Christopher Mah...'s  Instablog

Last month, I wrote "Why Monetary Stimulus Is Broken", in which I argued that (1) the money supply is not responsive to growth in the Fed's balance sheet because banks are hoarding cash instead of lending; and (2) that NGDP is not responding to the (modest) growth in the money supply because of a high liquidity preference at households and businesses. (I did not and will not today go into the whole expectations problem, which is also very important.)

Of the two transmission vectors, the one that seems most broken is that between the monetary base (the Fed's balance sheet) and the money supply (M2). The monetary base has grown exponentially since Lehman, from roughly $1T to $3T, while M2 has only grown from roughly $8T to $10T. The Fed would appear to be pushing on a string, and monetary velocity continues to decline.

Banks are leaving the Fed's money on deposit at the Fed instead of lending it. (A bank deposit at the Fed is not money, it's a bank asset; money is a bank liability which is created when a bank makes you a $1 million loan and deposits $1 million into your checking account, which is your claim on the bank. Now you have $1 million, and the money supply has risen by $1 million.)

There are clear linkages between bank loan growth and money growth, and between overall credit growth and nominal growth. Let's take a look at these two variables: bank loan growth, and overall credit growth.

Bank Credit Growth (FRB H.8)

Bank credit (now $10T) was growing around 10% before the Crash, contracted during the crash, rebounded to 6% after the Crash, but then slowed down to the current anemic 3.5%. This is not suggestive of robust monetary or economic growth. Total bank loans and leases, a slightly smaller slice ($7.3T), shows a similar pattern: 12% growth pre-Crash, a sharp contraction, recovery to 5% then declining to 3% at present. Bank credit growth is not robust.

Total Credit Growth (FRB Z.1)

Next we'll look at the Fed's Flow of Funds database to observe total credit growth. Looking at the broadest possible credit aggregate (TCMDO) which is now $57T, we see precrash growth of 10%, a mild contraction, and a current, rather weak, 3% growth rate. Now let's look at the four components: households, business, government, and finance.

Households

This is not a pretty picture, and would seem to be at the root of the problem. HH credit ($13T) was growing at a feverish 12% precrash, then it began to contract and has continued to do so ever since. It is still contracting, which goes a long way to explain what's wrong with the recovery.

Business

The Business picture is much brighter than the HH sector. Business credit ($9T) was growing at an overheated 13% precrash, contracted during the crash, but has since recovered to a very healthy 9% growth rate. Business credit does not appear to be broken.

Government

Credit to governments has been the mirror image of the private sector. As private sector credit contracted during the crash, government credit took up the slack. Regional government credit ($3T) grew rapidly during the crash, but has since stopped. Federal credit ($12T) grew very rapidly during the dark days after Lehman (35%) and is still growing at a 10% rate.

Finance

Most people exclude the financial sector from an analysis of domestic credit growth because it is not an important component of the economy, it is a derivative of the real economy at best, and it is rife with double-counting. Nonetheless, I think that it worth a look, because it has its own (unhappy) story to tell. The pattern of financial sector credit growth bears a striking resemblance to the HH sector. Once again, there was a feverish precrash growth rate of 13% followed by a very sharp contraction which has not yet ended. Banks and the Street are still licking their wounds.

The net of all this is that bank loan growth (which is a monetary policy transmission vector) is very weak, and is in fact slowing. Overall credit growth, which plays an important role in determining nominal growth, is also very weak. While business credit has fully recovered from the Lehman shock, household credit continues to shrink and thus retard the recovery.

The Fed's policy of relying on the banking system to stimulate growth isn't working. This is reminiscent of Japan which has had the same problem for two decades. Buying bonds from banks creates bank reserves, not money. And it would appear that however great the banks' reserves get, they are not creating inflation.

It may be that when rates are at the zero bound and the banking system is broken, the appropriate policy instrument may not be to buy bonds from banks, since buying them doesn't seem to affect the price level. Bernanke was certainly correct that the Fed could create inflation by dropping money on citizens from helicopters, but that would be a rather blunt instrument.

It seems to me that the Fed needs to buy something besides Treasury and agency bonds, and from someone besides banks. The obvious alternative to Treasuries would be foreign government bonds, or gold. Since the former would constitute a "currency war", that would seem to leave gold. Gold is not a bank asset, it's a "civilian" asset. Buying gold from nonbanks creates money and inflation.

I have no doubt that if the Fed were to announce that it will buy gold until it has achieved 2% inflation and 6.5% unemployment, it would get there. It would disrupt the gold market (and enrich some of the wrong people) but that is a small price to pay. No foreign government could object to the Fed buying gold; it's been doing it for 100 years.

That was an idle thought-experiment, in the sense that buying gold has not even been discussed at the FOMC or anywhere else. But I am quite confident that it would work better than the current policy of buying Treasury bonds from banks. And it is not unprecedented.

"The 'leave it alone' liquidationists were headed by Secretary of the Treasury Mellon, who felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: 'Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.' He said: 'It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people'..."

--Herbert Hoover, "The Great Depression"

Another Draghi press conference*, another iteration of Mellonist Thought. Draghi's basic position, which has been iterated and reiterated for four years, is that Southern Europe must continue to go through purgatory in order to atone for its original sins of greed and indolence:

"Fiscal consolidation is and remains unavoidable. It should be clear to everybody that you cannot have growth with endless debt creation. Sooner or later, you are going to be punished and the whole thing stops."

The ECB is not to blame for zero growth and high unemployment: that is the fault of the defective countries and their lazy people:

"You also have to ask yourself why these countries were not competitive. Why did they have to rely for growth in the good times, or "fairyland" times, on the protected sectors that were shielded from international competition?"

It appears that there is more than a bit of Savonarola in Mr. Draghi. Although a Roman Catholic, he has a Puritan heart. He is truly a man of the world, highly educated, highly intelligent, with a resume intimidating in its excellence: MIT, Harvard, World Bank, Brookings, Institute for Advanced Studies, Goldman Sachs, Bank of Italy, ECB. Whatever Draghi's problem is, it is not intellectual ignorance or a low IQ.

A bit of psycho-biography: Draghi has spent his entire professional life apologizing for Italy. Imagine his life, traveling around the world in order to explain and excuse his country's medieval politics and ungovernability. Try to imagine for a moment the depths of Draghi's contempt for Italian politicians (and voters), with their Byzantine disinterest in anything but power, family and money.

Could Draghi be unconsciously (or even consciously) seeking revenge on his country's unmodern political culture, the succession of Andreottis, Fanfanis and Berlusconis and all of their satraps and corrupt henchmen? Does he perhaps think, like Lincoln, that only by going through a cauldron of fire can his country atone for its sins and enter the modern era? Does he, in other words, think that his utopian ends justify his brutal means? Certainly the tone of his monthly Q&A would suggest impatience if not contempt for the complaints of those who would question his disastrous policies.

He explains to the doubting that near-zero inflation is a good thing:

"The fact that inflation is low is not, by itself, bad; with low inflation, you can buy more stuff..low inflation is increasing people's purchasing power."

Yes, it would if they were employed.

Why is aggregate demand so weak?

"You have a quite broad weakness in domestic demand and consumption, particularly because of the high levels of unemployment."

So the unemployed are the cause of unemployment. QED.

Is the ECB's Zero Growth Policy causing high unemployment? No, the problem lies with the occupied countries themselves:

"The Governing Council is of the persuasion that the present levels of unemployment are the result of a combination of cyclical factors, as well as structural factors. As of cyclical factors, there is no doubt that the labour market in general is experiencing the combined effects of a credit crunch and the unavoidable fiscal consolidation that many of these countries have had to undertake. It is also true that some structural factors are blocking the labour markets."

The people to blame for the eurozone's high level of youth unemployment are the unemployed youths themselves:

"A fast-moving world, in other words globalisation, requires new skills and investment in human capital, meaning that youth unemployment can also be explained on the basis of a mismatch of skills and human capital."

Are the ECB's policies responsible for the fact that business credit growth is shrinking and credit has been withdrawn from small businesses in the South? No, these are autonomous decisions being made by the banks:

"When you talk to healthy banks that do not need to be recapitalised, you ask them why they are not lending more. The answer you get is that the net rate of return, adjusted for the risk of lending, is not high enough for them to lend...(Another) reason why banks do not lend is risk aversion, which is both micro, with respect to their clients, and macro, with respect to the general economic environment and the high uncertainty that still prevails in some parts of the euro area."

Please don't hold the central bank responsible for negative credit growth.

After four years of zero nominal growth and with over 12% unemployment, might it not be opportune to change from a zero-growth policy to a policy of robust nominal growth? No, it wouldn't make any difference. The problems are cyclical and structural, and the solutions rest within the countries themselves:

"Ask yourself what should these countries change to become more competitive? And what adjustments are needed in order to achieve this objective?"

Have the ECB's deflationary policies been effective? Is rising unemployment a signal of policy failure? Not at all, in fact our policies have been very successful:

"When we all look back at what OMT has produced, frankly when you look at the data, it's really very hard not to state that OMT has been probably the most successful monetary policy measure undertaken in recent time."

So there you have the evidence. Draghi is not unfamiliar with the relevant literature. He studied at MIT under Modigliani and Solow. He knows all about Fisher, Keynes, Friedman, Eichengreen and Krugman. I'm sure he even knows about Market Monetarism (perhaps Mark Carney has mentioned it to him). He understands how the modern semi-capitalist economy functions. What he is doing is conscious, deliberate, sincere and not an act of misfeasance. It is true that he is bound by his single mandate and by the politics of his Governing Council. But that does not explain the evident sincerity of his monthly testimony. He is a true Mellonist, as Krugman would say. He wants to purge the rottenness out of the system. He wants people will work harder and live a more moral life.

Savonarola was tortured until he recanted, and then hanged and burned. I just want Draghi to recant.

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*Draghi press conference, 6 June 13.

A week ago, I criticized* the Bush Institute's "Four Percent Growth Initiative" because it made no reference to monetarist thought. It was subsequently brought to my attention that the Bush Institute has published a book** which contains a chapter on monetary policy. I bought the book and read the relevant chapter.

It is worse I expected. It is embarrassing and adds nothing to an informed discussion of monetary policy. I will not reiterate my earlier comments concerning the intellectual limitations of "Texas Commercial Bank Thought", also known as "Dallas Fedism", which is unsurprisingly the ideology espoused by the Bush Institute. I will simply provide excerpts from the chapter and allow the reader to draw his own conclusions concerning the intellectual value of the thoughts emanating from the Bush Institute in Dallas:

The starting point for 4% growth is a commitment to a sound dollar. In very simple terms, that means creating the expectation that the dollar will retain the value that it has now for the next twenty or fifty years.

It costs the government nothing to create new dollars to offset dollar weakness, and there's no competitiveness gain because of the reduced investment, so the theoretical endpoint is hyperinflation.

We need a strong and stable dollar policy. To create such a policy, the president should state that a strong and stable dollar is part of U.S. growth policy and will be implemented by the Treasury and the Fed. The White House should then insist that the policy be evaluated regularly by measuring the dollar against the price of gold.

The Fed should follow up by using each FOMC statement to reinforce the policy of a strong and stable dollar. It can do that by using FOMC statements to measure the dollar against the value of gold and other currencies and also to discuss any inflation implications.

To emphasize its intention of putting a long-term floor on the value of the dollar, the Treasury should issue debt payable in dollars and payable in gold, as economist Judy Shelton has pointed out.

The United States is practically alone in pursuing a near-zero interest rate and letting its central bank to borrow short-term to buy up the national debt.

For those who can borrow cheaply, corporate proceeds often go abroad while most of the subsidized government borrowing turns into extra deficit spending.

Under the 2010 QE2 Fed bond-buying scheme, the more the Fed intervened in markets, the weaker GDP growth was each quarter.

Near-zero interest rates tag the dollar as the flight currency of choice for world markets.

There you have it. I won't attempt to explain it. President Bush intends to have his presidential institute taken seriously in national policy discussions. Unfortunately, no one will take his institute seriously unless he does so himself. He really should ask qualified professionals to review his Institute's publications before they are published. Had he done so, he might have been persuaded to have the chapter on monetary policy written by the man he appointed chairman of the Federal Reserve, or at least by someone who understands the monetary policy which was pursued during his administration.

But is President Bush aware that there is an unbridgeable gulf between Ben Bernanke's views concerning monetary policy and those expressed in his institute's book? I ask this because it has been reported that "Bernanke's academic research hadn't been discussed when President Bush was weighing his appointment to the Fed Chairmanship." I wonder if Bush knows that Bernanke is a monetarist?

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* "A Critique Of The Four Percent Growth Project at the George W. Bush Presidential Center"

** "The 4% Solution", George W. Bush Institute, 2012