Putting Banks First Is An Economic Dead End
It is commonly understood that inflation, especially the official and accepted definition of it, is entirely a monetary phenomena. Inflation, that is the general rise in the level of prices across the entire economy, is caused and aided by an imbalance in the level of monetary growth relative to growth in the real economy. It is an under-appreciated sentiment in that it might be the only place where contemporary economics sees daylight between the financial economy and the real economy. Ironically, this separation is currently being used as an excuse to continue monetary debasement in the name of saving the global banking system.
Outside of that narrow view, the distinction between the financial economy and the real economy has been lost, intentionally blurred by modern economics' perceptions of necessity. The 1970's were a perfect example of just how these two realms are really separate systems that intersect only at vital nodes. In August 1971, in a powerful show of force determined to combat inflationary "expectations", Richard Nixon's government instituted a 90-day freeze in wages and prices, unprecedented in peacetime. It was a real world, real economy "solution" to 4-6% inflation rates. Inevitably the 90-day period was extended into four "Phases", lasting in some forms all the way into April 1974. Inflation had reached 10% by then, on its way to even higher levels (and continuing to be a problem throughout the decade).
After Nixon, President Ford's Whip Inflation Now (WIN!) campaign was "creative", but it was as ineffective as Nixon's attempts at central planning. Inflation, as it is commonly accepted, was "ended" by the "heroic" monetary actions of Paul Volcker's Federal Reserve (I have argued that inflation was not defeated at all, it only transformed or transferred from the obvious consumer price-type inflation to asset prices which are far more palatable, at least initially). Despite the fact that monetary imbalances had real world consequences, the attempts at real world solutions failed to bridge the causal divide between the monetary and the real spheres. This was a nearly universally recognized parameter of the separation of finance from economy. It is also a hard, but unfortunately fading, reminder that the financial economy should take no precedence over the real economy - the monetary realm should only be a compliment to the transpositions of the true system of economic transactions. Finance can be at times a tremendous, undue burden of mistaken philosophy.
In 2012, there is no such recognition. Finance and economics have become intertwined in ways never before contemplated. How many times have we heard that a failure of the banking system necessarily and conclusively would/will lead to failure in the real economy? The Great Recession was supposed to be that irrefutable piece of evidence that banks are part and parcel of the real economy, that there no longer exists any daylight between the monetary and the real. This was the basis for Treasury Secretary Paulson's sales pitch for TARP: the banks fail, the global economy fails.
The Federal Reserve has gone far beyond TARP into ZIRP (zero interest rate policy). ZIRP is a direct tax on savers, figuratively taking money out of the pockets of those who have acted responsibly in the real economy, transferring it to the banking system (especially the largest investment banks, the very banks responsible for most of the credit creation and monetary imbalance of the past asset bubbles) that was negligent, reckless and complicit in this disaster. Monetary policymakers, the gatekeepers to the realm of the monetary or financial economy, now intentionally and directly penalize real economy actors in favor of financial economy actors. They do so with this narrative that as the financial economy goes, the real economy will follow. Very few people seem to challenge this as backwards, certainly not anyone in a policymaking role.
The primacy of the banking system informed both iterations of quantitative easing in the US, and, make no mistake, it now informs the decisions about policies surrounding the very real world fate of Greece and its Mediterranean cousins. Banks have to be "fixed" first in order for the real economy to follow, a strain of modern economics that seems to have penetrated every national boundary. We have "progressed" so far since 1980.
This evolution in economic thought traces back to the Great Depression, specifically with a new generation of Depression-researchers that came to prominence in the 1970's and 1980's. Among these diligent scholars was Ben Bernanke, producing impressive material and thought that did advance our understanding of that unique period in global economic history. There is little doubt that the collapse of the banking system in the early 1930's was responsible for mutating a bad recession into economic calamity, but does that necessarily mean it can or will be replayed under different, unique circumstances?
I don't think it is controversial to state that this line of thinking got a huge boost in the early 1990's as the Federal Reserve and federal government successfully "managed" both the S&L crisis and the marginal economy. Anyone who remembers that crisis, especially the early period in 1989 and 1990, remembers the numerous and constant references to the Great Depression. It was a fear that was shared at nearly every level of the economy; the first great banking panic and collapse to occur since the 1930's and no one really knew where or how it would end.
The banks were bailed out by taxpayers, the Fed began unconventional (at the time, today they seem comically tame) monetary easing in various forms, including an interest rate target that had not been seen since the early 1960's, and the economy only experienced a mild recession (though the recovery was weak). It was the golden age of economic micro-management, giving rise to the idea that monetary policy could be an effective tool for controlling marginal activity in the real economy. The key was the banking sector, particularly the growing importance of investment banks.
Of course the vital link between the financial economy and the real economy is money in various forms. Not only is there the physical form of money, such as real dollar bills and coins, there is also credit money. The traditional notion of money, the one that most people seem to hold even today, is one of a physical system of real dollar bills and coins. Under this system, such as it existed in the 1930's, physical money was a liability of the central bank (the U.S. Federal Reserve) but was safeguarded by various and dispersed banks throughout the country. In terms of owners of that physical cash, a bank was nothing more than a vault for safekeeping these cash piles.
However, these physical stores of cash also formed the basis of the fractional reserve credit money pyramid. Banks "loaned" out this cash by creating deposit balances for borrowers, essentially conjuring additional claims for every physical dollar in "reserve" (this is hypothecation). When a bank failed because too many owners tried to reclaim physical cash at the same time, owners of physical money that were unable to validate or act on their claims to money lost everything. That created a problem when physical money was the only money available to conduct basic commerce. As bad as unemployment was, the general public could not even fall back on their savings to meet basic needs - people literally became penniless.
This shortage of currency, physical dollars, created the conditions for the very destructive deflationary pressures that made the Great Depression what it was. Deflation is a currency "disease", essentially a circumstance where the demand for money is far higher than the supply - the inversion of fractional lending. The shortage of real money was so acute that the population often resorted to the firesale of real goods to raise at least some cash to generate basic commerce, essentially devaluing the entire productive economy at once. This spreading of financial deflation in asset prices and credit into deflation in the real economy occurred because physical money was the basis for both. In the parlance of the 21st century, this physical money link was the pathway for contagion.
The very nature of money and banking has shifted dramatically in the decades since, however. Banks are no longer just storage vessels for physical dollar bills. The first major evolution was check writing - essentially a method of moving money without moving physical money. Check writing is really nothing more than accounting adjustments between different institutions, taking the basis of the financial economy impact on the real economy onto banks' balance sheets - with a central bank acting as the clearing agent between all these accounting transfers, giving it a central role in the accounting schematic. Banking has evolved further with the technology of plastic, where physical money itself has become a relative relic.
In this vital way, the banking system's added "value" or intersection of the monetary economy with the real economy is in both these accounting transfers and the growing importance of credit money. Functionally, you are able to walk into a grocery store and purchase real goods with physical dollar bills, a personal check, a debit card or a credit card. The latter three of those methods entail only balance sheet adjustments to the transacting banks, making those forms of money almost entirely digital (there are still physical cash reserve requirements, though they matter very little in today's banking system).
That brings us to the collapse of the banking system in 2008. There is no denying that it was a catastrophe and that there was a significant negative impact on the real economy. In response, central banks around the globe began to reverse their course (until September 2008 they were still primarily worried about in flation) and enact "unconventional" policies to ward off any hint of deflation. Flooding the world with money was both an expected means to create inflation expectations (to counter any possibility of deflation) and an expected means to circulate that money in the real economy (the philosophy of credit creating economic activity). So, reaching into the Great Depression handbook that Bernanke helped develop over the past forty years, banks have been afforded first priority of both monetary policy and political maneuvering.
But how much economic damage was due to a shortage of money? Or, to put it another way, how much of a deflation danger was/is there?
I believe that none of it was, and that there was/is absolutely no danger of 1930's-like deflation. Even during the worst days of September 2008, after Lehman Brothers failed and Wachovia and Merrill Lynch were "shepherded" into the arms of suitors, there were no massive lines waiting outside banks to withdraw physical currency to allow for the conduct of basic commerce. The general population was never in danger of losing the ability to exchange cash for goods and services. Without that dangerous shortage of a valid means of exchange, true, real economy deflation was never really a possibility.
The shortage of money was confined to the interbank mechanisms of those accounting transactions. It was bank balance sheets that were short of currency - quality, liquid collateral, not physical cash. Despite all the panic within the financial realm, there was never a period where millions, let alone even hundreds, of people tried to empty ATM's. The monetary issues of financial and asset deflation never spilled over out of the financial economy into the real economy because money as means of exchange no longer formed the basis of the banking system's pyramid of fractional credit. Accounting transactions and balance sheet numbers were/are the basis of panic, something that has no direct impact on how people access or use modern forms of money. The vital functions that money performs in the real economy was never an issue, only money in the financial economy sense was/is.
In very basic terms, the Great Recession has never been about a shortage of money, it has been about a shortage of income - the methods of circulating money through the economy. Millions of people lost jobs, but they never lost the ability to exchange money for goods. The Federal Reserve and FDIC appropriately stepped in to guarantee depositors, the one real role central banks should play. Their primary goal should not be the banking system, it should be to safeguard the access to money for real economy participants. Putting the banking system first is not a pre-requisite to accomplishing this goal - allowing banks to fail and making sure depositors are safe are not mutually exclusive.
What the Great Recession has been is a reversal of the idea that credit and banks are equal to the real economy. Since 1990 (and really before that, but the S&L crisis and the 1990's elevated this "ideal") marginal economic activity had been increasingly accomplished through asset price inflation and related debt accumulation financing consumption. Deflation in asset prices since 2008, especially credit, simply blocked off that route for monetary circulation. The real economy still functions, only the quantity of activity has changed as the credit path to marginal activity has not been replaced by any real substitute (governments have tried through transfers, but they are even more ineffective and inefficient in terms of circulating money).
No matter what the financial and economic problems, there has never been a shortage of money outside of the banking system. Sure, the real economy is performing at a sub-optimal level compared to perceived "slack", but since the economy was geared for so long toward the artificial financial economy it cannot easily transition back toward its sustainable foundation without dislocation and weakness. On top of that, how much of this current weakness is simply a function of so many resources being squandered on the attempt to restore the dominance of the financial economy?
In other words, economic potential is far less than what the economic textbook perceives it to be given this massive misallocation of resources. In order to increase potential it is necessary to remove artificial obstacles to allow the economy to effectively and efficiently re-allocate resources. Efficiently allocating scarce resources means effective intermediation from the financial economy, something that is impossible under current circumstances where central banks are using "intermediaries" for other purposes.
Central banks and fiscal authorities continue to try to circulate money through inefficient and ineffective means (central bank balance sheet expansion to kickstart the banking system and government borrowing for more transfers), but these attempts are not neutral propositions. The adoption of these policies adds further burdens to the real economy in the form of commodity prices and tax increases (or the expectations for more of both). Recoveries are not forced into existence; they are the willing acceptance of real risk (not financial risk) when real economic participants deem it appropriate to do so. Recoveries are the beginning process of re-allocation, so the desperate attempt to maintain the old system is counterproductive.
However, if we look at the system in this historical light, particularly the evolution of money, the philosophical foundation of this debt-first regime falls apart. There has been no shortage of usable money in the real economy since any deflationary pressures were completely confined to finance - the reversal of all the asset inflation built up over the previous decades. Furthermore, the determined attempts to create inflation have largely failed because the financial economy can no longer create and maintain pathways to circulate credit money. The banking system cannot even create additional debt (there is still a desperate shortage of balance sheet capacity), and any hope of dispersing it fails with the new emphasis on adhering to actual lending standards. The bank-first approach needs to end because it is a dead-end. Greece is just the first demonstration of where the dominance of the financial economy inescapably leads. Gasoline prices are another.
If the problem is a shortage of income, then the focus should be on income. Credit creation and asset prices are not the same as jobs. The most efficient way to circulate money in any economy is the direct trade of labor in a productive process. That creates true wealth, the very basis of the real economy. Throwing trillions of fiat units at the banking system is the opposite of true wealth. Eventually, given the gravity and growing resistance to this method of "resolution", the idea that the real economy and financial economy are not the same thing will be reinstated within the framework of economics and monetary policy. The question is how many crises it will take.
