The Fed Exists As the Barrier to the American Dream

The Fed Exists As the Barrier to the American Dream
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I find myself in the very uncomfortable position of agreeing with the Federal Reserve.  Its policymaking body has already voted twice to raise the target range for federal funds, and if recent speeches and mannerisms are to be believed they will do it again at some point.  In fact, I would go so far as to propose that unless the economy falls directly into full-blown recession, that will remain the case.  From the official agency perspective, there is nothing left for the central bank to do. It is on that point where we are in agreement.

Monetary policy is intended for specific purposes, though it has evolved in popular imagination toward something of a generic catch-all or monetary Swiss Army Knife.  The myth of Alan Greenspan as the “maestro” has been hard to kill, as there are still to this day some who believe there is nothing the Fed can’t do.  The “Greenspan put” remains a topic even though the dot-com bust as well as everything that happened between July 2008 and March 2009 thoroughly disproved it. 

It is in monetary officials’ best interests to allow that sentiment to propagate and continue.  Monetary policy works best when everyone simply believes it works.  Central bankers therefore talk about credibility with good reason; if the central bank is credible then in actuality it will have to do very little.  The whole point is for everyone to believe that you can do something so that the mere threat of doing that something will cause markets to do it for you before you ever have to lift the slightest finger in that direction.  That was the late 1990’s, but not so much the 21st century.

The Fed and other central banks to have surrendered (my term) last year is a bit of a conundrum.  Surveying the economy, there is very little about it that would seem to qualify as justifying removal of “accommodation.”  The manufacturing sector only very recently ended a two-year contraction, and rather than emerge into recovery as it had in the past it simply continues along a shallow trajectory replacing small minuses with small pluses.  The Fed’s own statistic, Industrial Production, an economic account that plays a central role in overall analysis, was but flat last month after likewise contracting for over a year – during which the FOMC voted in favor of both rate hikes so far.

The economy far from having recovered from 2008 let alone 2015, it seems to be at odds with conventional thinking where the Fed is removing itself from what may be perceived convention.  They have only themselves to blame, of course, having spent the last decade overpromising what they now admit they never could have delivered.  When Ben Bernanke wrote his (in)famous op-ed in November 2010 trying to justify a second QE, he didn’t write that it was his intention to accomplish very little (if anything) with it and by extension end that program as well as ZIRP with a mathematically established lost decade. 

In orthodox terms, monetary “stimulus” is a demand policy.  The principle of monetary neutrality means that is the only channel for the Fed to achieve its aims.  The supply side, the side that determines the long run potential, is by its own view out of reach according to this view. 

Similarly, however, a recession is not supposed to affect potential, either.  A recession is a temporary deviation from that trend, not a permanent alteration to it.  Thus, if the Great “Recession” was a recession, a huge hole in aggregate demand, monetary “stimulus” should have been effective at closing what economists call the output gap.

What happened last year was that in all likelihood the output gap finally closed after almost a decade.  But it did not disappear in the manner in which everyone thought it would, in what would have been a full recovery as it is still described in the media. It disappeared because from the bottom up, the demand side, the economy never recovered.  Instead, by several sources and estimates, economists have been writing down potential, the supply side, so that after enough time, 2016 it appears, the output gap is completely removed from the top down. 

The Congressional Budget Office offers us some very good estimates for confirming this suspicion.  The Federal Reserve does not publish its internal output gap calculations, but we can infer their stance somewhat from the language of official statements, such as the policy minutes released at every policy meeting.  The claim that “risks are balanced” is one such declaration that would align with a small or erased output gap.  The CBO, by contrast, actually publishes its estimates for potential (related in terms of real GDP) using the same types of models as the Fed.  Therefore, it is reasonable to infer the situation presented by the CBO is close enough to what the Fed might be calculating and interpreting in its policy deliberations.

As of the latest update last month, the CBO figures that economic potential is lower yet again.  As such, through the latest GDP update for Q4 2016, the output gap which was at the trough of the Great Recession about 10% is now less than 2%.  The difference is, again, trend not demand.  Using the January 2008 CBO baseline for potential, the output gap instead would still be 13%!  In other words, across the whole of the “recovery” after the Great “Recession”, the output gap from the demand side actually got worse.  It is this result, replicated in so many ways, that demands quotation marks around the words “recession”, “recovery”, and, as always, “stimulus.”

Without an output gap, there is, again, nothing for the Fed to do; the federal government, either. The very good possibility that the trend is utterly collapsed is now, from the FOMC’s perspective, someone else’s problem.  I say central banks (and this goes for more than just the Fed) surrendered when from their output gap numbers they claim stimulus simply did its job; QE didn’t fail, it, for them, had no chance to succeed.

It’s a problematic deduction on a number of levels, starting from that January 2008 baseline.  In other words, why didn’t anyone see this coming?  The way in which economists are now trying to reconcile lack of recovery with what they are also claiming as full recovery as far as it ever could have gone is to further claim the problem is primarily demographics.  I have a great deal of trouble with the Baby Boomer retirement excuse, because though it may seem plausible it really doesn’t make much sense starting with why nobody in early 2008 thought it was going to be that much of an issue.

The whole point of the CBO’s models, as well as those run by the Federal Reserve’s staff, is to give officials (and the public, in the CBO’s case, at least) the best statistical predictions as to what is already known.  The models, of course, didn’t know anything about the Great “Recession” which had already begun, but again that isn’t a trend issue. In truth, there is no reason to believe that Baby Boomer retirement is even a sliver of the cause as to why the Great “Recession” has proved to be a permanent (so far) break in trend. 

The generational changes are supplemented so far as an excuse by other cited labor market factors, such as this “skills mismatch” that has been increasingly emphasized. In this view, there are jobs but they go unfilled because Americans are lazy.  That wasn’t the way it was described in official discussions which has been very careful, in public, to be more polite and reserved about it, but in the uncomfortable circumstances within which officials find themselves currently the mask has started to slip.  What other choice do they have?  They better come up with something as to why they are declaring a recovery where none exists.

In late January, Philly Fed President Patrick Harker said that the labor participation rate in the US was “lower than I’d like” and that it has a great deal to do with keeping back productivity and thus growth.  These are the supply factors that are captured by the CBO estimates in more quantified detail, and rather than the reserved language Harker used the CBO numbers suggest he was being purposefully coy with “lower than I’d like.”

This week, the unfortunate Fed official made a far more direct reference. He openly stated opiate abuse especially among prime working age males, saying “there are people who are just disconnected from the work force.”  It is becoming common where “skills mismatch” is actually code for lazy and drug addled.  And economists have begun to turn more and more to this view because the output gap was erased from the top.  It’s another way of saying they didn’t fail, Americans did (let them eat heroine).

I can’t help but be struck by how backward that is, in the same way Fed officials get interest rates backward. They see, or did before the output gap closed, low interest rates as further stimulus, the fruitful gain of monetary policy at its first functional step.  In reality, persistently low interest rates reflect something much different, a lack of opportunity which triggers what John Maynard Keynes once called liquidity preferences in another setting.  The flat yield curve remains flat, no matter some level of “reflation”, not because the Fed decrees it but because the market doesn’t actually think the Fed is capable of decreeing anything aside from the irrelevant federal funds rate.

In terms of the structural issues, might authorities be conflating cause and effect? They are saying America’s drug addiction is the cause of the supply side collapse, or at least a primary one, when in fact it seems more reasonable that Americans have turned to drugs as an escape from the desperate lack of economic opportunity. If you think you are going nowhere because the economy is going nowhere then escapism in all forms is that much more appealing.  History is replete with these correlations, including low birth rates, between social distortions and economic ones.

I find it curious and in many ways infuriating that these economists now claim America lost its work ethic.  They don’t bother to explain, as Baby Boomers, why that seemed to have happened right around October 2008; or, to go back to an earlier disruption, March 2000 at the peak of Total Hours which just so happened to coincide with the peak in the dot-com bubble.  Why did the CBO wait for August 2015’s calculation of potential to start to more seriously consider, meaning reduce it significantly more, the labor effects of heroin and gray hair?  The answer is obvious, meaning that these aren’t actually answers.

I think the numbers are right in a more elastic, qualitative sense, however.  The output gap is surely gone and the economy right now is operating at or near its potential. No matter what has transpired over the past ten years, after falling sharply during the worst of the Great “Recession”, it has actually swayed very little, staying ever faithful to stagnation.  The form of that narrow channel is what I have written about many times before, this unevenness where any good quarter, or what may pass for a good quarter in this climate, is followed almost immediately by a dissatisfactory or bad one.  It’s always one step forward, one step back; or one step back, and one step forward.  There is never any positive momentum.

That would seem to indicate a very low ceiling.  But it is not drugs or the elderly who have hung it so low.  I believe the answer is Keynes – not Keynesian dogma or doctrine, but rather his views on liquidity preferences.  Invoking his name or any of his views runs the risk of inviting logical fallacy on the part of those who don’t agree with his overriding views or philosophy.  I count myself in that category, as I find Keynesian Economics in general to be conjecture predicated loosely on backward understanding.  He may have been wrong about a lot, but that doesn’t mean he was wrong about everything.

In Chapter 13 of The General Theory of Employment, Interest, and Money, Keynes introduces the concept of liquidity preferences as they relate to consumer decisions about money.  According to his theory, consumers determine their own demand for liquidity as the balance of three motives:  the transactions motive, holding enough cash on hand so as to be able to engage in commerce because income is spaced out over time; a precautionary motive which is like savings for an emergency; and, a speculative motive where cash balances will be held in lieu of possible better opportunities that might arise at a later time.

Thus, in order for consumers or businesses to give up their cash, they have to be presented with the opportunity to be compensated for their preference to hold liquidity in whichever of the three formats.  Future compensation, however, entails risks so the rewards have to be both sufficient as well as sufficiently realistic (only an exceedingly small proportion of people part with liquidity so as to aid, for example, one of Nigeria’s many purported princes).  I believe something very similar happens on the supply side of the economy and in a couple of very important ways.

The first was a general embrace of Nigerian princes by the entire global banking complex.  It wasn’t that specific scam, of course, but by and large bank balance sheets from the early 1990’s forward were built up in what looks in hindsight like the biggest con of them all.  It was so alluring that these (shadow) banks didn’t just hand over cash they had on hand, they first absorbed depository banking almost in whole and then even after that created it in all kinds of new and exotic ways just to participate.  The lie was simply that they could monetarily transform the risky into the riskless, and further that they could do it with almost anything.

Having first been shown the error, they then compounded it.  Part of it related to the mythical Greenspan put, the idea that if exponential growth didn’t provide sufficient liquidity for exponential growth (this circular reasoning was a core principle) then the Fed would.  There were suspicions this wasn’t true throughout 2007 and early 2008, even after Bear Stearns fell, but in July 2008 they found out the hard way it wasn’t ever true.

The Fed, of course, didn’t sit idle; it had one more trick with which to overcome the renewed objections of liquidity preferences.  It would engage large scale asset purchases (QE) with which to expand its balance sheet, what looked suspiciously like money printing. But in 2011, that, too, was revealed more myth than real, with FOMC members confusedly muttering in the systemic illiquidity of that summer, “but $1.6 trillion in bank reserves.”

Even JP Morgan’s London Whale fits easily into this paradigm, but more so as one last cautionary tale.  It was a $7 billion mistake betting on the Fed in late 2011 and early 2012 just as the monetary errors of 2011 were about to be unleashed upon the global economy of 2012.  The entire monetary paradigm had been reversed, put upside down.  Rapid growth before 2007 was all reward with no assumed risk; lack of growth after 2007 was all risk and increasingly no opportunity for reward.  Liquidity preferences redefined, global banks which once only grew by leaps and bounds in the shortest of time frames now shrink at the drop of a hat, the slightest breeze of expected vol. 

But how does that impact the supply side? There is the none-too-small matter of the global credit-based currency system which no longer features expanding credit (capacity).  Such an unstable system does two things simultaneously; it raises the bar for other economic agents’ liquidity preferences by making future rewards that much more uncertain.  A prime example is stock repurchases versus productive capex.  Even though stocks appear overvalued in every way and even historically so, it isn’t clearly wrong from the view inside the boardroom to see buying back more shares as the safer option, particularly when the other choice is expanding facilities and capacity in a world without topline revenue growth.  The shakier the financial system, the less likely you are to believe that will change anytime soon (especially if you, as in the mainstream, used to think the Fed had some say about it but at the very least have started to wonder).

The second downstream effect is more direct, as the global economy on the supply side was built on the eurodollar on its way up.  It’s easier to see overseas where starting from more of a blank slate the influence of eurodollar capacity on foreign productive capacity is undeniable.  China’s economic miracle, as well as those from all across the EM’s, was no miracle but money.  The asymmetry of risk applied just as much there as here or Europe, meaning that banks would create it on the slimmest of opportunities because China will always grow. 

What happens, then, when it doesn’t?  We’ve seen the results. In the mainstream it is still wrongly categorized as “capital outflows” when in fact it is pre-crisis liquidity preferences stated and acted in reverse.  As the global supply side is starved, opportunity disappears from everywhere leaving that much higher of a hurdle for liquidity preferences to be overcome to create a real recovery at some still-future point (economists call this hysteresis).

For the Fed, ECB, and others like the Bank of Japan, they no longer see that as an option at all.  The closing of the output gap is their end of the story.  If that means Baby Boomers and drugs, as if the 1960’s all over again, then so be it.  We are by no means, however, bound to such ideological constraint.  There is a recovery because the supply side dwindled in a manner that is eminently correctable, just not with the current regime of central banks and more so central bankers. 

The problem with the Fed is not so much the Fed as those who are currently at it. As if we wouldn’t know already by their condescending and nonsensical insult to American workers (and American commonsense), nothing would change if President Trump fired Janet Yellen tomorrow.  She would be replaced in exactly the same manner as she replaced Ben Bernanke, who replaced Alan Greenspan, etc.; people who have in the failure of their best designs now blame dumb, lazy Americans for systemic despairing. 

What overcomes the dollar shortage, which is itself nothing more than a symptom of monetary instability, and thus liquidity preferences, is monetary stability.  What may look like a quantitative problem is not, meaning the answer to a shortage of unstable currency is not to figure out how to manufacture more of that unstable currency, it is to get rid of the unstable currency altogether and replace it with a credible design.   That is the recovery scenario that gives us back opportunity.

This used to be the Land of Opportunity, but they would have you believe, in polite terms, it was squandered by you and me.  Forgive me if I don’t believe that America stopped being America at exactly the moment central bank monetary failure was most exposed for what it always was – a lie.  The consequences of it have finally been revealed even to the ideologically blinded.  Both the Fed and I agree for once, the output gap is gone and there is nothing left for them to do. In fact, if they would all just resign, then the road to recovery might actually begin, no rehab or retirement facilities required. 

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

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