3 Percent Growth Should No Longer Be Something From the Past
There is a logical fallacy underpinning the current state of mainstream economics. It is surely due to that discipline’s religious use of models which are nothing if not captured by the past. Indeed, that has been its downfall, for after 2007 the future would no longer look like the past, leaving statistical constructions to constantly expect a world that didn’t any longer exist. Ten years has apparently been enough time for them to catch up, to rebuild assumptions on this more recent past so as to model more realistically the near future.
The “rising dollar” period was dispositive in that regard; and it is no small wonder. It was the point where the mathematics of the pre-crisis era became most exposed. Janet Yellen’s Fed declared full recovery imminent, while the eurodollar futures market, well, went the other way. The global economy followed the latter, leaving the Fed and its models no longer just embarrassed as they had always been but by early 2016 dangerously without much credibility at all.
Having used a whole decade to finally acclimate to this new reality, the models are now in danger of making another fatal mistake, one that is perhaps worse than the original. President Trump’s initial budget proposal has crystalized the potential and brought it up in at least a political format. It isn’t merely political, however, as it tells us a great deal about the future if left to these same people.
The idea of 3% growth used to be so uncontroversial it was practically religion. The postwar average of real GDP was 3.2%, including recessions, so to make 3% a baseline would be so perfectly natural. The Trump budget’s use of it, by contrast, has produced an enormous backlash. Some of that is simply due to the climate of 2017 where the mere mention of his name invokes immediate emotion, but we must remember that the climate of 2017 is almost entirely a product of this very debate.
Remarking to CNBC on the budget proposal, former Federal Reserve Vice Chairman Alice Rivlin stated the issue perhaps as well as might be expected. With respect to these expectations for economic vitality, she said very simply, “We haven’t seen 3 percent growth for a long time.”
Now that economists have finally come to expect it, they now expect only it; they have committed to that next logical fallacy. From their point of view, policymakers did everything right and it came out only wrong, therefore they now believe there are no answers at all. Who even thinks like that?
In any scientific pursuit, failure is welcomed as a means for pointing the scientist in new directions, hopefully toward the correct answers. It’s a bit different in economics particularly in any policy setting because the experiments are not limited to the setting of victimless laboratories; nor are they often neutral (just ask the Japanese), meaning no harm, no foul. That isn’t how the central bank or government handbook is written in the chapters on the economy. Here, there is only one way of doing things and if that one way doesn’t do the things it is supposed to then the only conclusion officially available is the complete abandonment of any solution whatsoever.
This is why the Fed is currently seeking to “raise rates” and maybe even runoff its balance sheet while its models tell policymakers the expected growth rate isn’t even 2%. They currently figure a trajectory of just 1.8% that is very likely, given the latest drop in the unemployment rate without any uptick in wages, about to be downgraded still further at the next statistical update. From that view of the world as it really is, a pitiful state by any standard, let alone that it has happened following the worst economic contraction since the Great Depression, a 3% economy just might sound laughably insane.
Where the Trump administration deserves credit is that it is clear they aren’t going to merely accept this condition as fait accompli, as economists and policymakers have. It is, after all, the one thing that put Mr. Trump into the White House, with Rust Belt voters delivering to him the decisive margin. Why should he now listen to these people who for ten years claimed this depression was impossible (because of their genius, no less) and now say nothing but this depression is possible?
Where the Trump administration deserves criticism, not the logical fallacies currently being served up by economists, is that there is an almost lack of urgency to the matter. They correctly diagnose what is wrong in the world, but then go about it as if the last fifty years didn’t happen. Or, to put it another way, they seem to buy the same premise as economists but are only changing how they would execute largely the same strategies.
That is what tax cuts and the rest amount to; using the same “solutions” with different packaging so as to try to accomplish what those same “solutions” didn’t the first (or second) time. The only things missing are some projections for a QE5. This is not to say that tax cuts or deregulation are not helpful, necessary even, just that they are all inside the same box as has been practiced during the last ten years of this “impossible.” What is demanded today is not slightly different more of the same but a truly radical departure.
What is so infuriating about it all is that the necessarily drastic steps are merely an answer to those taken a half century ago. It is cliché to write that the world doesn’t work the way people think it does. It was something altogether different to make that claim about the monetary system, especially in the age of Greenspan’s reputation. The Federal Reserve doesn’t know the slightest thing about the dollar? That can’t possibly be true. It’s been that way for fifty years? Sorry, that’s plain crazy.
But if you actually listened to Fed officials, particularly Alan Greenspan, particularly in the 1990’s, that is exactly what they were saying. They couldn’t any longer define money which includes the dollar among the categorization. Instead, they defined “monetary” policy under the guise of not having to, an important distinction that nobody seems to appreciate. If there is anything legitimately stupid in this area it is the idea that a small circle of economists who gather once about every six weeks to adjust a single interest rate a quarter of a point at a time could thus control an entire financial system being so drastically overhauled and the global economy with it. Somehow that sounded perfectly natural despite asset bubbles twenty years ago, but does it now in the hindsight of 2008, 2011, and the “rising dollar?”
In truth, it should have been laughed out of respectable discourse long before. In 1967, the pound sterling went into one of its almost regular crises. Though officially a co-reserve currency with the US dollar under the Bretton Woods system, both backed by gold but already having defaulted (London Gold Pool) years before by then, the UK currency was in no shape to hold such grave responsibility. As the weakest part of the system, it was the first to be exposed, as it was repeatedly.
But in being exposed it also at the same time uncovered what was already taking its place. Prime Minister Harold Wilson in July 1966 stated:
“Action taken by the United States' authorities has led to an acute shortage of dollars and Euro-dollars in world trade and this has led to a progressive rise in interest rates and to the selling of sterling to replenish dollar balances.”
Some of that was posturing to deflect blame, but a lot of it was still true. The American government considered the rise of the eurodollar system part of Triffin’s Dilemma and therefore took many official acts to try to strangle it. That they ultimately didn’t work and more so that the world so heavily noticed tells us that even by the mid-1960’s the eurodollar’s role was central to the global reserve system; supplanting even gold that early on. It was the wave of the future, as I wrote in December 2012:
“But the eurodollar market was also unique in that it relied heavily on interbank transfers for liquidity flow. As an interbank market, each individual participant would be free from the encumbrance of maintaining a large stock of liquid currency because the liability counterparties operating here were also banks that disfavored currency. Unlike banking regimes that were traditionally funded on deposits of real persons, this interbank market had little need for currency since each of the interbank counterparties were better served with just changes to accounts. That ultimately meant that transfers inside the eurodollar market were nothing more than bookkeeper entries on balance sheet ledgers rather than the actual transference of physical currency (let alone gold). It also meant that these ‘dollars’ were themselves intangible bookkeeping entries far removed from anything resembling legal tender.”
There finally sprang up great interest in eurodollars by 1969, lasting well into the 1970’s; of course there would be given that the period was called by some the age of “missing money.” Then, for reasons that can only be political, meaning for the state of economics and the placement of central banks, it’s as if the eurodollar dropped off the face of the planet. It was still there, of course, but officially it was not.
For its fourth quarter Quarterly Review in 1979, the New York branch of the Federal Reserve stated plainly the central bank’s dilemma.
"It has long been recognized that a shift of deposits from a domestic banking system to the corresponding Euromarket (say from the United States to the Euro-dollar market) usually results in a net increase in bank liabilities worldwide. This occurs because reserves held against domestic bank liabilities are not diminished by such a transaction, and there are no reserve requirements on Eurodeposits. Hence, existing reserves support the same amount of domestic liabilities as before the transaction. However, new Euromarket liabilities have been created, and world credit availability has been expanded.
"To some critics this observation is true but irrelevant, so long as the monetary authorities seek to reach their ultimate economic objectives by influencing the money supply that best represents money used in transactions (usually M1). On this reasoning, Euromarket expansion does not create money, because all Eurocurrency liabilities are time deposits although frequently of very short maturity. Thus, they must be treated exclusively as investments. They can serve the store of value function of money but cannot act as a medium of exchange."
Thus, it was a central bank dilemma only because central banks conveniently made it that way. In truth, the eurodollar potential was a threat because it showed a way for monetary behavior to take place where no central bank could influence it. Thus, it was authoritatively declared not “as a medium of exchange” when in all practical uses it was only that. In other words, the official doctrine of the eurodollar has it entirely backward. It was never meant in its final incarnation as a store of value. That view is predicated on the perspective of a depositor who might wish a higher interest rate on his or her deposit account, as if that was the sum total of activity rather than a very small part.
Though depositor behavior was the basis for the earliest development of the system, it was superseded even by the time FRBNY was essentially writing it out of the official doctrine in 1979. In other words, an offshore eurodollar bank had long before then realized that it needn’t any US onshore depositor at all to begin offering eurodollars, or “dollars”, to other eurodollar banks. It merely had to promise that it could obtain them at some future date should anyone actually want them. Nobody really did, as the whole point is not store of value but a medium of global exchange.
What is exchanged is as I wrote to end 2012, meaning ledger balances not currency. Since a ledger balance is a form of liability, in truth it could be any form of bank liability so long as the bank on the other side accepts that liability as satisfactory. Again, that is medium of exchange, not store of value.
The chief problem of this highly efficient arrangement is that it is all predicated on faith to some degree. Bank liabilities even in these more esoteric modern forms were treated as largely equivalent substitutes – until August 2007. If a grain of sand can ruin a semiconductor, a grain of doubt can obliterate a system run on faith. Since the eurodollar is simply promises of promises (of promises), doubt is its Achilles’ heel once you start questioning the chains of traded liabilities, tugging on any of the (trillions) loose threads. A “dollar” of this kind was supposed to be, in theory anyway, reducible to an actual dollar but nobody had any. Recourse was actually quite limited, where an emergency of any substantial size could only mean segmentation – that not all “dollar” claims would be treated equivalent (i.e., a run).
It was a situation anticipated in 1979, if under the more crude, rudimentary operative theory of the “modern” central bank.
“One of the traditional responsibilities of any central bank is to act as lender of last resort – to supply funds to a solvent bank or to the banking system generally in an emergency that threatens a sharp contraction of liquidity. This role normally has been framed with respect to commercial banks in the domestic banking system. But the emergence of the extraterritorial Euromarket created ambiguities about which central bank would be responsible for providing lender-of-last-resort support for overseas operations.”
It wasn’t until after Lehman Brothers failed that the Fed at least tried. They had opened dollar swap lines as early as December 2007, but they were initially small and limited in capacity. US monetary officials simply didn’t realize the global liquidity crisis was eurodollars not dollars. And offering just one form of liquidity in dollar swaps showed further that they still didn’t get it even when they belatedly figured out that there was this massive offshore component. That is why the dollar swaps didn’t work, nor did anything else that followed, including all the QE’s.
Though my writings tend by circumstances toward the pessimistic end of things, there is hope. Maybe that’s just my more natural affinity to being on the other side of economists. They were so optimistic the first lost decade, so it made sense for that reason alone to at least consider their “impossible” scenario more realistic, even likely. Now that they have abandoned all hope, an actual window for optimism is opened.
I have said since the beginning that I thought Trump’s election (along with the popularity of Bernie Sanders during the Presidential campaign on the Democrat side) was a positive sign not because he might hold the answers (it’s increasingly clear that he might not, at least not yet) but because Americans were finally reaching their limit; the voted outside in both directions as a matter of legitimate economic frustration. To take a page from Reagan, politics must be about fixing things and making them work rather than grubby resignation to such an awful fate (Carter’s “crisis of confidence”). There is a shining city on the hill, we just have to find it; or, more specifically, identify the right people who are actually capable instead of merely credentialed.
The Bank for International Settlements can be at times uplifting in that regard, while also downright infuriating. Standing back from some of their work, it just might be the messiness of at least the right instinct; to explore this vast unknown. The world began to talk about shadow banks in 2008 and then seemed to have lost interest without ever peering too far into them. It was several BIS researchers who were prominent in at least sketching some of the contours of those shadows, and have from time to time revisited them though without connecting all the necessary dots. There is institutional inertia at the BIS just like in any such organization that has to be overcome, in addition to the decades old self-imposed state of medium of exchange dogma.
Writing last month, BIS’s Head of Research Hyun Song Shin finally published something truly profound (not a criticism specifically of him, rather of Economics as a whole).
“Behind the financial channel of exchange rates is a dense matrix of financial claims in dollars. The global economy is a matrix, not a collection of islands, and the matrix does not respect geography. A European bank lending dollars to an Asian borrower by drawing dollars from a US money market fund has its liabilities in New York and assets in Asia, but headquarters in London or Paris.”
It was not profound because he had made a major discovery, rather it was because it signaled that maybe serious study might finally be conducted officially about what is really rediscovery. On a personal level, it was actually quite offensive at the same time, as I originally wrote last week that it should have been prefaced with a statement that said, “There is absolutely no excuse for that we should have known this thirty years ago, but we now realize…”
At some point, looking behind at such dereliction will be useful, likely necessary (Mr. Greenspan, Mr. Bernanke, and a whole lot of others have a lot to answer for). The task before us now is to look forward, not into the further abyss but toward that shining city on a hill. As President Reagan said in his farewell address almost thirty years ago:
“But in my mind it was a tall, proud city built on rocks stronger than oceans, wind-swept, God-blessed, and teeming with people of all kinds living in harmony and peace; a city with free ports that hummed with commerce and creativity. And if there had to be city walls, the walls had doors and the doors were open to anyone with the will and the heart to get here. That's how I saw it, and see it still.”
We can get back to it by regaining control of our monetary compass; to stop letting ignorant economists navigate by quarter point increases in a money market rate where nobody trades and even fewer meaningfully use because truthfully there is no money there at all. “Free ports that hummed with commerce and creativity” should no longer be constrained by the unimaginative, rigid, and politically self-interested. Never again should any official, current or former, have to say, “We haven’t seen 3 percent growth for a long time.”
