Laundering Away a Chance For a Stable Economy

For a brief moment on Tuesday the global financial world seemed to be a far better place. Greece has been under extreme pressure this month to meet maturing obligations of its own rolling debt and to repay a hefty €3.2 billion Euro bond due on August 20. To meet this fiscal challenge, the country earlier this week planned to auction €3.125 in three-month t-bills. In a non-competitive bid auction, Greece managed to "sell" €4.1 billion at a price to yield 4.43% (compared to 4.28% last month).

Having essentially defaulted on its debt earlier in the year, Greece can only struggle to maintain a place within the euro framework because it is fully unable to sell any debt to actual investors outside of Greek banks. But in a bit of a further twist, something that caught a lot of attention after the fact, on August 2, 2012, two weeks before the planned auction, the ECB changed its rule regarding Greek t-bill exposure. Previously, the Bank of Greece (the country's central bank) could only pledge up to €3 billion in t-bills as collateral for funding through the ECB's emergency liquidity assistance (ELA) program. The upper bound for borrowing was increased to, as you may have guessed by the amount of t-bills actually sold this week, €7 billion. Magically, the auction is a huge success and the Greek government can more than pay the maturing Euro bond with euros from the Euros.

Back in the real world, the country is in such dire straits that it is completely out of options in the private debt market, so the ECB is forced to funnel funds indirectly through what are, in all honesty, nefarious means just to maintain appearances. For a country that supposedly has very little impact on the wider world, authorities are going through every measure to ensure that there is no chance that it actually might. I met with a very astute client the day this transpired and he tried very hard to see any difference between this ECB backdoor funding and money laundering.

I say these are nefarious actions because in reality the real economy, where actual people actually operate under real constraints, this kind of indirect laundering of "money" has consequences. Spot oil prices (Brent) in euros are back above their 2008 highs and just short of all-time highs set earlier this year. The timing of these moves just happens to coincide with ECB actions (LTRO's and SMP's) and expected actions (Draghi will do anything to save the euro). Of course, there are other factors, including perceptions about real supply conditions, that play a role in energy prices and all prices for that matter, but the timing and coincident movements of energy asset prices in particular and overall commodity prices in general tend to follow central bank actions and expectations for future actions (as appears to be the case again since June 2012).

Switching gears for a moment, in a January 1996 paper for the National Bureau of Economic Research titled "Nominal Wage Stickiness and Aggregate Supply in the Great Depression", authors Ben Bernanke and Kevin Carey attempted to make sense of how money could be non-neutral over a prolonged period, a violation of their theoretical framework of monetary understanding. In adopting the larger view that the gold standard contributed mightily to transmitting the monetary distress globally, Bernanke and Carey view the downward slope of the aggregate demand side of the Great Depression equation as a function of monetary collapse. For them, that left the "supply" side of the equation without proper context, "why were the observed worldwide declines in nominal aggregate demand associated with such deep and persistent contractions in real output and employment?"

Setting aside completely any disputes I might have with their theoretical explanations for the Great Depression and the role of the gold standard, and using their own framework of understanding to help us observe the global economic condition as it exists post-2008, their conclusions lay out an interesting set of observations. Their run of data and analysis led them to conclude that "countries which adhered to the gold standard typically had low output and high real wages, while countries who left gold early experienced high output and low real wages."

Under the gold standard theory of aggregate demand collapse, the restrictions on monetary adjustments owing to preserving gold convertibility in some form meant that countries and their respective economies that followed these "rules", including the United States, were forced to adjust nominal output and employment instead of wages to meet changing price conditions (which were brought about by this monetary rigidity). Firms that were being squeezed by real deflation (the currency disease of monetary hoarding, not to be confused with a general decline in prices) logically responded by disgorging inputs, including labor. What economists like to argue is that there should be a coincident "devaluation" of wages akin to prices, but it did not take place in the 1930's where money stocks were being purportedly decimated by gold restrictions.

From that line of analysis it is likewise logical to conclude that the supply of money should be defended and any sort of process or event that attempts to restrict the flow of money globally or internally must be circumvented and/or defeated, or else the burden of monetary adjustment will fall on aggregate supply - output and employment - once more. What that means is that given the level of monetary declines or even a reduced growth rate, the labor force under restricted gold constraints prices itself out of the market for production or productive activities. With labor being "too expensive" given the decimation of "aggregate demand", the only response for firms is to continually cut costs through wholesale layoffs.

Given all that has occurred globally since 2008, there is a bit of dissonance between the implementation of "proper" policy procedures (which, I assume, includes Greek central bank laundering) and the ensuing economic nirvana absent the appearance of sticky wages or deflation. In the US, as well as much of Europe, the seemingly perpetually depressed circumstances in aggregate demand and supply, such that they even exist, would suggest that monetary "flexibility" might not be the sole factor determining wage "stickiness" or production/output constraints. If unemployment persists at high levels given all the monetary incentives for firms to engage labor, would that not suggest that labor is still "overpriced" given market conditions?

We know that a condition like this exists in Greece. Its labor force is far too expensive on a productivity basis within the euro currency; that is, after all, the primary factor that brought about the current depression in Greece. The same is true for the depression in Spain, with both countries suffering the inflexibility in currency relations with Germany. We can extend this idea further and draw the same conclusions for the malaise in the United States with its apparent and persistent labor shrinkage. The lack of improvement in the number of jobs system-wide suggests that, under the terms of conventional macroeconomic understanding advanced through Bernanke and Carey, US labor is not adjusting wage levels to form a market clearing price that would allow the overall level of employment to return to pre-crisis levels. Remember, under their conclusions restrictive monetary terms lead to high wages and low output - the very conditions apparently seen in these depressed countries.

Of course, conventional macro-economists operating under the assumption that the macro environment is a separate space from the micro environment would likely conclude that monetary policy is therefore still too restrictive. In Greece, that is surely the case, but monetary policy here means currency valuations rather than the availability of credit for the government. The Greek people have little need for an expansion of credit availability through the ELA or any other means, but have desperate need for the alleviation of productivity disparities and relative debt loads - something even the earlier debt restructuring did not provide in any way (because it was limited to government debt alone).

In the United States, the incidence of less-than-desirable growth in nominal output coupled with persistent unemployment will surely be seen as proof of the need for additional monetary "flexibility". The central bank must, according to these conclusions, take macro actions to "cheapen" the relative value of some inputs (credit) so that businesses find a higher equilibrium of labor utilization. Theoretically, the devaluation in the US dollar should accomplish some of this, particularly with regard to currency competitiveness for domestic production. But given the relative disparity among productivities with the so-called export economies of the world (Japan, Germany, and especially China), a massive dollar devaluation would likely be required to fully achieve parity. That is not the Fed's intent - the Fed only seeks to start a virtuous circle of a rising tide of activity, meaning only some marginal movement in the relative expense of labor is really required.

Under such terms, given the level and necessity of imported goods, the offsetting "inflation" or price adjustments in this space would undo whatever might be gained through labor wage parities. I believe that was the lesson of the QE's. In fact, I would go further and make the case that this imbalance of trade and the attempt to weaken the dollar brought about the very condition of wage stickiness that the Federal Reserve was, in part, seeking to avoid. Certainly the Fed's primary monetary role has been to preserve the banking system, but in terms of macro interventions it has been looking at inflation as a tool of circulating monetary means, including cheapening the relative cost of labor relative to expected future returns on production.

I argued last week that this was suicide in a service-based economy. Apart from that macro/micro distinction, however, there is another notion that I believe explains some of this potential re-occurrence of stickiness (or at least imbalance) exactly where macro-economics believes it shouldn't be. Under Bernanke and Carey's current theoretical construct of disorder, the primary cause of the incidence of high wages, low output was the inflexibility of the gold standard. But what if instead of gold-imposed rigidity the primary factor impacting the micro world of households was simple instability.

Given that central banks have gone to extra-ordinary lengths (even quasi-laundering) to ensure monetary flexibility, or at least the opposite of whatever the gold standard imposed on the real economy, and we end up largely in the same state anyway, it seems to me far more likely that micro-economic agents are not reacting differently to specific cases of monetary rigidity, but rather to monetary instability. If that is indeed the case, then the interventions themselves being a wholly separate and intentional means to sow instability (for different reasons) within the system create the same kinds of effects in the end (perhaps to different degrees, but the overall idea is the same).

I think it makes far more sense that households, people, business owners, etc., would react to any form of instability in mostly the same manner - being cautious. Again, though, there is no uniformity or macro construct that fills the role of a macro variable in a macro equation. That would extend to labor demands. While the current environment may not be conducive for workers to demand higher wages to offset those intentional commodity intrusions and pressures, that also does not necessarily mean workers will easily give back wage rates either. Logically, people under these constraints will try to do whatever they can to simply maintain what they have. And they will do so through different and largely non-measurable methods. Instability leads to rigidity, a bad condition for any economy.

The more central banks try to combat ghosts of deflation and politically-imposed imbalances through more and more ridiculous measures, the more the costs of these measures rise not just in terms of what can be seen in commodity prices, but in terms of overall economic rigidity. The one common trait between the Great Depression and the Japanese experience of its "lost decade" (or two) is extreme rigidity. Any healthy economic system needs a high degree of flexibility to maintain a sustainable and profitable long-term trajectory of rising "potential". The element of flexibility, unfortunately, seems to be only applied, by design, in the monetary realm, demonstrating yet again why modern economics is seemingly always backwards (the financial economy is always put before the real economy). In the end, however, this academic framing of wage stickiness and the threat of gold standard-like restrictions on the free actions of central banks to backdoor launder sovereign debt auctions may really be beside the point; perhaps even fully irrelevant. What matters most in a healthy economy is stability in all forms and places, and central banks are determined that it should never occur. Malaise and re-recession are the fruits of instability in any form.