We're All Keynesians Now Because We Have No Choice

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In 1971, President Richard Nixon is famously quoting as having declared, "we are all Keynesians now." As is usual in these cases, what he actually said was slightly different, and the context was not the end of Bretton Woods and the closing of the gold window that shattered August. Nixon's comment was made to Howard K. Smith of ABC News on January 4, 1971, off camera no less. Somehow it made its way into The New York Times three days later.

The President told Smith that he was, "now a Keynesian in economics." The point was easily understood at that time, a serious shift in mainstream economic thinking on the "right." The Times article reports that Smith was shocked at the statement, comparing it in religious terms to a Christian suddenly suggesting, "all things considered, I think Mohammad was right." It was, at the very least, a forecast of what was about to come, the "Nixon shock" of that summer.

Not only did the President order Treasury Secretary Connally to end US convertibility into gold, effectively defaulting on August 15, 1971, he also that same day issued Executive Order 11615 under authority of the Economic Stabilization Act of 1970 (you can always tell what won't happen by the names of these economic laws) that imposed a 90-day freeze on both wages and prices. Speaking to the American people on television that day, the President only made one true statement in his entire address. He said, "in the past 7 years, there has been an average of one international monetary crisis every year."

The quote attributed to Nixon was actually given by Milton Friedman - twice. The first was in a Time Magazine article from December 1965 all about Dr. Keynes. Friedman was purportedly very upset about his inclusion in the work, judging it to be a case of words taken far out of context. In 1968, he attempted to set the record straight, declaring instead that, "We all use the Keynesian language and apparatus; none of us any longer accepts the initial Keynesian conclusions." As Nixon would prove in just three years, all that matters is the former.

The true legacy of Keynes is not so much his General Theory rather that intervention is not just commonplace but demanded, an almost sacred duty. The market may be assumed efficient, but it was inefficient set against planned "optimal outcomes." No matter that Hayek described very well the hubris embedded in that self-assignment, the pretens(c)e of knowledge that Nixon would so ably embody, even the supposed libertarians were now in on the statism. Friedman's acceptance of the "language and apparatus" was, he hoped, only to provide a path for free markets to enter the top-down equation; to use central banks as the means for intervention as if that would preserve something great of free market potential.

It can only work, however, if you know what it is you are doing. As Hayek had warned, it is ever so infrequently the case. By 1980, even those on the "left" were entirely disgusted by Keynesianism that the bipartisan spirit of Congress was to be open and declared "supply siders." It wasn't exactly laissez faire, of course, but it was an important outcome quite against trying to command and devote "aggregate demand."

By early 2008, though, it was all back in that corner yet again. Across the intervening 27 years between the 1980 Joint Economic Committee report and Federal Reserve Chairman Ben Bernanke's January 2008 appearance before Congress, aggregate demand theory had been turned 180 degrees; shunned in bipartisan fashion by one generation who had seen up close its effects, and then embraced in equally bipartisan fashion by another who believed in some Great "Moderation" but only because they had convinced themselves there never were any asset bubbles (as if "global savings glut" was anything more than three words slung together in lieu of admitting global monetary arrangements were far different than the models). What Chairman Bernanke told Congress at the start of the Great Recession was his endorsement of all kinds of "stimulus", the full language and apparatus of Keynes.

Congress and President Bush dutifully obliged, cutting "stimulus" checks almost right away in 2008, culminating eventually in the American Reinvestment and Recovery Act under the next administration (again, you can tell what won't happen by the name). On the monetary side, pace Friedman, it has been constant intervention ever since.

The appearance of quantitative easing was all Milton Friedman, as he had written about the general idea as far back as A Monetary Theory in 1963. In 1998, he famously admonished the Bank of Japan for what he called the "interest rate fallacy." They were, he believed, confusing low interest rates for loose monetary conditions. History recorded the opposite in clear and convincing fashion. Richard Nixon's "shock" of 1971 and the rest of the decade did not occur under low interest rates at all, rather they would move only in the other direction. The Great Depression, by contrast, saw an unending trend of nothing but ultra-low yields and rates. Monetary economists were, by the 1990's, utterly confused.

They still are, apparently. Interest rates in 2016 all over the world are also heading in only one direction, and it is not the direction that we need. Yet, it is reported everywhere in the media from the mouths of central bankers that this is "stimulus"; that is, after all, what QE is believed to have been all about. The goal of the monetary intervention is to buy bonds and lower the interest rate; that there are now much lower interest rates seems to suggest QE's success, or at least that conditions are now even that much more "stimulative."

It misses a central observation similar to what afflicted Nixon's thinking that wage and price controls would somehow alter the Great Inflation into general prosperity. Even assuming that rates are reacting to central bank transactions overall, the very fact that it has to be repeated over and over, pushing rates lower and lower, still suggests a further overarching cause. It still adds up to Friedman's interest rate fallacy.

The incidence of low rates as a longer-term phenomenon is exclusively associated with "tight" money periods - in the real economy. QE by theory is supposed to be a temporary condition, where the assumed "liquidity effect" of lower rates in the short run are effective such that interest rates then rise over the intermediate term (also creating an orthodox conundrum of assumed efficient markets to be dealt with by "forward guidance" in its original form). It is this later "income effect" that QE is after.

Ben Bernanke well understands the almost paradoxical nature of the attempt, to lower interest rates so that they will rise. Writing in March 2015 for Brookings, the now-retired Fed Chair declared his sensitivity to savers and their place at the end of the line of this QE-world.

"Ultimately, the best way to improve the returns attainable by savers was to do what the Fed actually did: keep rates low (closer to the low equilibrium rate), so that the economy could recover and more quickly reach the point of producing healthier investment returns."

More than a year later, without the Fed buying any additional bonds in absolute terms (merely maintaining a steady balance sheet), interest rates are finding new lows all over the world including the US. It is the exact same scenario by which Milton Friedman scolded the Bank of Japan in 1998 - with one very, very important exception. Friedman wrote that to break out of the low rate hold, to get the economy moving again, would mean explicit monetarism; to raise the level of what he always called "high powered money."

The Japanese would eventually follow his advice, instituting the world's first instance of major QE in 2001. Ben Bernanke's Fed, after severely criticizing in June 2003 the Bank of Japan's first QE experiment, ended up only doing almost exactly the same. And interest rates all over the world only continue to fall.

Since Friedman is right about the interest rate fallacy, we are left only to conclude that QE does not alter the level of "high powered money", or indeed money at all. Bank reserves in the context of 2016, or even 1996, are not what they were in the 1930's. JP Morgan's hundreds of billions in "cash" on electronic account with the Federal Reserve cannot be used for any single good or service in the real economy; nothing. For that to happen it requires a further step on the part of JP Morgan, or any bank similarly situated holding the byproduct leftovers of any one of the four QE's. It is inarguable, then, that money for the real economy is a bank-driven occurrence.

This is why there has been the proliferation of suggested alternatives beyond QE, to NIRP or even "helicopter money." The former is an attempt to penalize banks for not adding to the money supply in the real economy, while the latter is an idea to just circumvent them entirely. Regardless, they are both admissions that Bernanke, as Friedman, were wrong about what QE accomplishes. They do not alter the money supply in the real economy; the "healthier investment returns" in Bernanke's words are further away today almost two years after the last QE's end.

But this is not strictly an American occurrence; it is decidedly a global problem. Friedman's advice was taken to heart in Japan, more than twelve times and counting, while Europe has conducted almost every form of bank reserve management ever contemplated. The results have been entirely uniform, which leaves even less doubt about the global monetary state of affairs - universal "tightness" in the real economy for the whole world.

Having now passed through an already-long age of the Friedman "shock", we are left with the same results as those brought about by the Nixon "shock": a lengthy period of malaise and stagnation leading to social breakdown and political realignment (at best). It doesn't matter the direction of the imbalance, inflation or deflation, as they are both symptoms of the same monetary disease. It all traces back to an unstable currency. In the 1970's, it was the rise of the credit-based global reserve, the eurodollar, and in the 2010's it is its unfortunate downfall.

I write "unfortunate" because the world is so clearly unprepared for it no matter how welcome it would otherwise be, especially the "other" surprise that seems to be looming now just over the horizon. To start with, central bank policy is designed to get the world back to 2005 as if the Great Recession was actually a typical business cycle. Like the Great Depression, however, it was instead a full rupture of the monetary variety. Bank reserves won't fix a world that has so very little use for bank reserves.

The eurodollar's big surprise, however, is the second end of what the eurodollar's final stage had wrought. We are all very well acquainted with the first part, the housing bubble and its relation to the dot-com bubble, but that was only ever half of the full bubble imbalance. The eurodollar's rise and 2000's mania fed in both directions; one into the developed world (DM) consumer debt of mortgages and the financial structures and plumbing that (badly) supported them; the other into primarily emerging markets (EM) to finance all the growth in productive capacity as jobs left DM economies under the flexible flow of "global capital" that the eurodollar provided. To economists, both sides looked like prosperity, but so far only one has been accounted for quite differently.

The EM capex boom of the late 1990's and 2000's is being totally unwound, pulled down by the enormous debt that financed it all to begin with. The eurodollar is not like hard currency or money, as everything it touches is debt-based. China, for example, does not just have an enormous overhang of productive capacity, it has a related financial imbalance that remains attached to it. In Brazil, this same monetary imbalance has already turned to depression. The full prognosis for China has not yet been delivered, but it isn't looking good after four years and counting of nothing but slowing.

The incidence of debt tautologically leads to its ownership. There are trillions upon trillions in EM corporate loans and bonds that are owned, possessed and in some way supported by global eurodollar banks denominated in dollars and euros. There are trillions more denominated in local currencies but again supported by "dollars" and foreign financial resources. In short, the eurodollar system flooded the whole world in imbalance, but the panic in 2008 only flushed out the one part most associated with the DM/consumer world; leaving in place the EM/production world still to be cleared of still-unknown levels of excess.

It is not a happy thought, especially since so much of that debt was put in place on assumptions that no longer apply in the slightest. Chinese-based financing went in as if the Chinese economy was going to experience 20-30% export growth as a permanent (or at least long enough to make it worth the commitment) baseline; Chinese exports, including those to the US, are contracting not here and there but month after month. A temporary recession, even a bad one, holds out the possibility of refinancing especially with the appearance of central policy support. An economic paradigm shift dries up all options at some point - further monetary tightening.

In February, the BIS reported that dollar credit to EM nations had fallen for the first time since 2009. In February 2014, analysts at Deutsche Bank estimated that European banks had extended in excess of $3 trillion in loans to EM's. The top six lenders alone had, they calculated, an aggregate $1.7 trillion in exposure (those "top" six were never named). These figures only include loans, so they are just the starting point of the conversation. Nobody in the mainstream was predicting an EM slowdown at that time, so it is relatively safe to assume that number has only grown in the two years since; likely not screeching to a halt until the "global turmoil" of last summer showed conclusively the futility of bank reserves especially in any EM context.

It would be tremendous coincidence that European bank stocks have once again occupied a central place in the daily newsfeed - just as they had done in 2008. From this perspective, we might be able to reasonably guess just who those "top six" actually were. There are almost daily stories about Deutsche Bank and Credit Suisse, both institutions that have seen their stock prices cut by almost 65%, with most of those declines happening after the events of last August. They are not alone, however, nor is this sudden concern limited to Europe's banks exclusively. US banks of the same wholesale variety have not suffered nearly the same degree, but the resemblance is unmistakable, particularly the inflection around the PBOC's "devaluation" event, and the scale so far is enough for concern.

It is the very same factor that the Fed, ECB or any other central bank never figured out about the panic in 2008. Subprime was never contained because it wasn't really about subprime - nor was it, for the 1,000th time, about bank reserves. If Deutsche Bank, for example, is overloaded with EM debt on its way down, that is an enormous problem for Deutsche Bank, the German government but perhaps more so still the rest of the eurodollar system. We have already seen this take place on several occasions - the global liquidations that were really "dollar runs." As DB stumbles, the rest of the eurodollar can't adjust or compensate for the lost capacity, leading only to further capacity reduction and withdrawal everywhere else - the most acute case of monetary tightness.

From the standpoint of monetary policy, the ostensible answer under a regime of "currency elasticity" is not bank reserves but rather to induce or replicate the full suite of products and offerings pulled back by DB's (or whichever other bank) questionability. In 2008, the only real policy with a chance of success (and I still think it small) was for the Fed to absorb AIG and monoline CDS portfolios not just with guarantees on contracts written but also to keep writing more - to supply the wholesale system with one primary element that was sorely lacking for both pricing and "regulatory relief."

In 2016, the shortage of CDS is still a problem for overall liquidity, but not even close to the primary form of this "dollar shortage." Instead, there are other derivative formats that cannot find any sort of stability; from interest rate swaps to cross currency basis swaps, there is ample evidence of a determined shortage in global eurodollar capacity. And it only goes one way especially as bank questions and concerns surface without forthcoming and forthright answers.

So Bernanke's problem, now Yellen's, is the same as Nixon's; because both had so totally accepted the apparatus of Keynes they compelled themselves to action without having even a minimal idea of the true nature of their action or the system that would receive it. Friedman said look to low interest rates as a definitive sign to add more "high powered money"; the Fed doesn't even know what that is. The Fed added four seemingly huge QE's and nobody can find a trace of them (beyond stock prices and at one time junk bonds), just as everything that was done in 2007 and 2008 ended in panic and massive economic dislocation anyway. You get the sense that there is no money in monetary policy even though orthodox monetary policy has been devoted to Friedman the entire time.

The global bond market screams of monetary "tightness" and the media all reports it as central banks doing a terrific job of "stimulus." We are all Keynesians now because we were left with no other choice, with everyone unfamiliar at any serious depth led to believe there has never been any other choice, and this shrunken economy and decaying financial system perfectly represents the lack of alternatives. The word Keynesian is synonymous only with instability, meaning markets have declared we are all unstable now.

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

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