A Contraction Is Not Only Likely, But Needed
With the debt ceiling drama resolved temporarily, our collective attention can return to where it really belongs. As much as a default or upset to the bond market would have had negative effects, the fundamental economy poses much greater risks. With last week's GDP revisions showing far more weakness than economists anticipated, especially a near-zero first quarter, the markets are now focused on both the severity of any slowdown (or contraction) and potential policy responses.
Though most economists casually dismiss any chance of a renewed recession, I have been making the case that a contraction is not only likely but needed. The financial problem of overpriced assets and the economic problem of too much activity predicated on those prices finally crossed paths beginning in 2007, accelerated in 2008, and for most people, came to a successful conclusion in 2009. The end of the crisis is largely credited to Chairman Bernanke and the Federal Reserve's aggressive policies - that is why he was Time's Man of the Year for 2009, after all. They, apparently, saved the system from total calamity and collapse.
So much of the rhetoric of that time centered on the need for aggressive action because without it the entire financial and economic systems would have collapsed into utter failure and chaos. There was this persistent belief that the contraction that was already well underway would not end. The economy had to be forced into recovery, although no real reason was ever given why that was the case.
If I am right about the downward economic trajectory toward a true potential that has been diminished by years of monetary miscalculations and forced imbalances, then we should expect to hear the same arguments advanced for the same policies to oppose that natural progression. The Fed will argue that more monetary stimulus is needed to "force" the economy forward. In other words, the Fed actually agrees with me about the natural direction of the economy, but not whether that direction is appropriate.
What monetary policy and economists fear more than anything is deflation. To them, it is akin to annihilation or economic Armageddon. As bad as they believe deflation is in and of itself, it takes on a whole new dimension when combined with an overabundance of debt. Add those to a system with pronounced "slack" in capacity and economists see only a negative feedback loop without an end.
Modern economic thought, traced all the way back to the Great Depression and Irving Fisher's contemporaneous explanation of how it unexpectedly evolved, holds that the burden of too much debt in the presence of a sizeable economic contraction leads to declining real prices. Borrowers are unable to pay off debts and are forced into firesale situations where they have no choice but to sell whatever assets are available at any price, just to extinguish debt. Falling prices then lead to more economic distress as productive firms that would otherwise be untouched are pulled into the widening vortex of rigid cost structures that cannot absorb those declining realized prices.
But Fisher's key observation, and the one Bernanke knows well as a student of the Great Depression, was the paradox of deflation and debt. Fisher wrote in 1933 that:
"...if the over-indebtedness with which we started was great enough, the liquidations of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to less their burden increases it, because the mass effect of the stampede to liquidate in swelling each dollar owed . Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: the more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing." [emphasis in original]
In the canon of modern economic science, the combination of debt and falling prices leads to a recession without end. It is imperative, according to central banking orthodoxy, to avoid falling prices in the presence of burdensome debt. Central banks must head off falling prices before they turn into a full blown disaster, but to do this they need to induce inflationary expectations while deflationary pressures are still building but are yet unseen. They believe that creating inflation during deflationary periods is the same as not having deflation at all. It is an academic exercise of the monetary theory that bred the crisis in the first place, an untested theory that rests on too many indirect relationships and assumptions.
Mr. Fisher, however, made another astute observation when describing the deflationary paradox. Deflation, he said in 1933, was a "dollar disease". He fully admitted that economic contractions and over-indebtedness can occur simultaneously and independently of that deflationary paradox. It turns to its worst, unending form only when it infects the currency.
In the banking panic of 1929-33, households and businesses rushed to take dollars out of the banking system because of broad-based failures that obliged losses on everyone in the liability structure of banks - depositors and bondholders alike. The desperate panic forced individuals to value currency over any other asset, financial or tangible. The desperate rush to physical dollars turned an already nasty, debt-fueled contraction into the Great Depression.
Does that describe the panic in 2008?
However bad it may have been, there was absolutely no simultaneous rush to dollars by households or businesses. The only "dollar disease" was eurodollars, with concurrent distress in the domestic interbank market. It was the massive interbank money markets that were the epicenter of collapse. There were no mass conversions of deposits to cash, nor was there even much shifting of funds out of the banks that were shepherded into takeovers. In fact, September 2007 saw more of a disruption to the deposit base than September 2008!
Beyond depositor panic, there was certainly no massive rush by consumers to sell their personal possessions to buy food and necessities. The dollar disease was not really dollars at all; it was a malady of financial collateral and mortgage paper.
Deflation, such as it was, stayed a financial phenomenon in 2008 and 2009. The prices of financial assets quickly declined, particularly the derivative mortgage bonds and structured financial products that had been widely accepted as top quality collateral in the short-term money markets, especially the eurodollar market. It was not individuals and households that were seeking the safety of cash, it was financial institutions frantic to avoid each other that drove the cost of marginal dollars to unbelievable heights. Fed funds and LIBOR skyrocketed because banks and money market funds no longer trusted each other or the collateral they all posted amongst themselves . It was the first banking panic in history that entirely consisted of banks panicking.
The first moves by fiscal and monetary authorities in response to this systemic alarm were TARP and ZIRP (zero interest rate policy). Both policies had one goal in mind, to expand Tier 1 capital enough to allow the banking system to absorb losses without extending haircuts further up the liability structure.
Those measures were not enough, however, so accounting rules were altered and the Fed announced the first program of quantitative easing (QE 1.0). Changing FAS 157 allowed financial institutions to sidestep marking their assets to market, thereby ending the income statement losses that were devastating bank earnings - a big component of Tier 1 capital and ongoing bank unease. QE 1.0 restored overnight funding simply by overriding the eurodollar market with a newly created cousin of the Fed's discount window.
"Saving the system" through these measures essentially meant that the Fed believed that deflation would have spread without them. The nasty panic amongst banks would have, they believe, further destabilized the wider financial system, eventually embroiling households. But would panicky households ever have rushed wholesale to withdraw currency? Even if currency withdrawals had occurred, there is no reason to believe it would have ever led to a dollar shortage for basic transactions amongst individuals.
It was not physical dollars that were in short supply; the banking panic was not about actual currency. It was balance sheet capacity that was in short supply as marked losses had eroded retained earnings and Tier 1 capital levels. The threat of being exposed to "toxic" collateral froze the credit markets, not the age-old conversion of deposits to cash. The comparison to the 1930's became invalid right there. There is no direct relationship in the historical record for a shortage of balance sheet capacity, it was and remains an entirely new occurrence.
Considering that credit has continued to contract despite the Fed's expressed intent to foster otherwise, it is really hard to see how monetary interventions helped "save" the economy, at least directly. That leaves the indirect consequences of stoking inflationary expectations. Since the Fed was extremely concerned that deflationary conditions were evident within the banking system, it made the wider inference that those conditions would spread into the household sector, and from there devastate productive businesses through the process that Irving Fisher originally described.
By manipulating inflationary expectations, monetary policy wanted to create economic conditions where deflation would be impossible. Since these assumed deflationary pressures had been completely absent in the household sector and the wider economy, even at the worst days of the crisis (again, there was no mass movement to sell personal furniture and clothing to buy food and shelter), Bernanke was taking it as an article of faith that it was better to inflate than to let the natural economic course play out. He was invested in the idea that shrinking balance sheet capacity would eventually lead to an actual dollar shortage.
The entire deflationary question continued to be the primary factor in monetary decisions throughout 2009 and 2010. As late as October 2010, Chairman Bernanke remarked that he was still concerned about being constrained by the zero lower bound (short-term rates already at zero) and that "the risk of deflation is higher than desirable". So QE 2.0 was designed for one purpose: to create negative real interest rates, a condition extremely fertile for inflation (as well as dollar devaluation).
As a result of this fixation, the entire recovery period has been conducted under the auspices of fighting deflation. The Fed has intentionally created inflationary expectations, primarily by devaluing the dollar through those negative interest rates, to "ensure" that wider economic damage was minimized. In the end though, monetary policy simply traded one dollar disease for another - dollar hoarding by banks has been changed to dollar avoidance by the rest of the world.
It appears as if there is a growing, if belated, recognition that monetary policy has brought the economy full circle. We have gone from a potential collapse in 2008 and 2009 to a potential collapse in 2011 and 2012 through different means. Where deflation deprives productive enterprises of value and wealth through their normal productive processes, dollar destruction robs consumers and businesses of purchasing power in the global system of acquiring useful resources and goods. The methods are very different but the economy ends up in the exact same place: systemic destitution and privation.
Was the round trip worth the massive efforts?
There is simply no reason to believe that the financial panic of 2008 was in danger of becoming a dollar disease, leading to full collapse. But even setting that debate aside, where is the justification for continuing the radical inflation of the Fed's balance sheet, the negative interest rate regime and the subsequent dollar devaluation? The panic had subsided, for the most part, by March 2009. The best explanation that can be offered is that the Fed is so fearful of deflation that it voluntarily went to extremes - it was intentional overkill.
By being steadily aggressive, I believe that the Fed has essentially created an extension of Fisher's debt paradox. The more aggressively the Fed acts to counter deflation that may or may not exist, the more they create counter-pressures that guarantee we end up experiencing the very conditions they were trying to avoid in the first place. The more monetary policy tips the economic boat toward inflation to fight deflation, the more it will capsize in either direction. The bottom line is that deflation is not what they should be concerned about, it is destabilization.
Unfortunately, this new paradox is not a neutral proposition. It has taken up valuable time to get to essentially the same place. And we are far worse off for the trouble (see balance sheet, United States). As bad as it may have gotten in 2009, by now we may have actually grown out of it and into a real recovery. Unhindered price discovery and market discipline may have unlocked the true economic potential that has been hidden behind decades of monetary machinations, putting to rest for good the uncertainty and unease that has plagued these past three years of constant intervention. The Great Recession and its dislocation might have been even larger and more painful, but at the same time short and invigorating.
In a recovery free of intervention, 99 weeks of unemployment insurance may have been more than enough for those unfortunate workers who were caught up in the storm to move to a more sustainable employment position. Instead, 99-weekers are today falling off the rolls into the abyss.
Counterfactuals are always difficult because we will never really know. What we do know, in August 2011, is how monetary interventions have actually performed. If we are truly in the same economic place as 2009, with all that it has cost to get here, we should at least have an informed discussion of what to do next. If interventions have failed as miserably as I and many others strenuously assert, then we need to find another solution. I believe that the Federal Reserve and mainstream economics have proven that they have no answers outside of devaluation, poverty and unending crisis. Perhaps a true market-based approach would be better.
