Even Monetary Authorities Think We're In a Depression

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You probably aren't aware because it isn't a topic that gets discussed much if at all on the outside, but increasingly even monetary policymakers are coming around to the idea that we are in a depression. What choice do they have, really, since practically any chart of any economic account in any economy shows as much. The gathering in Jackson Hole late last month was really an internal discussion in how to think about keeping current central bank frameworks alive in such a world.

Earlier this week, San Francisco Fed President (and CEO) John C. Williams spoke in Nevada on just that topic, though they call it "normalization." Straight away it is misleading because his speech was about how to "normalize" monetary policy in which the outcome of that attempt is anything but normal. Central bankers have become obsessed with what they now see (and this is the big change) is a low interest rate/inflation world, quite contrary to the cyclical expectations they had been declaring all this time. They do not, of course, speak at all about why it took them nearly ten years to come to this realization.

In both Williams' speech as well as the one Federal Reserve Chairman Janet Yellen gave at Jackson Hole, there are references to the growing official angst about 3%. Economists in this age of econometrics are arbitrary by their nature, so there is no immediate significance to 3% except that is where, apparently, most of their mathematical models agree this new "normal" will triangulate. In other words, contrary to actual normality they do not now believe the federal funds rate will go much higher than 3%. That is a problem for them because when the next downturn hits ("unexpectedly") they have much less room for "stimulus."

For the layperson, the immediate response might be "so what." Alan Greenspan delivered a federal funds rate of 5.25% from which Ben Bernanke could "stimulate" and countermand the forces of the Great Recession; which he, by his own repeated words, claimed to be able to do. Instead, we are still talking today more than nine years after it about recession and hoped-for recoveries. As Williams' speech suggests, even economists have begun to think in terms beyond cyclicality.

The problem for these orthodox views is something they call r-star, or R*. This is the econometric variable for the so-called natural (or neutral) rate of interest. Because it has been given a special place in their regressions and models it is treated as if handed down by God. Like Keynesianism, however, R* had been so thoroughly disabused by events that it rightly spent a great deal of time in the intellectual wilderness, only to be resurrected in the 1990's by the computing power of the internet age.

Columbia University economist Michael Woodford brought back the natural interest rate concept, which was first developed in a more primitive format before Swedish economist Knut Wicksell molded it into a modern theory of money and prices. It is, Wicksell claimed, the rate of interest of money by which both employment (or output) and inflation would remain stable. It is therefore of no surprise as to why central banks, given their normal statutory mandates, have a starting interest in the concept. What Woodford did was to reorganize the natural rate into R* using the neo-Keynesian framework that somehow survived its Great Inflation debunking, relating it to productivity "shocks" and changing consumer or business preference functions.

To illustrate the power of Woodford's work on the current framework of central bank philosophy, the Federal Reserve Bank of New York along with Columbia University sponsored a conference in May this year in "Honor of Michael Woodford's Contributions to Economics." Speaking at the conference's opening, current Vice Chairman of the Federal Reserve Stanley Fischer was enthusiastic in his participation, saying, "It is an honor for me to speak at the opening of this conference in honor of Michael Woodford, whose contributions to the theory of economic policy are frequently a central part of the economic analysis that takes place in the policy discussions at the Federal Reserve."

The problem of having Woodford's R* as a centerpiece of monetary policy is what it now says about the state of both monetary policy and the world at large. By all current orthodox reckoning, R* is either close to zero or negative. In other places around the world, most especially Europe, it almost has to be negative. It immediately raises issues of basic logic, as how can the rate at which employment and inflation normalize be less than zero when nominal rates are constrained by a zero lower bound? We must destroy money to get inflation?

Part of the reason R* lay dormant for so long was that even Keynes himself rejected the idea as a matter of monetary policy. Not only that, Wicksell made a poor defense of his conceptions as a matter of real economic consequence in famous debates (or arguments) with fellow Swedish economist David Davidson. Is there really such a thing as a seemingly all powerful rate which could harmonize economy and inflation? It sounds too good to be true because it is.

Many economists, including Keynes, recognized that even if the idea were valid the economy is so complex that there would likely be more than one "natural" rate, and further those "natural" rates would change over time as the economy was structurally altered by true natural changes (innovation).

Indeed, the latter is recognized by the current thinking of central bankers like John Williams. It has been Williams more than anyone who has tried time and again in the 21st century to actually calculate R* using Woodford's starting point and also his (and his fellow researchers') contributions. He told his audience in Nevada this week that they had figured R* to be 2.5% to 3.5% in 1990 in the US, Canada, the UK, and Europe. By 2007, it had declined somewhat to 2.0% to 2.5%. As of 2015, they put the "natural" rate at 1.5% in Canada and the UK, "nearly zero" for the US, and "below zero" for the euro area.

Williams claims it has declined because:

"The underlying determinants for these declines are related to the global supply and demand for funds, including shifting demographics, slower trend productivity and economic growth, emerging markets seeking large reserves of safe assets, and a more general global savings glut."

The last two of those are essentially the eurodollar system only put into nonspecific, mysterious terms that economists are forced to use, thus already suggesting the very problem economists like Williams will never be able to solve. The key is productivity, as even Wicksell acknowledged more than a century ago. We have to keep in mind that it was central bankers at the Fed but also elsewhere who at the turn of this century thought the opposite for productivity.

Alan Greenspan's Fed was absolutely convinced of something like a 1920's new permanent plateau of prosperity during the dot-com bubble because productivity seemed to be so robust. As I have noted constantly (for these reasons), that myth lingered in official monetary policy for a very long time. It was, in fact, none other than Janet Yellen who on the cusp of the Great Recession was still confused about how productivity in the middle 2000's just didn't live up to the permanent plateau idea. Rather than rethink their own grasp of economics (in the real rather than academic sense), Yellen (in May 2007!) maintained that she and her fellow economists expected 1990's productivity to return.

"But the hypothesis that the recent decline in productivity growth is mainly structural does not seem to me to square well with the broad range of available evidence. Recall that in the 1990s there was a whole constellation of evidence-including a booming stock market, robust consumption, and rapid business investment-that was consistent with a hypothesis of a lasting increase in the rate of productivity growth. In contrast, over the past year or so, business investment in equipment has been very sluggish and more so than seems warranted by the deceleration in business output."

Calculated productivity has declined for each of the past three quarters, the worst stretch for estimated productivity since 1979, a comparison that though mirrored is a clue to all the answers. It has been close to zero for years now dating back unsurprisingly (from the eurodollar perspective) to 2011, leading economists to assume that their R* is really telling them something. In point of fact, what economists are doing is reverse engineering observations so that they can fit within the academic, neo-Keynesian paradigms of their regressions.

Even the R* number itself can never be directly observed; it is fitted and imputed from other indications. Thus, central bankers simply assume that if inflation is high or rising, whatever the current money interest rate is must be below R* as Wicksell hypothesized. Conversely, if inflation remains subdued, the current money rate must therefore be above it. And so if that current money rate is zero already and still no pickup in inflation, then by this backwards view R* must be zero or negative. Policymakers are trying to calibrate monetary policy by filtering real economic variables and assuming causation.

The correlation to productivity is exactly that - correlation. The money rate of our discussions here relate to the federal funds rate which hasn't been relevant to actual money markets in a very long time. In overall eurodollar function, the federal funds rate may never have applied at all. Witness, as I wrote last week, the incomprehensible explosion of credit default swaps from 2004 forward written while Alan Greenspan was raising the federal funds rate intending to "tighten" and bring down inflation. It didn't work because CDS were a form of wholesale money, especially when used for regulatory relief by banks (primarily European, as AIG "helpfully" noted deep in their own footnotes of the time). Thus, contrary to what Williams asserted, there was no "savings glut" that thwarted the policy "tightening" in the middle 2000's, there was only the improper assertion of monetary control through the federal funds rate.

For the eurodollar system, if there ever was such a thing as R* it would never have been related to federal funds, or if it was in some small way it wouldn't have been the primary applicable rate. Instead, by taking this retrograde approach to translate the real economy into their statistical language, economists are involuntarily coming to terms with this very notion and more importantly its hugely dire consequences.

That means depression, a notion that John Williams describes without acknowledging, of course, just how close of a description he used.

"In this new normal, recessions will tend to be longer and deeper, recoveries slower, and the risks of unacceptably low inflation and the ultimate loss of the nominal anchor will be higher. We have already gotten a first taste of the effects of a low r-star, with uncomfortably low inflation and growth despite very low interest rates. Unfortunately, if the status quo endures, the future is likely to hold more of the same-with the possibility of even more severe challenges to maintaining price stability and full employment."

Except for leaving unexamined the cause, that is probably as close to a textbook definition of depression as one might expect any central banker to get (for now). Unfortunately, popular convention about depression relates only to the Great Depression as if it were the only one. When using the term, most people immediately imagine 1929 and the bank runs, the massive contraction that completely rewrote history. A depression is actually two parts that when combined create the lingering effect: a crash and then the very different economy that results. In other words, unlike recession, a depression is where the economy from before the crash is left behind in a new regime of "longer and deeper" as well as a whole lot of "slower."

From that proper definition we can appreciate that though the crash in 2007-09 was nowhere near as severe as 1929-33 what has followed is quite and convincingly similar. All we need know about 2007-09 was that it certainly qualifies as the start, while the lack of recovery thereafter completes the definition (seven years since the official end is more than enough time to make such a determination; especially since economies are again turning worse, not better). And to get to depression one must examine money and its true relationship to interest rates.

In December 1967, Milton Friedman delivered the Presidential Address to the 80th Annual Meeting of the American Economic Association in Washington, DC. In his speech, Friedman evaluated this unappreciated dichotomy between interest rates and money in a manner that reading it today seems as if he wrote it specifically for today.

"These subsequent effects explain why every attempt to keep interest rates at a low level has forced the monetary authority to engage in successively larger and larger open market purchases. They explain why, historically, high and rising nominal interest rates have been associated with rapid growth in the quantity of money, as in Brazil or Chile or in the United States in recent years, and why low and falling interest rates have been associated with slow growth in the quantity of money, as in Switzerland now or in the United States from 1929 to 1933. As an empirical matter, low interest rates are a sign that monetary policy has been tight-in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy-in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted."

It was Friedman, of course, who, along with Anna Schwartz, noted that money was the central issue of the Great Depression. On the occasion of Friedman's 90th birthday in November 2002 at a Federal Reserve-sponsored conference to Honor the Work of Milton Friedman, Ben Bernanke closed out his speech by confessing to the money issue about the 1930's. "You're right, we did it. We're very sorry. But thanks to you, we won't do it again." Except already by that point the Fed had almost guaranteed that they would, having determined all further parts of monetary study as unnecessary because of assumed correlations with and of a single interest rate alone.

Why has R* fallen to zero or less? Central bankers assume it is because this new depressionary economy "requires" a great deal more "stimulus" just to grow slowly. Putting low interest rates into their proper perspective, however, shows something else entirely - that neither the federal funds rate nor the creation of "bank reserves" through quantitative easing are actually stimulus. In other words, if you view low interest rates as Friedman did then you realize that the real economy has been experiencing "tight" money conditions for the whole of the Great Recession and its "mysteriously" lingering aftermath. And that is largely because neither the federal funds rate nor bank reserves count for much if anything for actionable money supply.

In the case of bank reserves it is the literal truth. No person or company can walk into a branch of the Federal Reserve and withdraw from the trillions on account to use in real economic functions. Bank reserves especially as the product of QE are very narrow constructs; they are numbers on a computer screen that apply only to primary dealer banks and nothing more. They are not currency and certainly not Federal Reserve Notes; they are only one form, and an unusually constricted one, of bank liability. It is the sum total of all bank liabilities that creates modern "money."

Thus, no matter how big the balances of primary dealers holding idle on account at the Federal Reserve, if their balance sheets are constrained in other ways through non-related processes then the money supply in the real economy will likewise be constrained regardless of monetary policy and interest rates. Money supply and interest rates are not the same thing, even though that continues to be an unchallenged assumption across the world despite it having been disproven time and again. As I have documented over the years, unlike eurodollar capacity there is no shortage of examples in how that has been the case especially in derivatives and especially in FX derivatives of late (aggregate balance sheet capacity).

There is very little appetite for productive investment during depression because businesses realize very easily there is little return on investment under those conditions. Thus, economists believe low rates are incentivizing businesses to invest through the low costs of borrowing when in fact businesses refuse to borrow because as a matter of basic logic and common sense there is no reason for them to do so (at the margins) no matter how little it supposedly costs. It doesn't matter if you can borrow all you want at zero interest, if you think the economy is bad now and will remain that way you aren't going to add a liability that doesn't actually create expected wealth. The interest rate isn't the issue. That is a much different process than the one suspected of an R* at zero or negative.

It is, however, the opposite case for financial investment. Companies that experience depression in the real economy can be incentivized to participate in debt that flows entirely into financial progressions such as share repurchasing or M&A at greater and greater prices. These are, essentially, alternate outlets for resources because of the low reward paradigm in the depression economy, an almost paradoxical parallel to John Maynard Keynes' liquidity preferences. That has the effect of redirecting even more monetary flow via credit away from the real economy for distinct circulation outside of it. Productive investment creates jobs and incomes; financial investment creates unrealized gains and perhaps dividends. Despite the contention of economists (yet another correlation/causation fallacy disproven), there is no wealth effect from record stock prices leaving the economy further worse off (and creating a self-reinforcing spiral where less money to the economy creates more incentive to do even less in it).

Persistently low interest rates as well as productivity are symptoms of a depression economy. Economists and policymakers are being forced into that conclusion though they might be doing so for now on their own terms. Even Wicksell provided a "test" which was actually the basis for all this R* obsession in the first place. He wrote in his 1936 book Interest & Prices:

"This does not mean that the banks ought actually to ascertain the natural rate before fixing their own rates of interest. That would, of course, be impracticable, and would also be quite unnecessary. For the current level of commodity prices provides a reliable test of the agreement of diversion of the two rates."

There is more complexity when we talk about inflation, of course, but by and large it is commodity prices that have thwarted John William's (or Janet Yellen's) "normalizing" narrative. Commodities have been falling more intensely since the middle of 2014 but really dating back to the middle of 2011. Both of those inflections recall and are related to obvious eurodollar or global wholesale money events. Thus, even subscribing to Wicksell's theory, the current rate must now be, as it has been, above the natural rate, unambiguously indicating "tight" money. Whether it is via Friedman's interest rate fallacy or Wicksell's natural rate hypothesis, both arrive at the same conclusion due to seemingly intractable market prices.

Central banks assume that means they have to "stimulate" more when in fact it is just their math telling them they haven't stimulated at all - at least not where it counts and has been needed. Translating depression into econometrics is a long and costly affair, but it is at least starting to be done, slowly and in discrete pieces. R* may yet be of some great value, insofar as further calculating just how little monetary authorities know about money.

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

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