We actually said last week we would not comment on Bernanke's truly cringe-worthy speech delivered last Thursday. Our reasoning was that he didn't say anything unexpected or anything we have not heard a thousand times before. This is certainly true, but we now feel compelled to comment anyway, if only to shine a light on what a horrible steward of the monetary system he is – while acknowledging that he certainly didn't design said system and is in equal measure its prisoner as much as its director.
Following his speech he was subjected to a soft-balling exercise (Q&A) at the National Press Club in Washington, as Randall W. Forsyth put it in Barron's. Below we'll quote the synopsis of the important parts of the Q&A as related in the Barron's article.
The whole thing was as good an example of Bernanke's Princeton-bred sophistry as you will ever find. Princeton, of course, is the major hotbed of the semi-totalitarian Keynesian economic philosophy and the associated attempt to make economics more "scientific" by subjecting it to econometric methods, measuring what cannot be measured and deriving "models" and "theories" from these nonsensical efforts at imitating the natural sciences -- the same methods that guide the Federal Reserve in its decision-making process.
Proving Lincoln's adage you can fool some of the people all of the time, Bernanke asserted to the credulous DC press corps that while the Fed's purchases of Treasury securities played a role in the rise in stock prices since last August, they did not affect the prices of commodities, notably food. Moreover, he rejected the premise that the civil unrest seen in Egypt and Tunisia could be attributed to Fed policy, which the questioner contended was responsible for higher food prices.
Commodity prices, including food, were driven by supply and demand, the Fed chairman argued. And that demand was being elevated by rising prosperity in emerging economies, which means a desire for a better diet. That, in turn, was mainly responsible for the sharp rise in food prices.
At the same time, the liquidity created by the Fed's purchases of up to $600 billion of Treasury securities was working as planned, Bernanke continued. According to the Fed chairman, QE2 has boosted asset prices, notably stocks; lowered market volatility and thus, risk; narrowed corporate-credit risk spreads; and has lifted inflation premia in the Treasury Inflation Protected Securities market. That Treasury yields are higher since the Fed started buying Treasury securities is not inconsistent with QE2's working.
That's been the Fed's story, and Bernanke was sticking to it.
One thing must of course be admitted right off the bat – Bernanke wanted to see his inflationary policy to have clearly discernible inflationary effects in the form of rising prices, and he sure got his wish. Along with this comes the usual inflationary illusion of "economic growth," which we think should rather be termed "capital consumption disguised as growth" that makes it appear as though the policy was "working." It does so by misdirecting scarce capital into unprofitable ventures and creating illusionary profits, while in reality impoverishing us even further.
So Bernanke is actually correct when he says that rising treasury yields are part and parcel of his "success." After all, what else would inflation do to treasury yields? Unmentioned remained the previously uttered conceit that the Fed can actually "control" said yields and keep them lower than they would otherwise be. It could, of course – by stopping the money printing exercise, but not by continuing and enlarging it.
More amazing is his brazen assertion that the Fed's inflationary policies have only produced "good" inflation – this is to say, the effects of inflation that everybody, from the unwashed masses to politicians to Wall Street traders, loves – in the form of rising stock prices and the ensuing, as he put it, "virtuous circle," while refusing to countenance the notion that "bad" inflation – in the form of sharply rising commodity prices – may have anything to do with the same policy.
As Forsyth summarizes further:
What Bernanke didn't address was the uneven impact of the rise of equity values and commodity prices. The theory he espouses is that monetary policy works through boosting asset prices, which in turn encourages consumer spending, business investment and then hiring. He did not mention that a major channel for the transmission of monetary policy — the housing market — has broken down, which is obvious given record-low housing starts and simultaneously near-record-low mortgage rates.
The Fed chairman did assert that rising costs for food and fuel are not feeding through to so-called core inflation and, by implication, weren't a cause for concern now. As he noted, the jump in food and energy costs have not increased compensation. The Labor Department reported earlier Thursday that unit-labor costs fell 1.5% in 2010, matching the decline in 2009. That was the result of a 3.6% increase in productivity last year, a hair higher than 2009's rise.
There isn't a manager in American business who isn't getting his staff to do more with less. The vise on hiring and compensation is even tighter as costs of materials rise. And so the Fed's efforts to boost employment may backfire if companies try to offset rising input prices by holding down personnel costs.
Let us address this bit by bit. What the "broken down housing market" tells us is an age-old truth about inflationary policy – its instigators cannot control what prices exactly will rise. It is a good bet that reversing the collapse of the housing bubble was and is on the Fed's agenda, so it should be no surprise that this evident failure didn't rate a mention by the chairman.
However, even if the policy did "succeed" in this particular respect, it would only mean that the liquidation of unsound investments in the sector has been arrested. This is not a feat to be celebrated, but dreaded – since all it would achieve would be a stay of execution during which the underlying fundamental situation would have time to worsen, necessitating an even bigger retrenchment at some point in the future.
The same holds for those areas where the Fed's policy is allegedly "succeeding," i.e., the "virtuous circle" Bernanke maintains has been set into motion by rising equity prices, falling risk premiums, and the attendant increasing willingness of consumers to consume rather than save and the willingness of businesses to invest.
To these things we note: The bust was not a result of people saving too much, but saving too little. It is not as if the economy was starved for consumption; it was starved of real savings. How even more unfunded consumption (this is to say, consumption not funded by preceding production) is going to lastingly improve the situation remains mysterious.
It appears at any rate that, from all that Bernanke said, the experience of the 2003-07 boom has taught him ... exactly nothing. The very same arguments he is using now to defend the Fed's loose monetary policy have been used before by the Greenspan Fed, of which he was part. Deflation had to be avoided at all costs, a "virtuous cycle" had to be created somewhere in the economy to get over the slump in business spending on account of the technology bubble's bursting, and back then housing provided the playground for all these allegedly salutary effects of money printing to play out. The end result was the biggest economic and financial crisis of the entire post-war period -- in short, a rare achievement in economic destruction.
The notion that exactly the same policies that have led to this fairly recent near-fatal iteration of the boom-bust cycle will now magically produce something sounder and more sustainable strikes us as plainly insane. To paraphrase Einstein: Trying the same thing over and over again and expecting a different result is the very definition of insanity (even though Einstein was no psychiatrist, this particular bon-mot drips with common sense).
Inflation or Deflation?
The Post-War Inflationary Era
If we were to characterize the post-war era, and specifically the post-1971 era's monetary system, i.e. the period during which the last restraint on monetary expansion in the form of a loose tie to gold was thrown overboard ("temporarily," as Nixon assured everyone back then), we would call it a period of constant, accelerating credit and money supply inflation, interspersed with occasional "deflation scares."
These scares in turn invariably involved a sharp decline in the prices of those assets everybody loves to see increase: Financial assets, real estate, art, and so forth. As a rule, the deflation scares immediately led to the Federal Reserve "opening the spigots," as the saying goes, engendering a bout of massive monetary inflation.
As the crises of the "unanchored" fiat money system have grown, so have the Fed's reactions to them. The biggest such reactions yet have been encountered after the bursting of the Nasdaq bubble, when the growth of the Austrian true money supply measure TMS (or TMS-2 as we now call it) shot to 21% annualized, and the period following the 2008 bust, when annualized growth of TMS-2 has been at or above 10% in 23 of the past 24 months.
A recent paper by Vijay Boyapati needs to be considered here in the context of what the future may bring. An excerpt of the paper containing what to our mind is the more important part of Boyapati's argument can be found here.
Credit Inflation Technicalities
Still, we briefly want to comment on Boyapati's technical comments regarding bank credit inflation, in which he references Steve Keen's "chain of credit inflation causality" to show that an increase in free or "excess" bank reserves at the Fed on account of quantitative easing is of no import to the inflation argument. To summarize, Keen first drew attention to himself by enunciating what some people declared to be a revolutionary insight: Namely, that "banks expand credit first, and go about acquiring the necessary reserves later."
Our first thought upon hearing this was: So what? After all, since 1995, there have de facto been no reserve requirements whatsoever. The necessary administrative ruling was implemented by the Greenspan Fed in that it allowed the banks to make use of so-called "sweeps." Henceforth, the unused portions of sight deposits, which traditionally bore the greatest impediment to bank credit inflation since a 16% reserve had to be held against them, could be reclassified as "savings accounts" (or to use the precise designation, money market deposit accounts, or MMDAs) for the purpose of lowering the reserve requirement to essentially zero.
To read up on this inflationary sleight of hand in detail, we refer you to a report by Charles Hatch, which essentially explains how it was possible for the money supply to expand parabolically from 1995 onward without a commensurate increase in required bank reserves at the Fed. If one wanted to look for a limiting factor in the creation of fiduciary media by the banks, one had to look at the Basel capital adequacy rules.
Naturally, the banks were quite ingenious in circumventing those rules as well, by separating loans and securities based on loans from their balance sheets with the help of SIVs and similar constructs, methods in which they acquired a great alacrity. Likewise, securitization as such allowed banks to retain certain income streams as servicers of the loans underlying such securities, pocketing interest rate spreads and garnering fees for marketing the securities to investors, while freeing up capital for yet more lending.
What off-balance sheet constructs like SIVs and SPVs (Special Investment/Purpose Vehicles) and many run-of-the-mill securitizations -- and, later, more ingenuous mutations such as CDOs and CDOs squared -- all had in common was a distinct failure to actually properly disintermediate risk. Either the banks themselves furnished guarantees in order to ensure a better credit rating (and hence a bigger spread for themselves) for the vehicles and securities concerned, or alternatively risk was placed with insurers who either didn't understand its significance or were simply reckless (from the mono-lines to AIG).
To the extent that the banks themselves held securities insured by such firms, they weren't properly insured due to underestimating counterparty risk. The point of this being that not even Basel rules could keep inflationary bank credit expansion in check, nor would bank managers worry about the obvious increase in their exposure to credit risk both off- and on-balance sheet, since they had no incentive to do so; large bonus payments and the moral hazard of the "too big to fail" doctrine combined to produce this blatant disregard of risk.
It is important to realize that the money substitutes/fiduciary media that were created during this inflationary blitz sans any increase in reserves continue to exist. The inflation of the money supply that has happened during the inflationary credit expansion of the housing boom has not been "taken back." The times when a bust would actually reduce the amount of fiduciary media in the system via bank insolvencies and old-fashioned bank runs are a thing of the distant past – in modern times, both the FDIC insurance and the "lender of last resort," the Fed, ensure that this money, once it has been created, is no longer destroyed.
For the sake of completeness, also note that prior to the 2008 crisis, there were practically no excess reserves kept with the Fed, due to these reserves representing "dead money"; they earned no interest. This has changed since 2008, when the Fed altered its policy on bank reserves by henceforth paying interest on excess reserves.
A few more words on excess reserve technicalities. First of all, they don't form part of the money supply, since they sit idly with the Fed. Basically these are bank cash reserves, deposited with the Fed. As far as inflation of the money supply is concerned, they represent only "potential inflation," since the commercial banks could in theory use them as the basis for creating more inflationary bank credit.
There are a a number of factors mitigating against this at the moment. For one thing, the banks still suffer from the after-effects of the crisis. The previously biggest source of credit expansion – real estate lending – is frozen. Losses continue to be incurred in this segment of the credit market, as more and more borrowers default. Banks are well aware how interbank lending came to a standstill during the crisis, which is one more reason to keep precautionary cash balances in place. Also, the Fed currently pays 25 basis points in interest on such excess reserves while the effective Fed Funds rate remains most of the time below the upper range of the target rate of likewise 25 basis points. This reduces the incentive to lend out excess reserves in the interbank market.
Lastly, the Fed keeps insisting that it will eventually exit from its extraordinary debt monetization measures; such an exit would tend to lower excess reserves, so keeping them in place may also be a precaution against this particular eventuality. If you believe there will ever be an exit, think of a certain bridge that's for sale in Brooklyn. The Fed's balance sheet has historically often expanded, but it seldom shrinks (seldom enough that we might just as well have said "never").
Nevertheless, we can state that at the moment, monetary expansion is not firing on all cylinders. The Fed's QE effort creates additional bank deposits to the extent that bonds are bought from non-banks, and banks in turn have begun to buy securities, but lending to the private sector is still not growing appreciably at the moment. This has, however, not kept the true money supply from rising by more than 30% cumulatively since August of 2008; in short, the Fed's extreme monetary pumping has more than made up for the reluctance of the commercial banking system to expand lending to the private sector. Inflation of the money supply has not only continued unabated; it has in fact accelerated markedly relative to the 2004-07 period. This is a fact. There is no guesswork involved.
[Click all to enlarge]
Excess reserves held by commercial banks at the Fed; a small uptick recently, but QE 2 has not translated into a 1:1 increase in these reserves, as the banks are buying securities to ride the yield curve. Meanwhile, non-banks also receive funds from the QE exercise, which increases both bank reserves and fiduciary media in the system.
Banking or Political Interests?
This brings us to the second major – and far more important – point made by Boyapati; namely, that the interests of the political and the banking establishment are not necessarily congruent when it comes to the topic of inflation. We think this particular argument is substantially correct. The banking establishment favors "slow inflation," but cannot possibly be eager to see out-of-control inflation. We can also safely assume that the banking establishment knows better than the average politician how the system works and what could possibly provoke an uncontrollable loss of purchasing power of the monetary unit. This includes to the Fed itself, which sits at the center of the banking cartel. If it lost control over inflation, the danger of making the bulk of its reserves and the currency it issues worthless would in fact endanger its very existence.
In that sense, Boyapati is correct that perhaps a policy of "controlled deflation," as he calls it (similar to the BoJ's long time policy) would be more palatable to the banks than the risk of inflation getting out of hand.
However, if we look at the Federal Open Market Committee that is responsible for the setting of monetary policy, then we note that its membership consists of academics , a number of lifelong bureaucrats as well as a few bankers. As it were, the FOMC consists of seven permanent members – comprising the Fed's Board of Governors – as well as four of the regional presidents that are getting a vote on a rotational basis (for instance, famous 2010 policy dissident Kansas Fed president Thomas Hoenig no longer has a vote in 2011).
The Fed's Board of Governors in turn consists entirely of political appointees – they are appointed by the president and confirmed by the senate for 14-year terms. Once appointed, they cannot be removed for their views on monetary policy. Not only that, these governors are expressly forbidden to hail from the banking system. The Board of Governors is in the legal sense a pure federal entity, i.e. a government body .
This distinguishes the Board from the regional Federal Reserve Banks, which are owned by the system member banks in their respective districts. These banks appoint six out of nine of the directors of the regional Fed boards (however, the Board of Governors must approve the appointment of the president of the board, and it gets to appoint the remaining three board members of each regional Federal Reserve bank – these are supposed to represent the public interest).
In short, even if in the course of the FOMC rotation all four of the regional presidents were arch-conservative former bankers with hawkish views, they would be outnumbered seven to four by political appointees with no ties to the banking system whatsoever.
From this, we can see that Boyapati's argument has a decisive weakness. While an appointment to a 14- year term should ensure a degree of intellectual honesty, if you will, it can hardly be argued that banking interests have a larger stake in the Federal Reserve's policy making than political interests. In fact, we have historically seen numerous instances of the political pliability of the Fed , with chairman Arthur Burns who served under Nixon perhaps one of the most glaring examples.
Paul Volcker will always be remembered as a Fed chairman who withstood political pressures and instead engaged in a tight policy designed to smother an incipient uncontrollable inflation, but we cannot tell for sure how much of the political criticism was for show and how much of it was for real. Furthermore, Volcker soon abandoned his monetary rectitude , as can be gleaned from the fact that in mid-1982, money TMS - after actually contracting slightly for one year (a truly rare exception in the annals of the Fed) -- jumped by about 170% quarter-on-quarter and nearly 50% year-on-year. So he made up for all that "deflation" of 1980-81 in one fell swoop in 1982. In short, after just two years of "monetary rectitude," Volcker presided over the biggest short-term expansion in money TMS of the entire post-war period.
We will be the first to admit that even from a political point of view, uncontrollable inflation is not a desirable goal. Politicians may prefer an "inflating away of the debt" in view of the government's huge and growing debt load and its even larger unfunded liabilities, but a hyper-inflation brings about a complete economic collapse and as such an outright default may be considered preferable – especially given that so many treasury securities are held by foreigners, which theoretically opens the door to a selective default.
Note here that we are not even going to dignify the government's finances with the preposterous idea that they represent anything but a looming default, in whichever manner it will occur. It should be clear to everyone that no Western welfare/warfare nation government will ever be able to repay its debts. The shrinkage of government that would be necessary to achieve a repayment is entirely antithetic to the system as it is now constituted.
The reality is that government is growing bigger every single day – think of it as a fungus that is slowly suffocating its host. Nothing but a final collapse will rectify – or let us say, at least change – the situation. The only open questions are how long the muddling through toward the inevitable end will take (this is unknowable, but as we noted before, if the Soviet system could last for seven decades, our "mixed" economic system should be able to last even longer) and what form the apocalyptic final act will take.
However, to stay with the topic at hand, we note that first of all, the Fed is already a political animal first and a creature of the banking system second – at least in terms of how its leadership is appointed – and secondly, a recalcitrant Fed can always be politically commandeered. The Fed's charter can be revoked or altered by Congress at any time. Such a step would not be taken lightly to be sure – if anything it would probably only ever be considered at a time of severe crisis and faltering economic and market confidence. Alas, the point remains that in extremis, it can be done.
The "Volcker spike" in money supply growth in 1982 in its full glory. The "tightfisted" chairman became extremely loose at the first opportunity. The cumulative amount of TMS-2 outstanding, meanwhile, shows that at no time during the recent bust was there a natural decline in fiduciary media such as we would have observed without the backstopping of the banking system by the Fed and FDIC. In fact, it is quite clear that beginning with the demise of the Nasdaq bubble in 2000, money supply growth has exploded – soon total TMS-2 will be about three times its level of 2000.
In the second part of this essay (here), I discuss how an inflationary conflagration could still happen down the road.
Charts: Bloomberg, St. Louis Fed Research