President Trump Misses What's Really Missing from Monetary Policy

President Trump Misses What's Really Missing from Monetary Policy
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Fed Chairs and their Presidents. The central bank is supposed to be independent, of course, but it’s not always been the case that either party sees it that way. More often than not, there is tremendous coordination among policy goals. Ten years ago this week, for example, the Federal Reserve came together with Congress in the last days of the Bush Administration to prove yet again none of them had any idea what they were doing.

On October 3, 2008, the Emergency Economic Stabilization Act was signed. Title I of the law delivered the Troubled Asset Relief Program, or TARP.  Only ten days after being handed the authority to buy “troubled assets”, Treasury Secretary Henry Paulson in close consultation with Federal Reserve Chairman Ben Bernanke and others chose to “invest” a quarter trillion in banks instead.

It wasn’t working; it didn’t work. Rather than stabilize the economy, the US system would go on to shed an astounding 7.5 million payrolls over the next eighteen months. The worst economic contraction since the Great Depression propagated worldwide.

The seeds of the disaster were planted four decades earlier during a time when Fed officials weren’t so welcome at the White House, or wherever else the Chief Executive might’ve happened to be. In December 1965, President Lyndon Johnson recovering from gallbladder surgery at his Texas ranch was enraged at the central bank’s action. “You took advantage of me and I just want you to know that's a despicable thing to do,” the President told Chairman William Martin.

Johnson had on his mind enlargement of the Vietnam War at the same time as fashioning his Great Society. These were hugely expansionary propositions. To Martin, they were hugely inflationary propositions.

LBJ knew that he needed a booming economy to help pay for everything. The Federal Reserve had voted to raise the discount rate to 4.5% from 4% despite weeks of negotiations and pleading. The President thought that he had gotten through to Martin, but the Federal Reserve Board, with Martin on board, felt differently.

“You've got me in a position where you can run a rapier into me and you've done it.” Johnson unleashed his famous temper on the mild-mannered central banker.

It wasn’t just LBJ’s agenda that the Federal Reserve had in mind, however. Since the late 1950’s, the Bretton Woods system had increasingly come apart. By November 1960, the formation of the London Gold Pool was a tacit admission that it no longer worked. The national parties to the agreement hoped that it would be a temporary fix, but contemporary accounts show quite conclusively that there wasn’t really much optimism nor much resolve to do anything about it.

The primary defect of Bretton Woods was that it never accounted for money demand globally. We today think of globalization as a relatively new phenomenon when in fact there have been episodes throughout history. One big globalization push came in the 1910’s and 1920’s – only to be interrupted by the unequal distribution of gold/money once fear and hoarding obliterated the mechanisms for flow and redistribution.

The chief designers of Bretton Woods, John Maynard Keynes of the UK and Harry Dexter White of the US, didn’t allow for the possibility that globalization of earlier decades had been merely put on pause by the Great Depression. Increased global demand for trade required, unconditionally, a monetary system able to efficiently match money supply with money demand.

Bretton Woods could not, leading to what became known as Triffin’s Paradox. Robert Triffin proposed the two things were incompatible, yet simultaneously necessary. The US and UK together would have to supply sufficient currency, pounds and dollars, for use outside of their borders at the same time doing so would undermine the gold standing of each.

Following the Suez Crisis in 1956, which itself followed an enormous sterling crisis and devaluation in 1949, Bretton Woods would shift from a co-reserve system to a single reserve system based in dollar rather than pound denomination. Since trade and global economic expansion will always take first priority, that meant dollars would have to be overseas in abundance.

Where did they come from? It seems like it should have been an easy answer. Grounded in traditional separate systems understanding, Economists and policymakers kept turning to the US current account. It never occurred to them that monetary innovations in the face of overwhelming need might render traditional notions, even to the point of monetary accounting itself, obsolete.

Several times throughout the decade of sixties, the Fed would act on their view of a rising current account deficit paired with the steady and sharp loss of gold reserves. Triffin’s very dilemma. The booming global economy needed money to stay booming, but it was playing havoc with central bankers. In 1964, the Federal Reserve Board noted the tension:

“There was extensive discussion...about the proper course of monetary policy in the light of the serious and persistent balance of payments deficit and the urgent need for additional measures to deal with it. At the same time it was recognized that the domestic economy was not expanding at a rate sufficient to bring about full employment soon and that a more rapid rate of growth was to be desired.”

The rate hike in December 1965 was only partially about the worries over inflationary consequences of the Johnson Administration’s activities. The US could ill-afford to lose more gold without further jeopardizing the dollar’s standing and therefore the global framework that at the time was barely holding together. Plagued by so many concerns in so many different directions, the central bank’s actions were haphazard – one reason why LBJ wasn’t expecting opposition.

In 1971, Economist Paul Samuelson would call this dollar policy “benign neglect.” In a sense, the government would do very little about either the dollar or the budget and just hope for the best. The Federal Reserve was a full party to it, William Martin in 1970 finishing off his very long tenure in office saying, “I’ve failed.”

In August 1971, President Nixon officially closed the Bretton Woods era by defaulting on the country’s gold obligations – the dollar would no longer be convertible by anyone into gold or anything else. This was only one measure among several Nixon would take.

The following month, September 1971, Congress’ Joint Economic Committee held hearings on the proposed economic plans. On the second day of testimony, the Committee pitted Samuelson against Milton Friedman. The latter testified in his prepared remarks:

“If I may summarize to you briefly what I have said in the rest of this particular section, it is that the President's action gave a formal signal that the Bretton Woods system is dead, that it will no longer be revived. This opens the opportunity for a more meaningful development in world monetary relations.”

In Friedman’s view, a new international monetary order had to be created but it would not be imposed again from the top-down. “I think international systems grow out of real economic forces and cannot be invented, that basic economic forces are stronger than the Central Bankers or the international monetary officials.” By de-linking from gold, the balance-of-payments problem for the dollar would completely disappear. No more Triffin’s Paradox. Exactly how the world would manage money supply versus demand, Friedman wouldn’t venture a guess.

Markets are messy and often unpredictable.

For Friedman, the argument was easy in the shape of globalization as we know it. The fixed gold price, or what he called the “fetish of fixed exchanges”, was inhibiting the free flow of goods and capital. It produced massive distortions “leading to a waste of capital in building plants simply to scale tariff walls.”

Samuelson agreed that the gold window should have been closed, but then worried about the direction of American labor.

“In a moment, I shall comment upon various policies of benign neglect which are urged upon you gentlemen. But one of the greatest costs of that policy in the past and one of the costs of that policy in the future if you accede to it will be a perpetuation of the employment problems associated with international trade. And you will feed the fire of protectionism.”

Indeed, President Nixon in allowing the dollar to float also imposed an enormous 10% import surcharge. The President’s intent was to correct for what Samuelson argued in front of Congress – that currency values did not accurately reflect parities. Therefore, simply revaluing the dollar in gold would not, in Samuelson’s mind, change the policy of benign neglect. The world needed a clear monetary directive, else protectionism (or populism) by default.

“I think you do not change the Las Vegas odds by this token change here, that 30 years from now gold will be out of the monetary system by 1 percent probability. That has to be fought on its merits. And I will remind you of what Mr. Roosa used to remind you of in testimony when he was in office years ago, that de facto, a large part of the world's reserves today are official gold. Those will have to be replaced.”

Robert Roosa also testified to the Joint Economic Committee in September of 1971. He had been Treasury Undersecretary for Monetary Affairs during the Kennedy Administration, using that position to advocate for a global dollar standard.

What he had to say to the Committee was a bit different from either Friedman or Samuelson; and not as a matter of politics or even economic debate. He agreed that the US should abandon gold at $35, but that it should not abandon gold. Gold reserves indeed would have to be replaced, but with what? His view was more toward the functionalities of this brave new emerging monetary order.

“Another contribution to the solution of the long-term international monetary problem would be the following: The United States is being urged by other countries to pay for its deficits in reserve assets-gold, SDR's and foreign currencies-instead of paying in dollars. This is a request that is not completely without reason. On the other hand, it is quite impossible for us to pay for our short-term capital movements in anything but dollars, because these run into the billions, and tens of billions. Very often, they have nothing to do with the United States. There may be movements out of the Eurodollar market into national currencies, say, out of the Eurodollar market into marks. We cannot be held responsible for that and come up with SDR payments or drawings on the IMF. That has to be settled in dollars.”

It was a tacit recognition of the world behind the last years of Bretton Woods. By being forced to substitute reserve assets for dollars on international markets, the US position was, under benign neglect, to simply do as little as possible forcing the growing demand for international money to look elsewhere for it. The result of which was distortions and trade barriers, the rise of protectionism at home as the economic order descended toward more open chaos.

Misunderstanding was at the heart of it.

By alleviating the reserve requirement in gold or whatever else, the supply of dollars could be matched with the demand for them that wasn’t tied to a specific dollar value. Money as purely a medium of exchange stripped from any store of value function.

The reference to the eurodollar was not accidental on Roosa’s part, but it was grossly unappreciated. Roosa would contend that in removing restrictions like those arising from Bretton Woods “most of the financial business now done in the Eurodollar market would have been done in New York.”

He was especially wrong on that point; once the official nonsense of the last years of gold-exchange were eliminated, the eurodollar market exploded; it didn’t move back domestically. In other words, Roosa saw the eurodollar market as a symptom of Bretton Woods’ flaws rather than, as it had already become, the world’s answer to them.

Friedman wanted floating, Samuelson an end to benign neglect, and Roosa some form of preserved dollar standard. They all agreed the old way wasn’t working. They also agreed the costs of such breakdown were adding up, and, as Samuelson pointed out, these weren’t solely economic costs.

To some extent, they all got what they wanted. But it wasn’t anything like what they might have conceived in 1971.

Robert Triffin had pointed out several times it wasn’t so much that gold’s price was fixed against the dollar, it was that the international money supply was itself haphazard – dependent upon South African mine production or the political considerations of US central bankers and whether or night they might be swayed by government necessities or those of the markets. And then whether they might choose domestic or foreign markets to set policies and try to positively influence, or further distort, any number of seemingly intractable imbalances.

Globalization is wildly misunderstood. The free flow of goods upon the unencumbered flow of capital all sound like very good things, unqualified progress. While that may be true in principle and in theory, it does very little in the details. When you get down to it and peek behind the curtain you find such blandness to be unhelpful to the point of harm.

Everyone’s heard of a reserve currency, but what does that actually mean?

The fact of the matter is that there are very real impediments that cannot so easily be overcome. These are not artificial barriers like tariffs or recalcitrant labor groups; the bridging of any divide between vastly different systems requires immense consideration.

Officials, most of them, proceeded from 1971 as if Roosa and Friedman had been correct – a floating dollar standard emerging out from the shadows of a gold fetish and into a new era of globalization. That’s why in 2008 TARP was introduced to such little effect, and the global economy suffered that disaster.

It is also why, ten years later, globalization has become a dirty word in so many places. In many ways, we are right back to the same place as benign neglect – only it’s not so benign.

When the eurodollar system was expanding it provided the supply of money required for that medium of exchange function – so that an export firm in Sweden could easily and readily supply goods to a receiving firm in Japan. Without the eurodollar system to intermediate, the Japanese firm would have to find a way to come up with kronor, or the Swedish firm some way to dispose of yen.

That’s the natural monetary barrier which the eurodollar system overcame by allowing businesses and people from all over the world to intermediate (and standardize several other functions) easily in dollars – sell yen for dollars and buy kronor with them without incurring uneconomical costs and bearing inscrutable inefficiencies. So long as everyone (meaning global banks) has dollars, this works very well and solves the Bretton Woods deficiency. The free flow of “capital” is hailed as a stunningly remarkable achievement.

When banks don’t have dollars? This kind of intermediation suffers in the distortions and setbacks very similar to those witnessed in the breakdown of gold-exchange. Only this time the key symptoms are deflationary rather than inflationary. That’s another reason TARP was so ineffective; it was designed for a subprime mortgage problem rather than a global money squeeze.

In that way, neither central bank independence nor coordination really matter unless either follows from competence. Neither Martin nor Bernanke were prepared for these systemic, global monetary breakdowns. President Trump might be like President Johnson angry with his Fed Chair for raising rates. But also like Johnson, he should be more upset by what’s really missing from monetary policy regardless of rates.

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

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