The Credibility Fairy

The SNB has to pick its poison. It is damned for one set of reasons if it holds the currency peg, and damned for another set if it ditches the peg. Welcome to the world of horrible dilemmas facing modern central banks.

Ambrose Evans-Pritchard, 15 Jan 2015

For every credibility gap, there is a gullibility gap

Richard Cobden

The decision by the Swiss National Bank (SNB) to release the Swiss Franc from the peg it had to the Euro, and indeed the consensus reaction to that decision, should disavow the notion that the current economic situation is not one that is based on the whims of central bankers. Since the Global Recession of 2008, the major central banks of the world have been trusted with the task of ‘fixing things.’ Owing to a shared economic philosophy of intervention in markets when things don’t go according to plan, the majority of mainstream economic commentators have a tremendous amount of faith in central banks, only quibbling with them on secondary issues.

In removing the peg, the SNB effectively tightened its monetary policy, thus doing an about face in a world in which the conventional view is that there is no such thing as monetary policy which is too easy. Thus, the SNB invited upon itself a torrent of criticism. Most of the criticism revolved around two ideas, the first being that the SNB decision is simply bad for growth prospects.

The second, and more interesting point of criticism, is the perceived loss of credibility the SNB has now sustained. Given the elevated stature the central banks have attained post-2008 as the ‘saviors’ of the world, their every policy announcement, press conference and media appearance has been treated by market participants and economic reporters as though it were the Word of God being delivered by Moses from Mount Sinai. When viewed in that context, it is easy to understand the disappointment in the SNB. An institution viewed by many as infallible abruptly reversed course, essentially admitting it wasn’t as foolproof as once thought. The ultimate significance of this, however, lies in the fact that the situation the SNB got itself in was a microcosm of the situation global central banks have gotten themselves into.

Less than two weeks after the SNB relieved itself of the peg, the European Central Bank (ECB) embarked upon a period which will be similarly trying. The much awaited entrance into the QE game went relatively smoothly, but it is the Greek elections that are sure to increase the tension across the continent. Should the victorious Syriza stick to its guns, the fabric of the status quo will surely be ruptured, further calling into question the fortitude of central bankers and other bureaucrats who have thus far been able to hold things together with mere assertions.  Alarmingly, it is this brand of ‘credibility’ upon which global markets rest.

The Critics of the Swiss National Bank Have It Wrong

Before delving into the wider significance of the SNB decision, the more proximate perceived consequence – a descent into recession – deserves further treatment. This view, of course, is nothing more than the old canard that deflation is bad, and thus, the instant appreciation of the Swiss Franc (CHF) is bad because will result in deflation, which in turn will lead to disaster. Below is a chart of EUR/CHF in the aftermath of the SNB announcement:


Violent as that move is, the move downward (stronger CHF) was a move in keeping with the underlying trend. Observe the following, which is a chart of EUR/CHF over the last 10 years.


EUR/CHF made its last major top in October 2007, at a price of roughly 1.682. It then spent the better part of 4 years trending lower, flirting with parity, before the SNB acted in September of 2011 to peg EUR/CHF at 1.20. The critics claim that the ending of this peg, and the resumption of the downtrend (EUR/CHF traded as low as 0.85 after the announcement), will lead to recession for the Swiss economy. If the move from 1.20 to 0.85 will usher in pain and suffering, then surely we can look to the move from 1.68 to parity for some insight as to how much damage will occur, and what the Swiss can do to brace themselves. The following is a chart of Swiss inflation during the time in question:


As one can see, the inflation rate was less than 1.5% for all but 18 months of the nearly 9 year period depicted. This is particularly worrisome for modern economists who believe that inflation rates that are ‘too low,’ as defined as being below 2%, are the starting point for economic disaster. Given the Swiss economy spent the best part of 9 years in this condition, one would expect Switzerland to be an economic wasteland by now.

The following is a look at the unemployment from 2007, through to the present:


Now Exports from the same time period:


Retail Sales:


Hardly gloom and doom, and hardly what one would expect if one accepts mainstream economic theory with respect to strong currencies and falling prices. To put it plainly, price movements are the effects of changes in real economic developments. Modern economists mistakenly treat price movements as the cause of real economic developments. It is not the change of price that should be feared or welcomed in isolation; it is whatever caused that price change that needs to be assessed to determine the positivity or negativity thereof. With respect to the Swiss economy, it is on relatively sound footing, and Swiss companies in general produce high quality products that are widely sought.  The result of that is continued demand for Swiss Francs, as well as downward pressure on prices thanks to high productivity.

Unfortunately, the recognition of the unambiguously positive condition of economic stability/progress has been trumped by the modern fear of falling prices. This has led central bankers, fervent adherents of these faulty views, to prioritize the state of price trends above all else. The fact that the SNB felt it had to initiate the peg, in the face of positive real economic developments was Munchausen-like. Yet it was viewed as sound policy across the sphere of economic commenters.

Redefining Credibility

If taking putting the peg on – to keep the Deflation Boogeyman at bay – was sound policy, then taking it off must be suicide. So it was reported, in the aftermath of the SNB decision. Apart from the predictable calls for Swiss recession, the belief that the SNB had completely lost its credibility was the most revealing one to me.

What the SNB essentially did was admit that it could no longer fight the trend of CHF appreciation. In order to prevent CHF from rising, it had to purchase large quantities of Euros, thereby saddling its balance sheet with assets that were more likely than not to continue depreciating.

Furthermore, the sheer size of these purchases, in comparison to the size of the Swiss economy meant that the SNB was taking great risks in creating dislocations elsewhere. The drastic reduction of interest rates triggered by the SNB actions enticed borrowing in CHF, mostly for mortgages. Both domestically, and in neighboring parts of Central and Eastern Europe, household borrowing increased, leading to a Swiss property market which is frothy, if not an outright bubble.

In ending the peg, the SNB prevented further losses to its balance sheet, and prevented the continuation of a negative process in which cheap loans foster unsustainable asset increases, which in turn begets more credit creation to sustain further asset price increases, and so forth, before an inevitable bust. That this behavior constitutes irresponsibility, and signifies a loss of creditability should give one insight into the Orwellian nature of modern economics.

Some point to the fact that the SNB made the move in a surprising fashion. To use modern econospeak, the SNB did not ‘telegraph’ their intentions beforehand, even stating that the peg was the centerpiece of its policy only days before the January 15th announcement. For market participants to take umbrage with this sort of bait and switch further underlines the importance of central bankers over the state of affairs. In other words, market participants have now elevated the central banker to deity, and without his or her guiding hand at every step of the way, the market is lost. The kicker is that most of those people will turn around and claim we have free markets.

The bottom line is that the SNB peg made no discernable economic impact that could be credited to the policy itself, rather than the intrinsic nature of the Swiss economy. Yet it was creating problems in the shape of a possible credit boom and future risks of increased prices. Modern economic dogma completely disregards any risks of central bank policy as long as it is done in the name of deflation prevention.  According to most economic commentators, the ‘dilemma’ Ambrose Evans-Pritchard alludes to in the opening quote does not really exist. As long as deflation is avoided, the belief is, nothing else matters. Any problems that do occur are rationalized away, misattributed to some other reason, or simply ignored.

The myopia of deflation-phobia is so acute that Larry Fink, CEO of BlackRock, thinks that the Swiss not going into recession as a result of CHF appreciation is a risk. His rationale is that the Swiss negotiating the CHF appreciation smoothly will send the message to Germany that ‘de-pegging’ from the Euro in the shape of returning to the Deutschmark will be sound policy. The truth is that it probably is the right course of action, but the message is clear from Fink: the Status Quo must be defended.

When it comes down to it, this is the heart of the matter. The SNB and the Swiss economy in general have simultaneously shattered two, if not three tenants of status quo economic belief. The first is regarding the perniciousness of strong currencies, which I have discussed before.

The second is the more general view that central authorities can reliably and indefinitely counteract trends in real economic conditions through printing money, and can stop at any time without negative effects. Recall the EURCHF chart from the time of the SNB announcement, reproduced here:


Also, recall that the 3.5 year peg did not prevent the underlying trend from resuming. Real economic conditions always win out, regardless of the actions of central bankers. The only thing the SNB succeed in doing was change the date when the EURCHF traded down to 0.85. Instead of happening in 2012 or 2013, or some other time, it happened in 2015. But it was always going to happen. What the SNB did accomplish was enabling that move to happen in the space 30 minutes instead of 30 months. In other words, as a result of the peg, the move was far more violent and disruptive, as virtually nobody had time to adjust to the movement, a feeling that many in the financial world as well as Eastern European debtors can attest to. A much more protracted and orderly decline would have been much better.

What is truly alarming is that every major central bank across the developed world has done the same thing as the SNB did, writ large. They have not necessarily employed the same tactics as the SNB in that a currency peg was not the tool of choice. However, the major central banks of the world have all done the same thing in that they have all engaged in expansionary policy to fight real economic conditions. More specifically, they have engaged to fight the effect of weakening economies – deflation – rather than to cure the causes.

In essence, the 3.5 year period of peg-induced stasis on the EURCHF chart is analogous to the stimulus-induced stasis in low growth rates experienced by much of the developed economies. As Evans-Pritchard suggests, the dilemma for central bankers will come when they stimulate to the point where prices are too great and debt loads to excessive for the average consumer to bear. From there, the choice is either to further stimulate, risking total destruction of the currency, or the cessation of stimulus, which will see a sharp drop in growth rivaling that of the EURCHF chart after de-pegging. One thing is for certain, and it is that real economic conditions will assert themselves once again. They always do. To the extent that policymakers keep fighting the effects of these conditions rather than their causes will be the extent that they further expose the futility of their efforts, This in turn exposes the futility of the ideology it is based on, thus terminally losing the credibility they seem to hold so dear.

Underpants Gnome Economics

‘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:

  1. Collect Underpants
  2. ???
  3. Profit

(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:

  1. Ease monetary conditions
  2. Demand for consumption and investment goods is restored, thereby restoring Economic Growth
  3. 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.

Is Keynesianism Misrepresented?

I came across this interesting piece from Cullen Roche last week, in which he critiqued a critique of Keynesianism written by John Mauldin. In it Roche takes Mauldin to task for not only the usual crimes of not viewing the world through a MMT lens (even though that lens is just an obfuscation of reality enveloped in ‘accounting realities’), but for misrepresenting Keynesian economics. Perhaps one day I’ll take on MMT tenets in full, but the focus of the piece was on the obfuscation Mauldin was guilty of, namely the misrepresentation of Keynesianism. (more…)

The Debt Ceiling, Government Shutdown and Optics

In contemplating human transactions, the law of optics is reversed; we see the most indistinctly the objects which are close around us; we view them through the discoloured medium of our own prejudices and passions; the more familiar we are with them, the less truly do we estimate their real colours and dimensions.

– Richard Whately

We are currently in the midst of another government shutdown, which, in conjunction with the fast approaching debt limit, present plenty of discussion topics in early fall. With respect to the shutdown, the media has been in full blown crisis mode with its coverage, complete with pundits lamenting over the good old days. Like when President Reagan and Tip O’Neill were chums and bipartisanship was the way of the world. Except, of course, during the eight government shut downs that occurred during the Reagan administration. Of course one can point to the fact that they were different then, but every shutdown is different. Even prior to the Reagan shutdowns, President Carter went through several shutdowns, including five separate shutdowns revolving around abortion. This discrepancy between the actual goings on and the narrative highlights the issue of optics. The combined debt ceiling and government shutdown saga has allowed for the construction of the idea that the entire US economy is on the verge of collapse – all thanks to the Republicans. The following points help to shape the optics supporting that idea:

‘The Move to Shut Down the Government is Unprecedented in its Irresponsibility’

The narrative with respect to this shutdown, largely speaking, is that the Republicans in the House – the Tea Party in particular are being a bunch of children who are throwing a temper tantrum because they don’t like the legislation being passed. In fact the view is that it’s more pernicious than that, with opposition pundits and members of Congress accusing the Republicans of being terrorists holding the nation hostage with bombs strapped to their chests. This implication of the Republicans engaging in untoward or egregious tactics is out of order. A body of congress inducing a shutdown as part of negotiations isn’t unprecedented, as I wrote before it’s happened plenty of times over the last 40 years. Chris Matthews, speaking last Sunday attempted to differentiate this shut down from prior ones, stating:

Let me tell you this. They were issues of a day or two. They were issues of funding. Now, what I said before is, you can argue over numbers, and then you can — if it’s seven or nine, make it eight. But when you say we’re going to get rid of the number one program that you put into law and put in the history books, and your party’s been fighting for, for half a century, you can’t say, “Give me that.” That’s a non-negotiable stand. That’s the problem.

Matthews is wrong to make a distinction. This shutdown is also an issue of funding, specifically for Obamacare. The fact that it is the ‘number one program’ isn’t relevant. Consider the reason for the November 1981 and December 1982 shutdowns, as described in the Washington Post link from above. First 1981:

Reagan promised to veto any spending bill that didn’t include at least half of his proposed $8.4 billion in domestic budget cuts. The Senate passed a bill that met his specifications, but the House insisted on both greater defense cuts than Reagan wanted and pay raises for itself and for senior-level federal civil servants. Eventually, the House and Senate agreed to and passed a package that fell $2 billion short of the cuts Reagan wanted, so Reagan vetoed it and shut down the government.

And 1982:

House and Senate negotiators want to fund $5.4 billion and $1.2 billion, respectively, in public works spending to create jobs, but the Reagan administration threatened to veto any spending bill that included jobs money. The House also opposed funding the MX missile program, a major defense priority of Reagan’s.

As President Reagan in 1981, President Obama was not going to sign any spending bill that did not include 100% funding for Obamacare. Just as then, the House bill differed from the Presidents’ wishes, although unlike then the Senate and House did not come to an agreement. Again in 1982, the President was not going to sign any bill that included things he didn’t want, particularly funding for a major program which was an administration priority.

Interesting is the framing here – Reagan is the one who did the shutting in 1981, because he did not accept what Congress had put on his desk. This time around, the Republicans are seen as the ones doing the shutting – even though the Republican House has put forth spending bills. If blame was applied consistently, it would be the Senate and the President who are responsible for the shutdown, but that isn’t what the optics are.

The reason is a matter of scope. As Matthews suggests, Obamacare is a massive program, one that has been fought for across multiple generations. The weapons initiative that caused one of Reagan’s shutdowns seems fairly run of the mill in comparison. This difference in size doesn’t necessarily mean there is a difference in a legislative resistance to funding it. Let alone a ‘problem,’ or some sort of nefarious plot by Republicans to inflict evil on helpless people. It’s probably right that such a huge bill receives such strong scrutiny. The suggestion that such scrutiny is somehow underhanded in anyway, in light of the aforementioned historical discrepancies in apportioning blame, is just pandering to ideology and politics more than anything else.

Similarly, the debt ceiling has become such an important issue now as compared with years in the past because of scope. Rightly or wrongly, the current United States economic model depends on a continuing expansion of debt to operate. That fact means that anything standing in the way of continual expansion of debt is problematic. This reliance on ever increasing debt is something I’ve written about before in more detail, so I won’t expand too much here. Its relevance here is that it has become the underlying base of the framing of the debt ceiling debate, although it hasn’t been explicitly discussed. What has been discussed across the board is what a failure to raise the debt ceiling means.

‘The Failure to Increase the Debt Ceiling is A Default on the Debt Obligations of the United States’

The word ‘default’ has been used pretty recklessly during this saga, with everyone from the President, lawmakers, to TV pundits talking about how the failure to raise the debt ceiling would essentially be tantamount to default. This is wrong. The debt limit caps the amount of debt the US government can accrue. A failure to raise the debt limit merely means the total debt remains steady at that limit. A default, in the realm of repayment of that existing debt is simply a failure to make interest payments according to schedule and the principal at the end of the loan agreement. According to the Treasury, the interest expense for Fiscal Year 2013 came in at just under $416 billion. With revenues in excess of $2.5 trillion, there is no concern over the ability to pay the interest on the debt. When it comes to principal payments that come due, the debt ceiling does not prevent the Treasury from continually rolling over those debts that do come due since their rolling over would not increase the total amount of debt in existence. Thus there would be no default, in the manner in which many are describing, such that the rating, let alone legitimacy of US Treasuries would be called into question.

‘The Failure to Increase the Debt Ceiling is a failure to ‘pay our bills”

The link between increasing the debt limit and payments of bills is an interesting one, the implications of which have not been discussed in any real way thus far. From this CNN article:

If lawmakers don’t raise the limit on federal borrowing soon, they will put the nation at risk of defaulting on some of its legal obligations.

…which include interest on the debt, Social Security payments, and payments to federal contractors.

There is a difference between interest payments, and the other payments such as Social Security and payments to contractors. With respect to ‘paying bills,’ paying the interest is the only thing that credibly falls under that banner. That interest is on debts already incurred. Social Security payments, payments to contractors, and virtually all other spending are payments that have been promised. Failing to raise the debt ceiling would mean failure to meet some of the promised payments made, and while that would be problematic in one sense, there would be no ‘default’ in a technical sense, meaning the concomitant issues of broad based collapse in the Treasury market is unlikely.

Why the Debt Ceiling Exists in the First Place and the Consequences of Continually Raising It

From this report about the history of the debt limit, the reason it exists is the following:

The debt limit also provides Congress with the strings to control the federal purse, allowing Congress to assert its constitutional prerogatives to control spending. The debt limit also imposes a form of fiscal accountability, which compels Congress and the President to take visible action to allow further federal borrowing when the federal government spends more than it collects in revenues. In the words of one author, the debt limit “expresses a national devotion to the idea of thrift and to economical management of the fiscal affairs of the government.”

There are two interesting points to make here. The first is that the real consequence of a failure to increase the debt limit is the almost instant balancing of the budget. Without the ability to take on more debt, the Federal Government would be limited to spending what it collected in taxes, and will be forced to cut proposed spending massively. In truth, there would be other revenue boosting measures available, such as selling assets, but these pale in comparison to being able to increase the level of debt. The need to increase debt arises from the fact that proposed spending is not covered by the revenue brought in. This implies that the spending that the government wants to do is not necessarily backed by the willingness of the people to fund it. Congress, representing that will of the people (in theory), is only afforded a certain level of debt up to which it can accrue to cover this difference between what it wants to spend and what it can raise in revenues.

This brings us to the optical nature of the debt ceiling itself. The existence of a debt ceiling, according to the paper, conveys a sense of accountability and economical management of the governments’ finances. Constantly raising the debt ceiling every time it is reached is to merely render the idea of fiscal accountability and economical management of finances an illusion. Furthermore, the insistence that all hell would break loose if the debt ceiling isn’t increased means that it will never be increased. The same song was sung in the 2011 edition of the debt ceiling crisis. If it was true then and it is true now, it will be true the next time the debt ceiling is reached (assuming an agreement is made to avert the current situation).

Simply stated, if a constantly increasing debt is what is needed to avert crisis as is asserted, then crisis is inevitable. This is because the condition for ‘survival’, a constantly increasing debt, cannot persist indefinitely. This will be news to some of a certain persuasion, but there are limits to the amount one can borrow, regardless of whether or not you are the greatest economic power the world has ever seen. Should that time come, Federal Reserve and their ability to create money to buy all of the debt isn’t a solution either. That simply introduces the certainty of a currency crisis into the equation.

On the Optics of ‘Voluntary’ vs ‘Involuntary’ Crises

As written above, the fact that the US economy is so structurally dependent on constant increases in debt means any failure to increase debt becomes a blow to that particular structure. Thus should the debt ceiling not be raised, it is pretty clear that there will be an immediate downturn in the economy. This ‘voluntary’ crisis, brought about by not increasing the debt and thus denying promised payments, would not play well with the public. With respect to the ideas of more libertarian, free market oriented people, this would deal a very serious blow to their ideas. Recall that the narrative is that the Tea Party – essentially a group most Americans describe as libertarians and free market proponents – are behind the current shut down and debt ceiling impasse. Any downturn in the fortunes of the economy would fall squarely on their shoulders, at least optically speaking.

Before continuing, I must stress that the current economic structure of constant increases in debt to support spending and consumption is not an economic model that can last in the long term. I’ve expanded upon why a few times, as I’ve mentioned above. A dismantling of that economic structure would not be a bad thing if long term, sustained economic growth is the desired goal. The issue is how the transition from a debt-dependent-boom-bust economy to a longer term savings and production based economy would be viewed by the general public. Because this transition almost certainly involves some sort of crisis, as the debt dependent paradigm implodes, the way the next economy is shaped will depend on how the crisis is perceived. Yet more optics.

Should the crisis come about in ‘voluntary’ form based on the failure to increase the debt limit or something similar, the existence of crisis and potential hardship in the short term will supersede any of the longer term benefits in the view of most people. I believe that there will be a severe negative reaction towards Republicans, especially Tea Partiers, and anyone who has sympathy with the views of free market economics. It will be the fault of the ‘free market ideology’ that landed the country in crisis yet again, and surely subsequent elections will usher in politicians and movements in a direction opposite to free markets.

The ‘involuntary’ crisis happens if the debt ceiling is raised, and is continued to be raised, skirmishes notwithstanding. As I described above, the probability that the US can constantly increase its debt for the rest of time is zero. At some point, it will no longer be able to borrow, and enlisting the Federal Reserve to take over, explicitly monetizing the debt, would represent the last straw. In that event, there would be no conclusion to draw other than the continued proliferation of debt resulted in crisis. From there, a hard look would have to be taken at the policies and ideology that induced taking on so much debt. While that process leaves plenty of room for error, it is much more likely that the general public begins to lean towards a more free market solution than in the voluntary case.


For the record, I do believe that there will be an agreement to raise the debt ceiling. I believe this for the simple fact that the Republicans, while adorning the label of ‘the free market party’ are in reality far, far from deserving such a label. Political expedience and adhering to the line of least resistance will impel them to agree to raise the debt ceiling. With respect to Obamacare, for the sake of optics it is probably better that a deal is agreed there as well, with full funding for Obamacare. If the bill is fully funded and it collapses under its own weight, the problem will be there for all to see. In meddling with it however, a very easy argument is afforded the Democrats should it then falter – namely that it would have worked unencumbered, therefore government must move to increase its role in health insurance.

It is all a matter of optics.

Celebrating at Halftime

Reminds me of that fella back home that fell off a ten story building…as he was falling people on each floor kept hearing him say ‘so far so good, so far so good.’

  • Steve McQueen, The Magnificent Seven (1960)

One of the most memorable football matches in the last 10 years took place in Istanbul on the evening of May 25, 2005. That night, the final of the European Cup was contested between AC Milan and Liverpool. Both clubs boasted a great pedigree in the competition, having won it 10 times between them. Despite the glorious history of both clubs, the teams on that night couldn’t have been more different. AC Milan’s starting 11 contained three members of the Brazil team that had won the World Cup three years earlier, and three members of the Italian team that would win the World Cup one year later. Jaap Stam, Clarence Seedorf and Paolo Maldini had won the European Cup 8 times between them. Hernan Crespo and Andriy Shevchenko were one of the best forward partnerships in football, and the latter was the reigning European Footballer of the Year. None of the Liverpool players, bar captain Steven Gerrard and perhaps Xabi Alonso boasted the decoration of the Milan players. As such, Milan were expected to make quick work of their English opponents.

The match began conforming to the pre match expectation. In the first minute, Maldini scored from a free kick to put the Italians ahead. The match then evened out, with both sides occasionally threatening. Milan then found another gear and hit Liverpool with a devastating blow – two Hernan Crespo goals in the final six minutes of the first half meant a half time lead of 3-0 to AC Milan. The nature of the goals were particularly devastating for Liverpool supporters to watch. Both of Crespo’s goals – and indeed Maldini’s opener – were expert displays of football, carving open a Liverpool team which didn’t look anywhere near the level required to cope with, let alone fight back against, opposition of such pedigree. There was a rumor that the AC Milan players could be heard celebrating in the changing room during the half-time interval. Liverpool defender Jamie Carragher vehemently denied this rumor in his autobiography, but stated that:

Even if they did, privately, believe they had both hands on the cup, who could blame them?

Fast forward to the fall of 2008. In a vastly different arena, a vastly different sort of match was about to unfold. The two contestants were Global Central Bankers, and their sworn enemy, Deflation. In the United States, deflation had made its presence known over the preceding 18 months or so, after the height of the housing bubble had come and gone. The fall of 2008 brought the issue to a head, with the failure of Lehman Brothers precipitating a panic not seen since the Crash of 1929. In response, the Federal Reserve cut its benchmark rate to 0% and embarked on an asset purchasing program, Quantitative Easing, which has persisted in different iterations through the time of this writing. The response in financial markets was the cessation of declines and ultimately a rebound in asset prices almost universally. One nil to the central bankers.

Similarly, Deflation loomed over the Eurozone in the shape of a Sovereign Debt Crisis that threatened the viability of much of Southern Europe. In response, the European Central Bank put forth an acronym cocktail of programs intended to prevent interest rates from rising materially for many countries on the edge. If that wasn’t enough, ECB head Mario Draghi put his foot down during a September 2012 speech in London, declaring that the ECB was ready to do ‘whatever it takes’ to support the Euro, underlining it by declaring ‘it will be enough, believe me.’ Since these measures, markets for European sovereign debt have been comparatively calm, and many speculators have made great profits buying debt from countries pegged for depression just months before.

Most recently, the Bank of Japan, frustrated with twenty years of oscillation between periods of slightly rising and slightly falling prices, announced that it would embark on a doubling of the money supply in an effort to double the target price level increases. Thus, the central banks of the three largest western economies had now embarked on explicit, unprecedented tactics to prevent falling prices. The immediate reaction in financial markets has been undoubtedly positive. Equity, debt and commodity markets the world over have risen in the wake of these monumental actions by the central bankers. As such, the result is seemingly 3-0 to the central bankers. To echo Carragher, who could blame anyone for thinking, as the supporters of the central bank policies do, that the central bankers have got it right, and people in the opposition are clueless?

Unlike the Milan players in Istanbul, there is no question that the intellectual supporters of the central bankers and their policies have been popping the champagne corks over these developments. These declarations of intellectual victory over the ‘inflationistas’/goldbugs/hawks/Austrians/’inflation truthers’/etc. intensified in late spring and early summer. This seemingly vanquished group stands in opposition to the polices of the central bankers, on the grounds that said policies are ultimately the foundation for future problems, even as they may alleviate present discomforts. The sharp decline in gold, the appreciation of which seemingly defied the arguments of the central bank apologists, was the only source of real world evidence the ‘inflationistas’ could use to justify their claims, the argument went. Now, with gold seemingly in freefall, the last impediment to victory has seemingly been removed, and the apologists for central bank policy can begin to celebrate in earnest. And they haven’t shied away:

Joe Wiesenthal calls the fight, declares ‘economic elites’ winners:

So the collapse in gold is not about gold, but about vindication for a large corpus of belief and economic research, which has largely panned out. It’s great that our economic elites know what they’re talking about, and have the tools at their disposal to address crises without creating some new catastrophe.

Paul Krugman, in the wake of gold going down:

Well, the inflationistas/goldbugs are really, really annoying — all this air of having the secret wisdom when they actually haven’t a clue. And they have been a real destructive factor in policy debate, standing in the way of effective policy by raising fears of Weimar and Zimbabwe. So seeing the one thing they got right — betting on higher gold prices — turn sour is cause for a bit of celebration.

And again:

Maybe I actually am right, and maybe the other side actually does contain a remarkable number of knaves and fools… But can the debate really be as one-sided as I portray it? Well, look at the results: again and again, people on the opposite side prove to have used bad logic, bad data, the wrong historical analogies, or all of the above. I’m Krugtron the Invincible!… The point is not that I have an uncanny ability to be right; it’s that the other guys have an intense desire to be wrong. And they’ve achieved their goal.

You get the idea, but just in case, the likes of MattO’Brien, Noah Smith, and Jon Hilsenrath have all chimed in recently, expressing some variant of the same theme: the doves have been correct, and anyone in disagreement is now on the wrong side of history, to varying degrees. 

The issue with this declaration is the same issue that faced the (alleged) over exuberant Italians in Istanbul, and the sanguine fella from McQueens’ hometown: the story had not yet played out in full. Milan still had 45 minutes of football to navigate, and the fella back home still had the earths’ gravitational pull to navigate. Western economies are still yet to fully navigate the longer term, final effects of the easy monetary policies they have embarked upon. Declaring victory at this juncture is taking the risky step of celebrating at halftime.

The ‘Crank’ Argument Explained

In order to determine how wrong the ‘inflationistas’ are (if they are indeed wrong at all), it would make sense to outline what their argument actually is, and compare it against the data. In some of the celebratory pieces linked above, an attempt was made to differentiate between classes of ‘inflationistas.’ For clarity, I’ll be approaching this from a strictly Austrian angle, thus outing myself as a ‘crank,’ as per Matt O’Brien.

The Austrian argument, as it pertains to the issue of monetary stimulus, can be surmised from the following, oft referenced Mises quote from Human Action:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

The standard monetary stimulus programme espoused by the doves involves the lowering of the rate of interest and increasing the money supply, for the explicit purpose of facilitating credit expansion, which will ultimately support, and then raise prices. According to the above quote, it is this exact credit expansion which is the first step down an irreversible path to collapse. It is not that all credit expansion and lower interest rates are disastrous – the rub is in how that lower interest rate came into being. The interest rate in a market economy is ultimately determined by the supply of and demand for loanable funds. Financial crises and recessions are often characterized by a reduction of available credit and increased requirements to obtain loans, which result in rising interest rate. In other words, during a crisis, there is a short supply of credit, which can be replenished in one of two ways.

  • Societal time preferences change, induced by the higher interest rate, which leads to an increase in the savings rate and thus loanable funds
  • A central bank increases the money supply by purchasing bonds or other assets from financial institutions, thus increasing their reserves and thus loanable funds

The difference between the two methods is that the second way involves no changes in societal time preferences. With no central bank, the only way to increase the amount of savings (and thus loanable funds) is to reduce the amount allocated to consumption spending. In the second way, no such adjustment is required of society, as the central bank supplies the funds to replenish the loanable funds which lower the interest rate. The first method will lead to lower prices generally speaking, seeing as there is a reduction in the funds available to purchase consumer goods. The second method doesn’t require a lowering in consumption prices, as there is no need for society to lower its income allocation toward consumption goods.

Thus the immediate effect of the first method is to reduce consumer prices, while replenishing savings and investment. The immediate effect of the second method is to maintain consumer prices, while replenishing savings and investment. Given the doves consider a general fall in prices to be a disastrous thing, it is no wonder they opt for method 2 every single time.

The Austrian argument is that ‘method 2’ kicks off a cascade of events. The increase in loanable funds leads to an increase in bank loans to businesses and individuals. This increase in loans leads to an increase in demand for capital goods, durable consumer goods as well as the labor associated with those sectors. This increased demand manifests itself as rising prices for capital goods, and increasing incomes to the labor in those sectors. With respect to the increased labor income, it is crucial to note again that from the outset, method 2 imposes no need for society to change how it divides its income between consumption spending and savings. The portion of that increased income set aside by labor towards consumption spending represents additional demand for those consumer goods. Furthermore, that increased demand is exercised at a time in which new supply is yet to come on to the market. An auto worker hired thanks to stimulus, for example, is paid and can spend that money well before any new goods actually hit the market. This effect, according to Austrian theory leads to consumer prices rising.

Above is the savings rate alongside the Fed Funds rate going back to 1995. According to theory, the story begins with the need to replenish investment and loans to business. As written above, this can happen via an increase in savings or through central bank stimulus. The economy responded to the bursting housing bubble and the need to replenish capital by the first method, increasing savings. The spike in the savings rate from mid 2007 through mid 2008 took the personal savings rate to its highest point in nearly 15 years. The ‘problem’ with this method (according to the doves) is the negative effect this method has on prices, which again was touched upon above. This prompts the ‘need’ for central bank stimulus, which came in the form of zero interest rate policy and quantitative easing, initiated in late 2008. Since the introduction of central bank stimulus, the savings rate has declined steadily, the blip at the end of 2012 notwithstanding.

The above is a closer look at the prior chart, with the addition of consumption expenditures. The near tripling in the savings rate is not well reflected, but it is clear that following that spike, consumption spending fell, as is expected. Fed stimulus beginning at the end of 2008 allowed the savings rate to be held in check, and then to reverse, which coincided with the formation of a bottom and renewed upswing in consumer spending. This illustrates is why central bank stimulus is appealing, at least in the short term. The low interest rate environment enables increased bank loans, while at the same time consumption expenditures do not have to take the hit it would if further increases in savings were necessary.

Austrian theory states that the central bank stimulus leads to an increase in the demand for capital goods and employment in those sectors, leading to an increase in prices of capital/producers goods relative to consumer goods prices. This is illustrated below:

The above is the Producers Price Index divided by the Consumer Price Index, alongside consumption of durable goods and orders for new durable goods, which is used here as a proxy for producers’ goods. All three measures bottomed in early 2009 just after the initiation of stimulus. From there, PPI rose faster than CPI did and the demand for durable goods steadily increased. In early 2011 the relative price acceleration reversed, with CPI growing faster than the PPI. This is also expected, as described above.

From the Austrian perspective, what has been described to this point is the replenishment of capital with the aim to push into an expansionary phase. The future contractionary phase is essentially the result of the inability of producers, on the whole, to effectively recover the increasing costs of production once the final goods hit the market. Consider the following charts:

Above is durable goods data from the prior graph, this time compared with consumption expenditures. As written before, central bank stimulus is attractive because it enables both consumption and investment spending to increase simultaneously, at least in the short term. Without stimulus, the only way for capital to be rebuilt would be through a decrease in consumption (increase in savings) which would then allow for the larger demand for producers goods. The graph above would display the blue line continuing to trend lower, which would be the tradeoff supporting the higher demand for producers goods.

The fact that consumption spending (and price level) is supported in the short term does not bode well for longer term spending, because as demand is exercised in the short term, the ability to afford further increases in prices are restricted as time goes on. This means that producers, once they actually finish producing the goods, will be bringing them to market just as demand wanes at the higher price level.

The decrease in the rate of increasing consumption expenditures since mid-2011 is an indication of a reducing ability to afford goods at current prices. Should these trends continue, downward pressure on prices will lead to a cascade into the very crisis the stimulus efforts sought to prevent, or at least mitigate.

Unless more stimulus is applied.

Perma Stimulus?

Returning to the Mises quote:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

Textbook stimulus eschews the ‘voluntary abandonment of further credit expansion,’ explicitly attempting to increase credit expansion in hopes that loan-driven consumption and investment ensue. Austrians do not deny that, at least in the short term, this goal is met. The claim is that on the back end, the price increases that accompany the credit expansion will ultimately kill demand for goods at those elevated prices, prices which are necessary for producers to charge given the higher prices they had to pay to secure factors of production at the beginning of the productive process. Without further stimulus to bolster the demand for goods at higher prices, producers will only be able to sell goods at a loss, leading to bankruptices, layoffs and other unpleasantries.

Stimulus supporters tend to vehemently disagree with the implication of ‘perma stimulus’. Take Paul Krugman, writing in May:

Ending stimulus has never been a problem — in fact, the historical record shows that it almost always ends too soon.

Incidentally, foreign experience follows the same pattern. You often hear Japan described as a country that has pursued never-ending fiscal stimulus. In reality, it has engaged in stop-go policies, increasing spending when the economy is weak, then pulling back at the first sign of recovery (and thereby pushing itself back into recession).

So the whole notion of perma-stimulus is fantasy posing as hardheaded realism.

Krugman wrote in response to allegations that stimulus couldn’t be ended, as in a literal inability to ever stop stimulus. This is obviously not true – it can be stopped, but that’s not what is alleged here – which is that if stimulus is stopped, the recovery comes to a halt. Krugman’s comments go towards that point. In writing that stimulus ‘almost always ends too soon,’ and that pulling stimulus back is responsible for the push back into recession, he correctly implies that the stimulus is the backbone of the recovery. In other words, the stimulus has to be permanent or else we slip straight back to recession.

According to the Austrians, not only must stimulus be ever present for recovery to be sustained, stimulus must rise at an increasing rate as time progresses. Austrian economist Jesus Huerta de Soto, piggybacking a point Hayek made in Prices and Production (1932), explains why in the following passage, from the book Money, Credit and Economic Cycles (2006):

The need for this ever-escalating increase in the rate of credit expansion rests on the fact that in each time period the rate must exceed the rise in the price of consumer goods, a rise which results from the greater monetary demand for these goods following the jump in the nominal income of the original factors of production. Therefore, given that a large portion of the new income received by the owners of the original factors of production originates directly from credit expansion, this expansion must progressively intensify so that the price of the factors of production is always ahead of the price of consumer goods.

Bit of a long winded passage, so I’ll distill it. Remember that central bank stimulus is supposed to flow to businesses via the banks, and then to individual wage earners through employment. This increased income of wage earners then leads to increased consumption spending, driving up prices. If stimulus in each successive round does not increase by a greater amount, the income flowing through to wage earners for consumption will not be enough to drive prices up as much as it did in that last round of stimulus. This is known as ‘disinflation’ to the Keynesian mind.

In light of all of this, the Federal Reserve, while remaining ever present in its stimulus, has not increased the amount of stimulus by an increasing rate with each successive round. The QE beginning in December 2008 lasted for 15 months and injected $1.7 trillion into the economy, a monthly rate of $113 billion per month. QE2 began in November 2010 and involved $75 billion worth of asset purchases per month through June of 2011. The current QE is open ended, with $85 billion per month going into the economy. With many market participants believing that the Federal Reserve is poised to taper, reducing the current $85 billion per month in asset purchases, it is interesting to note the overall trajectory of asset purchases per month over the 5 year course of Federal Reserve expansion. In effect, the Federal Reserve has been ‘tapering’ since the end of QE1, increasing stimulus at a slower pace since. The effect on selected data points is shown below.

It is clear that QE1 had the most effect, while subsequent, lesser rounds of QE have presided over a flat line at best in the growth rates of the four data points in the first chart. With respect to the S&P 500, which I will use as a proxy for assets in general, QE1 coincided with the largest increase in the index percentage wise. The other periods of QE provided less of a jolt to the index, and the circled periods in which there was no additional QE saw little to no increase or substantial declines.

This is in line with the Austrian theory as written above. Should the Federal Reserve embark on a more explicit tapering, growth will continue to remain flat at best, more likely growing at a slower and slower pace before actually declining. The same could be said of the S&P 500. In the face of that deterioration, the Fed will have to reverse course and actually increase the size of its asset purchases in order to avoid, or mitigate a crisis. That about-face should make it crystal clear that the Fed can never taper, let alone pare down its balance sheet or raise interest rates, without problems arising. To reference Krugman, it will always be ‘too soon’ to end stimulus, because the entire recovery rests on that stimulus. In tapering (particularly the explicit tapering so many expect at the September FOMC meeting), the Fed will be taking a step down the ‘voluntary abandonment of further credit creation’ path in a Misean sense. This path leads to crisis, which will be undoubtedly countered by the Fed accelerating stimulus, which in turn culminates with the ‘final and total collapse of the currency system involved.’

‘Hyperinflation? We Don’t Even Have Regular Inflation’

The ‘final and total collapse of the currency system involved’ is just a fancy way of saying hyperinflation. While it is true that many Austrian commentators have called for a hyperinflation which has not yet come to pass, it is not necessarily correct to extrapolate from that the idea that their theory is then invalidated. What those Austrians are guilty of is skipping to the end of a logical exercise that begins with the acknowledgement that deflation is the ultimate evil to policymakers and mainstream economists. Hayek touched on this in Prices and Production, writing [brackets mine]:

My argument is not that such a development [rapid rise in consumer prices] is inevitable once a policy of credit expansion is embarked upon, but that it has to be carried to that point if a certain result – a constant rate of forced saving, or a maintenance without the help of voluntary saving of capital accumulated by forced saving – is to be achieved.

Recall that the point of stimulus is to achieve constant capital replenishment without allowing an increase in the savings rate and the commensurate decline in consumer spending. Hayek is saying that in order to achieve this objective, rapid price increases are inevitable since only a constant increase in the rate of stimulus will do the trick. If stimulus isn’t large enough and results in disinflation, the response will be to increase the stimulus until it does achieve those results. Indeed, FOMC members Bullard and Kocherlakota have recently made rumblings to this effect. Once the effect of any increased stimulus wears off, yet another round will be needed to stave off the subsequent disinflationary or deflationary pressures. Again, only stimulus of an ever larger quantity will suffice.

The limiting factor that determines when these increasing rounds of stimulus would finally lead to the rapid price increases is psychology. The point at which people seek to spend all of their cash as fast as they can is unpredictable. What one can say is that the conditions for such an outcome are almost optimal, given the ideological preference of policy makers and mainstream economists for deflation avoidance at all costs.

Three Goals in Six Minutes

The second half began in Istanbul all those years ago in a quite innocuous manner, before Liverpool hit back with 3 goals in 6 minutes to level the score. Milan, shocked, was almost instantly rendered a spent force and labored into extra time and penalties where they went on to lose. It was a remarkable comeback by Liverpool, one their supporters will never forget. Only time will tell, but it could be possible that Ben Bernanke’s Congressional testimony on May 22, which kicked off the ‘taper tantrum’ across financial markets, is the first goal in the comeback by Deflation. Central Bankers are in a bind. They cannot withdraw the very stimulus upon which recoveries in debt dependent activities rely upon, given their predilection for avoiding deflation. At the same time, an increase in stimulus maintains, and even raises a level of prices the economy cannot sustain on its own. Hence, the Misean dictum of the inability to avoid catastrophe following a boom brought about by credit expansion. The idea that such a catastrophe can be avoided is pure fantasy, and this will be demonstrated in relatively short order. For the ‘economics of the elite’ to be proven correct, the Federal Reserve must actually exit with no problems. Exiting was always part of the plan, after all. Until that happens, any declaration of victory is celebrating at half time.

Inflation, Inflation, and More Inflation

Perhaps no other issue is more hotly debated in the economics blogosphere than the discussion about inflation. Do we have too much or not enough? Will we have too much or not enough? What will the economy look like when these conditions exist? The stakes are high, not only for the real economy, but for bloggers and economists, who risk internet shaming and ridicule should they get their analysis wrong. Jokes aside, almost every major topic being discussed right now (sovereign debt, currency wars, etc) are at least indirectly related to inflation and its effects, so I think a comprehensive discussion of inflation/deflation is relevant.