Monetary Policy That Is Strangely Devoid of Money
Politics of the exact wrong kind have roared back to the forefront this week, as President Trump garners attention for reasons that most Americans don’t seem to care much about. It is, of course, difficult to assess what matters to the public, but what little data is available suggests James Comey’s circus isn’t one such. In a NBC/Wall Street Journal poll conducted last Friday, 32% of voters have no opinion on the issue one way or the other. The rest break down predictably along partisan lines. Social media research company SocialFlow reported that postings on Facebook pertaining to the FBI Director’s dismissal reached an average of just 37,000 users, compared to 112,000 after the passage of American Healthcare Act.
It’s likely not that most people don’t care, rather they care more about other things. The President was elected largely due to enormous economic dissatisfaction over an economy that eight years ago for “some” reason just up and shrunk. It contracted by the largest amount since the 1930’s and then never recovered. Being deprived of any and all explanation for that, or how it was even possible, populist movements have sprung up and taken hold of the political situation to at least try and find some answers. Donald Trump was the first (successful) major attempt in the United States.
The chaotic situation portrayed in the media comes at the worst possible time. The re-engaged positive sentiment, this “reflation” idea, has been running on fumes of late. In many cases and in many markets, it had already begun to reverse weeks and even months ago. Given that so much of “reflation” hope rested on what the Trump administration might be able to do that no other could have, political turmoil is bound to wreak havoc if only as it relates to how the administration will be impeded at each and every opportunity. The probability that nothing will change is therefore exceedingly high, exactly the world’s combined problem.
In truth, the chances that nothing would change were always high, which is why various markets are where they are. Eurodollar curves in this “reflation” attempt are far below each of the prior versions, displaying a broader, systemic pessimism about the long run that has been achieved the hard way.
It is ironic in a way that the Federal Reserve and its “rate hikes” have played a crucial role in setting back “reflation.” There was some renewed hope up until that last FOMC vote in mid-March. But since then, contrary to how markets “should” approach a higher federal funds band, bonds and funding have moved opposite. Swap spreads that for the first two and a half months of this year were decompressing, suggesting an easing in “dollar” pressure, began to compress (meaning for the 10s and 30s more negative) all over again after March 15.
It’s not difficult to assess why that was the case, where eurodollar futures, for example, could rise in price and therefore signal a (much) lower interest rate paradigm in the not-too-distant future despite the outwardly “hawkish” policy stance. I wrote earlier this week:
“The markets ‘wanted’ the Fed exit to be the one that was described three years earlier, where 'overheating' was a more common term slipped consciously into policymaker speeches and media presentations. But the Fed only disappointed, with Janet Yellen at her press conference forced by less fawning questioning to admit, complete with the deer-in-headlights stare only she can give, that none of the models foresaw any uptick in growth whatsoever. Worse, the FOMC statement confirmed that though the CPI was nearly 3% at that moment, it was indeed going to be just a temporary artifact of oil price base effects, and that officially inflation was not expected to return to 'normal' until after 2019. Major, major buzzkill.”
In other words, as we have been saying all along, the Fed is exiting not because recovery is coming but because it never will. There is, in their official judgment, nothing left for monetary policy to accomplish. This pathetic economic condition, which they describe in their own way, through calculations like low or possibly negative R*, is now our baseline. What was unthinkable just three years ago (in the mainstream) is reality; ten years ago, it was plain impossible.
In January 2009, I wrote, “The economy is not likely to repeat the Japanese scenario.” Unlike Japan, I reasoned, the American economy was far more dynamic and flexible, qualities that counterintuitively were on display at that very moment. US businesses were laying off millions of workers every month, a horrible result for them but systemically what was necessary to restore profitability and cash flow. Japan’s economy in the 1980’s and 1990’s was a contradiction of rigidity and a tangle of sclerosis, I thought, therefore its undoing and where the US would defeat the comparison.
Now so many years later, here the whole world sits in exactly the Japanese scenario. Boy, was I wrong thinking that the Fed’s inability to affect the monetary system would be so easily set aside; or, if not so easily than overcome after enough time through good ol’ Americana. I quite reasonably if naively assumed that faced with such incompetence on the policy level the far more dynamic American economy (which it was) would find its way out of that mess through other means. I had failed to appreciate the scale of the disaster on a longer timescale, how the eurodollar system had over the decades before entangled itself in everything here and everywhere else; and what that truly meant.
The most unambiguous and convincing evidence is how interest rates are low and have only remained that way no matter what, echoing what Milton Friedman wrote in 1963 about the 1930’s. The issue cannot be business but money.
“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.”
He wrote again in the 1990’s warning the Japanese of the same condition, calling it the “interest rate fallacy” because though it is a clear sign of monetary tightness it is made unclear by economists who never seem able to understand money. It’s a weird result for any central bank to be staffed with people who, at the top at least, can’t comprehend the nature of their own primary task. It is far more so when it is a major central bank in a premier economy facing an historic liquidity situation.
It is downright criminal given the economic consequences of it, first Japan now the world. The repeated situation strains all credibility, for the Japanese case was up to 2007 one of the most studied in all history. How in the world could US (and European) officials end up making all the very same mistakes?
For one, US policymakers believed, in a way as I did, that they were superior to their Japanese counterparts. In June 2003, the FOMC discussed these very scenarios and how the Bank of Japan was already at a place they increasingly believed they might have to follow. QE had begun in March 2001 on that side of the Pacific, and was expanded after only a few months. In the US, the Federal Reserve had lowered the federal funds rate, what they believed was “stimulus”, even well more than a year after the official end of the dot-com recession.
By the start of summer in 2003, the short-term money rate was down to 1%, a level only a few years before that was thought beyond the pale of good monetary stewardship; so much so, that the gathered committee members at that meeting waxed philosophically about what they were doing, and even as Alan Greenspan contemplated what they really could do. The tone of that part of the discussion, centered on Japan and its experience at the zero lower bound that for the Fed had suddenly come into view, was “what if it’s us?”
“MR. KOHN. Another problem in Japan was that the authorities were overly optimistic about the economy. They kept saying things were getting better, but they didn’t. To me that underlines the importance of our public discussion of where we think the economy is going and what our policy intentions are.”
That’s only true if you can be honest about it. Japanese policy was only ever the same as American policy in that respect, for in all cases central banks believe they hold enormous power that given the will to use can only result in the preferred outcome. Stimulus of the monetary type has been reduced to a tautology, or at best unchallenged circular logic; it works because it works. Or, as Ben Bernanke stated in his infamous “deflation” speech of November 2002:
“But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”
He made that statement which was received without controversy as a technical matter; philosophically, he was criticized in the Weimar Germany kind of way without thinking it all the way through. A year before, the Federal Reserve, as well as the Bank of Japan I have to assume, had already found startling contrary evidence, at least as far as quantitative easing was concerned. QE as an operative scheme is simple and straightforward; purchase assets from private banks so as to increase the level of bank reserves, therefore satisfying Milton Friedman’s supply critique. That was the same argument that Bernanke was echoing in 2002, to raise the money supply through whatever means so as to achieve what he claimed and therefore expected.
Mark Spiegel, an economist at the Federal Reserve Bank of San Francisco, had published in November 2001 an account of some already serious deficiencies observed in the effects of QE then ongoing in Japan. As everyone expected as a matter of basic central bank math, Japan’s M1 that had sharply decelerated in its growth rate reversed course with the introduction of BoJ’s bond buying scheme expanding so-called base money. But, as Spiegel detected, in the real world it wasn’t so simple and easy:
“While M1 has indeed enjoyed robust positive growth since the inception of the quantitative easing strategy, there has been a matching decline in the aggregate known as ‘quasi-money,’ which includes time deposits and a number of other less liquid assets. While the central bank can increase the stock of narrow money in the economy, the banks appear to be treating the exercise much like a swap of near-zero and zero interest rate assets, and they are responding with little change in their lending activities.”
The US and global banking system after 2007 has acted in the same way, as both Japanese banks in 2001 (and after) as well as American and European banks post-crisis did more than just what Spiegel had described. This liquidity “swap” was indeed far-reaching, eventually over time eroding balance sheet factors in any number of ways. I have tracked gross notional derivative books as a proxy for this very behavior, which suggests that in truth the conditions of bank balance sheets and therefore money in Japan as everywhere else is worse than even Spiegel spelled out fifteen and a half years ago.
We are left with one, and only one, conclusion; Ben Bernanke was right that the Federal Reserve as the duly appointed US government agency is in possession of the printing press. However, quantitative easing no matter how much academic gloss it is given is not it. Actual monetary conditions are determined by a myriad of other outside factors (relating exclusively to bank balance sheets) that appear impervious to QE-type strategies, a verdict rendered by sixteen years of experience in Japan and another eight in the US and elsewhere.
You could have made a quantitative case against QE in the Japanese or the first American instances, where the “Q” part was simply too small. In the last five years in particular that factor has, too, been empirically eliminated, most especially by the Bank of Japan’s QQE reaching now half a quadrillion in yen reserves with the same results (none positive).
Why the Federal Reserve merely followed in BoJ’s footsteps for all these years is almost inexplicable; almost. Again, going back to that meeting in June 2003, policymakers here knew it wasn’t working and Alan Greenspan began to wonder about his own capabilities.
“CHAIRMAN GREENSPAN. What is useful, as has been discussed, is to build up our general knowledge so that when we are confronted with the need to respond with a twenty-minute lead time—which may be all the time we will have—we have enough background understanding to enable us to make informed decisions. We need to know how the system tends to work to be able to make the necessary judgments without asking one of our skilled technical practitioners to go off and run three correlations between X, Y, and Z. So I think the notion of building up our knowledge generally as a basis for functioning effectively is exceptionally important.”
Or, as I put it a year ago, make sure you can actually do what you say you can do before you have to do it. The emphasis was in 2003 clearly on the “before you have to do it part” and largely because of how the Bank of Japan was executing a theoretically sound strategy that wasn’t producing the desired or expected results. But they never did that. The FOMC as well as most of the academic literature instead focused on BoJ’s execution of QE rather than the technical factors that were clearly suggesting (really proving) from the very beginning at the very least far more complexity in money than was assumed.
And so it brings the world back to repeating the Japanese mistakes, as Governor Kohn described them so many years ago, “They kept saying things were getting better, but they didn’t.” The Fed was never honest in its assessment of what it really could do so that by the time D-day arrived for them they were arrogantly dismissive even of direct market contradictions (especially eurodollar futures that were in early 2007 correct and have remained so despite all the QE’s). It wouldn’t have mattered if the FOMC had their skilled practitioners run off and do X, Y, and Z correlations, because X, Y, and Z were all based on the same mistaken premises, those of Ben Bernanke’s 2002 speech. Throughout the crisis period officials kept claiming “things were getting better” (subprime is contained) only to see the whole thing nearly collapse. Afterward it was always the same, “things were getting better” (green shoots) even though QE1 was followed by a QE2, another global liquidity crisis, a QE3, a QE4, and then another global liquidity crisis.
How can even the most robust and dynamic economy move even slightly forward under those conditions? That is another result we have over the last ten years fully tested and established; it can’t. Whatever the unobserved direct effects of monetary tightness, such outward and visible instability is another depressive factor all its own, and a very important one.
Because of one simple variable we have followed a path that a decade ago was believed literally impossible. Indeed, everything that has happened this last period had it been described to someone in 2005 would have sounded totally insane. And there is only one factor capable of creating that situation, the one, tragically, most experts were the least concerned about. Life does have a habit of unfolding in that way, where the one thing you don’t expect is what kills you in the end. Call it the maestro’s curse, no conundrum required.
We aren’t yet dead, though we are now living in John Maynard Keynes’ long run. Apologies to Dr. Keynes, it does matter, quite a bit actually. Chaos, whether social or political, is the inevitable product of extended economic dysfunction. People will put up with a lot, a large recession and even a sluggish recovery, but no people (the Japanese have committed to demographic suicide) will be able to withstand the social consequences of unceasing bleakness and no legitimate answers for it. Such a condition offends all modern sense of human progress.
It is a testament to how far down we have gone, that in 2017 pleading with the Fed to just say it one more time, “things are getting better”, because that is all that is left standing between the comforting fiction and the cold reality of Japanification. It could only have been a bitter blow, for the Fed in truth was up until now good for only that one thing, meaning optimism; carefully worded, of course, but in the end constant positivity about recovery even if always off just over the horizon. For many, that fiction was more meaningful than being led unwilling to the truth about a world without growth.
Thus, all hope is not extinguished, merely transposed to right where it belonged all this time. Central bankers have said “listen to us because that is the only way for recovery”; only now to say instead, “listen to us because there is no recovery” as if nobody is allowed to notice the change. We need only stop listening to economists altogether because they were wrong then and utterly so now. The problem isn’t economics but economists, the former having been removed from the latter generations ago.
That is the great unappreciated truth about Japanification. It was never about zombie banks and asset bubbles, at least so far as separate issues from economists who know nothing, prove they know nothing, and then refuse to learn when all results show it. Nobody ever bothers to challenge a central banker about money because who would ever do such a thing? It is such a thin façade, though, as once you move past it to do so is incredibly easy. One need read only a single FOMC transcript from 2008 (and now 2011) to establish this.
As “reflation” hopes fade just as they did three years ago, how the world proceeds is a choice. It is a collective one, but one that must be made nonetheless. We can allow nothing to ever change as the Japanese have. The political situation in Japan has been upended several times over the past quarter-century, but what is the one thing that has remained constant no matter which side sits in power? The Bank of Japan. Republican or Democrat, what is the one thing that hasn’t changed in America? Monetary policy that was and remains strangely devoid of any money.