The Monetary Tax Of Artificial Economy
European leaders got together just three days after stock markets around the world crashed on May 6, 2010, to plan and announce a $1 trillion bailout of their banking system. In heavy trading that Monday (and over the next few days) global markets cheered the fact that Europe had finally and forever solved their collective sovereign debt/bank exposure problems. The rally and good feelings, however, were fleeting as markets, with Greece off the front pages, refocused on growing pessimism about a sustainable and robust recovery for the developed world. It was the "Summer of Recovery", an altogether appropriate and lasting euphemism for the mathematical dysfunction of monetary and fiscal policies the world over.
September and October 2011 certainly have a déjà vu feel to them, as politics tries to solve the essential problem of economic flow. Policymakers have resorted time and again to the prime problem of the lacking functional circulation of money within the economy by increasing or threatening to increase the stock of money. The EFSF in any form is essentially a patchwork repair of credit production capabilities, one that re-jiggers loss exposures from one perception to another. In other words, it is a monetary attempt to remove perceived impediments to additional credit creation (whether or not that is possible given the realities of intercontinental banks and innumerable unmarked assets beyond sovereign European debt is altogether another question).
Even if you were inclined to believe that this risk/loss transferal process could succeed to "save" the European banking system, it does nothing to change the broken path of monetary flow that currently exists in the real economy. The reality is that for far too long the Fed and its central bank cousins have been using this stock "tool" to "stimulate" economic flow.
In the American version, the Fed set interest rate policy at artificially low levels, overriding the money cost limitation in credit production and extension. It also created money to enforce these low interest rates, actively allowing the increase in credit stock to build unchecked. The myth has been perpetuated that these "accommodative" measures led to beneficial economic growth, as newly created loans financed business expansion, leading to jobs and relatively cheery Americans. This was supposedly marked by rising asset prices and relatively low unemployment.
That is not what really happened. Economic flow since the mid-1990's has been increasingly based on the ephemeral price "wealth effect", replacing the more natural and stable wage income flow that marks a healthy economy fostering sustainable labor specialization. Though the move away from wage income to interest income began during the Great Inflation (especially after 1975), there was another fundamental change in marginal spending factors to price assets after the recession in the early 1990's.
Credit money in the last two bubble periods flowed to consumers indirectly through debt made more appealing by those rising asset prices. While this may appear to be natural economic flow or growth, it is a definite and historic change to the composition of output (some refer to this as aggregate demand). And it is a change that does not seem to be appreciated by policymakers or mainstream economics.
During the dot-com bubble, the level of consumer credit (debt stock) exploded well above historical norms. This was reflected by the collapse in the overall household savings rate. Essentially, despite the fact that wage growth was relatively robust during the period, this shrinking savings rate through debt accumulation meant that some level of economic flow was predicated on those prices (wage-based spending was indirectly supplemented by robust net worth growth). The psychological link between net worth growth and the falling savings rate is undeniable (which is why the Fed is always trying to influence expectations through the asset side of net worth), where debt is the link between the two.
The process was repeated in the next decade as the expanding stock of credit money pushed up the prices of real estate. Again, the essential link between those prices and economic flow was household debt, this time in the form of $7 trillion in mortgages. It was willingly added, the psychology of bubbles, simply because credit stock simultaneously acted transactionally on asset prices. The savings rate collapsed completely as wage income (or the distinct lack of it during the last decade) was essentially disregarded as the marginal source of consumer spending. As everyone knows, house prices became ATM's.
Again, the psychological link between money or credit stock and the issue of flow was the transmission of asset prices into incremental debt. From a policymaking perspective, then, it may seem logical to recreate that psychology to transmit additional money stock from both QE's (or the Bank of England's mini-QE or the ECB's debt monetizations) into still more marginal non-wage flow. The goal being non-wage, artificial flow leading or creating wage-based flow.
The link between stock and flow has been expressed in the modern equation of exchange: P x Q = M * V (where P = general price level, Q = economic flow or real output GDP, M = stock of money, V = velocity). Setting aside the numerous questionable certainties this equation assumes, it is taken as a given that increasing the stock of money leads directly to either an increase in prices (commonly known as inflation) or an increase in economic flow (commonly known as GDP), or even some of both.
What the housing bubble clearly showed, however, was that there is a definable and obvious difference between wage-based Q and artificial Q (not all Q is created equally). The stimulation of Q from money stock can be fairly called unsustainable and artificial since it is entirely predicated on the ongoing increase in the same money stock transmitting into prices, that then has to lead to further debt accumulation to transform into flow and a growing economy. In terms of the housing bubble, home prices had to rise at an increasing rate just to maintain a constant level of home equity extraction through debt, thus sustaining spending far above the natural level of wages (amply demonstrated by the near-zero savings rate in 2005).
The problem of artificial Q is that it does not give way to natural Q as central banks believe. Rather artificial Q attracts activity and resources (both monetary and real) away from natural Q . This weakens the fundamental and foundational level of real economic exchange flow, further magnifying the impacts of the eventual collapse in asset inflation.
This artificial, price-inspired Q has a finite existence predetermined by the very fact that central banks, as they currently construe monetary policy, will never continuously permit unfettered credit expansion. Since they believe that artificial Q is a temporary bridge to natural growth they will begin to shut off monetary accommodation at precisely the point that artificial Q seems to have worked. Unfortunately for the wider economy, at that point the bubble continues to draw resources and money past the inflection in monetary stance. The process of diminishing natural Q and rising artificial Q maintains the illusion of prosperity well past the policies to increase money stock.
The collapse of economic activity once prices can no longer sustain themselves is expressed through velocity (V). But velocity is a far more complex component to the intersection of money and economy (stock and flow) than just the simple idea of how many times a dollar turns over in a given period. Velocity, as I see it, is the expression of the savings rate (a direct velocity) and the preferences and choices made about savings. This gives rise to a layered, multi-dimensional velocity function.
The shortest path to natural economic flow is for businesses to contract with individuals to trade labor for money. Individuals then use the clearing function of money to further contract with additional businesses to obtain goods or services. This describes the most efficient path of money to allow for labor specialization and economic flow (what we would call a healthy economy).
The role savings play in the flow of the economy complicates the entire process. Though a reduction in spending velocity can be fairly expressed as a higher savings rate, a higher savings rate does not necessarily lead to a reduction in spending activity - it only changes the pathway money takes to get to spending. The overall level of money does not change here, only the method and preferences for those savings.
It is possible that given an increase in the savings rate of individuals, enough alternate money could find an alternate pathway to an additional form of credit to make up for the lost direct spending. In theory, an increase in available consumer credit to some parts of the economy could make up for a reduction in direct velocity in another. This theoretical possibility (which is more likely under conditions where credit and risk prices more closely resemble true value) is an example of where velocity is complicated by investment vehicles and incentives, often purposefully.
This additional layer of velocity means that there are distinct differences to those pathways, leading to an efficiency component of savings money. We can see this distinction expressed in the difference between holding money market funds vs. traditional deposits. Deposit money tends to fund the traditional banking system and its more traditional expansion of direct credit. Money market funds flow into repos and financial or asset-backed commercial paper, the very tools of the shadow and investment banking system. From there they recycle back to the economy through mortgages and structured credit while adding to the transactional nature of prices (including synthetic credit structures). These more complex elements of financial savings exhibit forms of leakage and leverage that can add additional changes to the form of savings money, making the impacts on final spending even more challenging and unpredictable. Yet given their complexity and opacity, during duress they are unquestionably a hindrance to monetary efficiency.
In our current predicament, we have seen an increase in the household savings rate, which reduces the most direct expression of velocity between business and labor. Large businesses, especially the multinational corporations that are seeing record profitability, have also increased their savings rate, as they are extremely reluctant to directly reinvest net income (though they seem unconcerned about expanding stock repurchases - again the financial economy over the real).
Further, there is an additional velocity within the banking system that has collapsed due to a lack of balance sheet capacity to create credit. So the movement of accumulated savings back into the traditional banking system, away from the shadow system, has not resulted in an increase in the efficiency of savings money. Rather, the subsequent change in savings preferences has been largely ensnared by the liquidity needs of the global banking system as it tries to fund past lending activities retroactively.
In a further form of velocity breakdown, the changing preferences for risky assets within investment savings (as the price and perceptions of risk readjust off their bubble levels) have favored sovereign obligors. This is in large part aided by the zero and low interest rates found throughout the developed world. In terms of velocity and flow, savings money now marginally flows through fiscal means (including the recycle of foreign trade money).
Effectively, the re-circulation of savings through government credit has been largely a disaster. Where it has reached the wider economy, it does so through transfer payments such as foodstamps and unemployment benefits. These are not methods that encourage money efficiency or reduce the savings rate (increasing direct velocity). Nor do any of these transfer measures recreate the productive wealth that basic labor/business contract does.
In response to all these building inefficiencies, central banks predictably enact measures that further change incentives to attempt to recreate past episodes of artificial Q. This, of course, leads to a perverted, and often inverted, incentive structure for savings that favors price action unfavorable to direct velocity. Commodity prices are a case in point, the expected "side effect" to fostering risky speculation in the vain hopes of enforcing "rational expectations" of inflation.
In other words, as savings velocity is taken away from a banking system that cannot get out of its own way, it is willingly redirected to other price avenues that hamper the economy beyond just monetary leakage. Commodity prices and the weak dollar (another expression of velocity - money flowing outside the national boundaries) actively suppress direct velocity as they force effective savings ever higher in absolute terms. Households are forced to cut discretionary spending just to maintain a constant savings rate in the logical and more rational hopes of rebuilding net worth.
The direct result of this convoluted yet vital notion of multi-dimensional velocity is a reduction in the overall efficiency of money in terms of economic flow. This, in large part, explains why the economy does not want to move to a recovery. No matter what means central banks take to increase the stock of money, they are more than offset by the accumulated reductions in money efficiency that this complex notion of interlinked velocity chains describes.
The worst part, though, is that the net effect of lower efficiency is, in fact, a direct result of past attempts to create artificial Q. Therefore, we need to not only split the Q variable into parts, the artificial Q component also needs to be expressed as a "tax" on future V. Again, as artificial Q is accomplished through the psychology of asset prices leading to debt accumulation, the inevitable removal of asset price inflation will always lead to a higher future savings rate, lowering direct velocity, as households (and businesses, particularly smaller entities) work to rebuild net worth through changing savings preferences and risk perceptions. This force is also amplified by additional velocity changes within the credit system and savings channels. So artificial Q not only reduces future direct velocity, it reduces the overall productivity of money in its ability to foster economic flow.
When the housing bubble counteracted the dot-com bubble, it simply increased the related tax on future V in all its forms. Each additional monetary application in the misplaced pursuit of a temporary artificial Q bridge simply ratcheted higher the future systemic cost to the economic system of monetary flow.
In theory, this tax could be absorbed by future growth if artificial Q actually did stimulate natural Q. But it does not. It stimulates the financial economy, not the real economy. All of the non-productive methods of money flowing through the economy have been accomplished at the expense of actual productive endeavors. So in terms of a describing the full cost to monetary interventions, there is a pro-cyclical double tax on the future economy as monetary designs for artificial Q reduce not only future velocity, but also diminish ongoing economic potential.
It is little surprise to see that at some point the inefficiency and reduced productivity of money becomes so great that monetary policy actually has little to no impact on even artificial Q (whether or not this is called a liquidity trap is really immaterial to the larger issues). However, at that point this double tax is enacted on an economy that is not even growing artificially. This leads to the formation of a second economic contraction that nobody thought was possible and monetary models are incapable of seeing since, among many other flaws, they are based on an incomplete equation of exchange.
While markets cheer the endless circle of unrefined, blunt methods of increasing money stock, the party will only last until the inevitable lack of flow re-imposes the ugly reality of the large tax due for the past and current episodes of artificial Q.
