Bernanke's Flexibility Is Constraint For You and Me

Federal Reserve Chairman Ben Bernanke's recent publicity tour included a lecture on the gold standard. Not surprisingly, Chairman Bernanke was very critical of the monetary gold standard, especially its limitations on central banks to effect policies that might alleviate economic imbalances. Primary among these imbalances, especially from the perspective of a central banker, are recession-induced unemployment and deflation. Again, the lessons of the Great Depression, according to Bernanke, bear out his perspective. Gold is simply too confining.

I have to agree with the Chairman on this point, but wholeheartedly disagree as to whether confining a central bank is actually undesirable. He might point to the Great Depression to press his case against constraint, but I will just as easily point to the current period as an equally strong counterpoint (even with the ultimate fate of the current period as yet unknown). However, if we really drill down to the base case, this disagreement is really over the role of creative destruction in clearing imbalances. The Fed, and this was admitted in the 1990's with great enthusiasm, has been committed to smoothing out the business cycle, to the point where it believed it could actually eliminate it altogether. The interpretation that should follow from that is that there is no role for creative destruction, that a market-based economy is an inferior form of economic management (since markets move in more than one direction).

By committing itself to eliminating the business cycle (completely setting aside the discussion of actually where a business cycle might come from, only stipulating here that one actually exists) over the past twenty-plus years has meant assuming a much more activist approach to the economy and markets. Bailouts had been practiced in isolation in the decades preceding the S&L crisis, but the Resolution Trust Corporation brought about the practical application of systemic bailouts and the primacy of credit creation (the favored status of the banking system in the economic order). The Fed played its part in the S&L crisis by directly "stimulating" the economy through monetary policies, and aiding the banking system directly by targeting interest rates.

From there we have moved from a capitalist, decentralized system of price discovery fostering the allocation of scarce resources to, as ZeroHedge has coined the term, a "PhD standard" of econometric models showing academics where to push marginal inputs in the "correct" direction, even and especially if that "correct" direction is in direct conflict with market determinations. We know this definitively by the obsession of current economic canon with the "output gap". The central bank and economists measure the current state of narrowly defined inflation in proportion to equally narrowly defined unemployment and calculate what the economy "should" be doing. If that "should" is greater than actual output (narrowly defined by the dollar amount of goods and services produced or traded domestically) the Fed moves into its toolkit to force various levers of monetary policy toward the desired, mathematically calculated result. The only role of markets in this circumstance is as a more direct (but still largely indirect) transmission of those policy objectives. Alternate opinions not only have no role, they are to be extinguished ("you don't fight the Fed").

The primary tool of the interventionist central bank in the past twenty-plus years has been interest rate targeting. Before the 1980's, the Federal Reserve set monetary policy by targeting a level of reserves within the banking system, allowing interest rates to be set by the interbank marketplace. Though still under the auspices of the central bank, this type of system more closely resembled the gold standard in that central bank money (reserves) was scarce. The perceptions of scarcity were transmitted as interest rates, meaning a market and market-based determinations set the systemic cost of money and financial assets.

For intermediaries, then, the knowledge and near-certainty of scarcity meant a higher degree of care in that role of intermediation. Banks were forced to increase the productivity of money by exercising specialized information and services to control the type and level of economic projects that ultimately were financed. Since there was only so much central bank money to go around, banks had to maximize its usage by making the most profitable decisions. That meant they had to be relatively sure that loans were made to the most desirable obligors, those that were judged (imperfectly, for sure) to be most likely to pay back those loans at some maximized, profit-inducing interest rate.

For various reasons stemming from its interpretations of the Great Inflation (which is another fertile subject) and its role in it and attempting to control it, the Federal Reserve believed that skipping the reserve-targeting step would be more beneficial to achieving its perceptions of its mandates. Instead of targeting bank reserves and letting the interbank market set the interest rate from that monetary variable, the Fed simply began to target the interest rate directly. From Chairman Bernanke's perspective, interest rate targeting allows more flexibility for the Federal Reserve to manage economic inputs.

Under the interest rate-targeting scheme, the Federal Reserve pledges to create and release, or retire and withdraw, an unlimited amount of reserves (central bank and interbank money) to achieve its interest rate target. If the Fed targets a Fed funds rate of 5%, it will create any amount of bank reserves to meet any and all bank demand for funding. As such, if demand for interbank money rises, which puts upward pressure on the Fed funds rate, the Fed releases additional reserves to keep the effective rate close to its target. The converse is also true. Should demand for interbank money wane, the Fed will withdraw "liquidity", creating an artificial scarcity that keeps the effective Fed funds rate up close to the official target.

When sketched out schematically like this, observing that potential interbank money can be moved in either direction (plentiful or scarce), it seems like interest rate targeting achieves monetary symmetry. Given such symmetry, it further seems plausible that symmetrical control over bank reserves, and thus credit potential for the economy, might result in a smoothing out of the business cycle. If the economy grows too fast, resulting in a negative output gap, withdrawal of interbank money theoretically slows credit production as reserves become more scarce, and therefore more costly. If the economy grows too slowly, with a positive output gap, banks know that there is an unlimited amount of liquidity available at a cheaper cost to expand loan growth.

Of course this system of economic management is highly dependent on the output gap calculation, otherwise, as is well known now to everyone outside of conventional economics, monetary policy will be badly aligned with reality. But that is not the only design flow in this credit/monetary regime. As it is construed with interest rate targeting as a restraining factor, it has achieved nothing like the expected level of symmetry. Interest rate targeting performs as expected under perceptions of a positive output gap, that is, unlimited reserves at low cost do create economic activity through credit production (even though the type of that activity may not be desirable over the long run). On the other side, though, the restraint of increasing short-term interest rates proved to be little restraint at all, at least in the manner in which it was intended. This has led to monetary policy that is completely one-sided.

Again, at whatever interest rate target the Fed sets, it will create any and all reserves to maintain that target. In the midst of the housing bubble, starting in the middle of 2004, the Fed attempted to restrain credit by increasing the Fed funds rate (I will also note that the direction and level of the Fed funds rate is closely matched by LIBOR, meaning the Fed has effective control over both the domestic dollar-denominated money market and the foreign dollar-denominated money market, the eurodollar market, a fact the Fed was and is aware of). Instead of constraining credit creation by making unlimited reserves more expensive, the move in rates simply pushed banks and equity-based shadow lenders further down the risk curve - the subprime boom.

Instead of reacting to an increase in the cost of funding by curtailing lending activity, banks instead sought to offset that increased cost through an increase in interest "earned" or through profits from other arenas. Despite the rise in interest rates on the short-end, mortgage rates failed to match that increase, severely reducing mortgage spreads, more than suggesting that the availability of funds in the mortgage market was maintained at a high level despite the Fed's intent. Instead, it only magnified the need to achieve higher realized profit through any means and all means. There is no mystery as to why subprime mortgages were prevalent during this period, and that the "vintages" of structured finance products were worst during this "constraining" attempt by the Fed.

The major abuses of the financial system during the housing bubble can be traced back to unlimited funding of reserves. The financial economy was essentially given unlimited resources to grow itself in any manner possible. This included the move toward gain-on-sale accounting and off-balance sheet arrangements that effectively expanded leverage within the system. When bank money is guaranteed to be plentiful, everything is on the table in terms of credit expansion and profitability. It is a license to make money in any way imaginable, which is why financial innovation has exploded right alongside the use of interest rate targeting.

Subprime would never have been a problem if reserves were scarce, either through a gold standard or even the former monetary system of reserve targeting. Had the system that prevailed in the 1970's been in use in the 2000's, when confronted with a central bank attempting to constrain credit growth, banks would have actually performed intermediation by weeding out less desirable borrowers because their access to funding would have been limited by the scarcity of reserve money. In addition, the systemic cost of risk would have been far more closely aligned to reality since it would also have been set by the market for those scarce bank reserves.

The impetus for moving out of reserve targeting was a desire for greater control over the ability to direct economic activity. Interest rate targeting, and thus the entire monetary framework of ultimate control that Bernanke is arguing as desirable, has largely disabled the entire process of intermediation. The pace of disintermediation has expanded proportionally to the control that the Fed attempted to exert over the economy. Calling this financial innovation is simply glossing over the negative impacts of all of this. That asset bubbles and economic conflagration have resulted is not surprising. A healthy economic system is dependent on productivity in both the real economy and in money (especially credit money). Intermediation is the key to that productivity.

Under the auspices of Federal Reserve flexibility, intermediation itself is transformed from trying to build a sustainable economic foundation to solely considering how to create any and all activity today. The time horizon for credit has been shrunk to essentially zero (especially in the cases where loans were originated with sole intent to dump on someone else), a condition that is the exact opposite of the maturity transformation of money that intermediation is supposed to enact.

In arguing for this freedom to disengage intermediation, Bernanke, on behalf of modern economics and econometrics, is also arguing for flexibility to react against external shocks and imbalances. Global trade is often where these imbalances originate. As I argued last week the Federal Reserve has perpetuated the global trade imbalance that has formed since the 1980's. The United States has willingly traded, under this PhD standard, true productive capacity for an enlargement of the financial economy. The former was shipped overseas in the name of corporate profitability and low consumer inflation, while the latter was allowed to grow out of balance to fill in the gap as earned and wage income languished through continued "outsourcing". This massive trade imbalance grew solely because of the central bank's ability to be flexible.

Under a gold standard, the festering trade imbalances would have induced gold (or capital ultimately convertible into gold, some kind of counterflow resistant to debasement, i.e., true reserves) to move overseas with the productive capacity. As such, the supply of bank reserves would have been diminished, restraining the ability of credit to fill in for lost wages as jobs left our shores. That would have restrained the economy from moving further and further away from its fundamental dependence on earned income and true (not paper) wealth. The financial economy would not have been able to overgrow because, in a scarce reserve regime, it is constrained by the real trade of real goods since money itself is directly tied to the mercantile balance. In other words, the productive real economy generates the wealth/money upon which the financial economy pyramids. Where the productive capacity goes, the money goes. As real money leaves with the jobs, that naturally self-corrects the trade imbalance since we would find it more and more difficult to steadily import goods.

While central banks find this to be in direct opposition to their output gap and perceptions of economic potential, most recognize, especially in light of today's economic circumstances, that it would have been better to allow self-correction to take place decades ago in the form of slower growth, much less debt and no succession of asset bubbles.

We had already experienced this kind of global imbalance in the 1960's, when the quasi-gold standard led US exported capital inflation (due to the dollar as reserve currency) to return as growing claims for the US gold stock (especially from France). As those claims grew untenable, the Fed in 1970 and 1971 had the choice of restraining money growth further (the economy was already in recession) or repudiating gold convertibility completely. Not surprisingly the Fed and the Nixon administration opted for monetary flexibility over restraint, and we suffered the balance of the Great Inflation as a result (a bit of oversimplification here).

Of course, contrary to Bernanke's recent pronouncements, the gold standard as it existed in the period preceding the Great Depression was about as constraining as the gold standard as it existed in the 1960's under Bretton Woods. As much as he has a vested interest in having the gold standard take the fall for the severity of the crisis, the 1920's gold standard was nothing like the gold standard as it existed prior to World War I - the classical gold standard. Under the gold exchange standard that developed in the 1920's and was "perfected" at Bretton Woods, there was not really much of a constraint on central banks to, as we saw in 1971, undertake offsetting policies that ultimately defeated the entire purpose of having a gold standard in the first place. Nowhere was that more evident than the late 1920's after Britain re-established the "gold standard" in 1925. It overvalued the pound, particularly in relation to the US dollar, but rather than allow a true gold standard to cure the imbalance, the U.S. Federal Reserve chose to sterilize gold flows that were created by that overvaluation.

That flexibility to sterilize sparked a bubble in credit, especially call money in New York, that ultimately led to the stock market "boom" and then the 1929 crash. Had the flexibility not been there for the Fed in the 1920's, the bubble-type pressures would not have been so severe and, arguably, the Great Depression also may not have been so severe (there were imbalances from other places that required creative destruction, so some kind of recession was probably inevitable). If a true gold standard had been allowed to constrain central banks, credit growth and economic growth would have been curtailed during the late 1920's "boom", taking a lot of steam out of the growing imbalance, likely requiring a far smaller negative adjustment or dislocation.

It is often cited in contemporary economic literature that the classical gold standard period saw much greater variability and volatility in both prices and output. Typically the classical period is compared to the "flexibility" period, encompassing Bretton Woods and the first part of the fiat period (1946-1990 or 1946-2000), often leading to the conclusion that empirical evidence suggests central bank flexibility is desirable. However, those calculations should change dramatically if the "flexibility" period is enlarged to 1914-2012 (not letting central bank proponents cherry-pick time periods), encompassing the whole of the period after the end of the classical gold standard. Not only does it include two world wars, there are three depressions (the early 1920's, the 1930's and the current period), the Great Inflation, the S&L crisis and the dot-com bust. And that is just the United States.

Ultimately it is a question of who better determines the "proper" course of economic and financial trajectories. Is the market more efficient or can PhD's better manage such a complex system? What Bernanke and his ilk are arguing, unambiguously, is that central planning in the central bank form is a better way of arranging national and global economic affairs than allowing decentralized marketplaces to allocate resources. Therefore there should be absolutely no constraints on the central bank to create and enforce monetary policies.

What I and many others argue is that central planning of this kind is not only not more effective (the laughably flawed output gap calculation, inverted and intentionally ineffective intermediaries), it is downright dangerous to give up so much power to one organization. It is further dangerous when such an organization is owned and run by the banking system itself, with only a loose (and often captured) relationship with our representative government. Without conclusively demonstrating that the central planning model is far better an economic and financial alternative, with the burden of proof on those that want to consolidate economic and financial power, I prefer a concrete and exogenous restraining factor on the flexibility of the central bank to unilaterally impose its own visions and calculations without discussion or opportunity for true dissent.

I am not necessarily advocating a return to the gold standard, even the classical gold standard. That should be part of the larger discussion taking place, where the priority is framing a system that decentralizes the ability of any agency or cartel to direct the economy and markets. Instead of giving the Fed more power and flexibility, we need to be designing a system where the central bank has a very limited and defined role (especially since it is largely responsible, through self-delusion, for destroying the banking system's capacity for intermediation). Freedom means checks and balances, meaning a reduction in the concentration of power.

Ultimately Ben Bernanke and central bankers despise gold and any gold standard because it restrains their power. Gold means freedom from central planning because it is the opt out when central planning inevitably goes awry. However, we would not need to opt out if central banks were severely constrained and restrained by some exogenous factor in the first place. Central bank proponents will point to the Great Depression as evidence of the gold standard's shortcomings, without answering for sterilization. They will look to the prosperity of the 1960's without explaining the 1970's. They will shout about the Great Moderation without linking the dot-com and housing bubbles. The current depression is a failure of capitalism that begs for more central bank control and flexibility, despite the unparalleled level of control and flexibility central banks have enjoyed, to the point that intermediation is no longer recognizable.

Failures are always market-based, while economic salvation always lies in greater, more centralized control. Perhaps if reality and history actually matched Bernanke's vision there would be so much less resistance to his desire to keep acquiring authority and power that once rested in the freedom of markets to decide these very important issues. Flexibility for him is constraint for you and me. Fortunately, the reverse is also true.