We're Living In An Age of Convolutions

Story Stream
recent articles

When historians look back on this specific period of time searching for a unifying moniker to create a justifiable shorthand and generalization it will more likely than not become known as an age of convolutions. That will apply more broadly than just economic description, but it is there it will be most appropriate. Since nothing has gone as planned, advertised and intended, the global economic regime of mainstream orthodoxy has bent itself into entertaining contortions about exactly why that is.

The current fad is secular stagnation, a reproachful attempt to let monetary policy off the hook for any of it since the supreme idea of monetary neutrality must be preserved no matter how badly its regressions miss on seeing the forest from the mathematically calculated trees. Part of that effort has been, very much like that which followed the Great Depression, to recast what exactly transpired six years ago. And the same part of the orthodox explanation that served as a basis for modern monetary "science" is again being applied in that direction.

The declarative gaze of "economists" has fallen back on the idea of the money supply once more, after having given it not much thought under the constant regimes of QE. Coming very late to the realization that the "money supply" itself is more complicated than the monolithic assessments that dominate orthodox theory, it passes for insight now to invoke once more the name of Milton Friedman and his interest rate "paradox."

The problem with that is Friedman was very much correct, but for reasons that he (respectfully) doesn't seem to have fully appreciated himself, and his intellectual descendants clearly don't. While the QE's were in full bloom and the prospects of recovery fully "inarguable" there were no thoughts or discussions given as to what QE actually was, not just in a philosophical sense but on the ground in terms of operations. To an economist, the money supply is the money supply; but on the business end of it all it is nothing of the sort.

The same can be said of the panic in 2008, begun inauspiciously more than a year before, as Friedman's paradox came to be on full display. Low interest rates count unambiguously as "stimulative" in the orthodox treatment used in setting the policy course, but in this example, like that of the 1930's, low interest rates meant trouble. The idea of fragmentation and the wider appeal of borrowing and even liquidity itself were not at all represented by the major published rates of the period. Fragmentation meant far more than interest rates, and it occurred in huge chasms across geographies, institutional size and even intent that eluded the generic, uniform interpretation of "money supply."

In short, the problem in 2007 and 2008 was not the supply of "money" but rather its useful flow to where it may have been needed the most. In reality, given the state of repo markets and securitizations priced on ill-suited derivatives, there really wasn't any way to keep the whole thing afloat any longer. It would not have mattered one bit whether the Fed engaged in Japan-style QQE (as it is called in its latest "shocking" version) before Bear Stearns had fallen apart because there was no way to circulate any "reserves" from the primary dealers to secondary institutions to cross-geographies in the form of currency swaps, all hedged with dealer-books' capacity and, most importantly, willingness to absorb additional risk, to the outer reaches of hedge funds and the broader class of "speculators" that had and have no extended pathway to liquidity.

But monetary policy itself, despite the name, features no money in the modern incarnation. Instead, policy was never intended to broach any indirect pathways to the wider system apart from very targeted programs designed ad hoc after the heat of emergency had already turned disastrous. Monetary policy is, in terms of "money supply", nothing but an elaborate ruse. The intent behind all of it, especially QE, is for the "market" to close the gaps in liquidity flow on their own by fostering nothing more than the impression that liquidity is good and righteous (that applies even where QE has more direct impact in terms of flow activity; buying in the TBA market for example). The appearance of low interest rates, however, may not determine much about actual function, as the recession of QE from the TBA market during taper has had a very negative and lasting effect on mortgage volume despite interest rates still retracing much of last year's selloff.

For a financial agent on the "wrong" side of flow, such interest rates and even the wasted and idle "reserves" of QE do nothing if they can't "fool" participants into giving up their reluctance in the first place. That is as true now as it was during the worst of it, as flow is dependent on the willingness and ability of participants to extend the real "printing press" and money supply of the system - balance sheet capacity.

Unfortunately for orthodox treatment, balance sheet capacity is also a disjointed idea that comes in far too numerous forms to be useful to the simplistic math of linear regressions. That could mean derivatives dealers, as implied above, absorbing more risk and taking on hedging demand during periods when such seems to be the most dangerous option - what does QE do to foster that "money supply" other than some kind of hopefully self-reinforcing positivism that spreads across a wide plane of financial function? As noted in prior weeks, balance sheet capacity also is tied directly to credit dealer inventories and again the willingness to take on "risk" when it is needed most. That's a far more complex calculation (both human intuition and actual risk measures like VaR) than is given by all these assumptions, and more often than not has little imprint of central bank attempts.

Traditional concepts of the "money supply", or how "loose" or "tight" policy may be at any moment, just don't apply. What's more, the Fed and its central bank comrades know it very well - that is why they don't really try to do anything other than influence the behavior and psychology of participants and agents. There is, again, no money in monetary policy, but there is a heavy dose of intended psychological manipulation.

In very plain terms, all central banks do is to try to get participants, counterparties, agents, whatever, to "feel good" and then act upon those positive feelings to open up the intended monetary channels. In other words, flooding the world with inert and un-useful "reserves" is intended as nothing more than reassurance. That is hard for some people, including most economists, to accept.

The downside of doing so is that once those "positive feelings" do, in fact, come about there is no means or methodology to control them. Inundating the world with the greatest and most convoluted psychological experiment in history has led to very real distortions in function and result that it even threatens the very view orthodox practitioners of monetary policy have of neutrality itself. You can lead a horse to artificial feeling so of liquidity, but absent the real thing the financial equine equivalent may not drink what you propose and anticipate.

So what transpires is an almost comical form of reductionism, whereby in the full-throated attempt to do nothing more than to "fool" agents and participants, etc., that function will not be impeded, central banks go to greater and more dubious lengths to engage in what amounts to stamping out any and all vestiges of something that might stick out. On the other side of the Pacific, the Bank of Japan engaged in QQE for nothing more than the expectation that such size would be enough of a "shock" upon expectations.

From the April 2013 policy minutes, Bank of Japan officials admit to as much:

"They [policymakers] agreed that, to this end, it was necessary to boost demand by exerting influence on long-term interest rates and asset prices, and to drastically change the existing deflationary expectations of markets and economic entities. They continued that the size of increases should be significantly large and unprecedented in scale."

Despite actually creating "inflation" in Japan, the intended result remains as elusive as ever, perhaps even more so now given the desperate collapse in the economy after the tax hike (and now the persistent downgrades to private forecasts and the "expectations" engulfing, dangerously, the yen for even more QQE!). But to all contrary evidence, the Bank of Japan remains as confident as ever, if only outwardly. Refusing to reduce their expectations for GDP in 2014, it is instead expected they will eventually succumb to reality by October but are waiting because they don't want to negatively influence economic behavior now when it is most crucial.

That last point is something that has been talked about in policy circles for as long as rational expectations have formed such a central piece of the monetary foundation. The idea was even given that recessions themselves were nothing but psychology and that admissions of negative assessments by those in position of influence actually contribute to the downturn. The extrapolation of that position is as the Bank of Japan is doing right now; not admitting that QQE has once again failed because doing so might extinguish some level of positivity that could somehow lift the Japanese economy from its doldrums. The problem in Japan is taken not as far as too much dominion of financialism and monetarism but rather because there is too much pessimism, now so heavily entrenched.

In fact, it's as if the current board of the Bank of Japan was listening to the FOMC chatter from a decade ago. In June 2003, the FOMC got together to debate what was then believed to be an extreme policy position, reducing the nominal federal funds target to 1%. That ultra-low policy (for the time) triggered a pile of worries about monetary policy under "unconventional" measures.

"Relative to the kinds of options that these gentlemen have put on the table today, I think there would be a lot of agreement that there was one thing the Bank of Japan did that was very wrong. Namely, at each step along the way they portrayed the situation as abnormal and an emergency, and they indicated that the actions they were taking made them uncomfortable and that it was their intent to return to more-normal operations absolutely as soon as possible."

In other words, central banks have to act as if historically extreme intrusions are no big deal and that the "need" to implement them is to be downplayed as if everyone else were children in need of psychological protection from their own illogical emotions. You have to be so very cynical about the nature of rational adults and their abilities to assess reality to engage in such misdirection out of concern that even admitting problems will lead to worse results. You also have to have a dim view of markets and their ability to process exactly the same perceptions in the ways and means to carry out vital tasks - more true now given that "money supply" is as elaborate as these expressed intentions for prescriptions.

As it turns out, that cynicism has been on full display ever since then-Chairman Bernanke first uttered the words "subprime" and "contained" together. From that point forward, echoing what was judged "wrong" in 2003 about Japan, central banks have been so utterly positive about everything, including prospects before and after the collapse. Ultimately, however they have shown so very little progress for such overwhelming sanguinity. The self-esteem movement in education is trivial compared to that which infests "monetary" policy in the 21st century.

But in doing so this positivism and appeal to nothing but psychology trivializes very real problems. In 2008, it wasn't just that banks were "feeling" bad about each other in need of a QE-type reassurance, they were very much aware of not just the potential for loss and how thin liquidity had become on the back of dealer wariness in many different markets, they also understood the basic function of "dollar" markets as it actually existed between NYC and London; dollars and eurodollars. That wasn't to be fixed with either increased "money supply" or inordinate and sustained sunshine from the committee to advance good monetary feelings. And the attempts that were made failed so spectacularly because of that tendency to reduce real problems to fuzzy notions of just interest rates and expectations, or some anachronistic concept of money supply.

Yet for all of that, central banks are still doing exactly the same. Just as economists are still pining for more "loose" monetary policy, central banks are still in search of perfect positivism. While Japan will only reluctantly and eventually admit QQE failed in every respect except the one means by which they could make it all worse (inflation), the ECB in Europe has undertaken what looks to be nothing more than a quixotic quest to corral Eonia to keep the recovery tale on life support if only for one more day.

I don't want to take too much time in the particulars of the European system, which is perhaps even more esoteric and technical than this side of the Atlantic, so more details can be found here. In short, the ECB's "shocking" decision recently to deepen the negativity of its rate "floor" appears, to me, not so much about the floor as the relation of the midpoint (MRO, the "main" rate) to Eonia (the "market" rate for unsecured interbank activity). Relating that to this idea of expectations and appearances, Eonia has remained under the MRO since 2008 in what is, and has been, a very visible signal that "something" is wrong.

For several years now, the ECB has engaged not only in reducing interest rate targets, which is all that gets recited in the mainstream, but narrowing its rate corridor. The reason for that is Eonia, in what can only be an attempt to "force" it to eventually return to its "rightful" place at some positive spread to the MRO. Cornering Eonia against the zero lower bound, as they have done, did not "work" so the ECB dropped the whole rate corridor again in August despite all expectations otherwise.

What would they accomplish in gaining an artificially positive spread over the MRO? It would be nothing more than the appearance of normalcy, a signal, though not of any market's making, that interbank function may have been wrestled down. Eonia, long a thorn in the side of policymakers as a less well-known but visible gesture of unsolved problems, could be used as something like low interest rates - to be what they are not in the hopes that enough participants are reassured as to act. Record levels of positivity have neither restored natural function in the European system, nor, as it turns out unsurprisingly, in the European economy as a whole.

Returning once more to that FOMC meeting in June 2003, Atlanta Fed President Jack Guynn anticipated what I think is the newest piece of the "paradox", specifically relating to interest rates:

"If we lower nominal rates to near zero and state publicly that we intend to keep them down until the economy recovers, then there's a nontrivial risk-especially if the economy weakens further-that the public's expectations for deflation will be heightened. That clearly happened in Japan. In other words, trying to avoid the Japan-type of liquidity trap could only increase the likelihood that it will occur because of the effect on expectations."

In other words, if all these convoluted and increasingly desperate attempts at artificially invoking "normalcy" coupled with the persistent and heavy sunshine approach about the economy fail to work and people, crude, dumb and illogical as they may be in comparison to the assembled wisdom of elite economists, get the sense of exactly that then there is no going back. This is a binary outcome, as suggested by Japan's now quarter century of tortured economic existence. If this all fails, then there is no escaping the dungeon of doomed monetarism. Orthodox central banking sees itself as both the only hope for the economy and, at the same time, the very means to maintain malfunctioning for the foreseeable future (yet there is great "mystery" as to where secular stagnation originates).

In that context the removal of QE in the US actually makes sense, as it has since it was first suggested now much more than a year ago. This is not at all driven by "incoming data" as Janet Yellen and the current host of expectationists proclaim, but rather a last ditch attempt at managing those expectations before they become semi-permanently ingrained. Like the Bank of Japan, they have no choice but to cling publicly to the recovery narrative while they take further precautions behind the scenes.

If QE exhibits diminishing impacts on expectations as President Guynn suggested a decade ago, especially where the real economy fails to follow the intended path time and time again, then maintaining QE will only deepen the hole. And since that means we are left with, at best, something like a stubborn malaise absent of true growth, the FOMC's focus becomes far more of "managing" what it takes as "secular stagnation"; that includes the very real downsides of financial intrusions now that behavior has been corrupted by all these increasing convolutions.

The impediment to recovery is not "money supply", nor is salvation contained within massaging economic self-esteem through contrary protestations. There needs to a realistic approach that is reasonable in its view of exactly what is wrong without boiling that assessment down to some kind of fuzzy notion about feelings and emotion, interest rates and money supply. You cannot so trivialize major imbalances, nor can you become so cynical over markets and then expect markets to suddenly act exactly as it appears in your regression equations. This is not, as much as it is made out to be, a short-coming of humanity in acting through markets as it is about true complexity that evades these overly simple assertions.


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

Show commentsHide Comments

Related Articles