The Economy Is Not Strong Enough to Withstand Today's Errors

Lost into the vast history of the eighties, there was early on in that decade a political fight over the modern state of banking.  The Reagan administration in 1983 had convened a far-reaching task force headed by Vice President Bush.  The way in which proposed reforms initially moved was not merely impulsive score-settling.  Its roots ran far deeper in time as well as within the industry itself.

By September 1983, initial reports suggested that the council was all but decided on the major topic. Some minor issues were, and would be accepted as, relatively uncontroversial, such as allowing the SEC sole regulatory discretion over stock margin, or the Justice Department handling any antitrust cases.  The big one was about bank regulation and supervision, more so about who was to do it.

There was at least near consensus about who should not be doing it. Bush’s staff as well as many across the sprawling federal government complex thought the Federal Reserve should be stripped of its banking authority. After recent experience, many were eager to see the central bank focus more exclusively on monetary policy alone (sort of a see if you can get that one thing right before trying to handle other complicated chores).  In May 1983, Comptroller of the Currency C. Todd Conover recommended specifically to the White House the creation of what would be called the Federal Banking Agency (FBA).

Under the final proposal, the task force on January 31, 1984, recommended the FBA be created within the Treasury Department to exclusively regulate all national banks.  Not only would they regulate them, this new consolidated body would be responsible for their supervision and examination.  The Federal Reserve Board was left with the state banks.

The more complex issue was bank holding companies.  BHC’s had been a problem for government regulation and responsibility for a very long time.  The Fed did not want to give up any power over them as a matter of monetary conduct.  These were the increasingly typical structures that exploded in the sixties and seventies as money and banking evolved.  Sandra Pianalto, future President of the Cleveland Fed, wrote on behalf of that branch in April 1984 what was driving all this fuss:

“New financial instruments, new breeds of financial institutions, and different market conditions have developed in the United States since the mid-1970s. The traditional product, geographic, and institutional boundaries of our financial industry have been questioned by advances in technology, inflation, high and varying interest rates, and an increasing demand for more and better services from financially sophisticated consumers.”

The real reason for the regulatory push was great and righteous dissatisfaction as a result of all those.  The Great Inflation was more than a decade of economic malaise that left the nation in the early eighties confronted with deep recession(s) as well as continued uncertainty.  There was enormous political desire to at least try to confront what had happened so as to prevent it from recurring.

Most people intuitively understood the problem of runaway inflation.  The common cliché of more money chasing fewer goods persists for a reason, empirically established then as a matter of especially Federal Reserve incompetence in the area of dollar money.  Even Volcker’s Fed in 1983 and 1984 wasn’t very popular, as most of the accolades and congratulations were never offered until much later when finally the Great Inflation was declared dead. 

But it was at first Volcker alone in the government who opposed the plan to strip the Fed of its bank authority.  He argued that for monetary policy to be effective it must have also the power to at least supervise and examine the whole banking system, especially its most important parts.  The FOMC minutes from the board meeting of November 22, 1983, note that the Fed’s position was resolute in this regard.

“Board members were unanimous in the view that under any restructuring format, the Federal Reserve must continue to be involved in bank supervision in order to ensure the effectiveness of its monetary policy and other central bank functions.”

How much of that was bureaucratic jockeying we may never know; no government authority or agency ever willingly gives up power, as any bureaucracy’s first instinct and task is to justify its own existence.  The same meeting minutes record what seems almost a childish tantrum along those lines, “the draft proposals were not a substantial improvement over the existing system.”

There was, however, truth in the attempt to do so at whatever other levels.  After the experience of the seventies, particularly the late seventies, there was something about money, supply, and economic output that had brought together banking and monetary policy like no other time in history. 

I personally wonder whether if for a moment these policymakers, particularly Mr. Volcker, were gifted a (brief) moment of clarity to see the future.  They might have guessed that in the coming years a Federal Reserve left as a rump bank regulator might be one on the road to obscurity, to fade and die as state banks disappeared from the landscape in the very modern future of not just BHC’s but more so internationally-focused BHC’s.

The FBA never did come into existence for various reasons of historical and political trivia. In truth, the go-go eighties happened followed by what would be called in the early 21st century the Great “Moderation.”  Reform is, as the FAA is often referred, a tombstone affair.  Nothing happens in airline safety (bit of an exaggeration, but not much) until after a crash.  So it is with everything else; people care about banks and the Fed when it is obvious there has been a big problem with banks and the Fed.

That certainly characterized 2008.  But despite popular cries of Too Big To Fail, the US central bank was actually given more authority of regulation and supervision in its aftermath.  Chairman Bernanke like Chairman Volcker before him had made much the same general argument, though this time from the inside out.  Volcker’s point was to make sure monetary policy would be strengthened by being inside the system and further pointing inward.  There is evidence this is the argument that won out.

Bernanke as a matter of pure necessity contended that what had happened during the panic was an outside matter; and therefore the Fed needed to be inside but pointing outward as a shield against this “other.”  You can see the outlines of this argument made long before the crisis.  The whole idea of Bernanke’s “global savings glut” from the mid-2000’s was exactly that.  There was this “thing” out there lurking in the world that had the potential to cause great harm and disturbance, and it wasn’t something the Fed or US banks did or had done. 

For as ridiculous as the “global savings glut” hypothesis always was and even remains (several prominent economists have maintained it throughout and refer to it still), there was some truth to it. It was not a strong truth, or one that accomplished what Bernanke has always sought (absolution), but important to consider nonetheless. 

We have to remember how bureaucracies operate.  They are rigid and often unflinching. The Fed views monetary policy the same way, and as part of its holistic mission of also bank regulation.  But who does the Fed actually regulate for its monetary policy goals?

It seems a stupid question.  After all, the topic has featured prominently the past few years.  Current Chairman Janet Yellen cannot say it enough how these new supervisory powers have made the banking system more “resilient.”  She even declared boldly not long ago that another financial crisis was “not likely in our lifetimes.”  For a woman of calculated and measured words, the statement stuck out as if delivered purposefully for emphasis.

She did not state because it did not need to be stated that she was referring to American banks and the American banking system. That is her directive, monetary policy as well as the regulation and supervision of the firms and institutions meant to carry it out.  The central bank’s two mandates are for low unemployment and stable inflation, and it is those American banks that are on the business end of making it happen; sometimes explicitly as in a QE (or four), sometimes in less appreciated ways.

We refer, as always, to the crisis because it provided the most obvious and often egregious examples of how it is all wrong.  One day after the desperate events of August 9, 2007, on August 10 the FOMC gathered for an emergency teleconference to decide what needed to be done to provide liquidity assistance as any central bank would do (currency elasticity).  Less than a week after that, on August 16 officials held another on the same topic with more urgency.  Never once on either call was LIBOR mentioned in some 50 pages of combined transcript.

It would not be until the regular September 2007 FOMC meeting that subject was finally raised. 

“MS. JOHNSON. So the spreads of overnight pound LIBOR, relative to target, opened up widely, and they were not addressed. They were allowed to just sort of sit there. The term pound market had a problem, too. Of course, many of the dollar issues that we have spoken of— and that Bill talked about—are really being captured as a London phenomenon. But you might say that, from the point of view of the Bank of England or the U.K. economy, these dollar issues are somewhat separate from the domestic economy.”

LIBOR was not, these bureaucrats believed, a Fed problem.  It was something for the Bank of England since these were British banks, or, as Kathleen Johnson called them, a “London phenomenon.”  In truth, they weren’t often British banks, either, but foreign banks operating in Britain, including American firms.  

US monetary policy followed from that view.  It saw American banks as opposed to British banks or European, when in reality there was no distinction between any of them; they were all eurodollar banks.  It was not several banking problems spilling over from several different places for several central banks to independently address; it was instead a single “dollar” problem that united everything from markets to economy. 

Is the Federal Reserve’s jurisdiction strictly American banks, or does it include the dollar as well?  The legacy of the Volcker Fed, rightly or wrongly, rests on the latter being included.  The key monetary transformation of the sixties and seventies, however, those that forced Volcker to take extreme measures in the early eighties, was this international dollar supplanting gold and domestic dollars for international liquidity. 

To Bernanke, that looked like in the 2000’s a “global savings glut” to his bureaucratically rigid mind when it was in fact merely a continuation in qualitative as well as quantitative explosion from the Great Inflation forward.  There was no Great “Moderation” in between, just a narrowed monetary perspective.

Despite all that happened in 2008, the problems linger on for these reasons.  Federal Reserve officials in 2017 have a growing inflation problem on their hands.  Their very credibility, what’s left of it anyway, now rests on getting at least this one small thing right.  They didn’t deliver any of the growth that was promised, nor much of a recovery at all, but they can and have pointed to the low unemployment rate as fulfilment of at least part their mandate. 

And yet, there is no inflation pick up evident anywhere (just as there isn’t an indicated economic momentum, either).  Just yesterday the Bureau of Economic analysis reported another downshift in the PCE Deflator, the Fed’s preferred inflation measurement.  At just 1.40% for July, more so the direction than the level further indicates that the problem isn’t outside the Fed but that the Fed is outside the problem.

It might even be much greater and more immediate.  Societe Generale’s Albert Edwards writes recently that core CPI inflation has plummeted in recent months.  Worse, core CPI less rent was actually negative over a six-month period for the first time in the series history (dating back to the 1960’s).  He writes in exaggerated response, “Deflation did not need a US recession to emerge.  It is already here.”

What do Fed officials talk about with respect to all this?  Unlimited wireless data plans.  Seriously. 

It’s a case of not being able to see the forest for the trees.  Mr. Edwards, though known as a pessimist, had importantly turned optimistic on inflation more than a year ago. He believed like Janet Yellen that there had to be something to this 4.3% unemployment rate (as it is now).  It can’t ever get so low without such a shortage of workers (and there isn’t a day that goes by without some new story about some local company unable to find enough workers) triggering massive wage competition. 

Despite what seems only logical, it’s not there; it’s never there.  The unemployment rate is hugely misleading for what it leaves out.  There are 15 or 16 million Americans who do not count for it in any capacity.  Considering that the BLS figures that there are a total of 147 million payrolls (Establishment Survey) in this country, 15 million “missing” is no rounding error.

Policymakers and economists have tried so very hard to ignore these people as best as they might.  By focusing exclusively on American banking they have overseen the devastation of a huge proportion of America because they cannot have it any other way.

By considering those millions lost in this lost decade, they would have to then further consider a monetary system and a currency that violates their bureaucratic rules.  Making no distinction between foreign banks and eurodollar banks reconciles the unemployment rate to reality through the crisis in 2008.  There is no other mechanism for any single economy, let alone the global whole, to just shrink in such a manner. 

Recessions come and recessions go, but for them the economy in short order gets about its business; this is very different.  The global economy fell off when panic was at its worst, and never came back.  The US unemployment rate is pure prevarication.  The unifying element can only be the very thing that through Bernanke’s bureaucratic translation brought to his rigid mind a “global savings glut”, only now a “global savings deficit”; only it’s not savings that are in short supply.

There are already growing indications (apart from receding inflation, perhaps deflation) that like last time (2013-14) this deficit is coming back.  In truth, it never really disappeared, for that is not what “reflation” has been this time or those before it.  It is instead variable, meaning that there are times like 2012 and 2015 when global money problems are acute, causing further damage and downturn, and those like 2010, 2014, and late last year when they are less so.  The economy never really bounces into an upswing during them because it is always being held back (liquidity preferences) to some degree.

If there is the smallest of silver linings, and it’s exceedingly small given the economic costs still piling up, it is that there is no effective champion for when politics finally gets around to erecting this latest tombstone. It took fifteen years of the Great Inflation to trigger a few years more of debate over what to do about it, so if that is a useful guide we might be several years more before it becomes a serious topic (with a whole lot of danger in between). 

There is no Paul Volcker this time, and certainly there is every reason to believe that if and when the discussion happens it won’t be taking place under conditions like the go-go eighties.  Where the Bush task force failed to defang the Fed three and a half decades ago, more so by killing its reputation than anything else, the next one just might succeed.  But it can’t actually succeed for what really counts unless it recognizes the dollar as its major component, the whole “dollar.”