Just As In the 1930s, Liquidity Preferences Still Rule

Just As In the 1930s, Liquidity Preferences Still Rule
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The price of oil has confounded most mainstream predictions.  This has been true for much more than the past year, of course, when going back to 2014 the price was thought exceptionally stable.  Everyone knew the US was pumping massive quantities out of newly developed shale fields, but until that summer it was believed that an accelerating global economy (demand) would easily absorb the excess.  Even when oil prices crashed at the start of 2015, it was proclaimed nothing but a “supply glut” and therefore a “transitory” issue not worth notice or concern.

Two years later, we are mired in the same expectations for all the same wrong reasons.  After having crashed over a period of several years, hardly transitory, oil was supposed to make something of a straight line back toward, if not over, $100 as if the whole thing never happened.  When it (WTI) reached $50 again relatively quickly by early June last year, it became common to hear that this level would be a floor for which further price increases would surely follow.

Instead, oil has stalled, trading mostly sideways ever since, with a downward rather than upward bias.  It seems as if $50 has been something of a ceiling rather than a floor, with the risks “somehow” all remaining to the downside.  Earlier this week, Bloomberg reported that Kho Hui Meng, head of Asian Trading for Vitol Group, the world’s largest independent energy trader, has apparently become cautious and frustrated because of it. He told the news outlet that, “what we need is real demand growth, faster demand growth.”  The article characterized Kho’s comments as simply, “demand isn’t expanding as much as expected.” 

The most recent trough for oil prices was February 11, 2016, a year and one quarter ago, plenty of time for a rebound in demand to take hold, take shape, and take off.  But this isn’t really about oil as much as it is the global economy now more than a year after the “global turmoil” that slowed it to a grinding halt. This year is so far better than last year, but that just doesn’t propose what people seem to think or want it to. It stopped getting worse, but that hasn’t meant it is getting better. 

The basis for that error is easy enough to understand, as that is what happened every single time in the past when an economy, any economy, went into a slump or recession; the downturn’s end always led to restoration of growth, usually in rapid and convincing fashion.  Maybe the world has finally come to realize that rapid is no longer a part of the conversation, but surely convincing? 

Bloomberg the last week had also reported on a related matter that at first glance seems to confirm these expectations, but in the cold, hard reality of the current monetary condition actually contradicts them.  Emerging market companies have raised record amounts via bond sales so far this year.

“Emerging-market companies are showing up to the U.S. debt market at the fastest pace ever, and finding plenty of appetite for their bonds.”

According to the article, corporates across the full sweep of EM jurisdictions have been able to float $160 billion in bonds year-to-date through April 30, 2017.  That is more than double, almost triple, the amount raised in the first four months of last year, surpassing by quite a bit the previous high reached, importantly, in 2013.  Ostensibly the story takes on the perspective of DM investors who are very willing to take on the bonds, and at still questionable prices, when in fact the real story, the only story, is on the issuer side.

For the past three years before later 2016, the EM world has been largely shut out of “dollar” financings, primarily through the bank channel which had been in some places the only source.  The cost of this illiquidity was enormous, on both the individual corporate level as well as economy-wide.  Currencies crashed into what became the “rising dollar”, rising only because it was in such short global supply. 

As we have seen time and again since 2007, whenever the banking channel is waylaid by its own contradictions agents that used to be so dependent on it for vital, necessary “dollar” finance have turned to alternate means as these banks retreat and never come back.  Here domestically it was an almost immediate bond market surge just like what Bloomberg is now reporting offshore.  US corporate bond issuance exploded in 2009 as companies sought to either replace an existing liquidity buffer or more often create an entirely new one. 

This crisis has been about banks from the very beginning, as almost all of them are.  The difference is simply that in the 21st century they create all the money (not the Fed) and that is what had been used as the primary avenue for global currency expansion.  It was not, and is not now, the only way for monetary expansion to take place, but it was by far the largest method and point of redistribution.  The bond market is another, but it isn’t nearly as nimble and flexible as the bank channel.

Thus, the appeal to it as an ad hoc bypass is an expression of liquidity preferences, those dragging desires to not be so exposed to the decay in global monetary access that just doesn’t ever seem to abate.  Better to get your funding now and as much as you can possibly pocket lest you be unprepared the next time the “rising dollar” strikes because there is every reason to believe there will be a next time.  Practical experience has proved that belief, and to this point more than a full year after the last one may have ended there are no indications anything has meaningfully changed; certainly not official responses and acknowledgements.

It is that part which has pushed these liquidity preferences to these chronic proportions.  Before 2007, it was widely believed that the Federal Reserve was more than capable of supplying funds if it was ever pushed to do so.  Money dealing creation and redistribution proceeded globally as if that was the case.  In rapid succession of misunderstood events, however, policymakers here and everywhere else showed themselves to be the opposite.  It was a lesson learned the hard way and one not forgotten, if in some places occasionally and briefly tempered.

Ben Bernanke appeared and testified before the House Committee on Financial Services as Fed Chairman in early February 2010, the theme of his presentation was, as hard as it may be to believe today more than seven years later, the central bank’s exit strategy.  It is a perfect demonstration of what was wrong then and remains so now, for there was at that time absolutely no awareness that what had just happened represented a permanent rupture in money as well as economy – they didn’t even recognize it as a possibility.  And it started with their assessment of their own performance during the crisis.

He started out with what I can only assume as intentional misdirection.

“In its role as liquidity provider of last resort, the Federal Reserve developed a number of programs to provide well-secured, mostly short-term credit to the financial system. These programs, which imposed no cost on the taxpayer, were a critical part of the government's efforts to stabilize the financial system and restart the flow of credit.”

Bernanke then lists all the programs and efforts the Fed undertook to do what he proposed at that time, “stabilize the financial system and restart the flow of credit.”  I have at various times produced the same catalog (for some reason mine end up being more comprehensive) but for vastly different reasons.  What he didn’t say then was all that mattered; in other words, the Fed did these things and the panic happened anyway.  The way he framed monetary policy is by skipping to the end, the assumed recovery part without accounting for what actually has mattered all along.

He summed up this assessment by further claiming, “The Federal Reserve believes that these programs were effective in supporting the functioning of financial markets and in helping to promote a resumption of economic growth.” Yet, more than seven years later the Fed is still mapping out, and in some important technical ways failing, its exit strategy.  He said these things as if they were true when by all established observation they never were then, and still are not now.

The really unfortunate part is that what has actually happened over the last decade is an eerie repeat of all the processes of the Great Depression, if not nearly to the same degree, that were studied to death by academics like Ben Bernanke.  When he said ten years ago that subprime was contained (not in those exact words, but that was the sentiment he wanted to project and did to an unfortunately successful degree) many people took it to heart because of his reputation for studying and analyzing the 1930’s.  If there was one man alive who the world needed in that position, it was widely believed Ben Bernanke was that guy.

Having been a disciple of Milton Friedman, however, it is clear that he never really understood the full scope of Friedman’s theories.  You could have pre-scripted the Fed’s 2007-08 as well as QE emergency responses merely by reading A Monetary History; it is contained within those pages written all the way back in 1963.  And that was precisely the problem, for all these economists were using a 1960’s frame of reference for the 1930’s to applied to a 21stcentury system.

It is easy to get lost in the technical aspects of A Monetary History, to be unable to see the forest from the trees, as it were.  Thus, it is slightly understandable how one might be left taking everything as literal truth, meaning that what counted under certain terms and definitions about the 1930’s would be applied the same so many years later.  But there were other levels to that book which seem to have defied these technical observations and references. 

Friedman and his co-author Anna Schwartz write in their chapter on the 1933-41 period, the recovery portion, that,

“It was widely accepted that monetary measures had been found wanting in the twenties and early thirties.  The view that ‘money does not matter’ became even more widely held, and intellectual study and analysis of monetary institutions and arrangements probably reached an all-time low in the study of economics as a whole.”

We are very nearly at the same point today.  The Fed and so many other central banks did their QE’s, their “money printing” operations, some to truly unthinkable degrees like the Bank of Japan and its half a quadrillion, and all failed.  There is therefore little interest in money because what more could the Fed have done?  That is the attitude central bankers have themselves currently adopted for reasons they can’t even specify, certainly not in the framework of a legitimate argument (drug addicts and Baby Boomers).

Yet, on the more basic levels of human behavior what banks have done over the last decade in every way resembles what they had done in the 1930’s.  Friedman and Schwartz again from the same chapter on “recovery”:

“The Federal Reserve repeatedly referred to its policy as one of ‘monetary ease’ and was inclined to take credit – and, even more, was given it – for the concurrent decline in interest rates, both long and short.”

Something cannot be right here, for the father of modern monetarism wrote this devastating critique about the Federal Reserve in the 1930’s that in every way applies to Bernanke’s tenure.  Bernanke has claimed as they all have that monetary policy has been hugely accommodative, and yet interest rates are behaving exactly like they were during the Great Depression. There are, of course, quite a few problems with modern monetary policy, but among them is this grave misunderstanding of liquidity and practical liquidity management.  It is a strange indictment to write, and perhaps stranger still to hear, for what does a central bank do if not liquidity?

There is one further observation that Friedman and Schwartz make in this part of their immense examination that is perhaps the single largest factor governing our current predicament, making it the predicament in the first place. 

“Retrospectively, the initial accumulation of excess reserves, after the banking panic of 1933 and before the devaluation of the dollar, to a level of about $800 million was welcomed in explicit recognition that the experience of prior years had altered commercial bank attitudes: a volume of reserves which would have been expansionary before 1929 might be contractionary in 1934.”

Here again we find a truly perfect parallel condition. If the Fed had in 2005, for instance, decided that monetary policy had become too tight for whatever reasons and wanted to expand its balance sheet by a serious amount, it would have led to further explosive monetary growth beyond the already absurd proportions of that time.  There were practically no bank reserves in the middle 2000’s, so adding hundreds of billions would have led to a far different result than the addition of trillions after 2007 (which failed on every count).

There is on some level an innate instinct toward mistrust in these circumstances. However much you may claim total monetary fealty to the Federal Reserve as a bank, after experiencing 2008 it can never be again total.  Thus, if the Fed has to add more bank reserves, what does that tell you about further conditions?  This was always the major if hidden problem with multiple QE’s, because if you have to do a second the first one didn’t work, and if the first didn’t work what does that say about prospects for the second? 

We know the answer by the banking system’s response to the events of 2011.  Adding reserves became contractionary, alright, especially after QE3, because banks realized that if the Fed felt it was warranted to add more than the reason they felt it was warranted was far more important than what was added.  That is what became the “rising dollar” especially for the offshore portion of the global “dollar” system, starting right in China.  As I wrote in March 2014:

“What all this data shows, as opposed to conjecture about the supernatural powers of central banks, is that yuan’s devaluation may be directly tied to dollar shortages. In fact, as I argue here, it is far more plausible that a dollar shortage (showing up as a rising dollar, or depreciating yuan) is forcing the PBOC to allow a wider band in order that Chinese banks can more ‘aggressively’ obtain dollars they desperately need. Worse than that, the PBOC itself cannot meet that need with its own ‘reserve’ actions without further upsetting the entire fragile system.”

The more central banks fail to stem the shortage, or lack of redistribution, the more liquidity preferences rise to privately alleviate the systemic mistrust.  It soon becomes a global phenomenon because the eurodollar system has been behind everything, the pre-crisis EM “miracles” most especially. 

The systemic holding of huge reserve balances by banks was a potential problem contemplated early on. The New York Fed branch wrote in its December 2009 magazine, “Other observers see the large increase in excess reserves as a sign that many of the steps taken by the Federal Reserve during the crisis have been ineffective.”  Among those who believed this way were Edlin and Jaffee who charged this was nothing more than “hoarding”, the very same problem attributed to the public at large as well as banks for causing and maintaining the Great Depression.

The writers for FRBNY, however, were having none of it.  Instead, they wrote that the level of reserves was only a byproduct of monetary policy (correct) and that these balances were being maintained by nothing more than the studious introduction of the IOER (incorrect). 

“When reserves earn interest, the multiplier process will not continue to the point where the market interest rate is zero. Rather, it will stop when the market rate reaches the rate paid by the central bank, since if these rates are the same, banks no longer face an opportunity cost of holding reserves. If the central bank pays interest on reserves at its target interest rate, as we assumed in our example above, then banks never face an opportunity cost of holding reserves and the money multiplier does not come into play.”

Setting aside the improper expectation for a money multiplier in a wholesale funding arrangement, this assertion is wrong on so many levels.  A bank will not forgo an possible investment opportunity so as to be paid for sure at some pittance of an IOER rate. What determines the choice between holding reserves and doing something with them is opportunity adjusted by perceived risks, primary among them in times like the 2010’s as well as the 1930’s is liquidity.

FRBNY’s whole theory proceeded from a false premise, written earlier in the piece as, “a bank holding excess reserves in such an environment will seek to lend out those reserves at any positive interest rate, and this additional lending will lower the short-term interest rate.”  It’s a textbook approach to banking rather than a practical one, for banks don’t work this way, and it’s pretty clear they never did.  They take a holistic approach to their balance sheet construction, factoring liabilities across the whole spectrum rather than one at a time. 

If they act as FRBNY contended in December 2009, why are government bond rates in so many places so negative and persistently so?  They are, especially in Europe, even more negative than the money rates designed (like IOER) to force banks to give up those highly liquid instruments in order to do something more productive with reserves (like create credit and thus an actual recovery as the textbooks theorize).  And still banks systemically refuse no matter how deep the NIRP. Was 25 bps paid on IOER really the cause of systemic inflexibility all these years?  Was it enough of a return so as to keep banks in the US at least from taking advantage of enormous dollar premiums that over the past three years in particular popped up all over the offshore “dollar” world?

Of course not.  The issue was always risk, not IOER or even bank reserves.  And therein lies the economic problem, just as in the 1930’s. Liquidity preferences still rule because there has been no reason for them not to; trillions in bank reserves count for next to nothing.  All that has happened in the past decade was to further demonstrate that the private eurodollar system was itself inherently unstable and the public rescue of it in many ways worse, even less reliable.  Milton Friedman was absolutely right to point out the dangers of “money does not matter” thinking, though apparently not effectively enough to survive in the doctrine that so often bears his name.  Ironically, it has been Ben Bernanke more than anyone else who proved as much.  Oil traders and EM corporates know it simply because despite a decade’s distance they have had no other choice.   

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

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