We Can't Endlessly Stimulate, and Expect 'Moderation'

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It is pretty unusual to find a Canadian-born academic buried in Arlington National Cemetery, but at Section 1, Site 527 lay the remains of Simon Newcomb. Taking advantage of the propensity for Southern naval officers to resign their posts in the years just prior to the outbreak of hostilities, he was appointed to the US Naval Observatory in Washington for the duration of the Civil War. Newcomb would use that position to enhance his own academic studies, given opportunities and resources not readily available at other posts of the age.

Active in teaching astronomy and mathematics at the observatory, Admiral Newcomb, however, was perhaps best known, unfortunately, for his bracing denial of man's ability to achieve true flight. In the October 22, 1903, issue of The Independent, he wrote that, "aerial flight is one of that class of problems with which men will never have to cope." Using his considerable mathematic skill and knowledge, as well as hard-earned reputation, he concluded that, "flight by machines heavier than air is unpractical and insignificant, if not utterly impossible."

Maybe no one would have noticed or cared that he made those conclusive proclamations if the Wright Brothers had not proved him wrong only a few weeks later. Because of that unlucky chronology, he is largely remembered for being dead wrong. It is very much like Irving Fisher's famous decree from October 23, 1929, where he declared, "stocks have reached a permanently high plateau." Black Thursday, of course, was the very next day, followed the next week by Black Tuesday.

But Fisher and Newcomb share more than ignominy over being exactly wrong at exactly the wrong time. In 1854, Newcomb first read Jean-Baptiste Say's rejection of the "trade cycle", with an emphasis on relative production in Political Economy. Despite a full schedule in astronomy and mathematics, including being credited with first theorizing and describing what would come to be known as Benford's Law, Newcomb charged into the field of economics. He would even go on to lecture on Say's Law and economics at Harvard and Johns Hopkins.

Contrary to what we might assume today, it was not all that unusual for astronomists to contribute so much to the study of economics. In fact, credit is usually given to Copernicus for first introducing a quantity theory of money. Owing to the monetary disaster in Poland, due in no small part to the Teutonic Order's propensity to dilute metallic currency, Copernicus wrote Monatae cudendae ratio in 1517 (published in 1526). "We in our sluggishness do not realize the dearness of everything is the result of the cheapness of money. For prices increase and decrease according to the condition of money."

In 1885, Newcomb wrote what he thought was a continuation in that long line of contributions, searching for a formulaic interpretation of money's impact on prices and economy. In Chapter XV of his Principles of Political Economy, Newcomb introduced his "equation of societary circulation." In it, he presented several concepts which would inform how economists would view monetary philosophy for the past century and a quarter.

Chief among them was Irving Fisher, who in 1897 first referred to his equation of exchange and his version of the quantity theory of money. Fisher would go on to dedicate his seminal book The Purchasing Power of Money (1911), "To the memory of Simon Newcomb, great scientist, inspiring friend, pioneer in the study of ‘societary circulation'."

While there were some significant differences and advancements from Newcomb to Fisher, the concept was largely intact. Newcomb used "rapidity" to describe the circulation variable, to which Fisher later ascribed "velocity." However, it was on the other side of the equation where differences were more than minor tweaks. Newcomb used K*P as the real economy, which was meant as a measure of prices and economic transactions. But he excluded from his method borrowing and lending, as well as any speculative investment. It was meant to be strictly focused on goods and services.

Fisher observed that no such limitation should hold, particularly since money, even commodity money, may transact business in the financial realm as well as real. To gain measure over that broader interpretation, Fisher's replacement of K with T included all bank clearings, which incorporated large volumes of financial transactions.

Because both Fisher and Newcomb wished to develop more than a theoretical notion of economic and monetary circulation, they were keenly aware of all the quantitative limitations their equations were exposed to. How does one measure every transaction in the economy, with or without the financial component? What constitutes prices, an aggregate index or sum of individual components?

On theoretical grounds, Fisher's equation was attacked almost immediately as nothing more than a tautology - it provided little insight into the economy, only describing what everyone already knew and perceived. But it was the drive toward mathematical precision that drove the quest for the equation's evolution and eventual widespread acceptance. It began a strain of economics that has changed and evolved into modern econometrics.

As economic theory advanced, the economics profession saw greater use of aggregate measures of economic accounts. First developed by Simon Kuznets in 1934, the advent of GNP (or GDP now) accounting began to reintroduce the desire to mathematically measure economic function and precision like that suggested by the equation of exchange. Conceptually, GDP consists of the summation of net contributions of various segments (C+I+G+[X-M]) yielding a potentially measurable and robust mathematical answer to the economy side of the equation.

Milton Friedman resurrected Fisher's formula in the hopes that it would provide the monetary answer to better economic control (though he never really phrased it that way). It was the rebirth of the monetarist school. Owing to the updates in economic statistics and accounting, it was believed that those measurement problems Fisher and Newcomb encountered were largely solved.

The fact that GDP (or national income in the Cambridge formulation) would substitute for all transactions never generated a great deal of concern. In many ways, that was reflective of conditions as they actually existed. Money was used in the real economy, and even savings were largely exclusive to vanilla investments in bank accounts or government bonds. It appeared as if the US economy was very much like a closed circulation loop which was accurately reflected by Friedman's update of Fisher - leaving out financial transactions. As he saw it, money (and credit) was nearly exclusive to goods and services, so the modern equation would fall closer to Newcomb than Fisher in that vital respect.

Any households that had managed to save "money" did so in the form of currency, either keeping it "under the mattress", thus diminishing velocity, or depositing that currency in a bank as bank reserves. Loans made by the fractional pyramid of bank reserves largely funded real economy projects, meaning "money" remained almost entirely within the closed loop. Businesses, where most credit volume was directed, before 1980 used debt financing almost exclusively for expansion in productive capacity or inventory.

Any that did find its way into financial transactions was minor, as the financial realm was drastically outclassed in terms of size by the real economy of that age. Friedman could ignore finance as largely a rounding error. That preserved the idea of precision via the equation. In other words, the lack of ability to measure all possible transactions, including the array of financial means, was never much of a problem with the economy in a relatively "primitive" state.

That began to change moving toward the 1960's, as the Bretton Woods system evolved further and further from the gold exchange standard. The US monetary system could not fully operate as a closed loop since the dollar was a reserve currency. Because dollars were needed abroad as well as domestically, there was always tension in terms of convertibility. That led to several "runs" on the dollar in the 1950's, culminating in the London Gold Pool in 1960.

This mismatch between the dollar's convertibility and domestic inflation suggested that the equation and its adherents were missing Fisher's insight. If US dollars were "printed" domestically, then transferred abroad (via channels such as the growing eurodollar market), then the closed system is really subject to leakage. After all, those now-foreign dollars might never see the domestic US economy, and thus have no bearing on US prices or GDP. If Colombia used dollars to pay Saudi Arabia for oil in the 1970's, where would that impact Friedman's equation? That would suggest that there might not have been such a direct and proportional relationship between the money side and the economy side as believed originally.

We have been led to believe that, armed with Friedman's equation insight, a new Golden Age of central banking, the Great "Moderation", was inaugurated by the Volcker Fed putting the quantity theory of money into practice. While there is no doubt consumer inflation ceased to be the primary symptom of imbalance, this view has never been reconciled to concurrent appearances of asset bubbles. That included the first almost immediately following Volcker's "victory." Beginning in 1982, there was an explosion in corporate debt issuance as interest rates began to subside along with consumer inflation. We now know it as the junk bond bubble, but it consisted of a relatively new trend in corporate borrowing.

Mergers and corporate takeovers were certainly not new by 1982, but they were usually small and sparse. The junk bond bubble, however, began to reshape the entire concept of corporate "investment." Corporate cash, subsidized by debt, would no longer be limited to building new factories or front-running inflation expectations through inventory building. This debt element of financial investment and the financial success it would bring to its proponents (the legendary corporate raiders, such as Asher Edelman) began to broaden the horizons of monetary intrusions. But these were financial transactions that fell outside the closed concepts of the modern equation of exchange, so the Federal Reserve and economists were more than satisfied that monetary imbalance was fully absent. Since consumer inflation remained relatively low, the proportion of monetary "stimulus" was assumed largely correct and thus beneficial.

This evolution in investing, riding that wave of debt creation, would extend into the consumer and household realm, as well. Gone were the days where households, if they managed to save anything at all, were limited to cash or deposit accounts. The advent of mutual funds broadened investment options to other financial transactions. As money market funds gained mainstream acceptance owing to regulation changes in 1990, the flow of "money" changed dramatically. That was further boosted by a huge surge in lending on stock accounts, i.e., margin. When Alan Greenspan's gave his "irrational exuberance speech" in late 1996, margin debt in stock accounts was about $100 billion, up from practically nothing in 1990. Margin debt would spike to $300 billion just before the bust a few years later.

At the end of the 1970's bear market in 1982, mutual funds owned less than 3% of all outstanding equities. By 1990, that proportion more than doubled to just under 7%. When the dot-com bubble finally ended in April 2000, mutual funds owned nearly 19% of all stocks. That proportional change represented a huge surge of "money" into the markets throughout two decades still described as "moderate."

The monetary imbalance would continue throughout the 2000's, as central banks were intent on taking advantage of the room afforded them by persistently low consumer inflation. The evolution in financial "investment" on the corporate side would bring about an explosion in share repurchasing activity in addition to renewed interest in M&A, including another wave of LBO's financed by junk (lessons of prior busts never stay learned for very long).

Stock buybacks, we are told by Wall Street analysts, are actually quite beneficial since companies are recognizing undervalued shares and therefore helping the market adjust by prudently deploying erstwhile idle resources. If that were true, however, we would expect to see more repurchase activity when market prices are low. The problem is that, empirically, repurchasing follows pretty much the same pattern as individual investors, pouring more and more into shares as prices rise higher and higher.

In 2007, at the extreme of the last "cycle", JP Morgan estimated that about $589 billion worth of shares were repurchased by their companies; more than half a trillion dollars in a single year. While some of that was certainly sourced through internal profits and cash flow, more often than not that share repurchase activity was financed via debt - either bonds floated in the secondary market or bank lines of credit. In 2003, total corporate debt owed by nonfinancial corporate businesses relative to GDP was about 44%. By the end of the cycle in 2007, it was above 55%, representing $2.5 trillion in additional borrowing.

Going by the modern equation of exchange and closed system approach, the moderate rise in consumer inflation during the whole of the Great "Moderation" (either the CPI or PCE deflator) was obviously disproportionate to the increase in debt, particularly factoring the rapid accumulation of mortgage debt and corporate borrowing. It was permeating every economic channel, leading to massive misallocations of resources, yet it never signaled alarm to orthodox economists and monetary officials (despite the revisionist history being spun about Janet Yellen's nearly assured ascension). Are we supposed to accept the idea that asset bubbles are spontaneously self-creating and self-sustaining? Even the Fed is (belatedly) coming around to the idea that there might just be a monetary genesis to them.

Even setting aside asset imbalances, the evolution of banking and "money" since the 1960's itself should be enough to force a revisit to the entire concept. We still have no idea what constitutes the money supply, let alone how to measure it. In Fisher's day, it was relatively straightforward, even incorporating banking. Today, there is a very valid argument for including yen deposits from Japanese housewives in the estimates of the US dollar money supply. After all, owing to advancement and evolution in global finance, currencies themselves are somewhat fungible given vast scale and complexity of derivatives markets and their transformations. Banks in India can create dollars in the eurodollar market sourced from locally denominated assets, never having touched the Federal Reserve system or the United States geographically.

The point here is not that the equation of exchange is flawed innumerably, but that it endures despite its defects; it is a tautology. Setting aside any problems or concerns over the concept of velocity, or whether price indices are sufficient for aggregate measurement, this conceptual formulation for the intersection of the monetary with the economy encompasses an enduring intuition that we can see and feel in a tangible way. It simply makes sense, though it is not so rigid.

But that has to include the monetary intrusion into financial transactions and the dynamism by which it all progresses. Financial evolution has opened the possibilities far beyond what Fisher or Friedman ignored. The monetary system and the financial system have nearly fully merged, and it has changed the economic system. You cannot endlessly "stimulate", openly encouraging banks to "print money" for decades, and expect "moderation." The incongruity of that should be fully obvious, but adhering to the Friedman closed system approach has blinded monetary policymakers. Even children learn at a relatively young age to progress beyond "that which I cannot see cannot hurt me." The first step to rectifying this is bringing back Fisher's fuller idea of T.


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

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