A Robust Economy Is The Fix That Policy Won't Allow

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In one sense, the proliferation and unending maintenance of "emergency" monetary measures should ring far more alarm than the complacency seen globally. The fact that "they" are calling for outright QE in Europe, more QQE in Japan and the perpetuation of the bubble cycle (or what is called secular stagnation now) in the US speaks to the very abundant indications that nothing is "right." In fact, though I spend an inordinate amount of time dissecting the relationship of Eonia to the Main Refinancing Rate and whether a -2.57% repo rate for the 5-year treasury this week is of crucial importance, we should have arrived by now at a place where no one, even me, really cares what Eonia actually is.

In the time before August 9, 2007, nobody did outside of a few operational managers at certain financial institutions and some very curious and ultimately incredulous outside observers. The plumbing and vagaries of the global dollar system were seemingly and certainly outwardly unimportant as it related to order and continued good operation. There were no obvious signals of dysfunction, so there was no interest in function.

That is, of course, a limited observation as there should have been more attention paid to the internal workings of the global eurodollar system (the term petrodollar is not sufficiently broad enough to convey what the global financial system has become in the decades after the gold standard). That is not to say that Eonia or various spreads over federal funds, like LIBOR, showed much of anything other than normalcy. Instead, in recognizing importance of wholesale funding, even under "normal" circumstances, there would likely have been appreciation for global financial evolution. Had that happened, the theoretical notions of things like collateral bottlenecks might (stress might) have helped to alleviate some pieces of the crisis before it struck its worst; or, even better, may have short-circuited the all-encompassing run toward debt, debt and more debt in the first place.

In that order, then, the current primacy of interbank function as it relates to continued economic dysfunction traces back to that central focus. As Ben Bernanke said in a November 2002 speech delivered years before his ascendancy at the Fed,

"When William Jennings Bryan made his famous "cross of gold" speech in his 1896 presidential campaign, he was speaking on behalf of heavily mortgaged farmers whose debt burdens were growing ever larger in real terms, the result of a sustained deflation that followed America's post-Civil-War return to the gold standard."

The role of monetary policy under just that understanding is clear, as much as it is in the modern era where money no longer exists in monetary policy. The appeal to silver was an appeal against "deflation", which the generations of 1930's scholars assume is the most vital factor in the course of economic management (rather than whether economic management and monetary socialism are at all worthwhile endeavors). The cross of gold which Bryan alluded to has been picked up and discarded by the Fed's policy apparatus from Greenspan's tenure forward.

It is a quixotic quest, however, tilting at the windmills of actual progress. What Bryan and his fellow farmers failed to count was that such deflation was not monetary in its origin (which the modern monetarists agree) so much as price pressures then were innovation being adopted and capitalism raising the living standards of everyone in clear market view of it. To debase the currency through silver, as was done leading up to the 1893 panic and depression, was beyond silly as it amounted to trying to undo progress.

As the cost of food fell under the positive spell of innovative adoption, producers unable to keep up with productivity are supposed to fall by the wayside. What good will it do to keep inefficient producers producing when their resources would be more efficient in allocation doing something else. The state of being on the "wrong" end of just such a societal advance is determined, messy though mostly fair, by profitability. Yet, even today the government "fixes" the price of so many farm commodities because "factory farms" are thought to be "destroying" farm families, without any regard to cost/benefit.

That process, thankfully, is small in comparison to the massive upward lift of progress in the industrial age. As people left "failed" farms for other places, it allowed the greater adoption of new technologies and wholly new industries to serve as the engines of great and sustained growth. The failure of family farm as a structure, as hard and painful as it was for those who underwent the transformation, was as good and righteous in economic terms as anything we have seen in our economic history.

It is that process that reminds of a passage from economist Joseph Berliner.

"But if Adam Smith had taken as his point of departure not the coordinating mechanism but the innovation mechanism of capitalism, he may well have designated competition not as an invisible hand but as an invisible foot. For the effect of competition is not only to motivate profit-seeking entrepreneurs to seek yet more profit but to jolt conservative enterprises into the adoption of new technology and the search for improved processes and products. From the point of view of the static efficiency of resource allocation, the evil of monopoly is that it prevents resources from flowing into those lines of production in which their social value would be greatest. But from the point of view of innovation, the evil of monopoly is that it enables producers to enjoy high rates of profit without having to undertake the exacting and risky activities associated with technological change. A world of monopolies, socialist or capitalist, would be a world with very little technological change."

A world without change is actually what all forms of central planning, including of the current monetary variety, actually seeks. You cannot dictate advance but you can try to manage (and fail) what you mistakenly see as decline and loss.

The 82nd Annual Report from the Bank for International Settlements in June 2012 chided central banks that year for the flood of "stimulus."

"First, prolonged unusually accommodative monetary conditions mask underlying balance sheet problems and reduce incentives to address them head-on. Necessary fiscal consolidation and structural reform to restore fiscal sustainability could be delayed."

The Bank was mostly referring to the sovereign level, as in nations that needed to get their fiscal house in order rather than taking the cheap borrowing route. But that sentiment could/can also be applied equally in the context of monopolies, cartels and all the oligarchical practices that circumvent Berliner's "invisible foot." A company has little incentive to adopt disruptive technology or even compete with it when it can so easily buy out its competitor before it ever really makes a significant impression.

The appeal of debt, on the corporate side, is one of the hidden costs of eliminating Bryan's cross of gold. A significant amount of scholarship has been devoted to the case study of employment gains by company stratification. That includes cross-sectioning by size as well as age. And in almost every case, large firms are net destroyers of jobs, while nearly all significant gains in jobs and payrolls are counted in small firms muscling their way through sheer will and innovation into the upper strata - the very life cycle of businesses.

That disruption, like the 19th century farmers, is taken as a net negative by monetary policy makers and the socialist planners that operate through this unhealthy monetary theory. In the past year, there have been a couple of studies presented where the pace of new business creation in the United States has been arrested to the point where the natural course of destruction of firms outnumbers new startups.

That is very visibly a regulatory problem, where the monetary side is not so much appreciated. One of the characteristics of the modern banking system, especially at the rather wide margins of "evolution", has been the growing factor of securitization of all means of debt and credit. The application of "liquidity" toward all facets of banking has favored the security over the loan, whereby loans of ill-suited factors were securitized by the trillions last decade. The shadow banking model runs on collateral, and thus all focus is upended toward collateral production.

The net effect of that is to push credit further and further upward, as corporate bonds are much preferred, by volume, than anything like credit to a startup. Of course, the entire preface of Silicon Valley seems to be a counterpoint, as venture capital has clearly found its way into this area despite any financialization preferences, but that is/was not a consistent process, instead clustered around two significant "bubble" events (one ongoing). The disruptive internet and computer revolution is already mostly past a half-century old.

Instead, the tide of credit "inflation" has been one toward stagnation, as any cursory review of economic statistics shows a decided lower bend in the upward trajectory right around the late 1990's. It's as if the economy suddenly shifted downward in trajectory, something that is now being admitted in that idea of "secular stagnation."

The most obvious outward face of this problem is wages and income. Despite the first annual gain (ever so small) in the past five years in 2013, median wages are about where they were in 2000. That more than suggests something awry in economic function, as if the 19th century farmers faced deflation and simply took it without any mobility. Does an economy really grow under such circumstances, or is it possible that it is simply redistributing from one to the next and counting those changes as positive growth?

I have to refer here again to Paul Krugman's enthusiastic embrace of the secular stagnation theory last November. It follows exactly this kind of theoretical tradeoff between "deflation" and progress and fighting against that with credit overflowing.

"This is the kind of environment in which Keynes's hypothetical policy of burying currency in coalmines and letting the private sector dig it up - or my version, which involves faking a threat from nonexistent space aliens - becomes a good thing; spending is good, and while productive spending is best, unproductive spending is still better than nothing."

What do you get for engaging in "unproductive spending" on a massive scale? To the Keynesian and monetarist you get economic activity for the sake of economic activity. That is the idea of generic "aggregate demand" where doing something for any reason whatsoever is much better than having resources "idle" awaiting to rather do the "right" something. Here, "right" means profitable, and thus sustainable; Keynesians and monetarists care not for profit in this context.

What monetarism does is exactly that, amounting to a government subsidy of "unproductive activity" as long as GDP is positive in the short run. The means and methods undertaken to achieve it are unimportant to the practitioner because all that matters is the simple numeric value of "inflation", which is simply taken, a la Bryan, as an equivalent to economic gain when in fact it is the actual correspondent of thwarting progress. This redistribution is inherently and axiomatically concentrating by its own means. The net effect of redistribution is to leave behind the very firms and sources of actual economic growth - the desire for profitability through all means as Berliner noticed contrary to monopolies.

This "socialist hand" as it exists now in the form of monetarism explains much of secular stagnation, as does the immense amount of resources "needed" to keep it all in working order (or in the chase for that, as we see now regularly for the past seven years). Redistribution of the credit kind is essentially an inorganic process of picking winners and losers, rather than allowing profit to function as that, which almost always favors the larger firms that destroy jobs.

If incumbent firms have little to fear from competition, and this applies very much to how monetarism enables crony capitalism and the growth and interplay between Big Business and Wall Street, they will act as much. Innovation and focus turns away from trying to adapt to disruptive technology and toward using cash resources for financial "investment" instead; as well as managing costs to maximize profits of existing technology rather than being forced to invest in new processes and products which is by its very adoptive nature labor intensive. A full part of that cost management is to focus whatever capital expenditures actually get made toward increases in existing efficiency, including "over"-managing those labor costs.

And what does the Fed do in a situation where firms are too cautious toward their cost structure, likely keeping cash idle instead for financial investment or liquidity reasons (since they are taking up so much debt from past monetary intrusions)? It pushes further toward the "monetary" solution that only reinforces all these negative economic pressures.

The next step in the "evolution" of central banking has already arrived in certain places, mostly in response to the fact that economies no longer function as they once did. The PBOC has engaged its SLF as a means for "targeted" monetarism, actively allocating resources in what it has decided is economically (though far more politically) "useful" (in this case, the SLF funding is targeted toward the refurbishment of "shanty towns" and other impoverished areas). In Europe, the ECB not only chases Eonia steadily lower, narrowing its rate corridor in a fashion that really should by now interest nobody, the central bank is also engaged in targeting, with nary a thought of profit. The raw "flood" of liquidity that marked past programs is looking to be itself past, instead overcome by events and finally some admissions about deficiencies in the very designs of monetarism itself.

And what does the ECB target with this new monetary program that only factors the cost of funding? Small and medium businesses that even the ECB suggests are underfunding owing to banks' cumulative preference toward the behemoths and their ability to "supply" credit in volume and known characteristics. Further driving that point home, banks in Europe in the first "tranche" of this "T" LTRO took up far less than anticipated, at just €83 billion. That, of course, does not prove anything with regard to so much stubborn economic insufficiency, or stagnation, but it does suggest more than a little something in that direction.

The cost of keeping Bryan's farmers solvent through inflationary silver would likely have been a premature end, or at least severe disabling, of the industrial revolution as it was adopted broadly. The reason "we" care about repo fails, a negative Eonia or whether and how Japan launches yet another QQE is because there is no solid economic foundation, just an unreasonable groping for one lasting well past a half decade now (and a quarter century in Japan). Redistribution and the promotion of "unproductive spending" have very real costs, though not easily observable, or directly perceptible, through traditional means of measurement. The more that is reinforced in a closed loop of persisting redistribution, the more that esoteric financial function "has" to matter. A robust economy, nationally and globally, would solve all these issues, or at least render them so very and permanently uninteresting.


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

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