With Each Central Bank Move, Nations Are Impoverished More

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Banca Monte dei Paschi di Siena SpA is back in the news again, making headlines for derivatives trades. The oldest banking concern in the world cannot seem to catch a break, having trod down the hidden road toward its own version of extend and pretend. When I last visited this colorful Italian saga, it was to chronicle the changing nature of money and the modern idea of what constitutes capital. Underlying that illusion of central bank "charta" was apparently even more illusion, off balance sheet, but all too real on the downside with further existential consequences.

In economics, this kind of hidden "reality" (for lack of a better term) is the opposite of linearity. Most economic theory hinges on the soft sand foundation of linear economic movement and a deterministic approach to policy and systemic "management". Deviations from linearity are what pass for "tail risks" in this age of statistical, but misplaced, elegance.

For example, in January 2011, the IMF forecast rising economic fortunes into the calendar year 2011 and beyond. The mathematical models at the IMF had seen a better than expected second half of 2010, coupled with "new policy initiatives in the United States that will boost activity this year." Those policy initiatives here domestically were, of course, QE 2.

Based on the linear understanding of modern economics, a QE 2 in the United States was good for one-quarter percent increase in global growth expectations for 2011, and good for 3% growth in the United States in 2012.

In Europe, ECB and EU measures to combat the growing sovereign debt crisis were believed to be good for 1.7% growth in Europe by 2012. The IMF noted of its forecast:

"This view reflects the limited financial spillovers observed so far across financial markets and regions, as well as the fact that policy responses following the Greek crisis helped limit its impact on the global recovery in the second half of 2010."

The linear thinking of stimulus/response, apart from being most appropriate for simple organisms such as amoebas, is the equivalent of a model that perpetuates success solely because it exists. Back in that January 2011 IMF forecast for 2012, they even expected 1.8% and 1.3% growth for Spain and Italy, respectively, due in full part to the monetary interventions.

As it is, every one of those forecasts were not only overly optimistic, they often got the sign wrong. The US is on track for only 2.1% growth in 2012 (perhaps much less in 2013), while the Eurozone as a whole is looking at -0.2%. Spain and Italy are contracting at -1.5% and -1.0% rates, respectively. Clearly, there is something other than a linear relationship between monetary initiative and real economy function. At the very least, there is something like a drag coefficient to the intended acceleration.

This idea of linearity permeated the FOMC meeting held on September 18, 2007. This policy gathering occurred in the direct aftermath of the London wholesale money freeze in August of that year (the event that presaged the panic that would inevitably follow in 2008) and in close proximity to the run and failure of Northern Rock bank in the UK.

A lot of the discussion on what was taking place in London took the tone of strange detachment. Part of the focus of the FOMC here was to debate a possible radical departure in Federal Reserve operation by opening dollar swap arrangements with the ECB and the Swiss National Bank (a full year before they were actually put in place, after the panic). For the most part, while there was genuine acknowledgement that some of what was occurring was absolutely new and potentially frightening, there was an awful lot of comfort derived from linearity, in particular expectations of responses to policy.

The standard modeled response to the financial disruption was:

"The central tendency for GDP growth in 2008 was revised down about ¼ percentage point and now centers on about 2¼ percent rather than 2½ percent. The central tendency for the unemployment rate at the end of the year revised up 0.2 percentage point."

Initially, this coincident assessment to the growing turmoil in London assumed that everything was contained in the euro markets for sterling and euros, with nary a concern for dollar funding. Fed Governor Mishkin pointedly asked Bill Dudley, then the Manager for the Federal Reserve's Open Market Account (now President of the Federal Reserve Bank of New York):

"One thing that is positive about all of this-although maybe I'm wrong about it-is that the spillovers into the other markets outside the United Kingdom have been very, very minor. Normally, what's happening in the U.K. context would be an information shock that could trigger problems. The good news here is that, if anything, the markets have actually gotten a little better since this whole episode occurred, and it has been contained in the U.K. context. Is this a fair assessment?"

It is now in posterity that the word "contained" has attached derogatory connotations for the economic practitioner using it (coming not long after Chairman's Bernanke's 2007 note that subprime mortgage problems were also "contained"). Mr. Dudley answered Mr. Mishkin's question in the affirmative before elaborating further:

"They seem to be able to sort it out as a specific problem pertaining to Northern Rock and the U.K. regulatory regime, not something that applies to a broader market. So I agree with that."

This answer came despite the fact that Governor Mishkin raised in his question the central, non-linear problem with the crisis staying within the confined walls of predictable, linear policy. The roiling wholesale market in London was ripe for an information shock to transmit globally. The FOMC had not yet fully digested the idea that liquidity would rapidly be tied to a lack of information about, mostly, financial collateral.

Despite this lack of specific concern about informational asymmetry, the FOMC discussed the very contours of what was actually happening before dismissing them. Fed Governor Warsh essentially outlined the pathway of contagion which would grip markets over the next few months:

"They [banks] have long since forgotten the robust times and the robust profits of the past five years, and they are looking at their capital ratios and getting some comfort from what their people are telling them. But when we look at these financial institutions, we are probably more prudent to judge them by their actions rather than what these capital ratios would suggest. Their actions are still not ebullient. Their actions are still not overly opportunistic."

The information conveyed by capital ratios was not sufficient to maintain an effectively liquid system since banks were actively hoarding liquidity. Fed Governor Kroszner furthered that bank capital point by noting:

"Regardless of what people may say about rating agencies these days, they are still sensitive to that. Banks are worried about making sure that they are perceived as having sufficient capital and sufficient liquidity. So one shouldn't just say, ‘Well, you can use up all that capital.'"

At the outset of the meeting, Mr. Dudley brought up the capital constraint issue directly:

"You can imagine a worst case scenario in which you can't syndicate any of the loans and then the loans have to be marked down significantly. That has an earnings consequence. So then the balance sheet is going to be affected not just by what's happening in terms of the assets but also by what's happening in terms of the capital."

After sketching out that worst case, Mr. Dudley rejected it as more "uncertainty than reality". That rejection was all the more astonishing because only a few minutes later Mr. Dudley noted that, "I think we have all been a bit surprised by the size of some of the conduits that some European banks were sponsoring relative to their capital."

Later in the session, Fed Governor Rosengren announced, "the significant swelling of bank assets in August. The monthly growth rate for bank C&I loans was 2.6 percent and for other loans and leases was 6.3 percent. These are among the largest monthly increases in thirty years."

Here we have all the pieces that foretold of an historic crisis, yet there was an easy dismissal for each of them that never allowed them to be put together into a realistic scenario. At each turn, these various segments of disaster, failures of redundancy, were overlooked by linear thinking about monetary policy and banking in general.

At the end of the first session, the FOMC board was presented with three options for changing the monetary policy stance. The recommendations for those options were based on simulations of Greenbook data and modeled relationships between econometric variables. For example:

"In the "greater housing correction" scenario, the subprime mortgage market is assumed to remain closed over the entire projection period rather than to recover partially as in the baseline, and housing prices decline 20 percent over the next two years, rather than just a few percent. In such circumstances, aggregate demand weakens considerably below baseline, and the Taylor rule suggests that the funds rate should gradually be eased to 4¼ percent by 2009."

For a large decline in house prices, the remedy is a gradual easing to 4.25%?

The "greater housing correction with larger wealth effect" scenario, in which the effects of the greater housing contraction are augmented by a larger sensitivity of household spending to household wealth, points to an even greater easing. Another possibility is that forced acquisition by banks of large volumes of ABCP, leveraged loans, and other assets erodes their capital ratios, bringing them closer to regulatory thresholds and benchmarks negotiated with rating agencies, and that banks respond by tightening credit terms and standards...But the "bank capital crunch" scenario in the Greenbook, which was based loosely on the early 1990s headwinds episode, suggests that policy might need to be eased significantly and quickly, with the funds rate dipping to 3¼ percent by June."

The worst case scenario, of the three presented, required a Fed funds target of 3.25% by June 2008? Linear thinking, encapsulated nicely by the seemingly codified ideological assumptions of monetary economics.

"The effects of a preemptive easing of policy-working through the standard transmission channels of lower long-term yields, a lower exchange value of the dollar, and higher equity prices and household wealth-might help cushion the economy from a sharp weakening of aggregate demand."

It was discussed briefly in Mr. Dudley's operational outlines that the Fed funds effective rate had tended to be below target after the initial August 9, 2007, shock. That formed part of this bias toward US dollar funding availability (something that we would see again in September and October 2008, demonstrating just how wrong this interpretation was), but it also masked the growing dysfunction of standard monetary operation as it related to interest rates. It should have been a prime clue that monetary problems were not localized to the UK, and that interest rates and standard monetary procedures were not suited here.

Parallel to the effective Fed funds problems, an unexpected fall in US t-bill rates was interpreted as a "flight to safety", when in fact it was a hoarding of US dollar collateral. This led to several members dismissing the rise in credit spreads as a function of declining t-bill rates rather than rising perceptions of overall risk. These interpretations formed the basis of discussion about moving beyond traditional means of monetary policy (into central bank swaps and an auction facility that might bypass the discount window stigma). But the central intent in any of these measures was to ensure credit would not be disrupted, or, ideally, would be increased in some sectors to offset the mortgage disruptions.

Debt was precisely the problem, however, in that it related not only to bank capital but operational liquidity and general solvency. Further, and far more importantly for you and me, debt was the primary pathway of real economy contraction. None of those monetary chains of transmission had a prayer of success because the artificial economic activity based on debt (largely mortgages) was finished. The FOMC as much acknowledged that the alternative mortgage credit channels were finished (subprime and Alt-A), but that did not mean much to their interpretations of the real economy because the modeled impact on demand was minor.

In that regard, the real economy problem is not aggregate demand, but aggregate supply - as in too much supply of goods and services based on the circulation of debt paper through wholesale means. But that is not something that is distinguished by conventional economics. For them, it is all one and the same. A real economy based on subprime mortgages and using houses as ATM's was not considered abnormal in the first place. It was all standard operating procedure.

Because the system had marginally formed around the idea of wholesale money in London, the UK turmoil was not at all about the UK, but of the entire build-up of economic activity based on that banking illusion. So now the IMF predicts economic recovery based on the same linearity between debt and banking that predated that September 2008 FOMC meeting. Despite debating and discussing the actual pathways of spectacular failure at that meeting, monetary policymakers still follow the exact same playbook and harbor the exact same expectations, as if any repercussions or re-assessments were/are impossible.

Before voting on the rate adjustment that September, Fed Governor Hoenig made one absolutely perfect prediction:

"Having been a part of this policy group for a while, the one thing I can tell you with certainty is that, no matter what we do today, it will be criticized, [laughter] and unlike us, our critics will be absolutely confident in their position."

Perhaps there is some nobility in that acknowledgement of uncertainty, and certainly criticizing momentous decisions with the benefit of hindsight is more than a bit unfair, but what occurred in the months after that meeting was not a shock to everyone (myself included). Moreover, given the discussions that transpired, it should not have been a shock to the FOMC board. The most common strand that can be gained from reading the full FOMC transcript and from the course of economics post-crisis is that economists are most comfortable in their own assumptions and critically incurious by what they don't know. Sure they recognized the practical limits of their modeled behavior, but there was and is no desire to press out the boundaries of that "enlightenment".

When the system manager of the Federal Reserve's open market operation proclaims that he has been shocked by the size of wholesale money operations in Europe relative to capital, that might be a good time to assess exactly what economists know about wholesale finance. If that same operational manager indicates some discomfort about the potential for balance sheet repatriation and the effects on bank capital regimes, it might be a good time for the Fed to use its powers of regulation to gather more definitive information about the relationship between capital and collateral. If they all note with approval that bank managers might not view capital cushions as some numerical, regulatory threshold, they might want to consider the vital pathways between capital preservation and liquidity that portend more than just an interest rate response in the real economy.

These are not intended to be specific recommendations for policies during critical moments, but as examples of how policymakers failed to push the boundaries of understanding to more closely align theory with the real world. The continued underperformance of the real economy relative to monetary measures may be some mysterious headwind in Washington, but only insofar as linear thinking about simple relationships permeates the policy edifice.

The finance/economy relationship is not some simple system that can be managed by well-meaning PhD's in a conference room in Washington or Frankfurt. Even when they are handed the very keys to the unfolding crisis, it is dismissed out of hand because of self-imposed limitations, including hubris. Acknowledging uncertainty and downside risks is not the same as embracing uncertainty and the full count of those downside risks.

The world, at least asset prices, as it enters 2013 is enthralled by the monetary management of the same people that failed so spectacularly the first time. And even where the faces have changed, the operative and philosophical theory remains, perhaps even further entrenched. Markets and investors cheer the universal debasement of money and capital on the basis that these well-intentioned, but uncertain, elite intellectuals actually know what they are doing. Or at least that they have learned from the mistakes of the recent past.

The IBEX 35, Spain's main stock index, is up more than 40% since the August lows. Over that time, unemployment has exploded upward to now 26% and bank loans are delinquent at a record pace. The economy is entrenched not in a slow rebound, but further and "unexpected" depression. So what does the Spanish market's rapid rise tell us about monetary efficacy?

The standard response has been "clogged transmission channels" - as in low interest rates enforced by the ECB have been thwarted by bond vigilantes in that nation. So Spain has been suffering because the ECB did not anticipate its lack of monetary follow-through (in an all-too similar manner to the Fed in 2007). That might sound plausible in view of a linear understanding of money and economics, but are the Spanish really suffering from a lack of cheap debt? Why didn't the ECB calculate and formulate its monetary responses (going back all the way to mid-2010) around these operational contingencies?

Perhaps the Spanish economy was simply too large relative to its debt before the property bubble burst, and that monetary means to fix that imbalance are unsuited to the problem. While that certainly would define a linear relationship, it would be separate and outside the context of conventional economics, and therefore is rejected by policymakers at the ECB.

Central banks and economists are still captured by the same biases as existed before, but have added a zero or two to the end of their linear responses. What investors are cheering is that perhaps stopped clocks are right more than twice a day. Every year, like clockwork, we are "delighted" by the resurgent optimism of recovery basking in the sun of central banking largesse, only to see it fall away by the turn into spring. Despite the promises of linear debasement, real economic fortunes decline as each episode further impoverishes each national system. Central bankers see it, but can never recognize it.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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