Jamie Dimon Finally Sees What Ben Bernanke Never Did

Jamie Dimon Finally Sees What Ben Bernanke Never Did
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Ten years ago last week, then-Federal Reserve Chairman Ben Bernanke testified before the Joint Economic Committee of the US Congress.  While that particular day is remembered for his prepared remarks about subprime being contained, it was other facets of his testimony that deserve our remembrance and scrutiny.  Subprime wasn’t ever contained, nor would it ever have been, but that was truly just a very small part of how the last lost decade has unfolded. 

You would think that it would have been the Federal Reserve’s job to understand the housing bubble, but that’s not how it works.  Any central bank views itself as an agent under monetary neutrality, which simply means the central bank sets monetary policy and the market, so-called, does whatever it does from there.  Using inflation, unemployment, and other economic factors as a guide, monetary policy shifts when those economic arrangements fall out of whatever bounds it sets for itself. 

From this perspective, the housing bubble was a market event not a monetary one. If that sounds surprisingly irrational that is because we have been conditioned since Paul Volcker’s Fed to believe that monetary officials are the wisest of stewards.  By its own rules, there was nothing particularly disturbing about the middle 2000’s.  The Fed knew that the housing market was well outside of historical bounds, but, again, that was from their view a market choice; consumer inflation as well as unemployment all remained within their boundaries for good conduct.

FOMC members had already raised the possibility in June 2003 that there was “something” missing from their set of rules and assumptions.  Drawing largely from experience during the 1990’s, it had come to be believed that simplicity was operative, and fruitfully so.  The Fed would adjust merely the federal funds target rate in order to steer the economy into its inflation/unemployment zones.  From 1992 until Bernanke’s testimony at the end of March 2007, the US economy had experienced only one extremely mild recession and all within a period of unusually low consumer price inflation.

Calling it the Great “Moderation”, Bernanke in particular therefore showed no capacity for anything beyond this convention, even after the experience of the dot-com bubble and bust.  In 2015, he told an audience at LPL’s conference that he left Princeton’s Economics Department where he was Chair and where he expected to be an “academic lifer” because of 9-11.  He wanted to get into public service “to help people live better lives.” 

Even contemporary, however, the term “moderation” struck a contradictory chord particularly with the public.  The very nature of housing as tech stocks advertised more than the academic settings. Bernanke’s tenure at the Fed was no different than his university career, thus keeping with his expectation to be one throughout.  If his motivation was to help people, he never showed the slightest inclination that perhaps he might not know how.  His testimony at the end of the first quarter in 2007 was a perfect example of this rigidity, one which his disposition fit perfectly within the institutional bubble of the Federal Reserve as a whole.

What was most interesting and truly relevant about his appearance back then was how it relayed the Fed’s dilemma at that time as policymakers saw it.  Clearly there were growing uncertainties centered on housing; earlier in February 2007 several financial institutions, especially HSBC, had rocked the Street with forecasts and projections that raised the possibility subprime wasn’t contained at all.  Then on February 27, stocks dropped sharply, the Dow down 416 points that single day.  Suddenly everyone was talking about shadows, the first suggestions that there actually was an undiscovered wilderness out there somewhere way beyond the borders of acceptable Economics.

But to the rules of monetary policy in effect, there was as much if not more to worry about on the upside as the downside.  As Bernanke said, “We are looking for a bit more flexibility, given the uncertainties that we are facing and the risks that are occurring on both sides of our outlook.” In the orthodox textbook, there is only supposed to be one or the other, a binary view where inflation and unemployment are to some great extent mutually exclusive.  This Phillips Curve basis had been updated after the economic experience of the 1970’s proved it invalid, but here again was the Fed expecting that very same tradeoff. 

Largely due to that view, it was the baseline expectation for monetary policy that what would happen from that point forward was something like normalization.  Bernanke, in his prepared remarks, claimed, “Economic growth in the United States has slowed in recent quarters, reflecting in part the economy’s transition from the rapid rate of expansion experienced over the preceding years to a more sustainable pace of growth.” If you view inflation as a tradeoff for unemployment or vice versa, then his would have seemed the most idyllic if not downright ideal scenario.  Rising inflation pressures would offset some of the negative financial forces from subprime or the reduced activity in housing. Conversely, a slower overall economic pace even with downside risks (which the Fed believed easily handled if needed) and uncertainties could be counted on to balance out those inflation pressures before they got too far. 

It is therefore established that Ben Bernanke got everything wrong over the last decade.  All of it.  He admits today that he was way off on only subprime, telling the same LPL conference, “Not my best call.”  But that was just the beginning, not the end. 

Starting with those inflation pressures, the Federal Reserve’s view of them were simply inappropriate in every way that should have been recognized as a fatal error.  The CPI or PCE Deflator was not moving upward based on economic strength but through continuing monetary debasement – a continuation of the “weak dollar” paradigm that was in reality offshore monetary expansion.  During the housing bubble period, going all the way back to the mid-1990’s, the eurodollar system expanded in two directions (well, more than two, but for sake of simplicity we can generalize two) simultaneously – the first in the form of consumer debt, subprime mortgages and beyond flowing to the developed world; the second in the form of emerging market debt, focused on overseas economic “miracles” particularly China.

The role of the eurodollar system was to create and sustain the flow of monetary (like) resources so that these two channels would be maintained in perpetuity.  It seemed like a perfectly stable system ready to do just that, eurodollar to debt to economy, but only if you viewed it as Bernanke did by traditional, overly narrow parameters.  Calling them the shadows was and is misleading, because by the end (of the growth phase) the shadows were an order of magnitude and possibly two larger than the visible monetary or even banking system.

Because these were a collection of often very different pieces, for a time it sustained itself by compartmentalizing.  The mortgage finance piece was becoming a drag, but onward flowed the EM part without any interruption.  In many ways, the latter actually intensified the more it was revealed just how wrong Bernanke had been; it had always been believed though never actually established or even tested that should the offshore system start to fail the Federal Reserve would be able to stand behind it. Thus, the more the Fed started to do, the more the “weak dollar” acted as if the Fed would overdo.  Oil prices, in particular, skyrocketed as the only real impetus for consumer prices during that time.

It would only last until July 2008, however, as even the “weak dollar” could not sustain itself due to the immense damage being done way beyond subprime.  The internals of the system, bank balance sheet capacity, had been so reduced as to be unable to provide sufficient monetary resources to anything.  That meant that though the CPI registered 5.6% in July 2008, it was nothing like the positive offset Bernanke had only a year before been counting on for ideal balance.  In fact, it would take just five months for the CPI to go from that seemingly overheating level to zero, and just three months more to fall below it. 

The reason monetary policy defines price stability as 2% inflation, for the PCE Deflator rather than the CPI, is actually for this very situation.  It had been modeled, regressed and math-ed to death that 2% was enough margin for any central bank to get in gear and respond to any monetary threat before it could become so devastating - as in late 2008 and early 2009.  Another monetary principle had been shattered and obliterated.  The US economy experienced sharply accelerating inflation and rising unemployment, and then deflation and sharply accelerating unemployment – all the while, the FOMC transcripts reveal, policymakers stood surprisingly aghast and befuddled.

And yet, all attention and focus afterward would be placed on the Fed’s version of “jobs saved.”  In other words, though the economy was by late 2008 left to suffer its fate quite directly against everything orthodox economics believed was ever possible, Bernanke would fashion himself with the aid of politics and the media the hero – the Great “Recession” wasn’t a second Great Depression. 

But was that actually the case?  There is no comparing the down leg or contraction phase this time to then, for the level of economic and monetary destruction in the early 1930’s might never be equaled again let alone surpassed.  But a depression is not merely that one part.  What made the Great Depression was its interminable duration; no matter what the Fed or federal government did to push the economy back to life it was never enough.  The US economy had stopped contracting, as did the global economy, but the restoration of plus signs to economic accounts and even price changes did more to obscure the full extent of the damage than to signify recovery. 

The one imbalance that would define that period was idle labor.  In 1929, the total US labor force measured just over 48 million people. Of those, 46.2 million were employed in one way or another.  By 1932, the labor force had expanded to 50.3 million, but by then only 38 million had jobs. From 1934 to 1937, in just four years, 8 million jobs were added back, but 8 million wasn’t nearly enough. Three million more Americans had come of age and entered the labor force during that time. 

It was the events of 1937, however, that really made the Great Depression stick.  All of that forward momentum was lost, even though it had been too “shallow” up to that point already.  The Federal Reserve badly misconstrued financial liquidity preferences as latent inflation pressures building during what it thought was a full and honest recovery.  Banks through the experience of the crash and seeing that monetary authorities were unreliable began holding a large proportion of excess reserves.  Thinking those reserves might be put to use, the FOMC voted in December 1935 to by the end of 1936 raise the level of required reserves in order to circumvent their use; and instead created an enormous monetary backlash as banks rebuilt their excess reserves anyway and in doing so created the economic setback that ended the recovery direction until WWII.

By the end of 1939, there were slightly less Americans working than in 1929, but the labor force had grown by 7.5 million people during that decade.  In 21st century terms, the US economy had a participation problem.

The only difference between now and then on these terms is that by today’s standards the Bureau of Labor Statistics would have excluded the vast majority of those 7.5 million from the official labor force due to bureaucratic rules about who is defined as officially part of the labor force.  As of the latest BLS estimates, there are as many as 15 million Americans who are “missing” in just that way, omitted from the labor force count because the economy has not recovered and in all likelihood never will (at least until all those who think and act like Bernanke are ousted from positions of influence). 

We have even suffered our own “1937” just recently to further establish the depression template, so to speak.  The “rising dollar” from June 2014 to February 2016 was in many ways the same kind of resulting downtrend due to liquidity preferences as in 1937 and 1938. Banks all over the world retrenched, some dramatically.  I have little doubt it was the combination of fragility with volatility, the worst possible condition for susceptible balance sheets. 

Some refuse to consider it was anything other than regulations.  Even if I was to stipulate that was the case, on this point it would make no difference anyway for it was regulation in 1937 that accomplished the same result.  Whatever ultimately the cause, the “rising dollar” killed the recovery in the same was as 1937 terminated all hopes for a direct line out of the Great Depression.

You need not take my word for it alone, as this is the position of Federal Reserve as well as monetary officials from around the world.  They refuse to clarify it publicly, of course, preferring instead to quietly refer to the “skills mismatch” or the related low and even possibly negative R*.  All of which adds up to something like secular stagnation, which in truth is nothing more than depression without official explanation of its origin and pathology. 

In October 2014, JP Morgan’s CEO Jamie Dimon confidently declared, “I’m a real long-term bull on the US economy.”  That wasn’t an unusual or especially brave position, for it was the default forecast of practically every economist and policymaker around the world at that time.  Like Bernanke in 2007, Janet Yellen around then talked more about the risks of overheating than lingering “headwinds”, though they remained.  Even into early 2015, our true 1937, Fed officials like Yellen were still rationalizing crashing oil prices as if some kind of enormous consumer benefit that would offset growing (and painfully obvious) global weakness, almost a mirror image of the early stages of the Great “Recession.”

Just this week, however, Mr. Dimon declares he is no longer so bullish.  The events of these past few years have apparently been enough to, like policymakers, disabuse all notions of recovery.  In his 45-page annual letter to JPM shareholders, the bank’s CEO now says, “there is something wrong with the US economy.”  Outside of Economics, banking, and politics, his summation was met with a resounding “you just figured that out?”

What’s perhaps most important about his sudden reckoning is that he looks everywhere else for its cause.  This is much the same problem as with Federal Reserve and indeed all global central bank authorities who do the very same, a tradition that started in Congress on March 28, 2007.  The last place any of them will look for answers is within. 

For JP Morgan, there are any number of balance sheet figures that show the bank’s part in all of this, from 2007 to the “rising dollar.”  For one, there are its liquidity preferences as defined in the most traditional way – “cash due” and “deposits with others”, a category that includes JPM’s reserve account at the Fed.  In 2007, only 3% of the bank’s assets were in cash, down just slightly from an average of 4.1% over the prior six years.  It jumped to 7.6% in 2008, which only makes sense, but then fell back to 2.3% in 2010 despite QE1 – or actually because of it.

In other words, it seems very likely JPM was confident enough in the effects of QE toward establishing recovery and a return to pre-crisis conditions so as to hold so little cash so close to panic.  That was maintained only to 2011 and resumption of the same monetary problems that have never been resolved.  The proportion of cash hit 6.4% in 2011, then 7.4% in 2012, nearly the same relative balance as during the worst of the crisis.  Rather than remove this idle liquidity in response to the third and fourth QE’s, JPM’s balance sheet at the end of 2014 would be 19.9% cash (only some due to regulatory changes).  The proportion has declined somewhat due to efforts in early 2015 to restrict institutions holding their cash balances at the bank. As of the end of last year, JPM still shows 15.6% of its assets as cash.

In the more esoteric and relevant monetary facets, JP Morgan’s behavior is exactly the same relating to liquidity preferences.  As with any wholesale or shadow bank, both sides of its balance sheet include basic wholesale formats like repo and federal funds.  Because of its place at the center of the triparty repo system, JPM had historically drawn in more funds from these channels than it sent back out (greater repo and federal funds liabilities than assets).  At one extreme, in 2002, the bank at year’s end took in $169 billion in funding, 22% of its total asset base, while forwarding just $65.8 billion back into the monetary system. It’s a bold position expressing confidence in being able to maintain funding in this way.

At the end of 2006, the balance sheet was more balanced, with a net intake of $21 billion.  Over the next two years of panic, that position reversed with JPM lending out funds in greater quantity than it took in.  In 2009 and 2010, that reversed again so that JPM was net taking $66 billion and $54 billion, respectively, in those years.  Not only that, the volume had grown considerably especially in 2009 and 2010.  Where the bank showed $154 billion repo and federal funds liabilities at the end of 2007, it reported $276 billion at the end of 2010 – in keeping with its very low cash proportion, and thus minimal liquidity preferences.

As with cash allocations, all that changed (again) in 2011.  The bank has funded less and less through wholesale liabilities, starting with 2011 where its balance fell sharply to $213 billion due to the renewed shadow crisis.  As of Q4 2016, JPM reports just $165 billion and a net outflow of $64 billion into wholesale money markets. 

The bank’s total balance sheet has grown by just 14.5% over the eight years since the end of 2008, and just 5.6% since the end of 2012 and the last of the QE’s.  In the eight years up to Q4 2008, JPM’s balance sheet expanded by 204% including mergers.  Of all the major global banks, JP Morgan is actually rare for its experience with even that level of reduced growth.  By and large, its peers have tended toward outright reduction. 

In terms of risk capacity, however, JP Morgan has been no different than the others.  At the end of 2008, JPM reported $88 trillion in total notional derivatives, a level slightly more than the $84.9 trillion it showed at the end of 2007 but actually considerably less when figuring the $14.2 trillion added in Q1 2008 when Bear Stearns was absorbed.  As of the latest quarter at the end of 2016, the bank reports just $47.5 trillion, about half its Q1 2008 combined notional exposure.  Between 2001 and 2008, JPM’s derivative book quadrupled.

In the 1930’s, liquidity preferences among banks meant an enormous loss of deposit capacity, the money multiplier of the traditional system.  It was not even for its time unduly low, it was but a paradigm shift in difference from how banks and money had behaved in the 1910’s and especially 1920’s.  In the 2010’s, liquidity preferences among banks mean an enormous loss of wholesale capacity in all forms, the monetary capacity regime of the shadow system.  It may not even for today be unduly low, but it is a paradigm shift in difference from how banks and money had behaved in the 1990’s and especially 2000’s. 

Such an enormous break in monetary capacity has at both times provided the force for dislocation rather than recession.  The economy shrinks in its contraction phase and then never goes back.  On both occasions, growth of some residue does resume after the downturn, but it is both insufficient as well as, owing to liquidity preferences, highly unstable.  In the end, what makes both depressions is that the economy at both times nets out going nowhere for those monetary differences and especially where labor utilization is concerned. The difference to the 1930’s is degree, not type. 

Therefore what Ben Bernanke failed to see and appreciate a decade ago is what Jamie Dimon now finally does.  That it took Mr. Dimon so long to finally get there demonstrates what neither he nor Bernanke are able to grasp; that the chronic “headwinds” of this lost decade originate right within their own sphere.  Ten years ago the pre-eminent economic and monetary official declared that the fallout from subprime was limited because he wasn’t actually either of those things.  It wasn’t contained and still today has yet to be even though we have been through this before. 

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

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