Thursday, June 27, 2013

Larry Summers For Chairman

I have always liked Larry Summers, for various reasons: his incomparable knowledge of economics; his massive brain;  his constitutional inability to mouth conventional nonsense; his amazing intellectual courage; and the identities of his enemies. I can’t think of anything that he has said or done that I have disagreed with.

He was literally bred for the job of chairman: when you mate two very smart professors of economics, you get one very smart professor of economics. He has a solid-gold resume: MIT at 16; Harvard PhD; youngest tenured Harvard professor in history; president of the World Bank; deputy treasury secretary under Bob Rubin; treasury secretary under Clinton; president of Harvard; director of the national economic council under Obama.  Unqualified?

Politically Summers is a Democrat, but his economics are decidedly and outspokenly free-market. He gives the markets and businesses confidence when he serves under Democratic presidents. During the Clinton years, Summers and Rubin balanced the federal budget while growing the economy for eight years. Under their stewardship the economy grew by one-third and the Dow rose from 3000 to 11000. Summers has successfully dealt with a number of major financial crises. He would be a masterful appointment that would help to demonstrate the president’s seriousness when it comes to the economy and financial stability.

Plus there is the whole matter of his sheer entertainment value. Larry Summers is no consensus-seeking middle-of-the-roader; he loves a good argument. I would enjoy seeing him as chairman, telling colleagues, congressmen and the media where to get off, tartly and succinctly.

I like Janet Yellen, and I agree with her monetary views. But I have no reason to believe that she is a forceful or dominant personality. She strikes me as a nice person who would seek comity and consensus, which is the very last thing the FOMC needs right now. Another round of Kumbaya at the FOMC and we’ll have no growth at all. We need a chairman with strong opinions who will kick ass and take names. That’s Summers, famously unfamous for his niceness or collegiality.

The president certainly knows and trusts Summers, and Jack Lew has worked with him in two administrations. They know what they will get with him: brilliance and controversy. Will the Legion of Political Correctness get a veto over Summers’ appointment? Let’s hope that his sheer ability counts more than our nation's obeisance to the absurd notion that all humans have exactly equal aptitudes and IQs.

Tuesday, June 25, 2013

The Bond Market Is Not Our Friend

Pundits are up in arms about falling bond prices: The End of the Bond Bubble! Unintended ramifications around the world! Bernanke misfires!

We should not care about the fate of bond investors or, even less, leveraged bond investors. Screw them. They made money on the same trade for thirty years and now the pond is fished out. The lowest bond yields in U.S. history may actually prove to have been historically low. Yes, I suppose we could peg to the yen and see even more miniscule yields. But if that happened, we’d be Japan, Land of Zero Growth and uncontrollable debt.

The bond market is not our friend, it is our enemy. It might have been our friend in 1980, when we desperately needed higher bond prices. But today, we desperately need  lower bond prices.  

The United States economy has been suffering from Chronic Fatigue Syndrome for the past four years. We have had no energy, and just taking a brisk walk around the block has been a strain. We have been suffering from an ever-growing nominal output gap (and indeed, a real output gap as well).

The economy lost its mojo after the Crash, and can’t seem to get it back. Real growth has been stuck at 2%, half of what we need, and nominal growth has been stuck at 4%, not enough to generate adequate real growth, nor to get us out of our debt trap.

You could say that the US has been suffering from Inflation Insufficiency Syndrome. We will never get 4% real growth with 3.4% nominal growth. If we want to speed up real growth, we will need to get nominal growth about twice as high as it is now. We don’t just need higher inflation, we need higher inflationary expectations. 

But as long as the FOMC goes on about how wonderful it is that “inflation expectations are well anchored”, we won’t get near 4% real growth. Yes, Bernanke knows this, but he lost his intramural war against the hawks. Or rather, he prioritized having a consensus with the hawks over growing the economy and helping the unemployed: the all-important “institutional credibility” mandate that always manages to trump employment.

So please close your ears to the screams of bond investors, and the still-louder screams of highly leveraged bond investors; they are our enemy. Carthago delenda est. Now unfortunately, I'm not predicting such a blessed victory. Certainly the tapering of QE is no reason for the bond market to crater. If the Fed ever really does hit the brakes, bond prices will rise, not fall. We will need much higher inflation for the bond market to really go under, and I don't see much hope of that. But that's what we need.

Pray for a bond market rout, but don't hold your breath waiting for it.

Thursday, June 20, 2013

Buy Stocks Now!

Why is the US economy stuck in low gear? Why can’t we grow the way we did before the Crash? Why are so many people unable to find work? Of course, one wants to blame our socialist president with his redistributive ideas, but he is not the problem. Socialist economies can grow. If you don’t believe me, then you have never heard of the country called China. It is run by the Communist Party, and it has enjoyed amazing growth since Mao died. The Soviet economy boomed after the war, and they did almost everything wrong. Don’t blame the Left for our current malaise; it’s not their fault. Socialism hurts everyone, and it limits growth, but socialism is not the problem today. The problem is 100% capitalist.

To understand the modern capitalist economy, one must consult Hyman Minsky. Minsky’s contribution to economic thought is that stability is destabilizing. Remember the 19th century, when the boom-bust cycle was decennial? The depressions were horrible, and people really did starve to death. But economic growth was quite rapid. We had creative destruction. There was no central bank to cushion the crashes. It was a Darwinian process.

Today we live in an era of safety nets. We just can’t stomach the awfulness of the 1890s. We can't stand it when kids starve to death. We want stability. The problem with stability is that it leads to complacency and an endless build up of debt. Debt capacity expands when everything is peachy. But trees don’t grow to the sky, and there is ultimately a limit to indebtedness. That limit comes when operating cashflow can’t pay the interest, let alone the principal. It comes when rents can’t pay the mortgage. It comes when Dad loses his job and throws the keys to the bank. It happens when a bank will make a 10 year loan on a Kia Sportage.

We hit that moment on Sept. 15, 2008. That was our Minsky Moment. That’s when the debt motor went into reverse. That was the Day of Reckoning. I remember saying to my friend Chester Murray: “Paulson let Lehman default on $700 billion of debt?”. In the immortal words of Christine Lagarde: “Hank, how could you?”.

Days of Reckoning like Lehman Day occurred with monotonous frequency under the gold standard. Every ten years, credit contracted and the price of everything collapsed. Popular virtue was something called thrift, which meant that you saved money to survive during the periodic depressions. If you don’t believe me, ask your grandmother how her grandmother felt about debt.

America has been living in a post-Lehman world for the past four and a half years. We have spent that time paying back debt. Instead of buying a boat or a BMW, we have been paying off credit cards and servicing underwater mortgages. That is why QE hasn’t worked. Delevering has overwhelmed the Fed’s bond-buying. Richard Koo, Nomura's chief economist, has labeled this phenomenon a “balance sheet recession”, which is accurate. As long as credit growth is negative, it’s hard to grow the money supply or the economy. (Not impossible, just hard.)

Since the Fed has rejected the use of creative ideas to grow the money supply, economic growth has faced very strong headwinds caused by credit contraction. Now that Bernanke has thrown in the towel and is planning his retirement party, we can forget waiting for the Fed to get off the pot. Economic growth now depends on a revival of private-sector credit growth.

The outlook for a resumption of credit growth is good, which is why I am bullish. Business credit is already growing briskly. Household credit has finally stopped shrinking. If, by the grace of God, household credit growth resumes, we are looking at stronger growth and a bull market.

As I have said before, stocks today are selling at bargain prices. Whatever fundamental yardstick you use, it will show stocks are cheaper than they have been since Millie was writing her memoirs. Today’s prices are a screaming bargain; whoever was selling their portfolio today was either an idiot or on margin. Anyone who doesn’t buy stocks now, meaning today, deserves to live on Social Security.

The Stock Market Doesn't Understand Monetary Policy

Stocks have fallen sharply in reaction to the latest news from the Fed about the end of QE. It would appear that the so-called “lead steers” have concluded that an end to QE would hurt growth and make stocks less valuable. I am sorry to have to say it, but the lead steers don’t understand monetary policy.

The lead steers are laboring under the misconception that growth and stock prices have been artificially stimulated by “massive monetary stimulus” since 2008. Where did they get such an idea? Do they own a computer? Can they google FRED? The last time that we had sustained double-digit money growth was exactly thirty years ago, in 1983, following the “Reagan Recession”.

I’m going to repeat this until it finally sinks in: money growth since the crash has been quite low. M2 has grown at about 5%, while the broader aggregates have grown by much less. There has been no monetary stimulus; Fed policy has not been “extraordinarily accommodative” no matter how many times Bernanke uses those words. The linkage between the Fed’s balance sheet and the money supply is simply nonexistent. QE has been pushing on a string, resulting in a massive buildup of sterile excess reserves that have no impact on the money supply.

It remains true that M x V = P xT, but QE has no influence on M. It is incorrect to say that “Monetary policy has lost its power”. The correct formulation is “The Fed’s policy of buying bonds from banks has lost its power”. If Bernanke had dropped $3 trillion from helicopters, or bought houses instead of mortgages, we would have had good money growth. People say that the Fed has engaged in “unconventional” policies. Well, buying bonds from banks is pretty conventional, if you ask me. When you take your balance sheet from $800B to $3.5T and money growth goes nowhere, you might consider doing something else. As far as we know from the FOMC minutes, there has never even been a discussion about doing something else.

Here’s the bottom line for stocks: since QE has had no impact on money growth, ending it won’t affect money growth, it will simply end the buildup of useless excess reserves. Money growth depends mainly on credit growth. As I have said before, the household sector has only now stopped deleveraging. When household credit begins to grow, we should see stronger money growth. That will happen this year, and therefore the outlook is bullish, not bearish.

If you use DCF to value financial assets, you will find that there is no alternative to stocks. They are the only asset left that will pay you any money. Once it sinks in that there is nowhere else to go, equity valuations will return to their historic levels, which means much higher PEs. You will not see these bargain prices again in your lifetime.

Wednesday, June 19, 2013

Bernanke Gives Up

Today was FOMC Day. The message was that the committee plans to start to taper QE this fall, and end it next summer, assuming its forecasts for unemployment and inflation don’t change. The Fed plans to continue its Zero Interest Policy for a good while after the end of QE. This shocking news sent the market down by 200 points, and caused bond prices to fall as well. I don’t understand what new information was provided today, but I guess some people were expecting QE to go on forever.

There was one bit of disappointing news, at least to me, and that is that the Fed doesn’t see inflation at 50% below target as a problem; they say it’s temporary. I guess they’re serving Japanese Kool-Aid at the Eccles Building these days. Since the purpose of QE is to lower the real funds rate by raising inflation expectations, you’d think that 1% wouldn’t be too helpful.

Bernanke said that “These large and growing holdings will continue to put downward pressure on longer-term interest rates.” How does he know? Bond rates are now rising, for some reason. Maybe the Chinese are selling?

This is what I see in terms of interpreting the Fed’s policy stance:
1. Moderate (5-7%) money growth.
2. The lowest inflation since the Crash (.7%).
3. Very low inflation expectations.
4. Very low LT interest rates.
5. Very low and falling (3.4%) nominal growth.
6. Low real growth (1.8%).
7. High (and rising) unemployment (7.6%).

That is not the picture of “extraordinary accommodation” or “massive monetary stimulus”. Bernanke says that he has his foot on the accelerator but he must be driving a lawnmower. The Fed is doing nothing for the economy as all of the telemetry shows.

Perhaps Bernanke has given up trying to convert the committee to Bernankeism? Maybe he’s just exhausted and coasting to retirement? Maybe he wants to give Janet Yellen a chance to be a hero next year? I don’t know, but it’s quite disappointing. The world’s biggest economy is a terrible thing to waste.

Tuesday, June 18, 2013

Stop Worrying About China

The media is once again banging on the “China Bubble” story. This happens about once a year. Today’s China scare has to do with debt build-up in the private sector, the shadow-banking sector, and local governments. Look out below!

Remember the Tienanmen crisis in 1989? That was supposed to blow a hole in China’s finances; it didn’t. Remember the East Asian financial crisis of 1997-98, when the common wisdom was that “China’s next”? That was because Chinese banks and provincial authorities (known as “ITICs”) were thought to be full of nonperforming loans, which indeed they were. Somehow this was supposed to lead to a financial crisis, but it didn’t. China sailed out of the East Asian crisis completely unscathed.

We are once again being told about how awful China’s financial system is, how overleveraged, how poorly regulated, how unreliable the accounting, etc. It all has to come tumbling down sooner or later.

Here’s why you can cross China off of your “The Next Black Swan” list: China operates in two currencies, one of which she prints, and the other of which she holds $3.5 trillion in reserves. The Chinese government is indebted in neither RMB nor dollars. China cannot have an external financial crisis because she has no external creditors. China cannot have a domestic financial crisis unless the Centre decides that it should have one. China has unlimited resources in domestic currency, and the Centre decides who is Too Big To Fail. (The Centre is the Politburo of the CCP and/or the State Council, the government. The CCP controls the government.)

In looking at Chinese credits, one should always assume that their intrinsic financial condition is unknowable, because Chinese accounting is a joke. But that is not the source of credit risk. The source of credit risk is that, for whatever reason, the Centre decides that a particular entity should disappear. Only then can you have a default. It’s your guess who is inside the magic circle and who isn’t. Entities controlled by the Centre are all within the circle. Other entities may or may not be. The decision who’s in and who’s out is political, not financial.

One should also remember that there is constant tension between the Centre and the provinces. Sometimes the provincial governors act like independent warlords until the Centre decides to intervene, as was the case recently in Chongqing. Entities that are controlled by the provinces may or may not be TBTF. You can never know. Everyone thought that the Guangdong ITIC was TBTF until it defaulted; it turned out that Guangdong was out of favor in Beijing that month.

Moody’s has the term “Government Related Entity” to describe state organs. Generally speaking, such credits are best analyzed as political institutions, as opposed to stand-alone entities requiring fundamental analysis. There are many insolvent GREs in the world, but very few debt defaults. Credit analysis of Chinese credits principally involves understanding the entity’s relationship to the Centre, a ministry or a province, not fundamental analysis.

Caution: When I say that the Chinese edifice is solid and crisis-proof, I am not referring to the stock market. That’s a different kettle of fish. I have no idea how anyone can claim to be able to analyze Chinese stocks; that’s a form of astrology as far as I’m concerned.

The problem of excessive debt buildup is a problem for China, not us. China will sort it out if, as, and when it decides to do so. There are no financial accidents in China, unless they are planned.  If I showed you China’s numbers without telling you whose they were, you would say “Sure looks AAA to me”. The reason it isn’t is political risk, nothing else. Stop worrying about China.

Monday, June 17, 2013

Charles Plosser’s Monetary Offenses

Charles Plosser is a distinguished economist who heads the Philly Fed. He has all the credentials one could desire. Whatever a man like Plosser says should be heard and considered, and should not be dismissed out of hand. Plosser is a hard money man, a hawk. Readers may recall my view that all the world’s problems have been caused by hard money, so you will appreciate that Mr. Plosser and I stand on opposite sides of the monetary policy divide. But it would be stupid to dismiss his views as misguided per se, because he is not some autodidact from the Ozarks. He is a serious economist.

Now, here is what Plosser recently said in an interview on Bloomberg TV:
“When governments don't work, people are out of work, economies aren't growing, easy money turns out to be the easy thing to do. It's the one thing that governments can do because they can't simply do what they're expected to do. And it's dangerous. In a funny sort of way, and you're not going to like this, central banks around the world have become something of enablers of dysfunctional democratic systems. And the day of reckoning will come and all of you have got to think about it. And that's the great unwinding. It will happen here, it will happen around the world…It's easier to print money than it is to raise taxes or cut spending. And when that happens, we know that that usually ends in a not very pretty place. And I think that it's very dangerous for us to think that monetary policy is a solution."

That is the voice of hard money fundamentalism. The voice of Andrew Mellon, Paul Volcker, Jens Weidmann and Mario Draghi. There is not the slightest genuflection to monetarism: “it's very dangerous for us to think that monetary policy is a solution."

But what exactly is Plosser saying? I would translate his remarks as follows:
“The goal of economic policy should be to maximize the ability of markets to function. Rigidities and frictions must be demolished. Governments should balance their budgets and then get out of the way. The best way to allow markets to work is to stop manipulating them, and provide price stability and nothing more. The magic of the marketplace will take over from there and create prosperity without inflation or deflation.”
How could anyone who is not a socialist not agree with that? Isn’t it almost axiomatic if one is a follower of Adam Smith or Milton Friedman? Yes, it’s almost axiomatic but it’s not axiomatic. There is still room in the capitalist house for monetarism.

The antimonetarist argues that money is just a yardstick, and thus doesn’t matter. Markets can function under any monetary environment. The same incentives create the same responses. Money is an illusion, irrelevant. The classic monetarist riposte to this argument is: “If money doesn’t matter, then all the world’s commerce could be conducted using a single penny”, which makes the point rather well. 

As I have argued before, we live in a nominal world. Dad doesn’t come home from work and say “Hey honey, I got a nominal raise today but in real terms my salary is falling.” Nobody says “We bought our house for $200,000 in 1970, and just sold it for $190,000 in 1970 dollars.” Money matters because that’s how people who don’t live in Latin America think. (Latin Americans have a much more informed understanding of what money is and isn’t, but even down there money still matters.)

Secondly, debts are denominated in nominal money. If you owe $100,000 on your house, and they shrink the money supply to a penny, you are in big trouble.Whereas if they quadruple the money supply, you will have done quite well. Money matters because that’s what debts are denominated in.

If you still think money doesn’t matter, consider this: what do you think the odds are that the eurozone can experience 4% real growth with 0% nominal growth? It’s just hard to imagine rapid growth in the face of deflation. If deflation doesn’t matter, how do you explain the collapse of the price level between 1929 and 1932--coincidence?

Monetarists say that not only does money matter, it’s all that matters. Plosser disagrees. He’s a Mellonist who would fit right in at the ECB. But he is 100% wrong. It was Mellonists like Plosser who Irving Fisher was talking about in 1933:
"If even then our rulers should still have insisted on 'leaving recovery to nature' and should still have refused to inflate in any way, and should vainly have tried to balance the budget and discharge more government employees, to raise taxes, to float, or try to float, more loans, they would soon have ceased to be our rulers."

Sunday, June 16, 2013

The Fiscal Crisis Is Not Over

President Obama and his party are what I call Kindergarten Keynesians because, whatever the problem and whatever the stage of the business cycle, their recommendation is always higher federal spending. And for a while, their wishes were coming true. Federal spending rose from 19.5% of GDP before the Crash to 25% in 2011, the highest level since WW2. For this reason, Obama has been seen as a big spender, and rightly so*. If it were not for the Republican House, stimulus spending would have continued after the midterms and there would have been no sequester.

However, since 2011, federal spending has not only stopped growing but, for the first time since demobilization, has begun to decline in nominal terms. This is because of low inflation, the winding down of two wars, the exhaustion of the stimulus, and the sequester. In fact, as the sequester begins to bite, discretionary spending may yet fall further in dollar terms. The CBO projects spending to GDP to decline for a few more years until the boomers start getting sick.

Does this mean that the fiscal crisis is over, and that we can end this so-called “austerity”? No, it doesn’t. There are two reasons for this: (1) federal spending remains historically high and needs to return to its normal level of 18-20% of GDP versus its current level of 22.5%; and (2) federal indebtedness is dangerously high and needs to decline in order to leave sufficient debt capacity to finance the retirement, sickness and death of the baby boomers.

Here is what the CBO has to say about the longer-term budget outlook:

For the 2014–2023 period, deficits in CBO’s baseline projections total $6.3 trillion. With such deficits, federal debt held by the public is projected to remain above 70 percent of GDP—far higher than the 39 percent average seen over the past four decades. (As recently as the end of 2007, federal debt equaled 36 percent of GDP.) Under current law, the debt is projected to decline from about 76 percent of GDP in 2014 to slightly below 71 percent in 2018 but then to start rising again; by 2023, if current laws remain in place, debt will equal 74 percent of GDP and continue to be on an upward path. Such high and rising debt later in the coming decade would have serious negative consequences: When interest rates return to higher (more typical) levels, federal spending on interest payments would increase substantially. Moreover, because federal borrowing reduces national saving, over time the capital stock would be smaller and total wages would be lower than they would be if the debt was reduced. In addition, lawmakers would have less flexibility than they would have if debt levels were lower to use tax and spending policy to respond to unexpected challenges. Finally, a large debt increases the risk of a fiscal crisis, during which investors would lose so much confidence in the government’s ability to manage its budget that the government would be unable to borrow at affordable rates. (Budget Outlook, May 2013)

Take that, Prof. Krugman. Far be it from me to argue with the CBO about fiscal policy! It is an undisputable fact that the US has been on a debt-binge, taking debt held by the public from $5T to $12T in just five years. To bring down the debt ratio will require nominal growth to exceed the deficit as a percent of GDP.  At present, the deficit is twice the size of nominal growth (7% vs 3.4%). The debt ratio is continuing to rise; hence, the fiscal situation remains dire.

Now, in principle, there is no reason why those of us who are alive today should not live well by burning the furniture, eating the seed corn, and using up the credit capacity of the next generation. The words “intergenerational equity” are abstract at best. Do we really owe our children the same debt capacity that our parents left us? Says who? Previous generations have left their children with much less. Our children should count themselves lucky that they live in America and not Zimbabwe. Let the party continue!

However, a word of caution. Debt capacity is a highly elastic thing. Whereas one country can borrow the next hundred years of GDP, another can’t even borrow next month’s. Every country has its own FICO score. The eurozone is a museum of countries who have recently learned just how small their debt capacity is, and how truly screwed their children will be.

We Americans are very lucky that the world still uses our debt as a reserve asset. Reserve status allows us a lot of freedom; indeed, much the same freedom enjoyed by Britain until sterling lost its reserve status.

Reserve currency status is not only a subsidy to our living standard, it is also a subsidy to our national security. Once we lose it, we can never get it back, and America will be just another country.
* CBO estimates that Obamacare will cost $160-170B per annum, roughly twice the savings from the sequester.

Thursday, June 13, 2013

The Impending Failure Of Ben Bernanke

There is a recurring theme among the Fed’s critics (and its dissidents) which runs like this: “The economy has been living on extraordinary monetary stimulus due to QE and has become addicted to this dangerous drug. It is time to wean the economy off of this dangerous drug in order to return to a more normal state.”

Those who express this view believe that the Fed has been providing the economy with extraordinary monetary stimulus since 2008. I can only ask that they look at the actual data, which show that money growth since the Crash has averaged in the mid-single digits, which is less than money growth in previous recoveries. The economy has received no “artificial stimulus”. The Fed’s futile machinations with QE1, QE2 and QE3 have failed to produce rapid monetary growth. Since 2008, the economy has not been on stimulants, it has been starved for oxygen.

I think this point bears emphasis: the modest recovery in economic growth and employment experienced since the Crash has not been accompanied by rapid money growth. I have to keep repeating  this because it just doesn't seem to sink in. The economy hasn't been on cocaine; it's been on aspirin. There is no dangerous drug for the economy to get off of.

This is not because the Fed has not sought to get control of the money supply, but because it has failed to do so. The Fed has not had control of money growth since the Crash. The Fed has pursued radical balance-sheet expansion  since the Crash; it has tripled its balance sheet buying bonds from banks. But this maneuver has  failed to affect the money supply because all of that money is still on deposit at the Fed (see Samuelson*), where it serves no purpose. The Fed may as well have been buying art for its offices for all the good that $2T in bond purchases has done. 

The monetary transmission vector is broken because the linkage between the Fed's balance sheet and the money supply (the money multiplier) has been severed (or never existed). To analogize: the Fed's foot is on the accelerator; the tachometer reads 5000 RPM; but the car is in neutral and the speedometer reads zero. It’s not the motor that’s broken; it’s the transmission. Excess reserves at the Fed are not translating into bank deposits held by the public.

I don't know why the FOMC thinks that, if it keeps pushing hard on the accelerator, the car will start to move, when it hasn't moved in four years; saplings are now growing in the front seat. There is nothing in the minutes or speeches that I have seen that even acknowledges this problem, let alone suggesting an alternative option. I did come across a staff paper* on the subject of the money multiplier which, using empirical analysis, concludes that the money multiplier does not exist. This should be pretty obvious from the experience of the past four years, when the M1 multiplier has declined from 180% to 60%. (You read that right: the Fed’s balance sheet is now bigger than M1; the Fed does not control M1 or M2.)

Let's go back to basics (and to morality). It is the lawful responsibility of the Fed to maintain full employment. It has failed to fulfill this mandate for the past four years. Unemployment has remained high while nominal growth has remained low. Parents are out of work, and young people can't find jobs. The Fed has failed to perform its duty to these people.

Bernanke is aware that in the past half-century, the US economy has never delivered full employment with nominal growth of less than 5%. Indeed, during the good years (Johnson, Reagan, Clinton, Bush), nominal growth has tended to be in the 6-8% range, or even higher after recessions. Nominal growth at the pace experienced since the Crash (3-4%) has been stuck at what used to be considered a recessionary level. Thus, the Fed has not been guilty of nonfeasance, because it has tried, but of misfeasance, because it has failed, and there is no moral excuse for failure.

Let's all agree that 4% real growth is what is needed to achieve full employment, and that 4% real growth never has and never will be achieved with less than 6% nominal growth. Therefore, to fulfill its mandate the Fed must grow the money supply (not the monetary base) fast enough to generate 6% nominal growth. More of the same policy (QE) is not going to get there, because QE does not affect money growth, not lately anyway. It is not that the quantity theory is wrong, or that "monetary policy has lost its efficacy". It is rather that the Fed has not found the right lever to influence money growth.

We must acknowledge that this is the first time in history that the Fed has had to conduct monetary policy at the zero bound, and the only textbook on how to do this was written by Bernanke himself. It's not like Bush and Obama picked the wrong guy for the job (and I shudder to imagine how things might have turned out with a different person in the chairman’s seat).

But, as I have said before, what Chairman Bernanke has been doing is different from what Professor Bernanke said we should do. When he went to Tokyo a decade ago to lecture the BoJ on how to operate at the zero bound, he did not tell them to grow their balance sheet. He did not even tell them to target inflation. He told them to target a price level, which would require higher than normal inflation. In other words, when you fall behind schedule, speed up in order to stay on schedule. Instead, the Fed has been targeting inputs ($85B/mo.) instead of outcomes.

The Fed is supposedly targeting employment, but you wouldn't know it from the unemployment rate. The Fed is supposedly targeting 2% inflation, but you wouldn’t know it from the CPI. The Fed is becoming a blue-eyed BoJ with endless reflationary campaigns that never work. If the Fed were really targeting employment, it would do something new until it got there. And tapering off QE is not trying something new; it’s giving up.

I am not going to revisit the sob story about how poor Ben has been stymied by those awful hawks on the FOMC. He's been chairman for six years; it's his Fed; it's his policy; and it's his economy. He has failed as Fed chairman if he leaves office with his mandates unfulfilled and twelve million people out of work. I have lost any sympathy for his managerial challenges, or for his desire for a collegial consensus; they are no longer an adequate excuses. The measure of success is hitting your targets, not a collegial FOMC.

In a previous post, I offered a non-exhaustive list of things that the Fed could employ to grow the money supply. I will repeat them:
1. Stop buying bonds from banks, and monetize the entire deficit by buying bonds directly from the Treasury. Ditto with agency paper.
2. Buy nonbank assets, such as precious metals and ETFs.
3. Stop paying interest on reserves and, if necessary, charge a custodial fee for holding reserves.
4. Buy foreign government bonds of all denominations and ignore the resulting squawks from the G-7.
5. Buy anything you can find denominated in RMB. Turnabout is fair play.
6. Buy private-label RMBS and ABS.

Do something.
*“By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves.”Paul Samuelson, “Economics”, 1948.
**Carpenter and Demiralp, “Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?”, FRB, May 2010.

Tuesday, June 11, 2013

Create Inflation Now!

"This country needs, and unless I mistake its temper, the country demands bold persistent experimentation.It is common sense to take a method and try it. If it fails, admit it frankly and try another. But above all, try something."
--FDR, 1932

I have been blogging about the failure of QE to achieve its objectives: 2% inflation and 6.5% unemployment (currently .8% and 7.6%.) Additionally, both real (1.8%) and nominal (3.4%) growth are subpar for three years into a “recovery” . The economy is growing, but is stuck in second gear, which is insufficient to clear the labor market.  By now we should be seeing precrash growth of 6-7% nominal and 3-4% real, and unemployment should be close to 5%. We are far from these numbers, and this failure is having real-world consequences.

I have discussed the failure of the Fed to increase inflation expectations, the failure of bond-buying to grow the money supply due to liquidity hoarding by banks, and the attenuation of the linkage between the money supply and nominal growth due to the broken credit system.

It is clear that the Fed cannot simply continue to do what it is doing, or even worse, to stop trying. As FDR said, it is a time for bold experimentation. The status quo is riskier than unconventional policy experiments.

The crux of the problem is low inflation and low inflation expectations. Statements by the FOMC no longer have any credibility with respect to the formation of inflation expectations. The time has come for the Fed to stop fooling around and raise the rate of inflation to 4%, now. The best way to raise inflation expectations is to raise inflation.

Bernanke has advocated inflation-targeting, which is to target the price level which would have been reached if previous policy had been successful. In other words, when you fall behind your target, you speed up and create above-target inflation. I’m not going to whine about the hawks who would squawk if inflation went above 2%; that’s politics and I’m talking policy.

The only way that we can get to 4% real growth is via 6-7% nominal growth, which will initially require around 4% inflation. Since we know that inflation is always and everywhere a monetary phenomenon, we cannot accept the FOMC’s excuses about why we are running far below the Fed’s target. Any schmo off the street can create inflation. I am holding in my hand a half-inch stack of one hundred trillion dollar notes, issued by the Reserve Bank of Zimbabwe in 2008. That’s one hundred times one hundred trillion or ten quadrillion dollars, in the palm of my hand. If Mugabe can create hyperinflation, we can create 4% inflation.

Mugabe created hyperinflation by monetizing massive fiscal deficits.  But it does not require massive fiscal deficits to create inflation. All a central bank has to do is to buy stuff with newly-printed money until the price level begins to rise at the desired pace or to the desired level. Let’s remember that the FOMC succeeded in creating double-digit inflation in the 1970s--without even trying!

So here is my laundry list of ideas for the fed to experiment with:
1. Stop buying bonds from banks, and monetize the entire deficit by buying bonds directly from the Treasury. Ditto with agency paper.
2. Buy nonbank assets, such as precious metals and ETFs.
3. Stop paying interest on reserves and, if necessary, charge a custodial fee for holding reserves.
4. Buy foreign government bonds of all denominations and ignore the resulting noise.
5. Buy anything you can denominated in RMB. Turnabout is fair play.
6. Buy private-label RMBS and ABS.
But above all, try something.

Monday, June 10, 2013

The Money Problem

Last month, I wrote “Why Monetary Stimulus Is Broken”, in which I argued that (1) the money supply is not responsive to growth in the Fed’s balance sheet because banks are hoarding cash instead of lending; and (2) that NGDP is not responding to the (modest) growth in the money supply because of a high liquidity preference at households and businesses. (I did not and will not today go into the whole expectations problem, which is also very important.)

Of the two transmission vectors, the one that seems most broken is that between the monetary base (the Fed’s balance sheet) and the money supply (M2). The monetary base has grown exponentially since Lehman, from roughly $1T to $3T, while M2 has only grown from roughly $8T to $10T. The Fed would appear to be pushing on a string, and monetary velocity continues to decline.

Banks are leaving the Fed’s money on deposit at the Fed instead of lending it. (A bank deposit at the Fed is not money, it’s a bank asset; money is a bank liability which is created when a bank makes you a $1 million loan and deposits $1 million into your checking account, which is your claim on the bank. Now you have $1 million, and the money supply has risen by $1 million.)

There are clear linkages between bank loan growth and money growth, and between overall credit growth and nominal growth. Let’s take a look at these two variables: bank loan growth, and overall credit growth.

Bank Credit Growth (FRB H.8)

Bank credit (now $10T) was growing around 10% before the Crash, contracted  during the crash, rebounded to 6% after the Crash, but then slowed down to the current anemic 3.5%. This is not suggestive of robust monetary or economic growth. Total bank loans and leases, a slightly smaller slice ($7.3T), shows a similar pattern: 12% growth pre-Crash, a sharp contraction, recovery to 5% then declining to 3% at present. Bank credit growth is not robust.

Total Credit Growth (FRB Z.1)

Next we’ll look at the Fed’s Flow of Funds database to observe total credit growth. Looking at the broadest possible credit aggregate (TCMDO) which is now $57T, we see precrash growth of 10%, a mild contraction, and a current, rather weak, 3% growth rate. Now let’s look at the four components: households, business, government, and finance.

This is not a pretty picture, and would seem to be at the root of the problem. HH credit ($13T) was growing at a feverish 12% precrash, then it began to contract and has continued to do so ever since. It is still contracting, which goes a long way to explain what’s wrong with the recovery.

The Business picture is much brighter than the HH sector. Business credit ($9T) was growing at an overheated 13% precrash, contracted during the crash, but has since recovered to a very healthy 9% growth rate. Business credit does not appear to be broken.

Credit to governments has been the mirror image of the private sector. As private sector credit contracted during the crash, government credit took up the slack. Regional government credit ($3T) grew rapidly during the crash, but has since stopped. Federal credit ($12T) grew very rapidly during the dark days after Lehman (35%) and is still growing at a 10% rate.

Most people exclude the financial sector from an analysis of domestic credit growth because it is not an important component of the economy, it is a derivative of the real economy at best, and it is rife with double-counting. Nonetheless, I think that it worth a look, because it has its own (unhappy) story to tell. The pattern of financial sector credit growth bears a striking  resemblance to the HH sector. Once again, there was a feverish precrash growth rate of 13% followed by a very sharp contraction which has not yet ended. Banks and the Street are still licking their wounds.

The net of all this is that bank loan growth (which is a monetary policy transmission vector) is very weak, and is in fact slowing.  Overall credit growth, which plays an important role in determining nominal growth, is also very weak. While business credit has fully recovered from the Lehman shock, household credit continues to shrink and thus retard the recovery.

The Fed’s policy of relying on the banking system to stimulate growth isn’t working. This is reminiscent of Japan which has had the same problem for two decades. Buying bonds from banks creates bank reserves, not money. And it would appear that however great the banks’ reserves get, they are not creating inflation.

It may be that when rates are at the zero bound and the banking system is broken, the appropriate policy instrument may not be to buy bonds from banks, since buying them doesn’t seem to affect the price level. Bernanke was certainly correct that the Fed could create inflation by dropping money on citizens from helicopters, but that would be a rather blunt instrument. It seems to me that the Fed needs to buy something besides Treasury and agency bonds, and from someone besides banks. The obvious alternative to Treasuries would be foreign government bonds, or gold. Since the former would constitute a “currency war”, that would seem to leave gold. Gold is not a bank asset, it's a "civilian" asset. Buying gold from nonbanks creates money and inflation.

I have no doubt that if the Fed were to announce that it will buy gold until it has achieved 2% inflation and 6.5% unemployment, it would get there. It would disrupt the gold market (and enrich some of the wrong people) but that is a small price to pay. No foreign government could object to the Fed buying gold; it’s been doing it for 100 years.

That was an idle thought-experiment, in the sense that buying gold has not even been discussed at the FOMC or anywhere else. But I am quite confident that it would work better than the current policy of buying Treasury bonds from banks. And it is not unprecedented.