The Monetary Authorities Aren't Capable People

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In 1953, Milton Friedman staked his case for the demise of fixed exchange rates. The classical gold standard, he argued, had been a one-time aberration. The dramatic growth of the 19th century due to the waves of industrialization had produced a unique set of circumstances. Among them, an enormously flexible labor system.

Because of innovation, it was always in flux. Itinerant farm workers didn’t just move all at once to the cities in order to work in brand new factories springing up all over the United States and Europe. More than just ebbs and flows, ways of life were being rewritten from the ground up. It was hard to anchor anything let alone something so intangible as pay expectations.

What that meant in monetary terms was simple: workers tolerated, as much as they could, often wild swings in wage rates. Monetary shortages, mostly the results of intermittent bank panics, would lead to deflation in wages. That was how businesses back then had reacted to the negative pressures of the business cycle, by cutting back pay rates rather than payrolls.

John Maynard Keynes had it exactly right in the 1920’s. Both inflation and deflation are evil, he wrote, but they are not equal in how so. The latter is by far the worst, mainly because of where it ends up forcing these dramatic swings. On labor.

“The Inflation which causes the former means Injustice to individuals and to classes—particularly to rentiers; and is therefore unfavourable to saving. The Deflation which causes falling prices means Impoverishment to labour and to enterprise by leading entrepreneurs to restrict production, in their endeavour to avoid loss to themselves; and is therefore disastrous to employment.”

More of a 20th century phenomenon, as industrial economies advanced their labor forces grew more rigid. The most obvious example of this was the Great Depression; because of these modern rigidities businesses would react to the monetary shortage and banking crisis by cutting back the number of workers rather than just the rate at which they were paid. Mass unemployment.

While deflation was the greater of the two monetary evils, mass unemployment was the greater of the two employment disasters stemming from it. Is it better to have most people collecting somewhat lower paychecks, or to have a large proportion of workers receiving none?

Neither scenario is good, but history has shown it is clearly the former - but that doesn’t work in the modern economy. If anything, the labor force has grown still more rigid through time; as have businesses.

In other words, as Friedman wrote in his 1953 essay The Case For Flexible Exchange Rates, one of his included in the larger, famous collection Essays in Positive Economics, free societies of the modern age would no longer tolerate the “the harsh discipline of the gold standard.”

It sounded so simple to do otherwise. To avoid the greatest monetary evil, deflation, you simply avoid the circumstance under which it arises. No bank panics, therefore no deflation. To circumvent the horrific chain of economic events, forestall the thing right at its source. Absent the monetary shortage which prefaces the bank panic, no depression and no need to so dramatically adjust either pay rates or payrolls.

The modern central bank was born – in theory.

The idea is simple currency elasticity. Confronted with a systemic monetary shortage or setback, a setback that creates a further shortage, the central bank fills in the gap by undertaking whatever modern equivalent of Walter Bagehot’s well-known dictum: lend freely at high rates on good collateral. Monetary authorities, therefore, are providing currency to the good banks who need it for reasons that largely have nothing to do with them.

A monetary shortage’s most insidious and harmful effect was how it affected sound and stupid banks alike. In almost every case, the ranks of the stupid were incredibly small and yet enough to threaten and eventually dissolve so many sound institutions. During a systemic run, the baby is tossed out with the bathwater.

If only there were an entity which stood above everything and could save the sound from the stupid by issuing currency to the sound while letting the stupid rightly disappear; Bagehot’s dream. Preserve orderly markets and money while creative destruction did its wonderful work.

It is a task made all the more difficult by what Economists assume must be stupid people. Senator Robert Owen was as much a driving force behind the establishment of the Federal Reserve system as any other single person. He had good reason, too, having been a bank owner in Oklahoma during the Panic of 1893 and watching in horror as his sound depository was nearly destroyed by what he deemed irrational fear fanned by sensationalist media.

“It is the duty of the United States to protect the commercial life of its citizens against this senseless, unreasoning, destructive fear that seizes the depositor when he has been sufficiently hypnotized by the metropolitan press with its indiscreet suggestions."

It's not so easy, though, separating the sound from the stupid among banks as well as deposit-holders with the stupid newspapers printing up all manner of unsound salaciousness.

People often ask why the Federal Reserve and other central banks like it, most of them nowadays, target 2% inflation. This is your answer; the acknowledgement from the modern central bank that the outcome of deflation isn’t so easy to avoid.

Monetary policy seeks a modest level (according to them) of positive price behavior so as to act as a cushion, to give central bankers enough time to understand the situation, craft an effective solution, all while figuring in and counting on the lags at which it might take for that effective solution to become effective.

Sound, proactive monetary policy overrides stupid banks and stupid people riled up irrationally by a stupid media.

One of the key features of the Great Depression, though, was its “somehow” global nature. The United States, obviously, was far from alone in its devastated misery. And it wasn’t just Germany and Europe, either, as scarcely any place on the planet had been spared.

In the aftermath of the depression and the second world war it spun off, a new monetary order was envisioned which would speak to the greater vulnerability of a more closely connected world.

As the monetary system collapsed, with the Federal Reserve already in place, mind you, even if the Fed had been successful in safeguarding sound American banks there were no guarantees anywhere else. The shockingly large monetary spaces in between countries unfilled by any mandate or government reach meant there was practically no escape regardless of internal, domestic efficacy.

The Federal Reserve, had it acted sufficiently might have saved the banking system in time - only for it to have been wrecked at a later date by the global monetary collapse.

Bretton Woods in 1944 was only a start in thinking about how to deal with international currency conditions. In fact, the very first sentences of the introductory statement to the conference sessions dedicated to the creation of what would become the IMF reflected this thinking:

“When currency systems were restored after the last war [WWI], there was little or no attempt at coordination of measures to provide stability; no machinery was set up to facilitate an orderly adjustment of exchange rates when fundamental conditions necessitated such a revision.”

It had come to be widely believed that the gold standard had contributed to the scope and depth of the Great Depression by forcing monetary constriction via fixed exchange; yet another form of its harsh discipline.  

This was a start down the road toward floating exchange rates, the possibility Milton Friedman was very much in favor of by 1953. By allowing currencies to float, the world could absorb international imbalances more easily without it necessitating the huge internal monetary adjustments like those undertaken in the fixed system during the Great Collapse (1929-33).

In fact, as Friedman argued, theoretically the imbalances would never grow to be so large to begin with. The global system would more easily adjust on the fly; rather than let pressures build up until they exploded.

And where those imbalances did grow large, there stood the IMF to make sure these were handled in an orderly fashion; if not quite a global central bank, then at least a mechanism for taking on the stupid international cases. All of it designed to break the chain of deflationary causation from the global perspective.

You may have missed it, but late last week the IMF’s Managing Director begged for more money. Actually, Kristalina Georgieva implored for help with more dollars. She asked that the fund’s emergency capacities be immediately doubled, to $500 billion, while estimating the organization’s overall lending capabilities needed to be expanded from $1 trillion to $2.5 trillion.


“We have seen an extraordinary spike in requests for IMF emergency financing – some 80 countries have placed requests and more are likely to come. Normally, we never have more than a handful of requests at the same time.”

Ms. Georgieva further admitted that those eighty were just the first wave and that more, a lot more, were expected in the near future.

Thinking back to the time before the COVID-19 outbreak, you might remember the IMF already being quite busy. In June of 2018, as the rising dollar was getting started pummeling emerging markets, Argentina had been one country early in requesting emergency financing. This quickly ballooned into the largest national bailout in history, some $57 billion pledged along with reworked requests to (try to) rejigger the peso.

Not even a year later the whole thing was in tatters. Former IMF Managing Director Christine Lagarde, who, as “luck” would have it was on her way to a promotion, confessed they’d screwed up Argentina because it wasn’t such an easy thing after all.

“The Argentine economic situation has proved to be incredibly complicated and I dare say that many of those involved, including us, underestimated a bit, when we started with the Argentine authorities building the program.”

It actually wasn’t all that complicated; what officials like Lagarde underestimated “a bit” was the dollar situation globally. And that was just 2018.

I trust by now you can see right where I’m going with this; eighty Argentinas as the opening salvo! A global dollar shortage the likes of which is on pace to surpass GFC1 (Global Financial Crisis 1, 2007-09) thanks to the sublimely unshakable belief it had been about subprime mortgages. Even if you believe the Fed acted soundly a decade ago, stupidity still “somehow” won the day anyway.

And let’s not forget about that first one as this current one, GFC2, takes on its proportions even in its earliest stages. The prior one had gone just as Keynes had said – the world’s labor markets suffered greatly in mass unemployment because of a peculiar monetary panic. Worst of all was a third evil; the first deflation, the second mass unemployment, number three being the long-term nature of it.

In some places like Europe, the unemployment rate remains elevated to this day. Over here in America, ours omitted tens of millions of prospective workers (deemed by Economists to be too old, lazy, or drug addicted) from its denominator so as to sparkle misleadingly at a 50-year low. Stubbornly low participation rates (along with the never-ending plethora of anecdotal millennials stuck in basements) more accurately demonstrate the ramifications of this greatest of all monetary evils.

In other words, all of those things described above, all of the purported lessons learned from the Great Depression, they happened anyway. Not only that, these things took place under the watch of a guy who had been celebrated as one of the great Great Depression scholars, Ben Bernanke, and who stood up in front of Milton Friedman and said, as a Federal Reserve representative, Milton had been right about the thirties and the Fed would never let it happen again.

You’ve probably heard about the collapse in employment underway as I type. Initial jobless claims, those filing for unemployment relief for their first time, hit 3.28 million last week. An incomprehensibly enormous total which nearly doubled this week. Ten million American workers thrown out of work in just a fortnight!

But that’s not actually what I’m writing about here, those amazing tallies certainly not the fault of Jay Powell. Those are the direct results of the economic shutdown the federal government has imposed in order to combat the coronavirus pandemic.

No, what we all should be far more worried about is how many of those millions, and millions if not tens of millions more who will file in the coming weeks, get to go back to work when all this is over. Soundness would mean most if not all of them; stupidity would mean…

Globally, governments like the Trump administration have proceeded with these shutdowns under two false assumptions. A no-win situation either way, they’ve prioritized stay-at-home-orders figuring the economy was in good to great shape as the pandemic started and then that it would bounce back quickly and comprehensively once it was all clear.

The economy instead was in poor, near-recessionary shape to begin with and GFC2 will only impede the otherwise natural rebound. However, just like after GFC1, everyone will be left wondering why it wasn’t so robust as they were expecting at the same time businesses are already adjusting their longer-term horizons to include far, far less labor within them.

Just as Keynes had lamented.

This is true even if you somehow believe Jay Powell’s crew has been effective after a chaotic month of record volatility (which is a nice way of saying crashes). The standard by which he is being judged isn’t a reasonable nor appropriate one, though. The fact that there hasn’t been another Lehman Brothers isn’t the same thing as having avoided a GFC2.

A global dollar crisis doesn’t necessarily mean there will be a banking crisis. It just so happened that during GFC1 the predicate dollar crisis (shortage) led to both banking crises (there were two). As the thirties, even if Bernanke had been effective on the one domestic hand he was doomed by the other reaching out into the vast, much larger international monetary spaces.

As it turned out, Bernanke didn’t do much good for domestic banks, either.

The lesson the entire global officialdom took away from GFC1 was to avoid Lehmans rather than realize they needed, desperately, to fix the eurodollar.

So, while anyone might be reassured by the lack of Lehmans in the US, the IMF has a line out its door of finance and central bank officials from near every government on Earth pleading, begging for relief from the US dollar wrecking ball slamming each floating currency with devastating effect. King Dollar is actually King Kong Dollar, as Argentina could’ve told you two years ago.

Today there’s approximately seventy-nine others. Don’t bother asking Christine Lagarde about it, she’s busy screwing up Europe at the moment.

Milton Friedman should’ve known better in 1953.

The Great Fundamental Flaw in the Grand Post-War Economic Order wasn’t necessarily globalization, it was the people who supposedly stood watch over it. At each and every juncture, at each critical decision point, there are only Economists who we all need to act with precision and wisdom. They just aren’t capable; thus, the very reason there had been a GFC1.

Maybe the gold standard would inflict much too harsh discipline on the modern workforce, but it’s as hard if not harder to argue the lack of discipline in the official sector has been any better. Ben Bernanke’s successor Jay Powell because of Ben Bernanke’s prior failures is watching out for US banks like a hawk - while no one is watching out for eurodollars. Guess which one actually matters.

In the end, while the world was made to expect sound monetary policy as a prophylactic measure against stupid banks and stupid people, and the evil consequences so much stupidity would bring, no one took account, even after the experience of GFC1, of the whole monetary authority being the biggest stupid of them all.

March 2020 will stand as further evidence. Coronavirus dislocation, sure, but in terms of GFC2 this is only beginning. And that’s the worst evil yet. 

Jeffrey Snider is the Head of Global Research at Alhambra Partners. 

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