choosing winners and losers in the economy. This has been proven to be a sub-optimal approach to eliminating economic ills.
The most effective way to restore the economy to a sound footing is to let unprofitable firms fail so others can acquire their assets at distressed prices and proceed in a profitable manner.
Rewarding incompetence with bailout money is only prolonging the problem and will bring greater failure in the future. Dictating economic activity via regulation can just as easily reward bad activity or prohibit good activity as it can do the opposite.
does this mean buyers should get into oil and other commodities in 6 months to get ahead ?
My understanding of sterile issuance was that the FED would swap the already existing Treasury debt it owned for the MBS debt of banks. They stopped doing that when the FED ran out of Treasury debt a while back.
The FED has been increasing the money supply rapidly in the past couple months. You can see this in their own data:
Raw numbers: research.stlouisfed.or...
% annual change: research.stlouisfed.or...[1][id]=BASE&s[1][...
Well, the obvious solution for sterilization is for the Fed to sell its own bonds. After all, as the monopoly counterfeiter of the US, shouldn't their credit be good?
how can banks lend when warned to tighten lending standards and loosen up credit at the same time?
would you lend cash to your poor neighbor with big mortgage and car leases who just lost his job?
The USA will declare bankruptcy (default on sovereign debt) before this is finished. This little panic has been the last nail in the coffin for the dollar. And those who have prepared correctly will be punished the same way as "hoarders" in all hyper-inflationary collapses. We will be forced by law to trade hard goods for the worthless scrip.
On Nov 03 01:33 PM bbzz24 wrote:
> to whom should banks lend to? the deadbeats on the line after the
> ones that comprise the sub-prime sector? should we all them sub-sub-prime?
> or maybe soon-to-be-sub-prime?
>
This would certainly help with the hoarding problem, but it would take time and congressional action. Unfortunately I don't see a Democratic Congress as interested in providing banks with a special tax incentive at this time, despite its great potential.
I don't think the other regulatory powers that Treasury could utilize amount to much, which accounts for that increased possibility of higher inflation. Monetizing the debt has been used by the Fed in the past so it's the easy solution for them now, with all its negative ramifications.
A slower recovery will limit inflation, regardless of the money supply. As banks improve their liquidity and balance sheet, they will most likely repurchase the senior preferred shares that they issued to the gov't, and bailed out institutions like AIG will pay off their loans. This will essentially remove most of the $700b bailout money from the economy. This money would be replaced by higher consumer spending and more loans.
Lastly, consumers probably will not go out and buy homes like they did in the past and use them as ATMs. Those that want homes will probably already have a home. This will limit asset inflation to the core commodities (petroleum and fuel products) initially, and then it'll trickle down to everyday items. But it will prevent rampant speculation in housing in the early 2000's, which will prevent runaway inflation from the 1970s. I'd say 4-7% inflation, but not more than that.
process impoverishes many, it actually enriches some," John Maynard
Keynes, "The Economic Consequences of the Peace," 1919.
The US Federal Reserve has been moving away from the risky USTB (US treasury bonds) in great style with the currency swap operations, and now only ¼ of US Fed holdings are in US government debt. A brilliant US move as foreign demand for US treasury bonds (USTB) has declined in the last six months, so all the risk of the US fiscal and monetary imbalance of the US dollar has been transferred to non US central banks, banks and other bond holders from Brazil to Korea, including Singapore.
You are almost there. The Fed has screwed up - again. I know, it's really getting to be pretty tiresome, which is why we need to ABOLISH the hapless Fed ASAP and get some real talent working on this crisis.
The answer is to create a new commercial bank, run by bright, forward-thinking types and funded by the money-printing machine of the U.S. Govt. Call it FedBank. Let's face the facts - we need to inflate the money supply, and we need to provide credit and prime the economic pump - nobody in their right mind would argue with that.
The fact that we have given money to the "banks" whose management, in their corrupt and highly-self-interested way, have chosen NOT to lend (which of course is the desired goal) but instead to play the buyout game, should be - THE FINAL STRAW! The people who run our 'banking system' are a bunch of crooks, and should be removed from their posts ASAP by Presidential Order. Nothing less will stop the thievery and incompetence, IMO.
The new FedBank would lend where needed, un-freeze credit markets, and stimulate the economy. At this point, the utter jokers who used to be bankers are not even providing standard working capital loans. This is patently ridiculous.
We need a whole new paradigm in banking, and to fire about a thousand jokers who could provide the nation a bit of comic relief, standing in long unemployment lines, where they belong. Right along with the hundreds of thousands of hardworking (yet currently unemployed) Americans who are the unfortunate victims of the obviously flawed and highly corrupt Federal Reserve model we have suffered under for nearly a century.
A few answers to questions in the comments.
1. "Sunshine" really is my last name.
2. Application of tax law can be changed by Treasury without approval of Congress. For a recent example, the changes that the Treasury implemented in the NOL rules for banks was done without Congressional approval. There are a lot of technical ways for the Treasury to effectively raise taxes on Treasury securities and lower them for other types of lending. Stuff that wouldn't make sense for individuals but does work in the context of banking. For example, the application of certain types of interest income against NOL's would work and Treasury can do without Congressional approval. Another example is to change the ability to deduct loan losses and valuation reserves against certain types of income (like not allowing the deduction against interest income of Treasuries). Treasury can do that as well without Congressional approval.
3. Choices in the economy were always driven by the Fed and the Government. It is just a whole lot more obvious now that the Government is driving the economy (which I don't think is good).
4. There are pleanty of good quality borrowers and lots of opportunity to lend safely. But, what is taking place now is that good borrowers are getting left in the ditch. Simple things like trade finance transactions (which is low risk and really transactionally based) aren't getting funded and that is killing the economy. Hoarding is "death" to the economy. The liqudity trap is "death" to the economy. But, increasing money supply isn't the answer to the hoarding problem. Accelerating velocity is the answer and that is largely beyond Fed monetary policy.
5. The Fed isn't "sterlizing" which is why the money supply is growing so rapidly.
Thanks for reading and sorry for any typos in this comment.
he didnt go the basic idea of the currency swap operations...a fine option
to sterilization when other central banks wants your bad debt.
PS. I tried to prepare for this scenario by holding hard goods, but some street crooks already stole my hard goods. Therefore, I don't have anything left for anyone to take. However, conceptually hard goods would be the correct move to protect earned wealth. Not greasy USD.
On Nov 03 03:59 PM Pent up demand wrote:
> Exactly right. The "leaders" of the banking industry have completely
> lost touch with the notion that wealth must be backed by actual economic
> activity. They have been shoveling abstractions for so long that
> they think they can stop this freight train with a pile of freshly
> printed money.
>
> The USA will declare bankruptcy (default on sovereign debt) before
> this is finished. This little panic has been the last nail in the
> coffin for the dollar. And those who have prepared correctly will
> be punished the same way as "hoarders" in all hyper-inflationary
> collapses. We will be forced by law to trade hard goods for the worthless
> scrip.
The alternative would be to handle our debt honestly, reduce spending (consumer and government), increase taxes, lower our standard of living, and pay back our debts. If you see any pigs flying, let me know.
seekingalpha.com/artic...
Mark:
If I understand the second item in your comment, You are talking about Tax Regulations. I would agree that the Treasury has great power in that area. However, to my knowledge they have never used that power in an economic stimulation context, i.e. outside the normal, time consuming, proposal - comment - final regulation process. I am sure that if they did attempt to do so there would be some intense bureaucratic screaming from the direction of the IRS and from Congress.
This is a much more revolutionary article than I originally thought.