Market Forces and Intervention
Both inter- and intra-market correlations have lately become extremely pronounced. In the stock market it has become very difficult for investors to produce alpha, this is to say outperformance based on judicious stock picking. Generally speaking, the so-called "risk assets" group comprised of stocks, commodities and lower rated bonds tends to perform best when the market's inflation expectations are rising, in short whenever additional money printing is expected. It tends to perform poorly when inflation expectations are declining, or putting it another way: whenever the authorities give corrective market forces some breathing room.
After four decades of unbridled credit expansion post Bretton Woods, too many sectors of the economy have ended up with their balance sheets destroyed as a result of capital malinvestment. The banking system itself is continually under threat of a deflationary collapse due to the enormous amount of credit and fiduciary media created during the serial booms and bubbles.
Central banks have originally been founded for the purpose of forestalling a contraction of the money supply back to its specie backing during busts. Later deposit insurance schemes were introduced and the system was moved step by step toward fiat money, where bank notes no longer represent a claim on specie, but have become a claim on nothing in particular. All of this was done to keep bank runs at bay, take the risk out of fractional reserve banking and make massive government deficit spending possible.
In a fiat money system, an outright deflation of the extant fiduciary media would see the money supply contract back to its covered base (i.e., to currency and the deposits for which currency backing exists). This would be a cathartic event, given that of the roughly $7.1 trillion in money substitutes in the U.S. banking system only $1.64 trillion are actually "covered" vs. $5.45 trillion in uncovered money substitutes (or "fiduciary media").
Currency, covered and uncovered money substitutes in the U.S. banking system (data via Michael Pollaro). The surge in covered money substitutes owes to the sharp increase in excess bank reserves at the Fed.
The 1907 panic in the U.S., where JP Morgan organized and financed a banking consortium to keep a bank run from spreading was probably the crucial event leading to the third – this time successful – installation of a central bank (the groundwork for this had already been laid with the National Banking Act in 1863, which was strenuously opposed by the then hard money Democrats). The timing of its founding also conveniently happened to precede the beginning of WW I by less than a year. The result of seemingly taking the risk out of fractional reserve banking soon became manifest in one of the biggest boom-bust sequences in history.
As noted above, the move to a "pure" fiat money system happened step by step. After the breakdown of Bretton Woods, credit and money supply inflation really took off like never before. In 1995, the Fed reduced required bank reserves to practically nothing by allowing 'sweeps" (where sight deposits are swept into so-called "money market deposit accounts" overnight so they can masquerade as saving deposits), which gave the inflation of fiduciary media yet another shot in the arm (for details on this see this paper py Charles Hatch – pdf). Securitization later gave rise to even more pyramiding of money claims.
Every recession was countered with more monetary expansion, with the real economy's growth falling ever more behind relative to the credit and money supply expansion. This is illustrated by the following chart comparison (even though the GDP series is flawed, it gets the major point across):
Total credit market debt owed vs. real GDP, 1971 to today.
Another way of looking at this is to divide GDP by total credit market debt, i.e., a ratio chart that shows the decline of economic growth relative to debt growth. Note here that GDP contains government spending as well, while excluding all spending on intermediate goods (in other words, it includes what represents a burden on the economy, while excluding a significant portion of economic activity), but if we were to substitute the total of the gross domestic output per industry accounts for GDP, this would not alter the trend this chart depicts.
Real GDP divided by credit market debt outstanding, 1950 to today.
Another interesting aspect is that the rate of change of GDP growth actually slowed down around the time the debt accumulation accelerated. This can be seen by looking at a log chart of GDP:
Real GDP rose faster before the period of massive debt accumulation began.
When looking at a compounded annual rate of change chart of GDP, it becomes evident that economic growth was both higher and more volatile before the full-fledged fiat money system gave rise to the acceleration of the expansion of credit, the money supply and government spending:
Before debt growth really took off sharply in the early 1980's, GDP growth was higher, but also more volatile.
We conclude from the above that during a time when intervention was less pronounced, a higher frequency of boom-bust sequences allowed the economy to get back into a proper production-consumption balance faster and more often, which actually helped it to some extent to avoid the large scale structural imbalances that have emerged now.
This contention is buttressed by looking at the ratio of spending on capital goods vs. spending on consumer goods, a rough analogy for whether the production structure is being lengthened or shortened.
Note here that this ratio has remained in a range between roughly 0.3 to 0.4 until the abandonment of the gold exchange standard. Since then it has moved into a sharp uptrend, which has given way to a more volatile range between 0.8 and 1.1 since the peak of the technology boom in early 2000. Partially one can probably justify a higher ratio on account of the increase in the global division of labor (a lot of consumer goods production has moved elsewhere due to comparative advantage), but the fact that the extreme uptrend coincided with the biggest credit boom in all of history is surely not a coincidence.
That it represented an unsustainable lengthening of the production structure, i.e., malinvestment, can also be gleaned from the fact that the personal savings rate declined in parallel.
It is noteworthy that the ratio's biggest acceleration began in the early 1990's when the Fed first slashed interest rates to the bone in reaction to the S&L crisis, the precursor to today's banking crisis. Over this period the effects of the credit boom and the associated money supply inflation were mostly visible in the rising prices of stocks, this is to say, titles to capital. In short, there is evidence that the inflationary effect of the money supply expansion mostly distorted relative prices in the economy, instead of resulting in an increase in final goods prices – a side effect of sharply rising productivity due to technological innovation and a growing international division of labor. The very same effects could be observed during the "roaring 1920's boom" that preceded the Great Depression.
Note that in the early years of the depression, a massive deflation of the outstanding fiduciary media in the system occurred in spite of heavy monetary pumping by the Fed. This was mainly due to three factors: the gold standard enabled conversion of dollar notes into gold, and a run on the banks could not be smoothed over, as there was no deposit insurance scheme and only about half of the commercial banks were members of the Federal Reserve system at the time (whereas today the vast majority of banks are system members). Hence much of the money that had been created from thin air disappeared back to where it had come from, as banks that went insolvent took uncovered deposit money with them to money heaven.
The ratio of spending on capital goods to consumer goods production. After oscillating in a range between 0.3 and 0.4 until the early 1970s, this ratio has taken off in a strong uptrend since the abandonment of the gold exchange standard, in parallel with enormous debt growth and a sharp decline in savings.
The expansion of the Fed's balance sheet in the early years of the Great Depression: between January of 1930 and December 1933, the Feds holdings of government securities increased by 401% (from $485 million to $ 2,432 million) – a rate of monetary pumping of 98% per year.
The personal savings rate declined sharply during the credit and stock market boom of the 1980s and 1990s – a sign that increased capital investment was not supported by savings but mostly by the increase in inflationary bank credit.
As a result of the overextension of the banking system during the boom, the monetary authority has begun to actively inflate the money supply via debt monetization. During the boom it was merely passively accommodating the extension of inflationary bank credit by keeping the administered interest rate at a certain target level by providing additional bank reserves whenever rising credit demand threatened to move the rate above target. In fact, inflationary bank credit has gone into reverse and is now shrinking. The main danger from the Feds point of view is therefore deflation – which it tries to counter with quantitative easing. The government has been working in concert with the Fed by expanding its deficit spending, which has arrested a budding decline in total credit market debt outstanding.
(Click to enlarge)
Loan growth at commercial banks over three year intervals. Note that loan growth was barely positive following the S&L crisis, a smaller precursor to the 2008/9 GFC. Since 2008, loan growth has been negative. When more credit is paid back than extended in a fractionally reserved banking system, the money supply shrinks. This has been countered by massive government deficit spending combined with debt monetization by the central bank.
Richmond Fed President Jeffrey Lacker on the Feds Interventionism
We always try to keep abreast of the speeches given by various Fed members, not least because these days the interventionist decisions by fiscal and monetary authorities have become the most important market moving factor.
As we noted previously in "Ruled by Macro," the financial markets with their seemingly mindless risk-on/risk-off volatility appear to mainly react to interventions by authorities in the market economy, or to rumors of such interventions. Now and then we come across something interesting that is worth commenting on.
Richmond Fed president Jeffrey Lacker is one of the regional Fed presidents that can be called hawks, or perhaps better conservative central bankers. Due to the unique structure of the Federal Reserve system, regional presidents are not appointed by a political process. Six of the nine directors of the regional boards are appointed by district member banks, with only three appointed by the Feds board of governors (which is a federal agency). Barney Frank is eager to take the FOMC vote away from regional presidents because of this (i.e., he wants to ensure that only politically vetted appointees have a vote, presumably because literally all the hawks on the FOMC are presidents of regional boards; it is ironic to ponder in this context that the Democrats once went into conniptions over the National Banking Act because they rightly feared it would be the first step toward soft money).
One theme Lacker has frequently alluded to in his speeches are the redistributionist effects of the Feds interventions in the credit markets, which he strictly opposes. This is not to say that he opposes the elastic currency system as such, but he does oppose the notion of the Fed buying anything but treasury securities in its open market operations, as he feels this unfairly steers credit to some sectors of the economy to the detriment of others.
In his most recent speech he takes this subject up again – it is entitled Understanding the Intervenist Impulse of the Modern Central Bank and worth reading in its entirety. Below is a pertinent snippet:
“The ability of a central bank to intervene in credit markets using the asset side of its balance sheet creates an inevitable tension. The desire of the executive and legislative branches to provide governmental assistance to particular credit market participants can rise dramatically in times of financial market stress. At such times, the power of a central bank to do fiscal policy essentially outside the safeguards of the constitutional process for appropriations makes it an inviting target for other government officials. Central bank lending is often the path of least resistance in a financial crisis. The resulting political entanglements, as we have seen, create risks for the independence of monetary policy.
This tension is a classic time consistency problem. Central bank rescues serve the short-term goal of protecting investors from the pain of unanticipated credit market losses, but dilute market discipline and distort future risk-taking incentives. Over time, small "one-off" interventions set precedents that encourage greater risk taking and increase the odds of future distress. Policymakers then feel boxed in and obligated to intervene in ever larger ways, perpetuating a vicious cycle of government safety net expansion.
The conundrum facing central banks, then, is that the balance sheet independence that proved crucial in the fight to tame inflation is itself a handicap in the pursuit of financial market stability. The latitude the typical central bank has to intervene in credit markets weakens its ability to discourage expectations of future rescues and thereby enhance market discipline.
Solving this conundrum and containing the impulse to intervene requires one of two approaches. A central bank could seek to build and maintain a reputation for not intervening, in much the way the Fed and other central banks established credibility for a commitment to low inflation in the 1980s. Alternatively, explicit legislative measures could constrain central bank lending. The Dodd Frank Act took steps in this direction by banning loans to individual nonbank entities. But Reserve banks retain the power to lend to individual depository institutions and to intervene in particular credit market segments in "unusual and exigent circumstances" through credit programs with "broad-based eligibility." In addition, the Fed can channel credit by purchasing the obligations of government-sponsored enterprises, such as Fannie Mae and Freddie Mac.
Constraining central bank lending powers would appear to conflict with the popular perception that serving as a "lender of last resort" is intrinsic to central banking. But even here, I think our historical doctrines and practices should not escape reconsideration. The notion of the central bank as a lender of last resort derives from an era of commodity money standard, when central bank lending in a crisis was the way to expand currency supply to meet a sudden increase in demand. Indeed, the preamble to the Federal Reserve Act says its purpose is "to furnish an elastic currency," not to furnish elastic credit. The Fed could easily manage the supply of monetary assets through purchases and sales of U.S. Treasury securities only. While it might sound extreme, I believe that a regime in which the Federal Reserve is restricted to hold only U.S. Treasury securities purchased on the open market is worthy of consideration.
It might seem easy to criticize such a regime by reference to what it would have prevented the Fed from doing in the recent crisis. But thats the wrong frame of reference, I believe — its an ex post, rather than an ex ante, perspective. Such a regime, if credible, would over time force changes in market practices that would alter the likelihood and magnitude of crises and the behavior of private market arrangements during a crisis. It would strengthen market discipline and incent institutions to operate with more capital and less short-term debt funding — changes we are now trying to achieve through regulatory means. The relative costs and benefits of such a regime may be difficult to map out conclusively. But I believe this tradeoff is well worth studying.”
What Lacker is effectively saying is: if one credibly ensures that the central bank can no longer intervene in specific sectors of the credit markets to bail out those that have overextended themselves, then market participants may alter their behavior accordingly. In other words, to those who say, what else should the Fed have done during the crisis, he is countering: there may not even have been a crisis if commercial bankers and others had known beforehand that they would not be bailed out by the Fed. It is in short a question of incentives.
We agree to some extent – bankers may be more careful if they knew that the Feds room to intervene were more circumscribed than it is. One need only recall the takeover of toxic assets beginning with the Bear Stearns portfolio that became Maiden Lane, or the bailout loan granted to AIG in order to make its CDS counterparties whole (scandalously sans haircuts to boot) and the subsequent alphabet soup of emergency lending facilities. Lacker wants to see the inherent unfairness of this credit allocation process removed – he is therefore also against the idea of the Fed embarking on even more monetization of mortgage-backed securities (which is likely to happen in spite of his reservations).
However, even though a more conservative incarnation of the central bank may be better than what exists now, there is no reason to believe that this would alter the boom-bust potential. The main problem remains that the central planning of interest rates is going to lead to misallocation of capital, regardless by what precise method the interest rate fixing is achieved. In no other sector of the economy would economists think of price fixing as economically beneficial, but somehow money is supposed to be excepted from this rule, which really makes no sense. On the contrary, since the interest rate must be considered an extremely important price (it really is the agio of present over future goods), if not the most important, in the economy, it should be of paramount importance to let the free market determine it. Given its central role in coordinating investment, production and consumption, it should not be tinkered with by a bunch of bureaucrats. No matter how many data they look at, they will never be able to correctly divine society-wide time preference as expressed by the height of the natural interest rate.
We are certainly agreeing with Lacker that taking away the Feds power of allocating credit to specific sectors would be an improvement, but he is mistaken if he thinks that this would forestall future booms and crises.
A case in point is the ECBs current predicament. Although the ECB is by statute not allowed to allocate credit to specific governments in the euro area, this did not keep governments from overextending themselves during the easy money boom. In short, it appears as though everybody relied on the idea that the rules would be bent once a crisis arrived. They have in fact been partially bent, via the fully sterilized and relatively small scale SMP, but not to the extent apparently expected. Moreover, the ECB – contrary to the Fed – has refrained from inflating the money supply actively over the past year, which has hastened the arrival of the point of crisis.
Eric Rosengren on Misconceptions about the Fed
Even while Lacker – along with the remaining hawks – remains critical of the very organization he works for, Eric Rosengren from the Boston Fed (a noted dove) gave a speech defending the Fed against its critics, by highlighting what he deems to be four big misconceptions people allegedly harbor about the Fed (the speech can be read in its entirety here).
We only want to briefly touch on the first one, which is about the question of whether the Fed is being audited – Rosengren notes that it is indeed subject to audits, which is a bit of a so what to us. As it were, Congress has recently legislated far more detailed audits than those the Fed is normally subjected to. The Fed tried to head that off with the argument that it would shake market confidence in institutions receiving emergency funding, but it probably feared more that the very point Lacker criticizes would become additional fodder for its critics – namely the unfairness of the credit allocation process.
The second point regarding the perceived lack of transparency by the Fed is actually intertwined with the first. Rosengren says it is more transparent than it used to be, and not at all secretive anymore. Alas, this is not entirely true, given that it did definitely not want the details of the 2008 bailout lending revealed (the Fed also fought a freedom of information request by Bloomberg in the courts). The new legislation has in the meantime produced this detailed report by the GAO on the emergency loans made during the crisis, and it is not exactly an uncritical report.
We are however more interested in Rosengren's economic points. The third alleged misconception has to do with inflation. Rosengren says:
“We have indeed expanded our balance sheet – some call that “printing money” – but it is a misconception that it has resulted in significant inflation.”
As Bill Clinton would say, it depends on what your definition of is is. Or rather, in this case, how you define inflation. Rosengren's proof consists of a chart of the PCE deflator (Personal Consumption Expenditure deflator).
The PCE, over three-year periods. Rosengren: “… over the three-year period ending last quarter the U.S. has experienced the lowest average inflation rate of any such period over the past thirty years”.
However, the PCE deflator is only an imperfect measure (there are no perfect ones) of final goods prices – and conveniently the one showing the smallest increase among the various consumer price measures that exist. The problem is that with this he is trying to pass off one of the possible effects of inflation as inflation itself – in other words, we are led away from the cause and presented with just one possible effect that happens to look good at the moment. Consumer prices were increasing fairly slowly for the past 30 odd years, but that does certainly not mean that we did not experience the pernicious effects of inflation.
In terms of money supply expansion, the past three years have seen the by far biggest inflation rate over such a short period of the entire post WW II era.
Money TMS-2 with quarterly and annualized growth rates, via Michael Pollaro. The expansion of this money aggregate between January 2008 and October 2011 amounts to 52.3%. No inflation?
As we noted further above, the Fed is combating the natural deflationary forces of the market, as commercial bank credit has been shrinking over the same period. The private sector has effectively nothing left to lend, and there are few willing (and creditworthy) borrowers either. The fact that consumer prices as measured by the government have been fairly tame during this time isn't really telling us anything. We certainly know that there have been considerable effects on the prices of securities and commodities, i.e., we know that relative prices have been distorted. What we don't know – at least not yet – is what precisely the longer term lagged effects of the inflationary policy on consumer prices will be. We can make an educated guess that if money supply inflation continues at a similar pace as that witnessed over the past three years, a rather abrupt fall in the currency's purchasing power could one day occur. There is no way of making a quantitative forecast of this – the relationship between an increase in the quantity of money and prices is by no means linear. Once an inflationary psychology takes root (which is to say, once people stop hoping that the policy will one day be reversed), it can easily happen that the purchasing power of money drops even faster than would be strictly justifiable by the increase in its quantity. The fact that the demand for money has been very high during the recent period of economic crisis and uncertainty is not an immutable condition.
In any case, one can not characterize a 52.3% expansion of the extant money supply in the economy over a period of less than three years as low inflation. This is absurd.
Rosengren's fourth point is that it would be a mistake to believe that the Feds policy actions will have no impact on the economy, even though its administered interest rate is already at zero (we would note to this that a zero interest rate would indicate that time preference has disappeared – since this is not possible, it must be lower than the natural, or originary interest rate would be; conceivably, time preferences could rise to infinity if we knew that the planet was going to be destroyed by an asteroid strike in one weeks time, but they can never become nil or negative).
Unfortunately we must agree – its actions will have an impact. Rosengren relies on models that allegedly predict what said impact will be, by analyzing economic statistics of the past. He says:
“Researchers at the Boston Fed have conducted statistical tests to determine if the reaction to long-term interest rates is different after the crisis, and whether there is empirical evidence that lower interest rates would indeed have no impact. Research by my colleague Giovanni Olivei has found that prior to the crisis our statistical model of the economy would imply that a sustained decline in the 10-year Treasury rate of 100 basis points would lead to a cumulative increase in real GDP over two years of approximately 2.5 percent.
With the reduction in interest sensitivity in housing more recently, the model would imply that a sustained decline in the 10-year Treasury rate of 100 basis points would now lead to a cumulative increase in real GDP over two years of approximately 2 percent – as shown in Figure 13. Concerns with falling prices, high unemployment, and limited access to credit have likely all contributed to this lower – but clearly non-zero – response to lower rates in housing markets. The assertion that our rate actions simply will have no impact is not supported by our statistical work.
This assertion is accompanied by the following chart:
The problem with such statistical modeling based on past data is that it is essentially completely worthless. As a simple test requiring nothing but common sense: if it weren't, then no econometrician could have been surprised by the crisis – alas, all of them were. If anyone knows of a statistical model that predicted the bust, dont hesitate to apprise us of it.
Just as it is impossible to make quantitative forecasts about moneys future purchasing power based on measuring the past growth of the money supply, so it is with all other economic data. We can only make qualitative economic forecasts with apodictic certainty. And the main qualitative forecast we can make with regards to the Feds policy actions is that increasing the money supply will lead to more capital misallocation, while significantly arresting the liquidation and transfer of previously malinvested capital as well as lowering moneys purchasing power over time.
This may well result in a temporary rise in GDP – but it wont mean that sustainable economic growth and renewed wealth creation are underway because of it. In fact, as we have occasionally pointed out, if the economy's pool of real funding is already stagnating or shrinking – something that can not be measured, but can conceivably be inferred from circumstantial evidence – then the seemingly positive effects on economic activity stemming from monetary pumping will no longer last very long and will instead tend to give way to renewed economic contraction very quickly. Or putting it differently: the highs from administering the monetary drug will become far less satisfying as well as much shorter and the subsequent denouements will become all the worse.
Charts by: Boston Fed, St. Louis Fed, Frank Shostak, Michael Pollaro, Acting Man