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Is Overindebtedness Pushing Us Into a Deflationary Spriral?

The Gospel:
Aphorism? “Federal reserve had cut interest rates for a total cut of 1.25 bps to 3% in just 8 days. That is some high octane stimulus” Interest rates operate through the supply of and demand for LOAN-FUNDS, not according to the Keynesians, supply & demand for money. There’s no such guarantee that a decline in interest rates presages an increase in monetary flows (MVt). Plus, “easy” money & “tight” monetary policies are relative to the supply of goods and services offered in the marketplace

It isn't within the power or responsibility of the Federal Reserve to hold unemployment or even Gross Domestic Product to "tolerable" levels. In fact, to assume that the Federal Reserve can solve our unemployment problems is to assume the problem is so simple that its solution requires only that the Manager of the Open Market Account buy a sufficient quantity of U.S. obligations for the accounts of the 12 Federal Reserve banks. This is utter naiveté.

“We must not forget that for the last six to eight years, monetary policy all over the world has followed the advice of the 'stabilizers.'” Pure tripe. Monetary policy has relied on a “Taylor” like rule with assorted condiments (i.e., the federal funds bracket racket). It’s intuitively obvious that there were colossal rates-of-change in monetary flows (MVt) associated with the housing boom. Contrary to Gross there’s nothing artificial about these numbers.

“Von Mises, Ropke, Hayek, John Stuart Mill…laissez-faire proponent who held the opinion the majority of things are worse done by the intervention of government…": Encouraged by our “deregulated” environment, commercial bank legal reserves are no longer binding, and under the prevailing administrative “climate” institutions that provide a “financial smorgasbord”, including the capacity to create money have proliferated. We have discovered, too late, that money creation cannot be exposed to the forces of a free market. The money supply is not self regulatory. If private profit institutions are to be allowed the “sovereign right” to create money, they must be severely regulated in the management of both their assets and their liabilities.

Gross’s nondescript notion of “a showdown banking system” is queerly Keynesian. I.e., the lending capacity of financial intermediaries is almost exclusively dependent on the volume of monetary savings placed at their disposal. The commercial banks, on the other had, could continue to lend if the public should cease to saving al altogether. The lending capacity of the commercial banks is dependent on monetary policy, not the savings practices of the public.
If there is a parallel today with the Great Depression it is that we suffer from a brew of ill-advised deregulation and regulatory permissiveness that fostered an atmosphere in which greed seemed to triumph, especially if a little fraud was diluted with a heavy dose of incompetent supervision by the authorities & their examiners.
(1) U.S. needs a Krugman "demand-based" fiscal package alright, but a $300-$500 billion permanent one” (Classical Keynesian pump-priming) (2) “Keynes theorized & then Krugman affirmed, when private demand falters, it becomes the responsibility of government to fill the breach”, (3) dependent on reforms of monetary and fiscal policy resembling the 1930s more than our past decade. Krugman & Gross bastardize reality

There were years during this period when the “free” excess legal reserves held by the member banks were larger than the volume of “free” required reserves. The exercise of Fed policy was likened “to pushing on a string”.
Relative to nominal GDP we had the highest deficits during WWII and interest rates approximating the lowest levels of the Great Depression. Interest rates on Treasury obligations ranged from less than on percent on TBs to 2 ½ percent on long term bonds. This was accomplished by the Fed pegging the rates on all governments through the unlimited use of their open market power.
At the same time due to rationing and the absence of available goods transactions velocity of demand deposits fell from around 20 to 13. The production of houses and automobiles was virtually stopped and credit rationing severely reduced the demand for all types of goods and services not directly connected to the war effort this plus controls on prices and wages kept the reported rate of inflation down.

Not only were World War II deficits an unprecedented proportion of GDP; about 45 percent of the debt was monetized
It should have come as no surprise that we did not have a “primary” post-war depression; our problem was excess demand and inflation, not deflation and depression. By the end of 1942, unemployment was no longer a problem, and the bankers had fully regained their confidence; the banks no longer held excessive legal reserves. Massive deficit financing had ended the Great Depression.

It was true, as the Keynesians insisted, that monetary policy didn’t matter; fiscal policy was everything. No more. Never will we allow a financial panic to get out of hand, and never will we have another Great Depression. That does no mean the future is rosy. The future holds the prospect of sharply declining levels of consumption for the vast majority of the American people, who will be facing years of stagflation. It is probable that we will never be able to dig ourselves out of the present morass of debt and still operate the economy within the framework of a free capitalistic system.
Paul Krugman's book "The Return of Depression Economics', 1998, argues that "the crucial task of future policy would be to bolster demand as was the case in the FDR-driven 1930's as opposed to encourage supply which has been the case since the Reagan revolution…Public works programs, badly needed infrastructure repairs, as well as spending on research and development projects should form the heart of our path to recovery.”
The basic idea of supply side economics is to create an economic milieu that will foster increased production of higher quality goods and services which can be marketed at competitive prices. To achieve these objectives we need to reduce monopolistic elements in the price structure (monopolistic prices of goods or services tends to increase prices and restrict output); increase labor productivity; reduce unit labor costs; reduce transfer payments to the non-productive sectors; eliminate excess regulatory burdens, excessive rates of taxation on producers and savers, etc.
Like Krugman’s position: There is one all-important ingredient that the supply-siders ignore; namely that the demand for capital goods is a derived demand, derived from primary consumer demands. That even in a capitalistic system the end and objective of all production is human consumption. The demand for inventory or plant and equipment, however far removed from the ultimate consumer, is derived from final consumer outlays in the marketplace.
If the monies represented by Deficit financing are spent on projects which increase productivity and reduce waste, the deficits are beneficial no matter how financed. The initial inflationary effects of bank financing are quickly overcome by the larger output and lower unit costs. Debt incurred which reduces unit costs of production and promotes the health and welfare of the population obviously is “good” debt.
Debt incurred to finance transfer payments (interest, pensions, etc.) is of dubious quality.. Any enterprise, private or public, is in dire straits if it has borrowed in order to make such payments. That is to say classical “pump priming” will provide only some relief. There is a finite limit to this “remedy” Deficit financing to rescue the economy from a depression or even to prevent recessions because of the deficit’s sheer size.

Conspicuously absent from the prescriptions presented is our current account debacle. The U.S. dollar is no longer a safe haven for foreign capital. Nowadays there is a significant exchange rate risk. And the U.S. is no longer an economically undeveloped nation, but is increasingly an international debtor, what evaluation should be places on our huge trade and current account deficits? For the very short run these deficits keep prices and interest rates lower than they otherwise would be and they subsidize our standard of living. But the deficits also are inexorably forcing the dollar down in terms of its foreign exchange value—and no consortium of central bankers, treasury secretaries, et al. can stop the process

With a chronically depreciating dollar foreigners will be much less inclined to invest in the U.S. on a creditor ship basis, thus pushing up interest rates. The rising cost and diminishing volume of imports will contribute to an increase in inflation, and the expectation of further inflation will also push up interest rates. This spells stagflation.

A weak currency is not a cause; rather it is a symptom of a weak, noncompetitive economy. In time, of course, a declining dollar will eliminate the deficit in our balance-of-trade. But the price exacted will be a sharp decline in imports, principally oil, and the purchase of foreign services, reflecting our relative poverty and inability to compete in the international economy. The fact that we are the world’s number one producer of smart bombs will not arrest that trend.

The real culprit seems to be the cost of our products relative to their quality. Inferior is not a good buy at any price. The problem is that further depreciation of the dollar will not correct our foreign trade deficit.
Nouriel Roubini
“The “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don’t have direct or indirect access to the central bank’s lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities.”
This evaluation concerning the financial intermediaries is universal. There is total myopia and a complete misconception concerning the fundamental role of the commercial banks vis a vis financial intermediary’s .in the savings-investment process. Economists haven’t been unable to fashion the role of the commercial banks from a system’s standpoint. Commercial banks create new money when they make loans to or buy securities from the non-bank public. The commercial banks do not, and cannot, loan out existing deposits. .The confusion arises from a unique feature of the commercial banking system; the whole is not the sum of the parts in the money creating process.
Like Roubini says, the universal problem encountered by the financial intermediaries has been adverse interest rate differentials, the difference the intermediaries paid to attract and hold savings, and the return on long-term lending commitments made at an earlier and lower rate periods. Even for the most efficient intermediaries, a positive spread of at least two percentage points was required to break even.
What we should be concerned about is how to promote the orderly and continuous flow of monetary savings into real investment. And that objective is accomplished by eliminating the payment of interest on savings deposits at commercial banks (Reg Q in reverse). The revival of financial intermediaries is dependent on it (a repeat of 1966).
Quickly the principle issues: Everybody flunked accounting:
Commercial Banks as a system don’t loan out anything. They create money when they make loans
Money creation is not self-regulating
You can’t take money out of the banking system (only the FED can)
Savings transferred through the intermediaries never leaves the CB system. The intermediaries are the customers of the CBs.
Savings held within the commercial banking system are lost to investment or to any other type of expenditure.
From the standpoint of the economy the banks shouldn’t pay for something they already have. Payments on CB savings raise all interest rates; induce disintermediation among the financial intermediaries, shrink real-gdp, & decrease CB profits.
The long-term solution for the financial intermediaries (which originally didn’t have Reg Q ceilings) is to get the money creating depository institutions out of the savings business.