We May Be In For Another Malaise Worthy of "Great"

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On June 25, 1950, North Korean forces crossed the 38th parallel into South Korean territory, inaugurating the "forgotten war". The very next day, North Korean tanks had reached the outer edges of Seoul, and the day after that the United States was pledging naval and air support. It was a return to war only five years after the end of the greatest conflagration in human history. President Truman, in office for both, naturally expected this war to follow the same kind of pattern as the previous one, particularly from a fiscal perspective.

To finance World War II, the government ran massive deficits that were underwritten not so much by patriotic expressions of "war bonds", but by a central bank peg to the interest cost on government debt. In other words, the Federal Reserve agency oriented monetary policy so that bank reserves would be tied to the ability of private banking concerns to purchase government bonds at fixed rates of interest. This sounds very familiar to observers of today's monetary affairs, particularly this indirect arrangement whereby private banks "intermediated" the central bank and the central government.

The interest rate peg on government bonds began in 1942 after a period of moribund money growth (from mid-1940 through the early days of US direct involvement in mid-1942, the adjusted monetary base had only grown 9% vs 74% during the previous three-year period). The Federal Reserve had to expand the level of bank reserves to meet the spiraling demands of government expenditures.

The peg, however, outlasted the war, and by the end of the 1940's economists and Fed officials were beginning to notice the rather tight relationship of government borrowing to bank reserves to consumer inflation. So when President Truman moved to answer the North Koreans militarily, he anticipated little monetary opposition to financing the government's intended deficits. He was mistaken.

The relationship between the Federal Reserve and the US Treasury was already complicated by the Employment Act of 1946. That piece of legislation committed these two agencies to work in correspondence under their own individual competences toward a unified goal of achieving full employment as well as price stability. The Fed, as was understood, was legally bound to "coordinate" its monetary activities with the Treasury's fiscal activities. The theoretical achievement of full employment in the 1940's was believed to be as much or more a fiscal reaction than monetary.

By the Korean War escalation of 1951, however, Fed officials began to assert their own control over exactly what "coordination" meant. Obviously, from the Truman administration's standpoint, a continuation of the interest rate peg was the most desirable and hospitable to government deficit financing. The FOMC began to disagree as the late 1940's had already succumbed to a nasty recession, bookended by bouts of inflation (a preview of the 1970's) as inflation rates preceding that recession were 17% and 9% in 1947 and 1948, respectively.

By the middle of 1950, New York Fed President Allan Sproul recommended allowing rates to rise by 1/8 of a percent. That decision, of course, had to be approved by the US Treasury and was summarily rebuffed (the Korean action having taken place just after Sproul's recommendation to the FOMC on June 13, 1950). The economy had been expanding for a year and the Fed was again concerned about rising inflation taking hold again as it had in 1947 and 1948.

By the August 1950 FOMC meeting, central bank officials decided to directly challenge the Treasury. They had resolved to allow the one-year treasury rate to rise 1/8 of a percent, and to raise the discount rate by 1/4 of a percent. That set off a series of events and conflicts that ended with the Fed-Treasury Accord of March 1951.

That Accord has been utilized by conventional wisdom as the moment the Fed re-established its independence from the US Treasury Dept. In reality, however, under new Fed Chairman William Martin, the meaning of "independent" had only changed and only slightly. Martin himself would say that the Federal Reserve was only independent within the government, not independent from the government.

The FOMC had wrestled control of interest rates away from the peg of the World War II era, but that did nothing to alleviate its responsibility toward the Employment Act of 1946. Instead of pegging interest rates, the Fed now had the responsibility of ensuring the Treasury's ability to fund at market rates. That meant controlling the level of reserves around government bond offerings - increasing reserves a few weeks before, then re-absorbing them a few weeks after. Modern monetary policy was born here in the infrastructure of open market operations and what would become repos and reverse repos, maintenance periods and TOMO's.

Government deficits were a fiscal problem, so the Fed under Martin believed that it had no role in influencing the size of the deficit or the proportion of government borrowing to finance it. While the Fed and the FOMC often engaged in communicating preferences for tax increases rather than borrowing, the agency, again independent only within the government framework, would not allow monetary policy to intrude into fiscal matters.

This was formalized into what was called an "even-keel" policy. The supply of bank reserves before, during and after the government debt offerings were to be maintained at a consistent "market-based" level to allow for smooth issuance. That also meant that any "failed" offering would be fully absorbed by the Fed through open market operations - the Fed would buy the unsold bonds from banks.

For the rest of the 1950's, the administration under Eisenhower saw surpluses rather than deficits, so the even-keel policy was not much of a factor. Economic policy, such that it was at the time, was still largely believed to be primarily driven by fiscal factors. That meant tax policy was far more important for achieving full employment, with the Fed at best riding shotgun to the Treasury and Congress through even-keel.

That, of course, was a bit of a problem beginning in 1965. Government spending was to increase as the Johnson administration began the dual course of the Great Society and Vietnam War. From the Fed's perspective, however, President Johnson's refusal to finance these initiatives with tax increases was an abrupt change over the previous paradigm. Even the Kennedy administration had signaled the need and desire to incorporate tax increases into the fiscal equation of government spending initiatives, so Martin found himself in a difficult position.

The deficit had reached 3% of GDP (it sounds like a paltry amount today, but that used to be a big number) by 1968 and so did the instances of even-keel saving treasury bond offerings. Between 1961 and 1964, monetary growth was as even-keel as the policy name, between 1% and 3%. Between 1965 and 1968, when Martin finally got his tax increase, money growth was steady at 6%. This was the initial stage of what is now known as the Great Inflation.

The shift in monetary mechanics from the interest rate peg to the even-keel policy that followed it was really two sides of the same coin. Purportedly the market was setting the rate of interest for government borrowing, and thus performing the function of intermediation and resource allocation, but that wasn't really true. If the market was setting the real rate of interest for government borrowing then there would never have been inflation.

Any busted offerings (actual auctions were not instituted until the early 1970's) would have signaled to the treasury that the market was not receiving enough interest reward to cover the perceived risks for lending private money. The treasury would have been forced to respond by raising the offered rate or discounting the price. The market by 1965 was trying to push back against and check the rise of government borrowing, allocating money resources elsewhere in the real economy. The Federal Reserve overrode that allocation attempt by ensuring that additional non-market money was made available to the government regardless of market impositions. It didn't and doesn't really matter that these funds are routed indirectly through private banks since the end result is exactly the same. In other words, it was not a market-based system at all; it was, at best, market-guided.

In the decades since the even-keel policy, evolving into the "stop-go" presence of monetary impositions in the 1970's, to the general activism of monetary policy into "macro" variables and expectations in the 1980's, to the intended managerial regime of interest rate targeting in the 1990's and beyond, monetary policy has been evolving and growing into the role of overriding markets to achieve ostensibly political goals. It started as the little brother of the Treasury Dept., ensuring that market discipline would not be visited upon the post-war government, and has grown to consume market overrides over not just government discipline but economic discipline.

The consequences of intervening in market allocation functions and intermediation were rather stark and dire - fifteen years of economic malaise that transformed the very fabric of global finance and trade, as well as traditional economic mechanisms. It is little coincidence that the consumer economy began as an outgrowth of monetary expansion in the 1970's. The personal/household savings rate (which had been stable throughout the 1950's and 1960's) began to fall in 1975 and 1976, and did not stop until 2005. In the meantime wages began to stagnate though they were increasingly supplemented by ever cheapening credit access. Labor's share of GDP has been falling because the credit channel was viewed by both households and monetary officials as a perfect substitute for fueling consumption. For more than four decades now, monetary policy has seen to it that additional money is the allocation plugline or fudge factor in the economy that answers all problems: the key to the Great "Moderation" was simply expanding access to monetarism beyond the Treasury Dept.

Yesterday's announcement of an open-ended commitment to buy mortgage bonds (QE 5.0?) reminds me a lot of even-keel. The similarity for me is not so much the inflationary implications of unlimited monetaristic overrides of market allocation functions, but rather the imposition of theoretical flaws into the complex system of economic interactions - thus the potential for it leading to unknown unknowns. It essentially amounts to dismissing discipline because of circumstances with the intention of somebody somewhere returning at some point in the hopefully not-too-distant future. Human nature, especially of politicians, has a hard time appealing to discipline. In political cases it seems near impossible - ZIRP is almost four years old at this moment. Exit plans were supposed to be ready-to-go for 2010, 2011 at the latest.

So the removal of discipline becomes a permanent fixture, a distortive impact or perversion of the general operation of the economic paradigm. But it is not a benign distortion, it is an enforced and intended imbalance. Asset bubbles do not appear from nowhere, they are the very recognition that imbalances exist and require a return to disciplined circumstances. The collapse of asset bubbles is exactly that - the re-imposition of discipline along the asset inflation monetary channel.

The appearance and persistence of consumer inflation during the Great Inflation was the very visible sign of the monetary imbalance that grew out of even-keel. It was followed and accompanied by high unemployment, something believed to be nearly impossible according to the theoretical monetary understanding of that time period. High unemployment persisted because the monetary imbalance of consumer inflation eroded the purchasing power of economic agents. That erosion itself is a natural balance, but it was not allowed to reach fruition because of the central bank monetary input that continually feeds the imbalance. The central bank is the independent variable outside of the economic system, not central to it as the name might imply.

Similarly, it seems very plausible that the appearance and persistence of high unemployment right now is the very visible sign of the asset inflation side of monetary imbalances, with one caveat: the unemployment part is not coincident to the inflation. The process of inflationary intrusion is essentially the same whether consumer or asset inflation: consumer inflation destroys purchasing power directly, while asset inflation destroys purchasing power eventually through price collapse (asset prices can no longer support debt levels, so the relative ability of real incomes to flow discretionary funds is constrained or destroyed altogether). The end result is exactly the same but through different means and across different lags or timescales. Monetary imbalance, no matter what form, ends up in the same place.

The Federal Reserve and the ECB are combatting the artifacts of monetary imbalance with more monetary imbalance. Inflation and high unemployment are together or separately the fingerprints of the lack of discipline in the monetary side of the economy. They are most certainly not incidents of free markets. The even-keel of monetary imposition in the 1960's led to our own "lost decade" as it took fifteen years for the political will to at least attempt a rebalance. After yesterday's Fed announcement, coincident with the rash of economic indications of unrequited un-disciplined imbalances (the Household survey for employment has shown declines in four of the past six months), we may be in for another prominent malaise worthy of the "Great" distinction.


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

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