Overrated Central Banks Seal Our Depression Fate
The impulse to compare current events to previous events is a part of human nature. Indeed, most of our groping obsession with predicting future events is based in the past, particularly a search for patterns. So as the monetary edifice of the European Union sits upon the precipice of its first major setback, concurrent and very much related to the financial system's ongoing deterioration, one cannot help but look again at the 1930's. In terms of parallels, that period is the only "contemporary" set of conditions that even comes close to approximating our own.
As Greece wanders into the ether of currency devolution, with rumors of its banking system poised on the brink of a real run, the memories, or at least the stylized recollection, of May 1931 come into view. It was, for many scholars, the failure of Austria's largest private bank, Kreditanstalt, that served as the final catalyst in turning the tide of the Great Depression from bad recession to full global calamity. The banking system and the global economy had been badly battered in the months after the 1929 Wall Street crash, but it was this new wave of failures that drove money into extreme shortage, propelling economic destruction globally.
Interestingly, the first wave of bank failures was not synchronous with the stock market crash. In fact, it was a year later before that first trend of bank panics set in motion the processes of monetary collapse. This, I believe, demonstrates the human element to the economic and monetary questions, that people and investors are not necessarily moved initially even by serious negative events. The crash in stocks did not automatically lead to fear of banks. There is often pause, a re-assessment of the situation. Economists currently favor calling this "uncertainty". It is nothing more than the general class of investors or the general public waiting for confirmation for which direction to turn. In the great uncertainty about the future after something decidedly negative is unleashed, people usually wait to see what everyone else does.
The first wave of bank failures reached a crescendo on December 11, 1930, with the failure of the Bank of United States. It was the largest commercial bank failure in American history to that point. But even after its bankruptcy, as Milton Friedman and Anna Schwartz point out in their seminal work, "A Monetary History Of The United States, 1867-1960", there was another pause before the events in Austria. In that second pause, between the first banking crisis and the second, modern monetary policy has been formed.
Noting the behavior of banks in the second pause, Friedman and Schwartz discovered that:
"The yields on corporate bonds rose sharply, the yields on government bonds continued to fall. The reason is clear. In their search for liquidity, banks and others were inclined first to dispose of their lower-grade bonds; the very desire for liquidity made government bonds ever more desirable as secondary reserves...By reducing the market value of the bond portfolios of banks, declines in bond prices in turn reduced the margin of capital as evaluated by bank examiners, and in this way contributed to subsequent bank failures."
I think the analysis here is mostly correct, that the bond portfolios of financial institutions was the key "contagion". Modern monetary theory, at least that part devoted to crisis response, has been based on this supposition. Everything that has been done by central banks in the period since 2008 has been accomplished with this in mind. The global coordination of central banks has been about learning this lesson from early 1931 - to make the pause after the first wave of bank failures lead to a renewed sense of confidence. The key, according to this theory, is not allowing bond prices to infect otherwise healthy institutions.
If human nature causes people to pause and re-assess before acting, then it stands to reason that if conditions return to "normal", or at least normality is viewed widely as very plausible, the actions that result after that re-assessment would tend toward normalization. The first wave of bank failures, then, does not lead to the second; the bad recession is limited to that, and another Great Depression is forestalled. The script of modern monetary policy follows just this logic.
To that end, we have seen active intervention of central bank purchases of credit securities (both mortgage-based and sovereign PIIGS), a semi-permanent zero bound of interest rates, bailout funds and sovereign guarantees of bailout funds. All to the same purpose: bond prices.
The result has been a nearly four-year pause and re-assessment period. It has not been routinely uneventful, however, as the big pause has been marked with mini-pauses and crises. In each episode, the monetary prescription is nearly identical to the previous, all because of this theory of bond price contagion. Bond prices must be defended at all costs, or else round two will be upon us.
In their famous book, Friedman and Schwartz put forward evidence that bond prices, particularly the "lower-grade" bonds that banks disfavored in the second pause, were not being fairly or even reasonably valued by true fundamental conditions. That is, illiquidity and the lack of bid for these bonds were largely responsible for the declining prices. The authors make the case that it was not default rates or the actual taking of credit losses on corporate bonds that drove prices lower and spread contagion, it was irrationality in the bond market as banks groped for liquidity. This forms the basis of an interpretation for the modern monetary response to crisis - that market prices may not be a useful guide to bank assets.
Somehow, however, this potential parameter has been perverted into market prices are always wrong. If we accept the premise that Friedman and Schwartz put forth about corporate bond pricing irregularity in 1931 as a function of liquidity rather than fundamental and true value, then the monetary response of defending bond prices might make sense. But what if the market is correct about true value, even in a narrow subset of troubled credit?
Again, in the psychology of the pause and re-assessment, this disconnect between manipulated market prices and perceived notions of true value actually works against proffered policy. The key to monetary success is that the central bank must convince enough of the general population that normalization is plausible. Plausibility is diminished severely by the constant tug-of-war between manipulated prices and financial gravity in cases where the central bank is wrong about fundamental value. That is Greece (and likely Spain, Portugal and Italy).
But is it really the general population that is subsumed by psychological unease? I do not believe that is an angle or parameter that has been given enough examination and analysis. In the early 1930's, the currency disease of deflation (and the monetary ramifications of that disease) was clearly a function of the general population's changing liquidity preferences away from bank deposits. But it extended beyond bank deposits into a general disfavor of financial assets altogether. As Friedman and Schwartz note, according to an official Federal Reserve memorandum from December 1930, the bond market was not only experiencing severe duress in terms of pricing, but as a whole the bond market was "almost completely closed to new issues". Monetary dysfunction was total.
In the worst days of 2008 and early 2009, there was no such wide-ranging dysfunction. Corporations that had found themselves short of bank-issued credit began to issue new bonds in record numbers and amounts. Where the economy suffered (and continues to suffer to a significant degree) is that that workaround in credit disfavored small and medium businesses, while large corporations had little trouble bypassing banking. But in the overall picture of the crisis as it really was, it was not a general monetary breakdown like that of the 1930's. There was no shortage of currency or even credit outside of banking. Indeed, the bond market has continued to provide a steady, if diminished, supply of credit to at least the largest businesses and obligors.
The crisis that enveloped the global system in 2008 was one in and of the banking system itself. The collapse of monetary stock was not currency used in the day-to-day transactions of ordinary individuals and businesses, it was a collapse in financial collateral - the derivative currency of the banking system. The dreaded deflation that has become synonymous with depression was limited there. The pricing and market irregularities that developed were not because of psychological irrationality on the part of the general public - there was no bank run of people waiting in line at individual banks trying to exchange mortgage bonds for cash. The run in 2008 was banks waiting in line at central banks to exchange financial collateral for cash (since they could no longer do so with each other).
The subset of dysfunction was and is the banking system itself. In some ways, this is a circular effort - the banking system must be saved so that it can operate normally so that the banking system can be saved. The collapse of money stock in the 21 st century is not cash currency, it is interbank currency. The entire affair, then, takes on an element of self-similarity, whereby the actions of the marketplace and demands for currency seen in the general population in the early 1930's is replicated at a different scale entirely within the banking system after 2007. The mistake (not the only one) central banks are making is applying these general rules from the 1930's on the wrong scale. The key is not to make the general population believe in asset prices (though central banks clearly believe that will lead to significant benefits in the real economy, but we are talking strictly in terms of money here), it is to get the banking system itself to believe in asset prices.
To some degree central banks were successful, particularly in that PIIGS debt has exploded during the crisis period. The banking system itself was mostly responsible for that massive increase in issuance; what banks didn't buy and hold central banks filled in the difference. But again, this theory of pivoting a pause into normality turns on plausibility. Central banks got pieces of the banking system to buy into Greece, but that by itself did not fix Greece. And so, like the Pied Piper, the European Central Bank plied the bank lemmings (especially in the respective home countries of afflicted banks) into marching off the cliff. There is no plausibility when the market prices that central banks fought so desperately to deny were correct in the first place. There was no full-scale buy-in to the central bank manipulations because the math simply did not work - financial gravity asserts itself in terms of the true ability of Greece to pay back debt, with full interest. That math also applies to Spain and Italy (and, eventually, the UK & US).
Whereas Friedman and Schwartz might have a case for intervention in the 1930's, though this counterfactual speculation is far from conclusive, the case for overriding market prices in the 21 st century is far less easy to make. Sovereign bonds are clearly not priced to reality, nor were the majority of mortgage bonds and other amalgamated structured and synthetic finance products. It is exceedingly difficult to fight irrationality, even within the banking system, when that assumed irrationality is really rational and well-founded. If central banks were intent on following the script set by these monetary interpretations of the Great Depression, especially with regard to pauses, they far exceeded that script by unwisely intervening in markets where prices were being correctly set by fundamentals.
I think, however, that the larger problem is the implementation of monetary "solutions" on the wrong scale. In applying monetary fixes to the real economy (including the so-called "wealth effect"), central banks were/are attempting to corral the real economy into partially fixing the financial economy. This is backwards, especially given that the monetary issues were/are constrained within the financial economy. By trying to enlist all asset prices to "help" push toward a normative state (including stock speculation), there were offsetting speculative processes in commodity prices. As much as austerity is being blamed for re-recession in Europe, there should be a realization that energy and food prices are playing a large role (perhaps even a much larger role than austerity). Re-recession is not favorable to the plausibility of a potential return to normality.
If the direct link between recession and depression was bond pricing irregularities in the early 1930's, how should a central bank combat bond pricing regularity ? In other words, what monetary plan is there for when bond pricing and bank dysfunction is actually the rational behavior, and central bank liquidity and money elasticity is the irrational behavior? I think that this scale problem is contributing to this mismatch, and it explains why so much in the financial economy remains backwards or upside down. Reality is not conforming to the Friedman-pioneered script, a supreme error of modern central bank theory.
If I am correct about this, then the only solution is to allow the financial economy to devolve. After all, if bond prices were unduly robust to begin with, it makes more sense to let them adjust toward true value than to simply ignore true value in the vain hopes that rational behavior (current markets) turns irrational (central bank-inspired markets). Unfortunately, devolution will require a significant adjustment in the financial economy, including a severe curtailment of its size and scope. Central banks would be wise to spend nearly all of their resources into studying just how an orderly unwind of this tangled mess might be propagated, rather than going in the other direction by expending capital and credibility on artificially maintaining such unreasonable and implausible terms.
The element of self-similarity in all of this speaks to a complex system in a critical state. Such a system is one ripe for transition from one state to another. Actively seeking to keep the system from transitioning does not produce those results, rather it makes the transition more violent as internal pressures build in unanticipated ways, finally exploding as an unpredictable and massive phase shift. Logically, it might have been true that central bank action according to this script would have saved us from depression, but that does not preclude the possibility that central bank action can also be its cause. It is possible that this error in understanding and ability of central banks, rather than prevent depression, actually seals that fate.
