A Crisis Encapsulated In Past Economic Crises

In June 1938, the Bank for International Settlements (the central bank of central banks) looked back on the disastrous reversal of economic and financial fortunes that had ruined what nearly everyone believed was a well-defined recovery from the catastrophe of the early 1930's. It eerily concluded that:

"It is human to look backwards at past disasters in the hope of avoiding them in the future. But it might prove as dangerous to be led by fear of a deflation that may not come as it has been dangerous, in some cases, to be led by fear of an inflation that was not imminent. And if fear of deflation be identified with a fear for international monetary stability, this may so hinder economic recovery as to force deflation on a world gorged with gold."

It is hard, despite the warnings contained within this passage, to not see our current crisis encapsulated in the descriptions of this past one. The current Federal Reserve has feared deflation above all else out of its ingrained, institutional philosophy of never repeating the narrowly perceived mistakes of the early 1930's. But the BIS of 1938 is also warning of what it saw as the potential mistakes of 1935 and 1936, when the Fed increased reserve requirements out of fear of inflation that the vast monetary reserves of gold potentially represented. By increasing reserve requirements, our central bank effectively tightened the reserve cushion of the banking system, forcing banks in 1936 and 1937 to re-establish those non-required reserves through additional credit retrenchment.

So what came to pass in 1937 and 1938 was a second economic collapse, coming under conditions of what should have been plentiful money and liquidity - a world gorged with gold. But liquidity and overflowing money stocks were not the universal answers to the more fundamental problems of that age, a proposition that has not changed with the age.

What we see of that time period is essentially what we see of 2011. A world gorged with dollar liquidity still seems to be desperately short of dollars at the most critical periods - so we get the coordinated actions of central banks around the world to essentially transmit dollars into the liquidity desert I have described for months, one that officials thought impossible in the presence of $1.65 billion in bank reserves on the Fed's balance sheet. For all the sophistication of monetary structure and operations, it is essentially worthless at the point of interface with the real world. For all the dollars that are and can be created, they cannot move beyond the banking system without satisfying the human perceptions of the conditions beyond that banking system.

In other words, monetary policy is functionally and solely dependent on the banks it was created to serve. This is essentially the problem Milton Friedman contemplated when he came up with his famous "helicopter" allegory. If the Fed cannot push money into the economy through the banking system, then perhaps it should simply circumvent that system to deliver dollars directly to the population, via bags of money dropped from helicopters if necessary.

That is exactly where we find ourselves today, astride another growing, building banking panic where even large, international financial institutions find themselves in desperate shape simply because they are not directly connected to the monetary spigot of U.S. dollars (this is spread globally by the interconnected wholesale money market currently called eurodollars). Monetary policy is conducted through the primary dealer network (many primary dealers are U.S.-subsidiaries of foreign banks, helping the Fed connect to that eurodollar money market) and it is dependent on that network to amplify and transmit any monetary stock beyond itself to the wider financial marketplace. If, like today, the primary dealer network is fearful of even large, financial counterparties, those central bank-created dollars remain unmoved and ineffective toward the larger policy goals.

Inevitably this operational constraint has led to discussions of how to bypass it, without ever considering whether such interventions have created the very conditions causing the exasperating constraints in the first place (i.e., intentional instability and dollar destruction). And so the Federal Reserve begins to gas up its helicopter. At least members of the Fed and the economics profession begin to discuss even more unconventional ways to move money into the real economy through still greater levels of instability.

Conventionally, money moves in the clearing process of exchanging labor for it on one end, and then redeeming those coupons for goods or services at the other end. From a wider perspective, money flows from businesses to labor back to businesses and then to labor again in an endless cycle of exchange; the very essence of wealth creation. The Fed and central banks presuppose to substitute some links in that chain of economic flow by increasing the amount of credit available (artificial savings) or the price action of price assets (the esoteric "wealth effect" primarily of exuberant equities). However, even that substitution cheapens the entire chain since humans do not view the use of their existing pool of savings as a constant source for spending in the same way they view using money from solid and stable income.

So much of the primary economic problem is limited to conditions that are not directly related to the realm of money stock. The Fed can lead individuals to money, but it cannot force them to spend it. So it resorts to the "logical" policy of destroying, or increasing the costs of, short-term assets to penalize good people who resist spending out of emotional concerns for future abilities. We are supposed to completely disregard the tortured logic of economists who now contradict their chastising of Americans' spending habits and habitual debt usage of only a few years ago. Somehow it is forgotten that in the quest to rebuild 2006 it also requires a complete embrace of everything about 2006, including that which was once perceived to be harmful. The economic logic here is just another example of the backwards imposition of monetary intervention. A majority of the population has intuitively grasped the folly of asset bubbles and moved on, while central bankers pine for the "good old days"; same planet, different world.

In other words, the problem is psychology, or, in this case, what mainstream economists call velocity.

Gorged with gold may be an accurate description but, just like the 1930's, without a sustained will to use it in the exchange and clearing processes, all that money is just useless. Economists can lament the level of exchange, particularly as it relates to their estimation of what that level should be (potential), but monetary policy is essentially ineffective in the face of human emotion and perception. Yet, again like the conditions of the Great Depression, it is maddeningly silent on the idea of whether the existence of so much intervention actually contributes to the very conditions it is trying to overcome. Monetary intrusion may be ultimately useless, but it is not a neutral proposition where it is simply harmless to try or experiment.

In the face of repeated failure, policymakers instead assert that previous radical and unconventional policies were simply not radical and unconventional enough. If the banking system is the roadblock on the highway to money velocity, then moving monetary policy outside the confines of the banking system is the next "logical" step.

However, if we look at the credit system as it has actually performed since March 2009, we see that it has actually created its own workaround. Corporate credit has been issued at record levels for the past several years - large, particularly multinational, corporations have had no trouble transitioning from bank loans to bonds. Yet, for the nearly one trillion dollars issued in the past two and half years, velocity and economic flow have not appeared.

Unfortunately, by creating inflation psychology to try to force velocity, the Fed willfully destroyed the dollar, especially in relation to the denominations of certain imported economic inputs. By devaluing the dollar in the middle of a global exchange system, it placed an overemphasis on foreign and offshore capital investment and focus. In this respect, the dollar has been morphed into the yen. Multinational corporations have simply become an extension of the harmful carry trade, as they borrow at record low interest rates in dollars and then invest them overseas in various projects that create actual, productive wealth. Domestically, all we get is about two hundred billion in stock buybacks, the real legacy of the all-out monetary focus.

To overcome this flaw in design and execution, monetary policymakers have already begun to contemplate direct payments to individuals. Monetary theorists have, since those dark days in the 1930's, believed that moving money directly to individuals would solve the velocity problem. In theory, the federal government could expand transfer payments to the public and pay for them through newly created reserves at our central bank. If this is done with the banking system in the middle of such transactions, authorities can plausibly (not believably) claim that there is no direct monetization, a legal hurdle (for good reason).

Unfortunately, that is exactly what has been done since 2009. The federal government now sees 46 million people on food stamp assistance, in addition to the 11 million that have been eligible for 99 weeks of unemployment insurance transfers at some point in the last three years (millions have already exhausted their allowance). In addition, the "stimulus" bill transferred billions to state governments to forestall layoffs there. All the while, the Federal Reserve paid for a huge portion of the cost by purchasing bonds only days after auction settlement (meaning those newly issued bonds were only in the inventory of primary dealer banks for a couple of days, sometimes just hours). While it was not direct monetization in the legal sense, in the realm of perceptions it accomplished much the same as printing money would have.

That pretty accurately describes the combined effort of quantitative easing and fiscal stimulus. As much as the acknowledged failure of these efforts are now being blamed on a perceived lack of sufficient size, there is little doubt to me that this could ever work in any size. Even if we imagine the most extreme case where a majority of unemployed persons were given a job by the federal government to perform some "beneficial" task (repairing bridges, weatherizing schools, building pyramids in the desert or digging ditches with spoons) and the costs of these "jobs" were borne exclusively by newly printed dollars in a direct monetization, it would create nothing more than another cycle of bubble inflation and collapse.

What I just described in the above paragraph is exactly the policy carried out in response to the tech bubble collapse: the housing bubble. Marginal employment during the last decade was expanded to build infrastructure and houses. The rest of marginal flow and economic growth was based on "serving" consumers that were subsidized by ever-expanding real estate prices. Households were able to directly extract price action through home equity debt, and it was all "backed" by newly printed money in another corrupting form of inflation. The Federal Reserve is not the only entity that can create money; the banking system also possesses the ability to conjure credit out of nothing.

Essentially, the housing bubble was the combined effect of money stock and flow, put together in a nice, tidy package of disarmed human psychology and common sense - extremes that the Fed now wishes to revisit. One of the essential problems of that sorry episode was the lack of direct and sustained flow within the domestic system. In other words, people spent more money than they should have, but it did not stay within our national boundary, at least creating sustainable and long-term jobs here at home. Instead, marginal spending flows moved overseas where real productive wealth was really created, in another sad example of how backward monetary intervention really is.

In a bilateral trade system, that productive wealth offshore would have been returned as foreigners increased their appetite for American-made products. But we live in a world of constant intervention, where instead of a bilateral trade arrangement the current unilateral trade system flows to foreign banks and central banks. In that crucial step, rather than finance mutual trade, unilateral wealth acceptance was and is transformed from potential reciprocal wealth production into the demand for securities and money. Instead of purchasing U.S. goods or services from U.S. businesses, foreign dollar holders transformed those trade dollars into U.S. dollar-denominated debt. As money flowed overseas in the exchange of goods, it came back not in the further exchange of goods, but as money claims on future production.

Worse still, those marginal claims were often focused on further expanding the housing bubble since foreign central banks transformed hundreds of billions of U.S. trade dollars into government agency debt. The entire sickening system became a feedback loop, created and enhanced by official policies at both ends of the system - productive wealth was disregarded at home in pursuit of asset price psychology.

It is hard to see how anything has changed in the years since. Even if there were some marginal difference created by changing the mechanism of flow from housing-related debt to government transfers (removing any uncertainty of the private sector about having to pay back debt), marginal spending would still flow overseas to where production actually takes place. At that point, it would simply re-ignite the unilateral system of trade where marginal and beneficial economic flow is transformed into asset prices of some kind. Where that flow became housing debt in the last bubble, it would surely find another asset price outlet in a new bubble. We have already seen this in the limited appeal of the current recovery (the current account and trade deficits have returned, barely missing a beat). The Federal Reserve counts the U.S. as a "relatively closed system", but at the margins of production and wealth creation, it is anything but.

We would then be looking at another episode of price appreciation domestically predicated on the same thin and effervescent air. In the bigger picture, this means more money and claims on future money per unit of productive wealth. Since marginal productive wealth is still created overseas, domestic wealth is, at best, unchanged or slightly increased. In terms of sustainable and productive wealth, it would be seriously diminished domestically since all this marginal spending is completely dependent on the asset price/foreign transferal mechanism, rather than the natural perceptions of individual participants. Just like resources were inefficiently allocated to real estate-related activity and price appreciation, any new price bubble would similarly attract resources away from sustainable, long-term activities and enterprises.

This monetary-driven system is not effective because an economy is not a system that can be enforced from the "top down". The real economy, including human psychology, is "bottom up". A true, capital-focused economy works best when inputs into the billions and billions of economic decisions exhibit stability and predictability. The fundamental answers to the economic problems are to dismantle the monetary interference and allow a system of productive, sustainable wealth to grow itself in its own response to stable inputs. This is a natural system where artificial money has diminished perceptions - exactly the problem we see today in the form of another banking crisis that is questioning the price of so many paper claims in the context of a belated recognition of true, fundamentally diminished productive value.

Adding to the stock of money, just as the stock of gold increased in the mid-1930's, does nothing to solve the intrinsic matter of the fundamental psychology of stability. Rather, these efforts are counterproductive and lead to another feedback loop where one failed intervention simply leads to a sequentially larger one. Nowhere does anyone of authority seem to account for all the interventions, from themselves or those of others, past or present. All the while the experts of the economics profession scratch their heads and sit in closed-minded confusion astride their mathematical elegance.

Any artificial system that values and exalts money over wealth is doomed to fail right from the start. It is not enough to say that monetarism is limited by its incapacity to grow beyond math and statistics, it has to be said that is backwards and upside down at its heart. The only way to get goods produced and exchanged is to allow the system to create its own channels of capital , free from the interference and intervention of artificial money: market discipline over contrived price discovery. The fact that trading one artificial currency disease (deflation) for another (inflation) does not work should not be surprising. Perhaps we can look forward to a time when policymakers heed what might be the real warning from 1938, that flow is really quite simple - people don't really care what is causing instability, only whether it is present.