Central Banks Have Us In a Monetary Trap

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The focus of the early part of 2012 is no doubt on central banks. In Europe, calls for the ECB to "monetize" troubled sovereign debt and rescue European banks are still in a loud crescendo. Back across the Atlantic, the Federal Reserve has just paved the way for QE 3.0 with its very public release of a research paper detailing how to solve the real estate depression (without a lot of actual details). Since almost all of Wall Street expects QE 3.0 to be a lot like QE 1.0, with the Fed engaging in the wholesale purchasing of mortgage bonds, there is little mystery to the timing of this particular publicity stunt.

As much as there is a perception of disjointed confusion to all these "emergency" measures, including the ad hoc and disconnected timing to them, there is a definite element of commonality running through them, an unmistakable theme. Central monetary authorities are, in essence, running through a kind of pre-scripted economic playbook. As with most things monetary or economic it was developed from exhaustive analysis of the Great Depression.

Nearly fifty years ago, back in 1963, Milton Friedman and Anna Schwartz published, through the National Bureau of Economic Research, what amounts to the monetarist guide to handling a depression crisis, titled "A Monetary History of the United States, 1867-1960". It was a seminal work in many ways, not the least of which was that it offered an insightful, logical and, most importantly, a very plausible assertion of just how the Great Depression became so "great". Until its publication there was still, several decades afterward, quite a mystery as to how an estimated (their estimate) $2.5 billion in accumulated banking system losses, spread amongst deposit-holders and stock-holders of banks, could lead to an estimated $85 billion in losses to the value of all common and preferred stocks in the United States. As Friedman and Schwartz noted in their book, "A loss of $2.5 billion is certainly sizable, yet by itself it would not entitle bank failures to the amount of attention we and other students of the period have devoted to them."

The Great Depression, in their analysis, was wholly unwarranted because of monetary mistakes. The banking crisis permuted into a money crisis, the currency disease of deflation, simply because of two related and concurrent deficiencies or feedback loops.

The first was that currency was in short supply relative to the growing demand for it, as depositor faith in the banking system fell proportionally to the number and size of bank failures. Fractional reserve lending has always featured this kind of deficiency, namely that banks only have enough currency or reserves to repay or redeem a small fraction of their liabilities. Whenever the demand for that currency rises, there is the danger of a shortage, raising the cost of currency to inefficient and dangerous levels.

The Federal Reserve was created and empowered to alleviate just this kind of condition, known as money inelasticity. It was supposed to ensure that currency would never be in such short supply in the inevitable cycle of credit boom and bust. Yet, in the 1929-1933 collapse period "the banking system as a whole was in a position to meet the demands of depositors for currency only by a multiple contraction of deposits, hence assets." In other words, banks were forced into the desperate liquidations we now call firesales because, as Friedman and Schwartz believed, the Fed was behind the curve on systemic liquidity.

The second great monetary deficiency is where these liquidations became a systemic danger, where problem banks become a millstone around the neck of the entire system. The bank runs that fed the desperate process of firesale asset dispositions distorted market prices, leading to a systemic devaluation of bond prices since desperate banks are typically forced to raise cash in the most liquid markets. Without true currency elasticity, there are little options except to raise currency in markets where it is actually available, often meaning the markets for high-grade or first-rate securities.

"Banks had to dump their assets on the market, which inevitably forced a decline in the market value of those assets and hence of the remaining assets they held. The impairment in the market value of assets held by banks, particularly in their bond portfolios, was the most important source of impairment of capital leading to bank suspensions, rather than the default of specific loans or of specific bond issues. As W.R. Burgess, at the time a deputy governor of the New York Reserve Bank, told the Bank's board of directors in February 1931, the chief problem confronting many banks was the severe depreciation in their bond accounts; ‘given a better bond market and rising bond prices...the condition of banks now jeopardized by depreciation in their bond accounts would, in many cases, improve automatically beyond the point of immediate danger.'"

Indeed, Friedman and Schwartz cite several examples of how erstwhile "good banks" were ruined because of the market values of their bond investments:

"The depression of bond values, which started as far back as 1929 in the field of urban real estate bonds and reached foreign bonds and land bank bonds in the course of 1931, began to endanger the whole banking structure and notably the large city banks the moment first-grade bonds were affected in a most drastic way: From the middle of 1931 to the middle of 1932, railroad bonds lost nearly 36 per cent of their market value, public utility bonds 27 per cent, industrial bonds 22 per cent, foreign bonds 45 per cent, and even United States Government securities 10 per cent."

This led to an odd quirk of regulation, one that proved fatal in the cases of so many banks:

"Because there was an active market for bonds and continuous quotation of their prices, a bank's capital was more likely to be impaired, in the judgment of bank examiners, when it held bonds that were expected to be and were honored in full when due than when it held bonds for which there was no good market and few quotations. So long as the latter did not come due, they were likely to be carried on the books at face value; only actual defaults or postponements of payment would reduce the examiners' evaluation. Paradoxically, therefore, assets regarded by the banks as particularly liquid and as providing them with a secondary reserve turned out to offer the most serious threat to their solvency."

If a bank held bonds that traded regularly, chances were that those bond prices were irregularly devalued by the firesales of troubled banks, spreading further disease into systemic bond portfolios. Bank examiners, filling their bureaucratic role too well, read these prices as a measure of solvency, closing banks based on their perceptions of how said prices ultimately affected the overall condition of the bank (disregarding any thoughts of whether firesale prices are appropriate measures of solvency).

Because the most liquid securities were also thought to be the safest, and therefore were likely the most widely held, this distress was spread through the very securities that should have been the most insulated from crisis. So surprising bond price declines led to the suspensions of more than a few larger banks:

"The president of Federation Bank and Trust Company, closed by the New York State Superintendent of Banks on Oct. 30, 1931, explained that the bank had prospered for many years ‘and as a matter of fact right up to the past few months, when due to the nationwide rapid and unforeseen depreciation in bonds and other securities, the falling away in values of the bonds and securities owned by the company impaired the bank's capital structure'"

As these devalued bond prices transmitted distress across the whole system, the resulting bank suspensions fed into the already fearful population. The result was a self-sustaining feedback loop, where bank runs led to firesales, that then further suppressed bond prices, leading to more suspensions and then more fear and runs.

There is a healthy debate on just what kind of stance the Federal Reserve took in the early 1930's, but there is no debate about the results. The secondary effects of these two prime inadequacies were the shocking collapse of the money stock (estimated to be about an astounding 33%), ultimately leading to the collapse in national income and net national product (an unfathomable 53%). Thus the banking system's $2.5 billion in notional losses produced an oversized catastrophe that lingers in both the popular imagination and the professional instinct toward activism.

We see the implications of Friedman's and Schwartz's criticisms in nearly every central bank measure of the current crisis period. Money elasticity was enforced by quantitative easing and dollar swaps, ensuring (at least in theory) that there was enough supply of currency to meet rising demand (the Fed has misidentified which currency is in short supply, namely quality interbank collateral, but that is another topic). In addition, the bond market's fatal flaw, what is now called "contagion", is vigorously combatted by the (to this point ineffective) constant bond market interventions of both the Fed and ECB, where bond prices are supported by constant central bank bids, or even just the rumors of such. Further, as much as we might believe the suspension of mark-to-market in 2009 was a novel idea, it is directly implied here by the authors' work in 1963.

What is important to note is that none of these measures are proactive or precautionary. These are ex post facto measures designed for one single purpose, namely to keep the banking system from turning a cyclical downturn into a full-blown depression. Indeed, that is exactly what we have been told is the new conventional wisdom of 2009, that Bernanke saved the world from another Great Depression. Never mind that Bernanke downplayed the severity of the banking contagion, thought the economy would only experience slowing growth in 2008, and was desperately wrong on real estate prices, all that matters is that the Federal Reserve took Friedman and Schwartz to heart, heroically acting to keep the banking system off the same path to economic calamity that the 1930's economy tragically followed.

There has to be something a little more than troubling, then, that such valiant measures have had to be re-instituted repeatedly across the globe in the three-plus years since. If we do get to QE 3.0, it will be the fourth massive dose of money elasticity in as many years. To explain this chronic state of dysfunction, mainstream economics has coalesced around the idea that central banks have the right policies, and have correctly followed that 1963 playbook, just that the doses were too timid and were applied with far too much reluctance. In other words, central banks should have immediately embraced unbridled monetary measures including the outright printing of money (or at least its 21st century equivalent) and directly monetizing government debts. Even Milton Friedman's subsequent analogy of dropping money from a helicopter has been cited.

There is, however, an alternate explanation to the continued failure, even one that largely agrees with the framework set up in 1963. If we set aside any discussion about the predicate causation of the over-expansion of credit that preceded both the 1929 and 2008 collapses, there is still an obvious flaw to the central banking application of what came from Friedman and Schwartz (I believe they are wrong to downplay the expansion of credit in the 1920's as a proximate cause, just like it is wrong to overlook the rapid expansion of credit money in the 1990's and 2000's as anything other than another form of monetary mistakes and hubris manifesting as asset inflation). Without even getting into a discussion of just what causes these booms and busts, we can see the flaws of monetary suppositions on central banks' own terms.

If we identify the firesale prices of widely held, liquid bonds as the active transmission mechanism of wholesale malfunction, then actively encouraging, even herding banks to all purchase the same types and issues of bond instruments is both inherently dangerous and even suicidal. In other words, the true systemic danger to the banking system is not really the shortage of currency or money elasticity, it is homogenization. That was the reality of 2008 where the securitization and replication of structured finance meant that similar securities were in place at nearly every large financial institution on the planet. So when firesales started, the prices that saw initial declines forced losses on nearly everyone in the space (accounting for hundreds of billions of dollars).

In the years since, that systemic flaw has been intentionally replicated through the regulatory encouragement for banks to find "safe" collateral - which all happened to be the same basic type of bond. So the price of one largely affects the price of all, the very definition of contagion.

Even going back to the pre-crisis period, marginal credit expansion was accomplished through securities rather than traditional, idiosyncratically priced or unpriced loans. The over-expansion of the financial economy through the investment banking franchises of Wall Street led to dominant conditions where liquidity and trading were prized, necessarily precipitating the dangerous homogeneity that plagued the early 1930's.

Friedman and Schwartz note that by 1929, "investments" of commercial banks had risen from 29% of their assets in 1920 to 40% by 1929, a huge marginal expansion. Much of this rise had been due to merging retail banking operations with investment banking functions, "combining the function of investment distribution with that of credit extension". It is not hard to see why Glass-Steagall was instituted in 1933 (the second law that bears this name).

"These developments in banking were part of the general surge of financial activity so distinctive of the twenties. The main features of the financial activity, which culminated in the great stock market boom, were the public flotation on a large scale of foreign securities for the first time in U.S. history, and a widening shift by domestic concerns from bank loans to public issue of bonds and stocks as a means of raising funds."

That the financial economy of the 1990's followed right down the exact path of the 1920's seems to have been lost into the swirl of manipulated conventional wisdom of the 2000's. The Great Moderation was nothing more than a repeat of the "Roaring Twenties", complete with the inevitable collapse and despair. The absolutely vital lessons of the depression generation were ignored in the new age of mathematical predictions and complex bank evolutions.

Instead of putting lending back in lending, allowing traditional banks to set the marginal standards and pace of credit production, current policymakers do everything in their power to maintain the marginal importance of securities, trading and investment banking. Sure, there was some hand-wringing in 2009 and 2010 about the 1999 repeal of Glass-Steagall or ending "too big to fail", as well as some discussion about peripheral issues like the proprietary trading of these investment banks. But what is really outrageous is that not only has nothing been done about restricting the marginal importance of investment banking, and thus contagion danger, it has been allowed to progress to even higher levels.

In the end analysis, though, the reality is that the investment banks themselves are a politically favored class. Despite the mountain of evidence that their actions and even their current framework are inherently destabilizing and downright dangerous, there is no serious discussion about reining them in. The very handbook that forms the basis of current monetary crisis beliefs has been discarded on only this one point. For some reason, central banks desperately fight for monetary elasticity, but shy away from the real source of contagion as if there is no alternative.

What is really important and peculiar here is that central banks have utterly digested, incorporated and hold themselves to the 1963 script of crisis interventions; except for this one nontrivial aspect. Their failure to fully incorporate the ultimate systemic danger of homogenized banking renders all their efforts (no matter the magnitude) fully incapable of accomplishing the real task of economic healing. As long as the financial system continues on its path toward securities-based lending, and the constant emphasis on trading and imbalanced speculation, the systemic danger continues to multiply exponentially, not revert back to something more manageable and stable.

There are a number of answers as to why this is the case, why investment banking continues to garner such a preferential status. Some would surely argue that this investment banking model is a positive evolution or progression, so it makes little sense to revert back to the traditional fractional banking system that was also, or even equally, unstable (yet little thought is ever given to the whole idea of fractional lending itself). I have made the case that Wall Street is the realized ideal of monetary control, that the Federal Reserve has found its preferred tool for carrying out the transformation of a once free market economy to the soft repression of a new, lighter form of central economic planning. I have also made the case that the financial economy of the investment banking world has simply become too large, now a goal unto itself.

The full answer is probably a combination of all of these, as well as some other factors. The Federal Reserve, since its creation in 1913, has always been dedicated to one purpose, money elasticity. True elasticity, though, extends beyond just money printing or expanding its balance sheet. Real elasticity recognizes the destructive potential of systemic devaluation through homogeneity, regardless of whether it is undue or not, and how this kind of capital destruction is the exact same thing as destroying money.

With that in mind, the system finds itself in a bit of a paradox. To achieve true elasticity requires a sustained move away from homogenous credit creation, necessarily leading to a de-emphasis of investment banking. But any such move is vehemently resisted not just by the investment banks, but also central banks themselves, meaning the Fed or ECB can never hope to fulfill their true task of money elasticity. Perpetual crisis, volatility and instability are the fruits of this paradox.



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

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