Credit Is Plentiful In All the Wrong Places

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In April 1998, Milton Friedman wrote an article for the Hoover Institution at Stanford pertaining to the inability of Japan to pull out of economic malaise. In fact, it was more than any garden-variety dysfunction, as the Asian flu pushed the economic sputtering in the world's then-second largest economy into outright deflation. That was, and remains, orthodox economists' collective nightmare. Friedman, being one, simply applied his own advice and scholarly contributions to the Japanese situation.

To Friedman the approach was as simple as it was formulaic. Monetarists always and everywhere appeal to the "money supply". To begin with, Japanese monetary authorities created their economic track by being overly aggressive in currency and debt after the Louvre Accord in February 1997, where the Bank "bought dollars, in the process creating yen." It led to, as Freidman himself noted in the article, the "Bubble Economy".

A little more than a decade later, he was rebuking the Bank of Japan for money growth judged to be too little. Somewhere in that decade of monetary disaster lay the Goldilocks formula for just the right amount of monetarism, though it was, and remains, never specified. It is an abstract appeal toward an ideological formulation of how an economy should work.

Placing blame more specifically, Friedman believed, due in no small part to the work that brought him much-deserved fame and adulation, that the Bank of Japan had fallen for the interest rate fallacy. Low interest rates were, and still are, associated with "loose" monetary conditions; conversely high rates conventionally denote "tight" conditions. This conventional picture, as Friedman demonstrated of the US during the Great Depression, is false.

There were persistently low interest rates throughout the Great Depression and persistently high interest rates throughout the Great Inflation, reversing the conventional narrative through empirical reality. In the Japanese case, the Bank of Japan by 1995 had committed the same monetarist sin, believing that its reduction in the discount rate from 1.75% to 0.5% was evidence of "the easy stance of monetary policy." There was no attention, or even mention, of money growth and the previous orthodoxy.

Part of the reason for that was the change in theory away from true monetarism and toward a more credit/bank stance. Where the Federal Reserve once reflected such primary relationships, it now sought to control economic margins by interest rate targeting. In the late 1970's and early 1980's, the Fed's primary monetary measure and target was M2 and M1 money supply figures, but that all changed as they began to see the economy behave contrary to that focus. By the 1990's, it was firmly entrenched that interest rates were far more "constructive" toward economic management. It was not reasoned about cause and effect why simple money supply targets had lost their potency, that the Great Inflation and monetary mismanagement had laid the foundation, including moving away from gold as money, for creeping financialism.

That flipped Friedman's understanding on its head, as now low interest rates were "stimulative" instead of signaling constraint. The appeal was toward one of credit and debt accumulation, meaning that the primary means for monetary policy would be through banks and the carry trade (low short-term rates stimulate, so it is believed, banks' desire to lend into the economy). Bank liquidity and low interest rates became synonymous despite historical accounts otherwise.

Friedman's article, then, was an appeal to return to his orthodoxy and the Goldilocks monetarism of some assumed money supply target. The Bank of Japan, the Federal Reserve and every other central bank ignored its pioneer and continued on this interest rate path, appealing over and over to debt and credit as the primary economic tool. I suppose at the very least it can be said that Friedman's version contained actual money as the core property of monetary policy.

In 1972, the National Bureau of Economic Research, the private, non-profit research organization that determines official recessions (cycle peaks and troughs), where Friedman's most famous works were published, released an article from economist Ronald Coase, titled Industrial Organization: A Proposal for Research. The purpose of the commentary was largely to urge the NBER and the economics profession at large to move beyond its narrowing focus. Mr. Coase, who passed away this week, was perturbed by the movement of economics as a "science" or scholarly endeavor more and more into abstraction without qualification.

To some degree, this was understandable given the rise of computer technology and the very human urge to try to make sense of complex systems through mathematics. More computing power meant, it was hoped, the ability to model increasing numbers of variables in increasingly complex interactions - simulating something like an economy. Coase, however, realized that not everything in the real economy would translate; further there were dire deficiencies in economists' understanding of some basic formulations. These were not just mathematical deficiencies owing to the need for simplification, but downright ignorance.

His main concern was, as the 1972 article title denotes, industrial organization. Coates wanted economists to pay more attention to real economic fundamentals and interactions, to truly understand them and stop looking at these as simple variables to be included in a model. His main critique was a blistering attack on the tendency of economists to reduce all microeconomic interactions to variables centered on either tax policy or monopolies.

"Of course, more recently, the desire to reduce the burden of taxes has become another way of explaining why businesses adopt practices they do. In fact, the situation is such that if we ever achieved a system of limited government (and, therefore, low taxation) and the economic system were clearly seen to be competitive, we would have no explanation at all for the way in which the activities performed in the economic system are divided between firms. We would be unable to explain why General Motors was not a dominant factor in the coal industry, or why A & P did not manufacture airplanes."

The fruits of quantitative ability were, of course, believed to be better predictability, coupled with advanced philosophy, leading to economic control. What Coase was saying, in trying to attract attention to his area of study, was that economics was making leaps it was not ready to make, and thus were really leaps of faith rather than scientifically grounded advancements.

The Friedman critique of the Bank of Japan is of similar concern. Here he saw, after being lauded universally and globally for diagnosing tight money conditions in the US in the Great Depression, another central bank fully ignoring exactly what was recognized as obvious after he pointed it out. But I would also submit, as his Goldilocks scenario suggests, that Coase's critique applies in equal proportion to both strands of modern monetarism.

Beneath both ideological rigidities of money supply and interest rate targets lies the same tendency toward abstraction. In 1930, money supply was a rather simple thing, as in the actual supply of money or at least the supply of currency. Not so much in the modern system as even what constitutes currency is up for debate (there is no money). Yet the abstraction persists - credit and debt are universally desired and low interest rates are the means to achieve that economic goal.

What follows from that faith is beyond simplistic since it presupposes that banks have only one option or preference. If "money" is made artificially cheap and available through policy, then banks will always, or at least mostly, opt for lending into the real economy, creating the "stimulus" of orthodox lore. The fact that it is viewed to have worked so well in the 1990's and 2000's is willful blindness of the fact that there are multiple classes of financial firms, that financial firms have multiple options to grow balance sheets and expand currency fractions, and that credit creation can finance both artificial economic expansion and artificial asset price action at the same time (usually proportioned more to the latter). Furthermore, given the dollar's role as reserve currency, there is no geographical limitation to where credit expansion might flow and intrude.

If, however, the complex interpretation is correct where orthodoxy does not illuminate, then something altogether unpredicted occurs. Banks that do not turn monetary generosity into real economy lending, as we see up and down the globe, opting instead for "risk free" and liquid alternatives, depress interest rates down to nothing, or at least as far as monetary policy presumes as most abstractly beneficial. Low rates persist because banks find little "value" in lending on the risk curve, and thus keep monetary injections in a tight circle. There might be a supply of funds or currency, but it is most decidedly not uniform or homogenous - we call this fragmentation in the modern age.

I also think Friedman gets it partially wrong. The persistence of low rates in Japan in the 1990's and 2000's, and the United States in the 1930's (and post-2008) is not about monetary policy being "tight" or "loose" at all. It might simply indicate indifference (on the part of the economy) or even impotence (on the part of monetary policy), and that the natural level of demand is being oversupplied with credit and/or currency it has little use for. In that case, as Coase suggested, economists have no idea why IBM is such a serial stock repurchaser rather than undergoing serious productive expansion. IBM takes on debt not because it needs the funds to build new factories and pay for new employees, but because the funds are there and they can turn debt into non-productive shareholder returns.

But where Friedman may have represented the first iteration of monetary orthodoxy, and interest rate targeting the second, clearly the current regime of global monetary policy is a third. We have moved almost completely away from "money" or supply issues, instead preferring monetary policy as a psychological tool to control not just economic variables but individual actions. Since economists have little understanding beyond the abstract, this is more than a little dangerous.

If you or I refuse to participate in the recovery by spending at levels set by policymakers, they will visit financial repression on us and our accumulated savings. Not only will they appeal to inflation (or at least inflation expectations) to devalue them, the consistent application of zero rate targets will assure an environment of no return coupled with, as we are witnessing, higher risks.

In short, there is no freedom of expression through economic or personal financial means. Everyone must participate for the "greater good" or get punished accordingly through the monopoly exercise of monetary authority. Yet it persistently falls short of its goals and purposes because normal people don't take to such repression with a spurt of optimism and risk-taking. Instead, they (including businesses, particularly on the smaller scales) pull back even further desperately and futilely appealing to true money stability.

We can see this with near perfect clarity in the case of the renewed housing mini-bubble in 2012/early 2013. In anticipation of "tight" (low interest rate) monetary conditions in the MBS market due to impending QE 3, a flood of "money" flowed not to households and individual home buyers, but to hedge funds, REIT's and even ETF's. The Fed injected an opportunity for "free money" and leverage, and the public largely shrugged. Mortgage applications for home purchases, in sharp contrast to refis, have barely moved since 2010.

I have little doubt that it would be a totally different set of circumstances if Friedman's famous helicopter analogy were employed instead. Rather than push "money" through mortgage bond channels, if instead the Fed took applications directly for cash, meaning no obligation to repay, there would be a frenzy of Biblical proportions. Short of that, however, the only sectors of the economy interested in the outpouring of debt-based monetary beneficence are those that thrive on speculation, leading to only one conclusion - the real economy is not short of credit or in need of money supply measures.

If you wish to classify that as "tight" monetary policy, I suppose you could make such a case. In reality, it is both "tight" and "loose" at the same time - plentiful liquidity in all the wrong places, coupled with dramatic indifference to debt and credit where growth typically is predicated. However, there is no such econometric variable for this in ferbus, GARCH, TVP-VAR or any of the Fed's models. Economists never heeded Ronald Coase's warnings, they simply, as Friedman found out fifteen years ago, continued to evolve further and further, without pause of contemplation, into the ether of abstraction.


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

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