Chief Hooligan Shows Up
The Russian press just reported that Russia's prime minister and former president Vladimir Putin has a rather low opinion of the policies of the Federal Reserve and the people running it. Reports RIA Novosti:
Russian Prime Minister Vladimir Putin accused the US of hooliganism on Monday over the US government's efforts to ease its financial problems by injecting hundreds of billions of dollars into the economy.
"Thank God, or unfortunately, we do not print a reserve currency but what are they doing? They are behaving like hooligans, switching on the printing press and tossing them around the whole world, forgetting their main obligations," Putin told a meeting of economic experts at the Russian Academy of Sciences.
We confess that we have a soft spot for the ex-comrade, for one thing because he has spoken up in defense of free market capitalism in the past, but also because he has this very undiplomatic tendency not to mince his words. The practice of shrouding everything into euphemisms and politically correct terms is refreshingly alien to the man. By our standards for evaluating politicians, he has very high entertainment value indeed. It is amusing that he apparently doesn't quite know whether he should be relieved or concerned that Russia isn't printing a reserve currency, but the fact that the US dollar still is the world's foremost reserve currency understandably creates a certain degree of consternation vis-a-vis the practice of 'QE' among its chief holders.
Shortly after Putin delivered this harsh verdict, the leader of this alleged flock of hooligans showed up at the semi-annual Congressional hearing in order to deliver his assessment of the state of the US economy and to explain what the central planners at the Fed are aiming to do about it. One could actually safely skip the official statement by simply looking at the intraday move in gold futures.
(Click charts to enlarge)
Gold bulls are probably happy with the Helicopter pilot – he helped add some zest to the recent rally.
Gold, daily – it has gone up for seven days in a row, in the process achieving a new all time high. Probably a pause is due after this long string of up days, but it seems every day a new reason to buy gold presents itself, from the collapse in euro area sovereign debt markets to Ben Bernanke hinting at more money printing.
A Change of Tune
We previously noted that the markets hated the June FOMC statement and Ben Bernanke's subsequent performance during his press conference. As an aside, these desperate attempts to improve the Fed's crumbling public image by purportedly 'increasing transparency' are bound to backfire: since the organization is not truly transparent by its very nature, chances are that press conferences will only undermine its image further, even though journalists tend to lob nothing but softballs at the good chairman.
Anyway, during said press conference in June, Bernanke seemed to say, 'yes, the economy is weak, but there's nothing more we can do about it.' He even seemed to distance himself from his critique of the Bank of Japan and its 'self-induced paralysis' as he once put it. These days, so he opined, he had more sympathy for paralyzed central bankers.
We sort of suspected that this performance was specifically designed to counter the growing political headwinds the Fed faces over its policies. After all, more and more people are wondering: if QE is really such a good idea, where are the results?
The same can of course be said of deficit spending, which according to everyone from Bernanke to the president and his economic advisers is absolutely necessary to help the economy escape from its extended 'soft patch' (generally known as 'the depression' on Main Street).
As NFIB (National Federation of Independent Business) chief economist Bill Dunkelberg recently remarked in this context:
“Small-business owners are registering a vote of ‘no confidence’ in the federal government,” said NFIB Chief Economist Bill Dunkelberg. “Between the deluge of new regulations and a Washington policy agenda that is largely ignorant of Main Street needs, stubbornly low consumer spending, and grave concern among small firms about the federal budget, there is not much to be optimistic about as a small-business owner. Who can blame the prevalence of pessimism when administration officials are telling Congress that small businesses need to pay more in taxes to support government spending programs?”
While Dunkelberg mainly refers to the problem of Ricardian equivalence here – the fact that economic actors regard splurges in deficit spending as nothing but deferred taxation – the Fed is an arm of the government as well, and we may safely assume that monetary policy hasn't impressed small business owners either – not least because they're not interested in borrowing anyway. As the NFIB survey notes:
“Nine percent [of business owners] reported that not all of their credit needs were satisfied, 53 percent said they did not want a loan and 13 percent did not answer the question and might be presumed to be uninterested in borrowing as well.”
Small business confidence index – headed back down again in recent months, after bouncing to a level roughly commensurate to previous recession troughs.
In his press conference, Bernanke came very close to admitting that the money printing exercise has simply failed. He did admit that he 'did not understand' what was happening.
As ABC reported at the time:
“The economy's continuing struggles aren't just confounding ordinary Americans. They've also stumped the head of the Federal Reserve.
Fed Chairman Ben Bernanke told reporters Wednesday that the central bank had been caught off guard by recent signs of deterioration in the economy. And he said the troubles could continue into next year.
"We don't have a precise read on why this slower pace of growth is persisting," Bernanke said. He said the weak housing market and problems in the banking system might be "more persistent than we thought."
It was the Fed chief's most explicit warning yet that the economy will face serious challenges next year. For several months, he had said the factors working against economic growth appeared to be "transitory."
All in all, Bernanke seemed to say, 'things are bad, but we don't know why, and there's not much we can do about it'. This seemed a bit odd, considering his often enunciated strong convictions regarding the efficacy of central economic planning, Fed-style. We have always believed that what ensured his promotion to the post of Fed chairman in the first place was his famous 'anti-deflation speech' of 2002. In this speech he listed the policies the Fed would likely employ to counter the widely feared deflation bugaboo, which to his mind is automatically associated with an economic slump.
A first hint that the Fed has not yet given up on money printing was delivered with the publication of the most recent FOMC minutes a few days ago. Although the Fed seemed 'divided' as Bloomberg reported at the time, the key takeaway was this:
“A few members noted that, depending on how economic conditions evolve, the committee might have to consider providing additional monetary stimulus, especially if economic growth remained too slow to meaningfully reduce the unemployment rate in the medium run,” the Federal Open Market Committee said in the minutes of its June 21-22 meeting, released today in Washington.”
On Wednesday, Ben Bernanke confirmed that he hasn't given up on the idea either. What has presumably swayed him were the recent poor employment data. It does not matter that 'QE' has so far failed to produce results – his conclusion is based on the misguided theory that what the economy needs to grow is 'more and cheaper money'. If it doesn't work, that is not evidence of failure, but evidence that even more of the same is needed. The underlying mental condition that produces such trains of thought is colloquially known as 'insanity'.
The decisive passage from the prepared remarks follows below:
“Once the temporary shocks that have been holding down economic activity pass, we expect to again see the effects of policy accommodation reflected in stronger economic activity and job creation. However, given the range of uncertainties about the strength of the recovery and prospects for inflation over the medium term, the Federal Reserve remains prepared to respond should economic developments indicate that an adjustment in the stance of monetary policy would be appropriate.
On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support. Even with the federal funds rate close to zero, we have a number of ways in which we could act to ease financial conditions further. One option would be to provide more explicit guidance about the period over which the federal funds rate and the balance sheet would remain at their current levels. Another approach would be to initiate more securities purchases or to increase the average maturity of our holdings. The Federal Reserve could also reduce the 25 basis point rate of interest it pays to banks on their reserves, thereby putting downward pressure on short-term rates more generally. Of course, our experience with these policies remains relatively limited, and employing them would entail potential risks and costs. However, prudent planning requires that we evaluate the efficacy of these and other potential alternatives for deploying additional stimulus if conditions warrant.”
Well, what do you know, there was his list of possible options to combat the (entirely imaginary, so far) deflation threat again – albeit a somewhat shortened version thereof. 'Operation Twist' remained unmentioned, and so did some of the other, more exotic proposals from his 2002 speech.
Cherished Beliefs Persist
If you read through the statement, there are numerous revealing passages that show what the Fed chief believes – such as for instance:
“Much of the slowdown in aggregate demand this year has been centered in the household sector, and the ability and willingness of consumers to spend will be an important determinant of the pace of the recovery in coming quarters.”
This is putting the cart before the horse. Spending, i.e., consumption, can not possibly 'create economic growth'.. The ability to increase consumption is the result of economic growth. Before one can consume, one must produce. Before one can produce, one must save and invest. In the Fed chairman's worldview, production somehow just springs into being if only everyone consumes enough.
With its many 'on the one hand' and 'on the other hand' statements, Bernanke's remarks also inadvertently revealed the problems associated with central planning. At any given point in time, the world will always present the planners with such a bewildering array of possible future scenarios. They can cram as many 'incoming data' into their heads as they like – it won't change the fact that they can not possibly know which interest rate is appropriate.
Another revealing passage was the following:
“The second component of monetary policy has been to increase the Federal Reserve's holdings of longer-term securities, an approach undertaken because the target for the federal funds rate could not be lowered meaningfully further. The Federal Reserve's acquisition of longer-term Treasury securities boosted the prices of such securities and caused longer-term Treasury yields to be lower than they would have been otherwise. In addition, by removing substantial quantities of longer-term Treasury securities from the market, the Fed's purchases induced private investors to acquire other assets that serve as substitutes for Treasury securities in the financial marketplace, such as corporate bonds and mortgage-backed securities. By this means, the Fed's asset purchase program–like more conventional monetary policy–has served to reduce the yields and increase the prices of those other assets as well. The net result of these actions is lower borrowing costs and easier financial conditions throughout the economy. We know from many decades of experience with monetary policy that, when the economy is operating below its potential, easier financial conditions tend to promote more rapid economic growth. Estimates based on a number of recent studies as well as Federal Reserve analyses suggest that, all else being equal, the second round of asset purchases probably lowered longer-term interest rates approximately 10 to 30 basis points. 3 Our analysis further indicates that a reduction in longer-term interest rates of this magnitude would be roughly equivalent in terms of its effect on the economy to a 40 to 120 basis point reduction in the federal funds rate.”
Treasury yields actually rose for most the period during which QE was implemented, which makes one wonder why Bernanke seems to think that these yields were 'lower than they would have been otherwise.' In any case, it seems clear to us that manipulating financial asset prices upward and thereby lowering their yields by expanding the money supply – evidently the declared goal of the policy - can only lead to further distortions in the economy, and hence to long-lasting structural damage.
Consider also the second part we have emphasized above. 'Decades of experience' are allegedly telling the Fed chairman that the artificial lowering of interest rates 'promotes more rapid economic growth'. Alas, this statement omits what seems to us to be a very important point. Namely, it fails to provide an explanation for these observations. Let us think back to the housing boom for a moment. Apart from Ben Bernanke and a few apologists who get their paychecks from the Fed, almost everyone has probably realized by now that the 2002-2007 boom owed its existence to just such a manipulation of interest rates. But was it a good thing? The economy certainly seemed to 'grow' during this time period after all. In fact, Ben Bernanke himself engaged in premature victory laps as early as 2004 (see The 'Great Moderation'). A little over four years later he was whining about having to deal with 'the greatest financial and economic crisis since the Great Depression'. Could it perhaps be that artificially lowering interest rates is actually harmful? Judging from his remarks, the thought hasn't occurred to Bernanke yet.
The Failure of Monetary Pumping
And yet, the interest rate is not just a 'lever' that can be pulled by bureaucrats to 'jump-start' the economy, as is widely held. On the contrary, it represents the most important price, or rather price ratio, in the economy and as such should be market-determined. What Bernanke believes has been confirmed by 'decades of observation' was never genuine, sustainable economic growth, but the short run effect of the capital malinvestment that is set in train by monetary pumping. A boom may feel good while it is in motion, but it is in reality financed by capital consumption. Once this fact comes to light, the economy is faced with a bust – which is actually its way of rebalancing itself into a more sustainable configuration. It should therefore not be interfered with – and yet, such interference is precisely what Ben Bernanke precisely is tasked with.
Prevailing interest rates convey important information to entrepreneurs: they tell them the extent to which consumer prefer present over future consumption. Put differently, they tell them the extent to which consumers are prepared to forego consumption in the present in exchange for being able to consume more in the future. By foregoing consumption in the present, consumers free up resources that entrepreneurs can then employ in more time-consuming, and hence more productive methods of production by adding additional stages of production to the economy's production structure. In this way it is ensured that a proper balance between production and consumption schedules is struck. Interfering with this process necessarily creates an imbalance – an artificially lowered interest rate conveys falsified information to entrepreneurs, who then embark on investment projects that later prove to be unrealizable and/or prove to have drawn too many resources into the wrong lines of production (such as the building of millions of houses during the housing boom). The latter effect is the result of the fact that inflation percolates through the economy unevenly – new money will enter the economy at specific points and the lines, which will chiefly attract newly created money, can be different ones every time, united mostly by the fact that they are either temporally far removed from the stage at which they turn into the consumer goods they are ultimately designed to produce, or representing consumer goods that can from an analytical standpoint be treated as akin to capital goods due to the long duration over which they render their services (houses fall into this category).
While this process of resources diversion goes on, it appears as though the economy were 'growing' – economic statistics will confirm that boom times are underway. And yet, all the profits that accrue during the boom will eventually turn out to have been illusory once the boom falters. Ask any home builder, realtor, or purveyor of mortgage finance if they feel richer today as a result of the housing boom. The conclusion that the profits of the boom were an illusion is likely unambiguously clear to every single one of them.
In short, Bernanke's assertion that 'economic growth is promoted' by monetary pumping is based on an erroneous view of how the economy actually works. In case you're wondering why this time around, it appears as though not even the illusion of economic growth can be produced – in spite of the biggest monetary and fiscal intervention in all of history having been perpetrated – this can be explained by the finiteness of the pool of real funding. At any given time, even during a boom, a great amount of real wealth tends to be generated by the market economy. It would be correct to say that most of the time, a boom only impoverishes us relative to what would have occurred in its absence. And yet, by creating conditions that divert more and more resources into what are ultimately wealth-destroying activities over and over again (i.e., during every economic slowdown), the production of real wealth can eventually end up overwhelmed. It can therefore happen that the pool of real savings at some point stops growing or even contracts. From that moment on, monetary pumping can no longer produce any tangible effects in the real economy – instead, its negative long-run effects come to the fore much faster than they otherwise would do.
'The Mistake of 1937' and Other History Lessons
It didn't take long after the cessation of 'QE2' – and in view of the debate over the federal debt ceiling – for yet another gnashing of teeth to appear in print that references the so-called 'mistake of 1937'. This is a particularly persistent myth. The culprit this time, oddly enough, is Bruce Bartlett, who should know better (he once served on Ron Paul's staff, but appears to have remained untouched by Paul's economic views). Bartlett writes – in the New York times, which is certainly a proper choice of venue for this kind of editorial:
“The Federal Reserve has already ended its policy of quantitative easing, and many of its regional bank presidents are demanding higher interest rates to forestall inflation. Republicans and Democrats in Congress appear to agree that large spending cuts must accompany a rise in the debt limit, which will be hit on Aug. 2 if Congress doesn’t act.
Some economists are getting very nervous. With the economy in a fragile state, it may not take much to bring on another recession. Even a small amount of fiscal or monetary tightening may be enough to do that.
It is starting to look like 1937 all over again.”
We have discussed the erroneous interpretation of economic history on which these worries are based before. Now, it is true that a slight tightening of monetary policy preceded the 1938 recession-within-the-depression, alas, as we noted in a previous missive on the topic, quoting extensively from Robert Murphy's critique of Christina Romer's similar version of depression history (linked below):
“The argument by 'economic historians', this is to say, an argument based on 'historical data' is not an argument that holds up in light of economic theory. It does not even hold up in terms of the data as it were.
For instance, the notion that the orgy of spending engaged in by FDR's administration was somehow an economic panacea when compared to the not much smaller orgy of spending engaged in by Hoover's administration falls apart even when examining the historical record.
As Robert Murphy states in 'Christina Romer's Faulty Depression History':
An additional, rather decisive, blow to the 'historical argument' in favor of deficit spending is delivered further down in Murphy's article:
“As we've seen above, Romer's account relies on an implausibly large sensitivity of the economy to deficits; going from a deficit of 4.5% of GDP to one of 5.1%, meant the difference between disaster and impressive recovery.Yet even if Romer could come up with a fancy model to yield that result, she would then face the opposite problem: government spending and the deficit absolutely collapsed at the end of World War II, and yet the economy adjusted fairly quickly.Specifically, in FY 1945 the deficit was 21.5 percent of GDP.Yet two years later, the budget surplus was 1.7 percent of GDP! Since a sixty-basis-point swing (over one year) meant such a big difference between Hoover and Roosevelt, one would think that the 2,320-basis-point swing (over two years) would make a much bigger difference between the economies under Roosevelt and Truman. Yet the postwar recession lasted a mere eight months, and the official unemployment rate for (calendar year) 1946 was — get ready — a whopping 3.9 percent.”
The point made above is essentially: historical economic data can not be used to 'prove' a point of economic theory. What Murphy's examples show is that even while the the statistical data seem to support the views of economists arguing in favor of a 'laissez faire' approach rather than those of the interventionists, they can be and are used to prove just about any position. What is instead necessary is to proceed exactly the other way around: one must interpret historical market data in light of a correct economic theory if one wants to gain a proper understanding of economic history.
No doubt monetary tightening has contributed to the 1938 recession – alas, the correct way of interpreting this event is to state that this monetary tightening merely helped to reveal the preceding mini-boom as yet another inflationary illusion. The Fed may well have decided to continue with an extremely loose monetary policy, but this would have ultimately risked the destruction of the currency.
If there is a historical event that seems a tad more pertinent to the current dilemma, it is actually the experience of France's revolutionary government with fiat money inflation in the late 18th century. The French government at the time decided to introduce the 'assignat' - a paper currency ostensibly 'backed' by confiscated church property. What was so remarkable was that the inflationary issues of assignats (and later, after the assignat had been inflated to utter worthlessness, the 'mandats') initially seemed to revive the moribund economy, alas, not without costs in the form of rising prices. As soon as the newly printed money had percolated through the economy, the artificial 'stimulus effect' dissipated, and recessionary conditions returned. This seduced the assembly into issuing ever more currency, as it wished to recreate the stimulus effect. It was thought that these measures would only be 'temporary' and would cease as soon as the economy had stabilized. Alas, every time another issue of assignats was printed, the stimulative effect proved weaker than that produced by the preceding issue, while the effect on prices became ever more pronounced. However, the French assembly had clearly become addicted to monetary heroin. It simply found itself unable to stop – and had to resort to ever more repressive measures in trying to 'fix' the unintended consequences. It tried to outlaw the use and possession of gold and silver and introduced price controls. Penalties threatened for ignoring these edicts became ever more severe, including eventually the death penalty. This continued until the assignat had lost its value completely, upon which a new currency was introduced, the mandat. The game began anew, and the mandat lost its value even faster. Readers not familiar with this fascinating slice of economic history can download Andrew Dickson White's book 'Fiat Money Inflation In France' here (pdf).
The Federal Reserve today faces a dilemma that strikes us as very much akin to the one faced by the French assembly at the time. With every iteration of 'QE,' there is less effect on real economic activity, while prices, especially commodity prices these days, never fail to rise sharply. And yet, the Fed has also become 'addicted' to the easy money policy, all occasional protestations to the contrary notwithstanding. After all, 'decades of observations' have told it that loose monetary policy 'promotes more rapid economic growth'. While Ben Bernanke admits to being puzzled by the economy's failure to embark on a path of sustainable growth in spite of his ministrations, he assures us that he won't hesitate to try the same policy or variations thereof all over again as soon as the effects of the previous pumping episode fizzle sufficiently.
In a partly unintentionally funny report on Bernanke's testimony, Bloomberg relates that
“Federal Reserve Chairman Ben S. Bernanke signaled the central bank has more tools for monetary easing should the economy weaken and stymie efforts to generate jobs for 14.1 million unemployed Americans.”
The frequent reference to the Fed's 'tools' is what we find so amusing. It makes it sound as though Bernanke were a mechanic about to fix a car. This imagery is of course in keeping with the whole idea of the economy as a 'machine,' a 'stalled engine' that requires 'jumpstarting.' Alas, the economy is definitely not a machine, and every new intervention by the central planners is bound to make things even worse.
Unemployment data of post war recessions compared, via Calculated Risk. This is why we call the current recovery the 'fish-hook recovery,' to properly differentiate it from 'V'-shaped, 'L'-shaped and 'U' shaped ones.