How the Bond Market Currently Describes Our Situation

How the Bond Market Currently Describes Our Situation
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The year 1930 was certainly one of the most unique in history, the majority of it anyway. Sandwiched between the massive stock market shake-up begun the prior October, in 1929, and the first wave of bank panics which would shock the system in October 1930, for nearly a year an eerie sort of calm flourished in the general sense.

Yes, things were bad. The economy had been sent into a tailspin, an unusually harsh one. But America in its epic economic transformation from rural agrarian society consisting of mainly small towns and family farms into the global industrial powerhouse had experienced these before. They had become near regular features of modern existence.

In January 1931, New York Governor Franklin Roosevelt had written to one of his constituents urging him “not to yield to the counsels of despair because depressions always come to an end and business also eventually adjusts.” The subject of his letter to flustered Mr. McIntosh was the struggling agricultural sector.

Certainly there was a deep nostalgia attached to it; the early 20th century factory worker who might have fondly looked into history at the “way it used to be” and wondered if it wasn’t better before with all the romanticism an entire canon of literature devoted to it might have made it seem. William Jennings Bryan’s dramatic rise had been just a generation prior, within reachable memory, who had set fire under a large portion of the American population with his silver agitation on behalf of the careworn small farmers dotting the whole national landscape.

Even before the Great Depression there had existed a constant strain of economic belief that deflationary progress, the marriage of labor, innovation, and capital that capitalism provides, must be combated. Economies of scale, applications of technology, and mass production brought very clear benefits, lower food prices chief among them, though not everyone was so sure of what it was costing. The loss of family farms not merely sentimental tragedy for individuals, some very influential thinkers wondered if it amounted to a systemic undercutting of the very fabric of society.

In 1929, the new US President agreed. American farms had experienced a boom during World War I with Europe transformed into pastures of killing fields, and then became more productive in the twenties even as much of European farms were regrown. As a characteristic consequence, the sustained surpluses led farmers to curse the global prices of their various produce.

Hoover’s 1928 election wasn’t exactly a referendum on how to deal with agriculture, but there was a lot of 1896-style politics contained within it. The “wild jackasses of the desert”, as George Moses had called them, demanded 100,000 angry Western farmers march into Kansas City where the Republican National Convention was being held and raise hell for Illinois Governor Frank Lowden.

Oregon Senator Charles McNary and Iowa Representative Gilbert Haugen had tirelessly advocated for a proposed scheme to use the federal government as financing, marketing, and shipping agent on behalf of these floundering farmers. Beginning in 1924, the McNary-Haugenites, as they were called, demanded the creation of a Federal Farm Board empowered to buy up sufficient, if not all, excess crops and foodstuffs to bring up prices equal to their previous WWI era levels.

The government would then dump it all overseas. Call it charity, or something. President Coolidge instead sniffed out what would have amounted to a brazen bailout.

Hoover, on the other hand, he had been a corporatist since before President Wilson had tapped him to be America’s “food csar”, to manage agricultural equilibriums during the Great War. From there, the future President would run the American Relief Administration which managed humanitarian aid, especially food, flowing into war-torn Central and Eastern Europe.

A Federal Farm Board was kind of Hoover’s thing anyway.

Even though the McNary-Haugens proposals had been soundly defeated in Kansas City, a convention vote of 806 to 78 against, costing Governor Lowden his last shot at the nomination on the first vote, by June 15, 1929, President Hoover made a uniquely modern splash by signing into law the Agricultural Marketing Act in front of a wide bank of “talking-picture” cameras.

“We have made at last a constructive start at agricultural relief with the most important measure passed by Congress in aid of a single industry,” Hoover talked into them.

The Act would go on to make a Federal Farm Board out of the existing 1916 Federal Farm Loan Board he had known well from his time working with it in Wilson’s government. Crucially, though, the new board was appropriated an initial revolving fund of half a billion dollars, an absolutely enormous sum for the time.

When the Depression came on, in the early days of 1930 prices plunged – no longer the forces of productive deflation. Facing enormous pressure given its mission, the Board established the Grain Stabilization Corporation to purchase wheat directly anyway even though everything had changed. In its first few months of existence, the Farm Board was supposed to work through farm co-operatives rather than becoming the heavy hand in the marketplace.

As the month of May 1930 began, an estimated one-third of the entire national wheat supply ended up belonging to the federal government. And for a time, the aggregate price stabilized.

By then, though, the Farm Board had been forced to move on to cotton. June 1930 brought with it a plunge in those prices and thus the establishment of the Cotton Stabilization Corporation. Like its predecessor Grain twin, the Board had been making only supplementary loans in this other crop. These were not working, given over instead to direct purchases as with the Grain Corp.

Both contributed to the sense of calm that prevailed through much of that year. Americans were not unrealistically happy about everything, worried a great deal about their present circumstances and how it might ultimately play out. By and large, people were patient and willing to extend a benefit of the doubt for powerful people to act on their behalf and keep the whole thing afloat until the cavalry of recovery everyone had been conditioned to believe eventually rode into the frame.

What that had meant as far as the Grain Stabilization Corporation later on in 1930 and into 1931 was more than direct purchases of product. The government through the Farm Board and its Corporation became the market-of-last resort in futures trading, too. They couldn’t just buy up spot markets for physical delivery since the futures market would adjust and point downward all over again.

No, to really “support” agricultural prices would necessarily mean the whole thing. During this crucial period, late ’30 and early ’31, as the first wave of bank panic swept on over and wrecked the anticipated arrival of recovery cavalry, the Grain Corp. became practically the entire marketplace – including futures. It had written and held often well more than half of all open interest in wheat futures for each of the Chicago, Kansas City, and Minneapolis commodity exchanges.

In the Minnesota pits, during the month of March 1931, for example, the Grain Corp would become beneficial owner of a reported 93% of all contracts. The same estimates show that for 1931’s crop yields, the Farm Board ended up outright owning nearly three-quarters of the 340 million bushels of wheat produced for market.

One key reason why is obvious in the hindsight of rational analysis – though it should have been a full part making up contemporary thinking. Keeping prices high regardless of demand had encouraged farmers to make matters worse. Rather than rooting around for alternatives to unprofitable wheat production, the American government temporarily made it artificially profitable to produce even more.

The Federal Farm Board finally on June 30, 1932, admitted only radical change could solve the farm crisis. No longer seeing any benefit in continuing to futilely prop up agricultural prices that only crashed more, particularly those for wheat and cotton, the Board recommended to Congress that the scheme be reworked toward establishing “an effective system for regulating acreage or quantities sold, or both.” By regulating, they meant reducing.

In other words, the same thing the market price had been saying all along.

Governments are attributed many severe powers, no greater than the potential exercise over life and liberty. Only slightly less great are those where commerce and economy may be concerned, each contributing an unappreciated (never more so than today) huge volume to those others.

But government bureaucracy, as we find time and again throughout history, cannot repeal laws of economics (small “e”; though they do try often by creating schemes of Economics, capital “E”). We are all taught in any Economics class (there are only capital “E” schools) in the post-Great Inflation world the Keynesian approach which surmises governments only suffer from a lack of will not ability.

If some bureaucrat board buried deep within the federal Leviathan wishes the price of this physical commodity or that financial asset to be X, maybe corporate bonds being bought up by the Federal Reserve, should we really just believe such price is a foregone conclusion? More so will we just accrue the benefits of that presumed price?

Such is arguable under the most ideal of circumstances. Markets and economies are amazingly complex and bureaucracies are specifically ill-suited to mimic let alone replace the dynamic forces behind them; Adam Smith’s invisible yet supremely elegant hand.

It appears to some as if a panacea; control the price, control the very essence of industry (broadly speaking). Why wouldn’t the “unlimited” power of the federal government cornering 93% of open interest work? Because it wasn’t 100%?

We’ve been led to believe, the vast majority, I fear, that there is no power greater than that of a determined technocrat. In charge of the “printing press”, my God, what good, and only good, could be achieved!

Irving Fisher had once made the argument that the leanness and meanness of the Great Depression came about because of the debt burden the country had accumulated during the fat years before it. Monetary deflation, Fisher argued, placed an extraordinary burden on debtholders who were forced to pay back such debts with more and more valuable money; preferring instead to default thereby ruining the banks and leading to the ruinous waves of bank panics.

More modern analysis, particularly from scholars like Ben Bernanke, suggested a slight variation; he and others had inferred in the eighties that deflation also reduced the net worth of those who were overly indebted, thereby increasing their “real” leverage burden which then caused them to take fewer risks for the higher prospects of failure (while also ruining banks with defaults). Both aggregate supply, investment, as well as aggregate demand are crushed.

But these views presume that monetary deflation wasn’t or isn’t ever anticipated; it couldn’t have been.

Are prices static (stationary)? Going back long before William Jennings Bryan, there had been a tradition believing that they areand ought to be. Even cursory love for the classical gold standard presumes price stability to be akin to static levels (which doesn’t survive closer scrutiny of that very thing).

Heck, the Secretary of Agriculture under FDR, Henry Wallace, in trying to decide what to do with the Federal Farm Board and Hoover’s Agricultural Market Act expressed a determined desire to go back to the way it was; or, how everyone guessed the way it was must have been. Wallace’s economic advisors told him that the new Agricultural Adjustment Act of 1933 should explicitly aim to get farm and crop prices back up to where they were between 1909 and 1914.

Why those years?

"[That period had been] one of considerable agricultural and industrial stability...with equilibrium between the purchasing power of city and country…and the most recent period when economic conditions, as a whole, were in a state of dynamic equilibrium.”

You have to admire the brazenness of those Economists throwing in the word “dynamic” at the end.

In 1989, economist Stephen G. Cecchetti wrote a paper for the NBER where he examined the nature of price stability and its effects on the Great Depression (even thanking, among others, one Ben Bernanke for “comments and helpful discussions.”) If general prices were indeed nonstationary, as he surmised, then that would explain why they hadn’t corrected to the price levels (not inflation rates) which had prevailed throughout the preceding twenties; very quickly in the early 1930’s a roaring rebound of inflation.

Instead, Cecchetti writes up his reconstruction for real interest rates which can only be interpreted as refuting Irving Fisher; deflation wasn’t unanticipated, it was expected and furthermore it was broadly expected to continue – so long as the underlying deficiency remains in effect. Not productive technology being applied in the farm sector and elsewhere, not that kind of deflation.

By the way, current scholarship on the topic of prices agrees with this view. This is why central banks spend most if not all their time trying to “anchor” inflation expectations positively rather than price level expectations. Because they’ve realized once a deflationary situation develops, say when subprime mortgages are blamed for a systemic breakdown that was instead an unsolved global dollar shortage, it can continue to manifest absent effective intervention.

It's the most basic fundamental piece of the whole thing, making its difference even before productive progress. Money isn’t just an economic tool; history shows it is its first tool.

Thus, Ceccechetti’s final words are especially illuminating, particularly keeping in mind these were written in 1989 when the zero lower bound (ZLB) was on no one’s radar:

“First, it [deflation at the ZLB] drives up the real return on money and will lead to negative net investment. Second, when the zero nominal interest rate constraint binds, the opportunity cost of money to [sic] becomes negative, leading to a change in the nature of currency. The natural response is a flight to quality, in this case cash or other government liabilities, that puts the banking system at risk.”

Paramount liquidity preferences, in other words, expressed right where you’d think (assuming you thought outside the Economist’s box).

What ties together the old Farm Board with Ben Bernanke’s quantitative easing as well as Jay Powell’s QE plus corporate bond buying (and many other things) is how each represents the myth while also demonstrating these truths: that in the absence of effective monetary answers, market and otherwise, deflation can and surely will go on and on wrecking economic growth and not always in the same way or to the same degree; and that the will of the government to “support markets” is not the same thing as the ability to craft appropriate monetary or economic deflation-fighting strategies.

Rather, the more officials try to make the claim they are being successful without them actually being successful the more it contributes to our undoing. Upside down, governments no longer place any limits on their will to act, they instead perilously demonstrate their lack of ability.

We seem to have settled in to a similar state right now. The world suffered yet another big shock back in March, and ever since it’s been this seeming paradox of uneasy optimism. Hoping for the best of reopening, but like 1930 worried still about the potential for that next shoe to drop; even anticipating it.

This is how the bond market currently describes our situation. After more than a decade of disinflationary outcomes, and constant inflationary promises all along the way, the next direction post-GFC2 really can be further in that same direction. Inflation is never less guaranteed than at times like these, official “market support” never more suspect.

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

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