Last week, Josh Barro at Bloomberg’s Ticker decided to explore the mind of a hard money advocate. I’d like to assist him in that endeavor.
Hard-money advocates warn darkly of the risks of inflation to the dollar. They believe excessive monetary easing could lead to spiraling inflation and severe recession. One problem with this account is that it’s wrong, as you can see from the still-rock-bottom inflation estimates that are implied by bond markets, despite the Federal Reserve‘s unprecedented easing efforts.
A very popular retort to the hard money position is that the bond market, via the ultra-low interest rates currently on offer to borrowers, is implying that there are no fears about inflation from market participants. This is a very weak argument because the Federal Reserve’s unprecedented easing efforts are operationally targeted directly at the bond market itself.
Monetary policy injects stimulus into the economy via a mechanism by which the Fed buys bonds from market participants. These participants have previously purchased bonds from the Treasury in auction. The money with which the Federal Reserve buys these bonds is money it creates and credits to the institutions it buys from. The money that these institutions receive then enables them to purchase other assets. Ben Bernanke described this phenomenon as the portfolio balance channel in his 2010 Jackson Hole speech (emphasis mine):
Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.
The logic of the portfolio balance channel implies that the degree of accommodation delivered by the Federal Reserve’s securities purchase program is determined primarily by the quantity and mix of securities the central bank holds or is anticipated to hold at a point in time (the “stock view”), rather than by the current pace of new purchases (the “flow view”).
The application of the bold to institutional incentives and decision making is outlined in this quote from MMT advocate Dan Kervick (emphasis mine):
When a central bank announces that it is prepared to buy government securities, the announcement automatically guarantees an eager private sector market for the securities – if there wasn’t one already. If dealers know that they can promptly re-sell newly purchased securities to the central bank, at some amount over the purchase price no matter how low, then they know they can make a profit from the purchase.
So long as the central bank is buying, the term and price of the security is not even that important. If some imaginary government sells a dealer a 10-year security on Monday at some rate of interest X% and at a purchase price of $Y, and the central bank purchases that security on Tuesday for a price of $Y + $1, then the dealer has made $1. And $Y + $1 is always better than $Y. When the government redeems the security ten years hence, the entire X% interest payment is returned by the central bank to the treasury. So as long as the central bank buys the security, it really doesn’t matter much whether X = 1/10 or X = 100. And so as long as the central bank signals a willingness to buy government securities, there will always be a private sector market for the securities, regardless of the yield. The buyer needn’t care about the official yield at maturity, only the spread between the purchase price and the price the central bank pays to buy it back. But as a result of this reality, a government working with a sufficiently aggressive central bank can set whatever yields it wants.
Kervick makes this point in order to argue (correctly) that the US needn’t worry about a Greece-like default, but for the purposes of this post, the above two quotes (from easy money advocates, mind) expose the error in relying on the bond market as a reliable indicator of inflation expectations. He is also describing the conditions that characterize bubbles, although I suspect that isn’t his view. But he correctly points out that institutional demand, particularly during this era of unconventional policy, has been driven by the willingness of central banks to buy securities. Bernanke’s quote corroborates that. Crucially, Kervick states that the buyer doesn’t necessarily care about the yield at maturity, only the fact that the bonds it buys can be sold to the central bank at a profit. In other words, institutions are not making decisions based on fundamental factors (such as inflation, or perceived inflation), but simply on the fact that the price of what they buy will go up in the future as there is a guaranteed buyer with unlimited money. It is no different to the litany of internet companies during the tech bubble with little or even negative profits being valued at outrageous sums simply because their share prices were going up. To draw fundamental conclusions from such a scenario is misguided, to put it mildly.
Having identified one ‘problem’ with the hard money approach, he notes another, larger issue:
But the even bigger problem is that it does not account for the opposite risk: that insufficient monetary easing can spur an economic crisis. To see that risk, you only have to look to southern Europe, which has been forced into monetary austerity by the European Central Bank.
The New York Times reports today about a trend in Spain, where unemployment exceeds 25 percent: Employees who are no longer getting paid are continuing to work because they think they are more likely to eventually get payment from their current employers than to find a new job.
There is a tendency to think about monetary easing as a naughty, short-sighted solution that puts short-term gain ahead of long-term economic interests. But as Ramesh Ponnuru and David Beckworth have explained, that is wrong. Easing, when deployed at the right times, spurs real economic growth and avoids spikes in unemployment. In other words, it’s the medicine that prevents Spain-type disasters.
The apparent lack of perspective of the hard money types is a running theme throughout the piece. It is based on the basic idea that harder money regimes tend to lead to falling prices, which in mainstream economic theory is always bad. Thus, Barro implies that hard money types are out of touch and lack perspective because their view supports an outcome which is obviously bad. Ironically, the foundation of Barro’s point, the almost tautological view that falling prices = bad, is itself lacking in perspective.
The bias towards falling prices in much of the Western world is a direct result of the prior boom period that prevailed roughly up until the end of 2007. Long story short, the boom was driven by expansions of debt and increased leverage by various actors which drove asset prices to a point at which it could not be further sustained by further private sector borrowing and spending. The resulting period of deleveraging which began in 2008 was an attempt by the private sector to restore its debt levels to a more sustainable amount. This has a depressing effect on prices, given the credit expansion that drove prices higher in the first place now ceases to exist. Allowed to play out to its completion, the result is a level of prices and debt that is much more in line with the incomes of households and businesses.
The issue for easy money advocates like Barro is the troubles that accompany the path to this more sustainable outcome in the long term. The deleveraging of the household sector results in decreased spending at elevated price points, leading to reductions in profits for businesses dependent on those sales. This, in turn leads to increasing unemployment and a depressing effect on wages. Easy money advocates call for expansive monetary policy to mitigate these unfortunate circumstances.
This is at the heart of the differences between the two camps. The easy money advocates believe that the immediate issues of decreased spending, falling prices and rising unemployment must be fought at all costs. The opposing camp views these issues as unfortunate, but necessary components of a lasting recovery.
The hard money view would see nominal prices fall to meet incomes, while the easy money view would see nominal incomes rise to enable demand at higher prices. As stated before, prior to the collapse the higher prices were driven by higher debt loads and increased leverage by the private sector. In order to maintain higher prices going forward requires more debt, but as of 2008 the private sector is no longer capable of shouldering that burden. This is where the easy money advocates point to government and central banks. Easy monetary conditions facilitated by the latter and more debt and spending by the former can take the baton from the private sector and continue to support prices.
The immediate effects of this approach are usually positive, with respect to metrics such as GDP and unemployment. The problem with this path lies in the long term. The easy money advocates believe that government and central bank stimulus can hold the fort, stabilizing prices while the economy ‘recovers,’ at which point the private sector will be able to resume spending and borrowing and the government can remove its support. Logically this story falls apart very quickly given that the only reason easy money policies are ‘necessary’ now is because the private sector is still deleveraging. Once the private sector finishes the deleveraging process, sustaining the higher level of prices the easy money served to keep intact will be impossible without the private sector binging on debt like it had before. In other words, it will have to return to levels of debt and leverage it already proved it could not sustain, given those levels resulted in crisis.
The only alternative for the easy money advocate is that the government and central bank will have to continue providing support for the economy at the elevated price level. This too breaks down eventually because governments are not immune to the problems owing to excess debt loads and high leverage. Too much debt issuance can lead to higher borrowing costs which put further strain on budgets and increase the chance of default. In countries in which its central bank can just print money to buy bonds this ‘explicit’ default risk is transformed to an ‘implicit’ default via the repayment of debt in depreciated currency.
In the United States, the easy money prescription fighting price declines has been carried out, with the public sector debt expansion and unprecedented monetary easing by the Federal Reserve seeking to offset private sector deleveraging. The focus on GDP figures and a slowly improving employment picture seemingly buttress the easy money position, as the US has performed better in these metrics compared to the rest of the developed world. As stated above, the issue is one of longer term sustainability. The employment and consumer spending improvements have occurred against a backdrop of declining real wages. This is not surprising given the simultaneous existence of downward pressure on nominal prices amidst the support of general prices via easy monetary policy. The key here is that with a flat, or declining real income, the average wage earner is in no position to increase his or her debt burden. Thus, the last part of the easy money plan becomes impossible as the private sector is in no position to assume the ability to sustain demand at the higher price level. Thus, the support must continue from the government and central bank in perpetuity should the easy money dictum of ‘no falling prices’ be adhered to.
Prior recessions didn’t face this ‘dead end’ with respect to the easy money solution because there was a continued willingness by the private sector to increase its borrowing. However, unless one can show that it is possible for this willingness to increase in perpetuity in an exponential manner (hint: it can’t), there was always going to be a point where the private sector was going to be forced to deleverage. And at that point, in order to further support the elevated price levels the public sector will have to step in indefinitely, or until the currency is destroyed, whichever comes first (it’s the latter).
Easy money is better described as a ‘masking agent’ as opposed to the ‘medicine’ description Barro gives it. A situation in which the disease was overleverage and excess debt is not cured by increasing the leverage and debt to the same end (supporting prices), even if the actor taking on the debt is different. That action merely masks the problem and pushes it off to a different date in a different guise. Spain-type disasters are only prevented by not getting over levered and overburdened by debt in the first place. Having done so and blown up a massive property bubble in the process, the only real solution is to allow it to deflate as quickly as possible. Barro continues dissecting the ‘lack of perspective’ in the hard money position:
But another is to see it as reflecting a lack of perspective. (Ted) Cruz focuses on inflation’s effects on savers and their investments. It’s true: Unexpected inflation hurts long-term bondholders. But the typical middle-class person holds few (if any) inflation-sensitive investments and might well be advantaged by inflation that reduces the real amount of a mortgage balance.
This does not mean there is a plan by the “rentiers” to enrich themselves at the expense of the masses through tight money. While overly tight monetary policy and the high unemployment that ensues is especially bad for the poor, it also holds down real economic growth and is a decidedly negative sum game. If tight money is a conspiracy against the masses, it’s not a clever one.
It is true that unexpected inflation hurts long term bondholders. It is also true that expected inflation hurts bondholders. Quite frankly, inflation hurts anyone who holds the inflated currency. That the inflation is predictable or unpredictable just indicates the predictability or unpredictability of one’s possible loss of purchasing power. The picture Barro paints of a typical middle class person not being exposed to this risk while benefitting from the debt eroding property of inflation is a bit flawed. For a start, plenty of middle class people are exposed to fixed income in an increasing manner via their 401k. Note the exodus of funds from equity mutual funds into those of fixed income over the last few years.
More importantly, the idea that mortgage debt being eroded by inflation is a good thing for society does not take into account the large swaths of people (including many current homeowners) who cannot afford to buy a home at current prices. By continuing to inflate housing prices, a segment of the population is forever priced out of housing, unless of course they succumb to impossible debt burdens themselves. Many of that population (twenty and thirtysomethings) have accrued mortgage sized debt from college loans. This means that the very group tasked with the goal of boosting housing prices further by taking on more debt is exactly the group in the worst position to do so. Instead of allowing the price for homes to fall to a market clearing level, the easy money prescription of intervention means that the price stays elevated.
Should prices fall to market clearing level; by definition they will still be occupied. They will still have owners. They will just be different owners than exist currently, owners that are more capable of affording the home than their prior owners were. Getting from A to B is messy however, with foreclosures, personal bankruptcies and evictions being nasty occurrences. This is what the easy money crowd wants to avoid. But unfortunately, it is impossible for easy monetary policy to instantly achieve the desired sustainability. In the attempt to avoid the nasty side of restructuring, the easy money crowd is prepared to preserve the prior structure which couldn’t be sustained, to the detriment of some group of individuals. That is another takeaway: both easy money and hard money solutions impact some segment of the population negatively. The difference is that with the easy money solution the inherent flaws of a bubble economy are allowed to fester until some future date, while they dealt with immediately in the hard money solution.
Barro touches on the myth that the segment of the population most negatively affected by hard money policies is the poor. This is because harder money policies tend to increase the real values of debt burdens. While true, it also neglects the fact that the general decline in prices means that the cost of living has also fallen as well. For people with manageable debt burdens, these effects offset. Overburdened individuals may find the increasing real debt burden too much for them and may have to default and seek bankruptcy. This unfortunate circumstance is mitigated by the fact that, owing to the reduced costs of living, the need for increasing one’s debt in order to maintain a standard of living is diminished.
That higher unemployment and lower GDP (not necessarily interchangeable with economic growth) are a result of the hard money response isn’t disputed. What is disputed is the meaning of those developments. The fact that a bubble economy such as Spain’s (or the US) can’t be sustained means that the jobs that were created in its formation also can’t be sustained. GDP, which is really a measure of total economic spending, declines when the bubble bursts as the bubble spending also can’t be maintained. The easy money view sees it better to keep these metrics constantly moving in a ‘positive’ direction, even if that means preserving an underlying bubble economy that can’t sustain. In my view, that is where the true lack of perspective is displayed.