‘I see the problem of recovery in the following light: How soon will normal business enterprise come to the rescue? On what scale, by which expedients, and for how long is abnormal government expenditure advisable in in the meantime?’
John Maynard Keynes, New York Times, 1934
In 2009, then Federal Reserve Chairman Ben Bernanke outlined the ‘exit strategy,’ the steps which the bank could take to reverse its response to the Financial Crisis and subsequent Great Recession. Several measures were described with which the Fed could use to ‘tighten monetary policy when the economic outlook requires us to do so.’ Since then Fed began its systematic reduction of its latest easing program last fall, a process colloquially termed as ‘tapering,’ the discussion about the appropriateness of continuing further to normalize monetary policy has intensified. Some argue that the current economic expansion is evidence that the time is right, while others point out that the absence of significant consumer price and wage inflation dictate that not only is a complete exit premature, but so too is a shift towards the exit, which is what tapering represents.
What is nearly universally agreed upon is the idea that at some point the Fed has to exit. Sure, now might not be the right time, but a right time definitely exists, and the Fed will act accordingly when that time comes. Unfortunately, adherents of this view have been, unbeknownst to them, applying the Underpants Gnome business model to economics. For anyone unaware, the underpants gnomes were characters from an early South Park episode. Long story short, their claim to fame was their absurd presentation of their business model, which was the following three step plan:
- Collect Underpants
(Incidentally, had the underpants gnomes prepared their plan in prospectus format, I have no doubt they would have been able to go public at some point in the last three years, complete with multibillion dollar valuation, financial television fanfare, and photo ops at the NYSE, such has been the current financial climate and the intensity of the ‘chase for yield’)
The plan as applied to economics, or, the Underpants Gnome Economic Plan (UGEP), is basically the playbook the Federal Reserve follows when economic downturns present themselves. It is the following:
- Ease monetary conditions
- Demand for consumption and investment goods is restored, thereby restoring Economic Growth
- Growth feeds upon itself in a virtuous cycle
This playbook is heavily influenced by Keynes. As such, the vast majority of economic observers have by this point raised an eyebrow at the fact a comparison is being made between the foolishness of the Underpants Gnomes and the apparent time tested wisdom of Keynes. Indeed, there is even a tangible step 2 in the ‘Keynes’ version of the plan, so what gives? What gives is that most commentators are guilty of celebrating at halftime. After taking the events triggered by each step to logical conclusions over time it is becomes clear that this new step 2 is just as full of question marks as the South Park counterpart.
Step 1 – Ease Monetary Conditions
An interesting thing happened in late June/early July 2014. The Bank of International Settlements published its annual report which outlined its view that the actions taken by major central banks – including the Fed – are fraught with risks and the situation must be addressed. This is of interest only because of the source of the argument, not necessarily the argument itself. The BIS aligned itself with the Austrians, who until now had been the loudest proponents of this view. Perhaps it was merely a case of playing devil’s advocate, but the BIS paper did represent a clear split from the mainstream view from an entity very much in the mainstream camp. Janet Yellen, the current Fed chairman, essentially presented a defense of the Fed’s, and indeed the mainstream view, in a speech given a few days later at the IMF. At one point during the speech, she briefly commented on the role accommodative monetary policy has played in the recovery, stating:
In recent years, accommodative monetary policy has contributed to low interest rates, a flat yield curve, improved financial conditions more broadly, and a stronger labor market. These effects have contributed to balance sheet repair among households, improved financial conditions among businesses, and hence a strengthening in the health of the financial sector.
The interest rate is ultimately a manifestation of the perceived value of future goods in relation to present goods. All else equal, a collective preference for future goods will result in less consumption in the present, and more savings. This build up in savings is an increase in the supply of funds available for loans. As with any increase in supply, downward pressure is exerted on the price of that good, all else equal. With respect to interest rates, the end result is thus a lowering of the interest rate. Similarly, collective preference for present goods over future goods will eventually result in an increase of the interest rate.
Times of financial crisis are usually characterized by a lack of investment stemming from the diminished supply of loanable funds, which exerts an upward pressure on interest rates. In due course, market forces would address this issue through the higher interest rate incentivizing more saving and lower consumption of present goods. The mainstream, Keynesian view, does not wish to wait for the market to do as it must, because, according to Keyes ‘in the long run we are all dead.’ Meaning the consumer good price declines associated with increased savings and lower consumption in the short term will eventually lead the economy to a place it can’t recover from in the long run.
The Federal Reserve thus acts to bring about lower interest rates and easier financial conditions through its open monetary operations, circumventing the slower market process of increasing savings and the supply of loanable funds. In simply creating money and using it to buy existing government bonds from financial institutions, the Federal Reserve can expand the total supply of loanable funds in those institutions, which in turn serves to lower the interest rate towards whatever rate the Federal Reserve desires (currently zero), thereby making investment more viable in the immediate term.* Thus, the foundation upon which a new economic edifice can be built has been set.
*As an aside, I am fully aware of the fact that, in practice, commercial banks are technically the initiators of the expansion in the supply of loanable funds by making loans, regardless of their deposit level. This fact has been misinterpreted by many commentators as evidence that the Federal Reserve doesn’t really have control over this process and that they are merely passive actors. The reality is that institutions which exceed their required loan to reserve ratio temporarily must rectify that by either selling an asset, or borrowing funds from other institutions – actions that prevent the ability of the system as a whole to increase the supply of loans – unless the Fed is there to provide the extra liquidity needed. For more read the following.
Step 2 – Restoration of Economic Growth via Increased Demand
What is economic growth, and how does the process initiated in step one lead to it? For a brief, yet comprehensive explanation of economic growth and how it manifests itself in society, consider the following from John Hussman, who writes a must read weekly commentary. The full column I reference is here.
The standard of living of a country is measured by the amount of output that individuals are able to consume as a result of their work. The productivity of a country is measured by the amount that individuals are able to produce as a result of their work. Over time, growth in the standard of living is chained to and limited by growth in productivity. Productivity, in turn, rests on two factors: a productive capital base, and an active pool of productive domestic labor. The accumulation of productive factors is what drives long-term growth.
Economic growth is a process, which begins with the accumulation of productive factors (labor and capital), is continued through the act of production and completed with the act of consumption. The only way to achieve growth is to accumulate those factors of production. As mentioned earlier, financial crises are characterized by a lack of investment. Said differently, financial crises are characterized by a failure to accumulate capital and labor for use in productive activity. This is what policymakers seek to rectify when embarking on step one, the easing of financial conditions.
An important feature of the Underpants Gnome Economic Plan is the fact that the increase in loanable funds from the Federal Reserve is immediate, compared with the indeterminate period of time it may take unaltered market forces to solicit more loanable funds via increases in interest rates. Be that as it may, what is not and can never be increased with such promptness is the supply of real, productive factors. For example, at this exact moment in time, there are X tons of steel in existence, available for use in production. One second from now, there may be $X billion of new funds in the financial system courtesy of the Federal Reserve, some of which may be eventually used to fund investments which require the use of steel. In that second however, no new steel had been added to the stock of steel available. In order for more steel to become available, iron ore and other natural inputs must be collected, fashioned in blast furnaces, subjected to various other treatments and so forth. This takes considerably longer than the split second it takes the Federal Reserve to create billions of new dollars. This is important because it means that the only thing that the Fed can actually accomplish when it eases financial conditions is to promote spending on existing factors of production, rather than to promote the accumulation of additional productive factors, which, as Hussman points out, is the driver of long-term growth.
Since the immediate effect of step one is increased economic activity, shown in the increased demand for investment and consumer goods, most observers see little objectionable about it. Paul Krugman, the most visible of the mainstream economists, crystalized this belief in a column written last November, emphasis mine:
This is the kind of environment in which Keynes’s hypothetical policy of burying currency in coalmines and letting the private sector dig it up – or my version, which involves faking a threat from nonexistent space aliens – becomes a good thing; spending is good, and while productive spending is best, unproductive spending is still better than nothing.
Larry [Summers] also indirectly states an important corollary: this isn’t just true of public spending. Private spending that is wholly or partially wasteful is also a good thing, unless it somehow stores up trouble for the future. That last bit is an important qualification. But suppose that U.S. corporations, which are currently sitting on a huge hoard of cash, were somehow to become convinced that it would be a great idea to fit out all their employees as cyborgs, with Google Glass and smart wristwatches everywhere. And suppose that three years later they realized that there wasn’t really much payoff to all that spending. Nonetheless, the resulting investment boom would have given us several years of much higher employment, with no real waste, since the resources employed would otherwise have been idle.
As Yellen described at the IMF, the resulting infusion of cash into the economy from step one, localized in the financial sector, was deployed in various markets, positively affecting those prices. Generally, the process served to increase the supply of loanable funds. The increase in the supply of loanable funds enables more debt to be undertaken to fund investments. This increases the demand for goods and services related to the production process, as well as the securities of the companies involved. A further benefit has been increased demand for the labor required to see out the production process, and the greater demand for consumer goods and services the factors of production exhibit (a construction worker hired will be paid and in turn will use that money to buy consumer goods and services).
The problems present themselves in the longer term. The immediate phenomenon of increased demand for productive factors sparked by eased financial conditions leads to increasing costs of production (more money available for an unchanged stock of productive goods). From the perspective of the producer, this sort of increase in costs cannot be controlled. What can be controlled is the labor cost, the increase of which is kept to a minimum to avoid further gains in overall production costs. To translate: a limited rise, if any, in wages. The overall increase in production costs necessitates increasing prices of finished goods in order to recoup those costs with a profit. To the extent there is demand for those finished goods at an increasing price point is the length to which this step of the UGEP will succeed. The limiting factor is the fact that any wage increases lag behind price increases, eroding the capacity for income earners to spend. This capacity to spend can be ameliorated through debt, but that too is capped by wages. This scenario is illustrated in the following chart of real hourly earnings.
The highest data point on this graph is December 2008, which is when the Federal Reserve began its Quantitative Easing program. Since then real wages have declined, although not precipitously. Nevertheless, a restrained ability to spend does exist, particularly when the task is to spend at higher prices. This limit on demand means that at some point, the higher prices producers require to realize profitability cannot be commanded in the market. This downward pressure on prices leads to lower demands for future investment at the current price levels, which puts the economy back at square one.
Returning to the Krugman quote above, his example of illustrates the point quite nicely. Corporations flooded with cash (easy financial conditions) engaged in plenty of spending on ‘investment goods,’ such as Google Glass and smart wristwatches. If years later, the cost of all of that spending did not produce a positive result, such as increased productivity, the end result has clearly been a waste of resources. The natural resources, time and labor that went into the production of those smartwatches and Google glass could have been used to produce something which added to the stock of goods and services that are desired by us as humans. This would have increased the standard of living of humanity. Instead, nothing of value was produced, nothing was added to society, the standard of living was not improved, but rather reduced, given the potential improvement to the standard of living which was nullified.
According to Krugman and most mainstream commentators, none of that matters. The long run failure is an afterthought compared with the fact that in the short run there was spending. The perverse nature of this isn’t highlighted as much in Krugman’s example, given that on the face of it, the economy is prosperous enough not to feel a great deal of loss of capital in wasted smartphones and Google Glass. But these ideas are what drive policy for the economy as a whole. The result is a systematic destruction in capital, which effectively equates to a systematic decline in the standard of living. As shown below, decades of UGEP implementation across multiple business cycles have left us with progressively slower rates of capital accumulation, and progressively lower business investment as a percentage of the overall economy, ultimately indicating progressively lower increases in the standard of living.
In the long run, this is a step which is doomed to fail.
Step 3 – Growth Feeds on Itself in a Virtuous Cycle
Even though the UGEP is destined to fail by the completion of step 2, much like the original underpants gnomes plan, its initial success gives rise to the belief that eventually step 3 will be realized. The idea is that once evidence of growth appears, the Federal Reserve can exit to avoid the ‘inflation problem’ Bernanke wrote about in 2009. Once removed from the picture the market can stand on its own two feet, engaging in the accumulation of factors of production, production itself and consumption at the higher levels the Federal Reserve’s efforts engineered, under ‘normalized’ financial conditions.
Depending on whom you ask, this step is either in full swing, still in its embryonic stages, or so lacking in veracity that it is not really apparent that step two has even been completed. The policy recommendation of each camp thus varies from a push to normalization of monetary policy, a more cautious ‘wait and see’ approach, and a push for increasing accommodation, respectively. Indeed, the question posed by Keynes in the introductory quote is as relevant now as it was 80 years ago.
At the moment, the Fed is in self-proclaimed ‘wait and see’ mode, despite tapering, the first step along the normalization path. Yellen has reconciled this apparent discrepancy by repeatedly stating that the Federal Reserve stands ready to either engage in more or less accommodation, based on how the data looks. Perhaps the most important data point is inflation. Within the context of the UGEP, inflation acts as a buoy which helps the Fed navigate the currents of recovery. According to the playbook, the appearance of certain levels of inflation indicates that the recovery has progressed to a level that warrants the tightening of monetary conditions. Yellen has reiterated that those levels of inflation have not presented themselves in a sustained manner, and as such an accommodative level of policy is still justified. The important point here is not whether or not we are currently at levels that warrant tightening, but that the Federal Reserve will maintain accommodation and even increase it until it gets there. Thus for the purposes of this piece I will proceed forth with the exiting process.
Tightening monetary policy is simply the reverse of easing. Instead of creating money to buy government bonds and other assets, the Federal Reserve sells the assets it previously collected into the market. This selling removes cash from the market and draws it into the Federal Reserve. The effects of the easing process are also reversed under tightening conditions. Whereas easing enabled financial institutions to increase loans thus increasing the demand for goods and services, tightening decreases the wherewithal firms have to extend loans. All else equal, this decreases the demand for goods and services, leading to downward pressure on prices. While this may be ok in terms of putting the lid on prices before they rise too quickly, it also serves to compromise firms which needed those price increases to clear rising production costs, as previously noted above.
To explain differently, recall the discussion of the rate of interest in step 1. As mentioned, it is the manifestation of the value of future goods versus present goods. The manner in which the Federal Reserve eases monetary conditions enables valuations of future goods to rise while preventing valuations of present goods from falling such that the interest rate can be lowered seemingly without consequence. These increased valuations are backed by increased funds emanating from the Fed. The increased demand raises prices. When the Fed tightens, the reverse happens, as less dollars in circulation means less demand for goods and services, leading to lower prices. In theory the Fed should want this to happen at this point in the sequence, because thanks to excessive economic growth, prices have advanced too quickly.
Not only does active tightening place downward pressure on prices, but inaction by the Fed also leads to lower prices. Once prices have been pushed higher via accommodative policy, their continued rise depends on continued demand, which can only express itself when there are increased dollars in circulation. A relatively stable money supply does not suffice, and compared to an expanding supply, this stance is actually tighter, even though the absolute level of money in circulation may be very high. This is especially true in the face of an increased supply of goods and services.
No Way Out
Embarking on the UGEP eventually leaves the Fed with 3 choices: continue increasing accommodation in perpetuity, hold station at some level of accommodation, or actively tighten. All of them end in tears, meaning there really is no way out. The bottom line is that anything other than constant, increasing levels of accommodative policy will undo the gains made in prior rounds of accommodation, either during step 2 or step 3. Perpetual accommodation leads to an ‘inflation problem.’ The idea that the Fed can get in, stabilize conditions, and complete step 3, exiting without any problems is pure fiction, although the UGEP regards it as the truth. Yellen unintentionally supported the point of view that there is no way out at the IMF speech, when speaking about the prior expansion period in the middle of the last decade. Her remarks came in addressing the idea that the Federal Reserve should possibly have pricked the housing bubble of the last decade earlier through tighter policy so as to prevent the bubble from getting as large as it did. Emphasis mine:
It is not uncommon to hear it suggested that the crisis could have been prevented or significantly mitigated by substantially tighter monetary policy in the mid-2000s. At the very least, however, such an approach would have been insufficient to address the full range of critical vulnerabilities I have just described. A tighter monetary policy would not have closed the gaps in the regulatory structure that allowed some SIFIs and markets to escape comprehensive supervision; a tighter monetary policy would not have shifted supervisory attention to a macroprudential perspective; and a tighter monetary policy would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in risk measurement and risk management within the private sector.
Some advocates of the view that a substantially tighter monetary policy may have helped prevent the crisis might acknowledge these points, but they might also argue that a tighter monetary policy could have limited the rise in house prices, the use of leverage within the private sector, and the excessive reliance on short-term funding, and that each of these channels would have contained–or perhaps even prevented–the worst effects of the crisis.
A review of the empirical evidence suggests that the level of interest rates does influence house prices, leverage, and maturity transformation, but it is also clear that a tighter monetary policy would have been a very blunt tool: Substantially mitigating the emerging financial vulnerabilities through higher interest rates would have had sizable adverse effects in terms of higher unemployment. In particular, a range of studies conclude that tighter monetary policy during the mid-2000s might have contributed to a slower rate of house price appreciation. But the magnitude of this effect would likely have been modest relative to the substantial momentum in these prices over the period; hence, a very significant tightening, with large increases in unemployment, would have been necessary to halt the housing bubble.2 Such a slowing in the housing market might have constrained the rise in household leverage, as mortgage debt growth would have been slower. But the job losses and higher interest payments associated with higher interest rates would have directly weakened households’ ability to repay previous debts, suggesting that a sizable tightening may have mitigated vulnerabilities in household balance sheets only modestly.3
Similar mixed results would have been likely with regard to the effects of tighter monetary policy on leverage and reliance on short-term financing within the financial sector. In particular, the evidence that low interest rates contribute to increased leverage and reliance on short-term funding points toward some ability of higher interest rates to lessen these vulnerabilities, but that evidence is typically consistent with a sizable range of quantitative effects or alternative views regarding the causal channels at work.4Furthermore, vulnerabilities from excessive leverage and reliance on short-term funding in the financial sector grew rapidly through the middle of 2007, well after monetary policy had already tightened significantly relative to the accommodative policy stance of 2003 and early 2004. In my assessment, macroprudential policies, such as regulatory limits on leverage and short-term funding, as well as stronger underwriting standards, represent far more direct and likely more effective methods to address these vulnerabilities.
Yellen states that evidence suggests that the (low) level of interest had an effect on housing prices, and thus household leverage (easy financial conditions as per step 1 of the UGEP). She then links tighter policy to the adverse effects of higher unemployment and the inability for households to repay previous debt. It is interesting to note her explicit statement that it is the easing of conditions and the issuance of new debt which enabled households to pay off prior debts (and to indulge in other spending on consumer goods), very much in keeping with the UGEP framework. Her conclusion is that in the face of bubbles, the Federal Reserve is better off trying to regulate it away via ‘macroprudential policies’ than explicit tightening measures.
This reasoning is flawed, because any ‘macroprudential policy’ would have the same effect as explicit monetary tightening – that is it would serve to limit the increase in prices which are endemic of bubbles, and which are welcomed by proponents of the UGEP because it is a sign that accommodation is having a positive effect. Remember, in this framework any spending is good spending, even if it is unproductive. The obvious sign of increased spending is higher prices, so they are always a welcome sight. Looking back to the last bubble, the increases in complex financial derivatives, lower lending standards, and so forth were all noted in real time as existing and increasing at a high rate. However, the fact that these developments served to expand the bubble, and the increase in consumption and price appreciation that went with it meant that any dangers were rationalized away. As long as the objective of constant price increases is met, the methods by which these increases are obtained will never be questioned seriously, let alone regulated away in real time.
With respect to monetary tightening, if serious problems would have resulted from such a response in the mid 2000s, it stands to reason that the same sort of result would occur if applied to the current situation. Charles Evans, President of Federal Reserve Bank of Chicago, has echoed these concerns quite vocally in recent days. From a WSJ article covering a speech Evans recently gave:
“For me, the biggest and costliest downside risk is that in our haste to get back to ‘business as usual’ monetary policy, we could stall progress and backtrack to the economic circumstances of recent years” should rates be lifted prematurely, he said.
As he has noted in recent speeches, Mr. Evans is worried about repeating past policy mistakes, when officials have raised rates before the economy was ready. He sees that as a risk right now.
One can expect the likes of Evans to err on the side of more accommodative policy for a very long time. Evans and Yellen are presenting logic which is almost circular. Returning to normal rates would undo the ‘progress’ that suppressed rates enabled, so accommodative policy must persist. However, they both are ‘upbeat’ about the economy, which should necessitate rate normalization. But that would undo the progress made…
Indeed, within the post 2008 monetary regime, we have seen two instances of effective monetary tightening, namely the ends of the original QE and QE2. Ending in March 2010 and June 2011 respectively, their passing resulted in immediate drops in the S&P 500 (which I use here as a proxy for asset prices, the appreciation of which is a positive effect of the UGEP) of 16% and 21.8% respectively. Currently, the Federal Reserve is in the closing stages of tapering the latest round of QE, providing the economy another chance to show that it can stand on its own two feet. Given how it fared after the last two QE programs ended, and how the theoretical basis for continued growth in a world with less monetary easing is full of question marks, chances are the legs will look wobblier than those of Mike Tyson’s early opponents after being struck with a blow. Perhaps Evans and Yellen would point to those episodes as a sign that the economy wasn’t ready. But when will it ever be ready? When the economy is built upon a foundation of levitating asset prices, how can it ever be ‘ready’ to absorb prices which aren’t levitating as quickly, or even at all? It isn’t, which means that the Federal Reserve will ultimately have to reverse course on the accommodative continuum. Where it is currently moving towards normative policy, it will have to eventually move beyond accommodation into further uncharted easing.
The flaws in the UGEP ultimately stem from the fact that it does not allow the economy the time to accumulate the building blocks of economic growth, capital and labor, and to direct it in accordance to prices, and the changing spending habits of consumers. The UGEP circumvents the market attempt to reorganize capital and labor by forcing it into the same structure of production that existed before the crisis, a structure that was proven to be futile as evidenced by the existence of the crisis. In the process of trying to adhere to a broken structure, capital and labor are wasted. As such, having wasted the building blocks of growth, step 2 of the UGEP is an untenable, if not impossible prospect. As Hussman writes:
When the most persistent, most aggressive, and most sizeable actions of policymakers are those that discourage saving, promote debt-financed consumption, and encourage the diversion of scarce savings to yield-seeking financial speculation rather than productive investment, the backbone that supports a rising standard of living is broken.
From there, one wonders how a virtuous cycle of continuous growth can be achieved when merely sustaining growth at all isn’t possible, just as one wonders how a collection of stolen underpants may turn into profit.
There is simply no way out. But that won’t stop the Underpants Gnome Economic Plan from being the most widely supported and implemented view.