Right, For the Wrong Reasons

I was listening to Tom Keene on Bloomberg last week, and he made the observation that both right and left leaning observers are predicting that the economic woes of the West are set to continue, due to the perceived poor nature of government policy. Of course, they are doing so for different reasons. The left/Keynesian crowd claims that the disjointed and insufficient nature of stimulus efforts are the reason we are still in a rut, and should they continue, we risk going back into recession. The other side claims that governments have done enough and should allow the economy to stand on its own two feet and grow without the training wheels. They feel that continuing on stimulating and regulating risks stoking inflation and uncertainty. My own views are that elements of both arguments are wrong, but the conclusions they both reach are correct.

Not Enough Stimulus? 

Leading the ‘not enough stimulus’ crowd are the usual suspects, Brad DeLong and Paul Krugman. In remarks made before the Jackson Hole speech at the end of last month, Krugman wrote about what monetary policy ‘should be’ pursued by the Fed, and that the intimidating language used by Presidential candidate Rick Perry is standing in the way, at least on a political sentiment level. He writes:

An economist named Ben Bernanke offered a number of proposals for policy at the “zero lower bound.” True, the paper was focused on policy in Japan, not the United States. But America is now very much in a Japan-type economic trap, only more acute. So we learn a lot by asking why Ben Bernanke 2011 isn’t taking the advice of Ben Bernanke 2000.

Back then, Mr. Bernanke suggested that the Bank of Japan could get Japan’s economy moving with a variety of unconventional policies. These could include: purchases of long-term government debt (to push interest rates, and hence private borrowing costs, down); an announcement that short-term interest rates would stay near zero for an extended period, to further reduce long-term rates; an announcement that the bank was seeking moderate inflation, “setting a target in the 3-4% range for inflation, to be maintained for a number of years,” which would encourage borrowing and discourage people from hoarding cash; and “an attempt to achieve substantial depreciation of the yen,” that is, to reduce the yen’s value in terms of other currencies.

As a side note, it is interesting the way that people talk about the ‘policy tools’ the Fed has as though they are all separate and distinct actions they can perform. The reality is that the only action they can take is to buy or sell assets. And when we’re talking about the buying of assets, we’re talking about the use of newly created money to do so. The only distinctions you can make are the assets purchased. It doesn’t matter if they are 5-7 year government bonds, or mortgages or commercial paper, the basic action involved is the same. Creating new money to buy assets.

Going further, Krugman seems to be annoyed that Bernanke isn’t ‘taking the advice’ he gave Japan, but I’m struggling to see what Bernanke has failed to do in that regard. Purchases of long term bonds did take place with the last QE program, over $250 billion of the purchases went to debt dated longer than 7 years. The Federal Reserve did announce that short term rates would stay near zero for at least two more years, which actually goes a step further than Krugmans’ wish of a vague ‘extended period’ kind of language. That announcement was made on August 9, so it’s odd that Krugman would not see this and take it into account for an article written on the 26th. The fact that the Fed has not made an announcement that it would be seeking a ‘moderate’ level of inflation of 3-4% may trouble Krugman, but the fact is that we are already running an inflation rate of 3.6% annualized, at the time of this writing. And despite the apparent propensity to sit on their hands at the moment, the Fed doesn’t seem overly worried about that figure, which it attributes to ‘transitory’ elements, namely food and energy increases. The recent Fed minutes suggest that they will respond again should economic conditions deteriorate, and that inflation is not as big of a concern to them as Krugman claims it is. Finally, the issues Krugman has with the fact that the ‘yen devaluation’ bit of advice isn’t being taken seem out of place. The reason is because the dollar has been deteriorating pretty steadily for quite some time, particularly since early 2009. It looks like most of the advice Bernanke gave the Japanese is being carried out here, and will intensify if conditions deteriorate. I don’t think Krugman has anything to worry about on that front.

Brad DeLong adds this in the wake of the release of the aforementioned FOMC minutes – a praising of Fed member Charles Evans who was ready to engage in more stimulus at the last meeting and believes more is required. Naturally DeLong agrees, and crticizes Naranya Kocherlakotas’ inflationary risk based dissent:

There is no requirement in the Federal Reserve Act that the Federal Reserve never “risk” a rise in inflation above 2 percent. There is a requirement for price stability–and right now prices and demand are unstable downward in the sense that both are far below the values that everybody making plans back in 2007 counted on their being right now. It is not just that Kocherlakota and company are ignoring the employment and purchasing power parts of the Federal Reserve’s dual mandate–they are ignoring the “price stability” part as well.

This reveals what I think is massive flaw in the understanding of price stability that currently exists. Price stability means that prices stay in a relatively tight band. They are going to fluctuate of course – you are never going to have prices stay at the same exact level for a period of time. They may go up – but if you are interested in price stability, they must come down as well. DeLongs assertion that prices are ‘unstable downward’ is thus incorrect. The downward pressure on prices is itself a stabilizing force, in that it is counteracting upward pressures that drove prices higher prior to 2007. This must happen if you are looking for price stability. What DeLong is actually advocating is stable price increases, which is something completely different. Prices increasing by a certain amount every year – say the 2% inflation the Fed looks for is not the same as looking for price stability.  In that case, by ensuring prices rise (even at a stable rate), and actively preventing prices from falling, you prevent price stability. DeLong’s worry for everyone making plans in 2007 is one sided – what about people who made plans in 2003, who in 2007 were facing prices far higher than the values they had expected (prices rose between 2003 and 2007)? Nothing is said about that because the current view of price stability dictates that constant price increases are ok. Yet it is an equally disruptive problem, one that is never fought against in the manner DeLong and Krugman would advocate fighting the ‘problem’ of lower prices in this post 2007 context. The reality is that this is not a problem at all, because the lower prices are simply countering the prior price increases, ultimately seeking the price stability over time that DeLong supposedly wants.

The main reason why this economy is in such bad shape lies in the fact that prices were driven higher for years with no respite in the form of lower prices. As the costs of living rose, and wages didn’t, things got to a point at which the price level could not be sustained by the economy – no demand existed for goods at that level. The natural reaction in that scenario is for prices to trend lower, which they have since the 2007 bubble peak. This is what DeLong is lamenting, without understanding that the price drop is merely bringing prices back to a level at which the economy could support – a level at which demand exists for goods.  Yes, businesses who made plans in 2007 are going to suffer as a result of prices not meeting their expectations. That does not mean that we should engineer prices upward so that they cater to that subset of the population. Since when is the government in charge of making sure every decision made by businesses or individuals turns out to be profitable? Until that point is understood by the policymakers, we are going to continue to be in the doldrums.

More than just monetary policy is lacking, according to some. Fiscal policy is as well, and is found wanting. From Krugman again:

Political opposition has already crippled fiscal policy; instead of helping to create jobs, the federal government is pulling back, acting as a drag on output and employment.

It’s interesting to me that a government that is

  1. Running record deficits; and
  2. Responded to calls to merely slow the rate of spending (as opposed to actually pull back) by engaging in the biggest political dramabomb in my lifetime which included a credit downgrade

can be described as ‘pulling back.’ The government did spend and borrow trillions in response to the financial crisis, and it is still in the process of spending money. Krugman will note that the figures ‘weren’t large enough’ and ‘weren’t targeted,’ but that doesn’t change the fact that we are in a malaise despite record spending.

Misguided Recklessness

The dissent shown by members of the FOMC at the last policy meeting on August 9 prevented a continued policy easing from the Federal Reserve. As the excellent John Hussman points out, their reasoning was way off the mark, despite ultimately coming to the right decision – for now.

Part of the reason for the expanded discussion, of course, is that three FOMC members have already declared mutiny, opposing even the Fed’s promise to hold interest rates near zero through mid-2013 (which is the most resistance to a Fed decision in two decades). Still, this opposition unfortunately seems to be for the wrong reason – not because they recognize that QE2 didn’t actually work, nor because they understand that consumers don’t spend out of speculative gains – particularly in stocks and commodities, nor that they recognize that QE isn’t effective in relieving any constraints on the economy – given that interest rates are already low and banks are already awash in liquidity (though not necessarily capital – and there is a difference). Rather, the reason for their opposition seems to be that they don’t believe that economic conditions warrant further “stimulus.”

That is, those dissenting at the Fed seem to believe that the economy is past the point where it still needs training wheels, and that they need to come off in order for it to grow. This view is wide of the mark; most commentators are aware by now that the economy is rolling over. Their reasoning implies that when they figure out what everyone else seems to know, they will stimulate again. And, as I’ve alluded to before, it is not the right move and will not fix things, as the ‘Do More’ crowd seems to believe. Hussman continues:

The successes of QE2 included a brief boost to pent-up demand which has already reversed, a boost to speculation in the stock market that has already reversed, a plunge in the value of the U.S. dollar that has persisted because the increased stock of U.S. dollars has persisted, and a wave of commodity hoarding that injured the world’s poor by raising prices of food and energy – because commodities are viewed as currency substitutes when governments are debasing purchasing power through money creation.

Moreover, this failure was predictable even before the Fed launched QE2, because with near-zero interest rates, depressed long-term rates, and already massive bank reserves, the policy could not hope to relieve any constraints that were actually relevant to the economy (see The Recklessness of Quantitative Easing ); because consumers don’t spend out of volatile forms of “wealth” (see Bubble, Crash, Bubble, Crash, Bubble… ); and because a monetary easing that creates inflation expectations while pressing down interest rates invariably leads to an “overshooting” depreciation in that currency and a surge in commodity prices that are quoted in that currency (see Why Quantitative Easing is Likely to Trigger a Collapse of the U.S. Dollar ). Of course, given that other central banks have also attempted to keep pace through competitive devaluations, the most spectacular collapse of the dollar has been against the currency substitute that cannot be printed by fiat – namely gold.

Further stimulative efforts (particularly those from the Fed) will end up repeating what we’ve seen the last ones do – weaken the currency, raise the price of assets (possibly), and raise the price of commodities. When the spending and the easing stops or slows, the effects of such easing will also abate. The issue, especially with respect to prices, is that the duration of the easing period will squeeze the average person. The rise in commodity prices represent increased costs of doing business which will translate into either increased end consumer prices, or decreased ‘internal costs’ (wage repression or firings). We are already seeing this leg play out, with several companies such as WalMart, Dean Foods, McDonalds, Starbucks, just to name a few, lamenting these increased costs in recent earnings reports. Companies are reducing the packaging sizes (juice containers that were once 64 oz are now 59 oz for example) while keeping prices the same. The fact that wages will not  rise with these increases in prices means the end result will be continued suffering for average people as more and more of their paychecks go to maintain the same standard of living they once did.

The more we see these effects manifest themselves in food and energy, the higher the chance the US is going to see the consequences of increased social unrest in the shape of the riots and protests that have taken place in Middle East and UK over the last 6 months. It is critical that from here we reverse the policy decisions that have led us to this point, lest we end up in extreme turmoil. I suspect that we will end up going the way of Krugman, DeLong, Charles Evans and the like – the print borrow and spend approach. I believe this simply because the other option is totally foreign to policy makers blinded by ‘short termism’. Their fears about governments and central banks doing nothing will be allayed somewhat, but those efforts will be for naught in the end, and ultimately will do nothing but cement and prolong a devastating downturn when the short term effects have worn off.

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