Why Monetary Stimulus Is Broken

I am trying to understand the broken transmission vectors for monetary policy. It is clear that the gearboxes between the monetary base and the money supply and between the money supply and NGDP are stuck in low gear, and that the more that the Fed pushes, the lower the gearing goes. We are stuck in first gear, whereas we should by now be in at least third gear. Something is wrong.

Two gearboxes are broken: the one between the monetary base and the money supply, and the one between the money supply and nominal growth.

Let’s start with the first gearbox: the one between MB and M2 (M2/MB). The Fed has bought truckloads of bonds from the banks, creating massive free reserves ($2T) that should be used to fund loans. Instead, the banks are keeping these excess reserves on deposit at the Fed. Why? Well, for one thing, reserves pay .25% but attract a zero capital coefficient. That is a .25% return on nothing, which is attractive in a world where 1% is high yield. (Memo to Ben: the yield on excess reserves should be zero.) Another reason is that Dodd-Frank and Basel are imposing higher capital ratios on the banks, which makes it very expensive to grow loan books. (I am in total agreement with Dodd-Frank on this, but it’s timing is inopportune; it should have happened before the Crash.) So right now, banks are happy to have huge deposits at the Fed, which means that they are liquid and feel good about themselves. But this also means that the Fed is pushing on a string when it creates free reserves: the credit transmission vehicle is broken. And the credit aggregates bear this out. While private sector credit growth is no longer in reverse, it remains stuck in first gear: “No Cash for No Body”, as the Texans used to say. The good news here is that the trend-lines have now inflected and we should see household and corporate credit starting to grow (fingers crossed).

Next we come to velocity, the V in the quantity theorem (NGDP/M2). We appear to be stuck in what Keynes called the liquidity trap, when monetary stimulus loses its power because of diminishing returns (V goes down as M goes up). Why has V been declining since the Crash? V is the liquidity preference, the desire to hold liquid cash. There are two cohorts to consider: households and corporations.

For households, the Crash cut stock prices in half which put a psychological premium on capital preservation: cash may yield nothing but it cannot go down in value (and inflation is low). So households still have a cyclically high liquidity preference. I have seen this in my own infantile investing behavior: I placed capital preservation above capital appreciation for much too long after the Crash, even though I was smart enough to be able to calculate the ERP. Emotion overwhelmed reason; I couldn’t “afford” to have my wealth cut in half again.  I’m sure some rational actors went from cash to stocks in March of 2009, but not me. I was just another risk-averse rabbit.

Next are the corporations. Here is where I think I have some valuable insight, having been inside the minds of CFOs for thirty years. This is the key factoid that explains corporations’ high liquidity preference: there were two major credit breakdowns in the past decade. First, there was the credit meltdown of 2001-2, when the credit markets panicked after the carnage in the merchant energy and telecom industries. The debt markets closed for most of 2002 (and many companies got downgraded), which pushed many corporate treasurers to the edge. When you can’t roll your paper, you have to call the commercial loan officer whom you have been ignoring for years, and beg him for a loan. I have been that neglected loan officer (in 1985); I wasn’t exactly Father Christmas when the CFO called me; for once I had him over a barrel. That was a chastening experience for Mr. CFO.  And then, only six years later, Lehman defaulted and the same scenario was repeated: the CP market closed, banks couldn’t lend, and the debt markets had a massive heart attack. What was a CFO to do? It took heroic extra-legal measures by the Fed and the Treasury to prevent liquidity-driven defaults by major US corporations; the name GE comes to mind. No CFO has forgotten Christmas of 2008, when they were begging for money.

CFOs today still suffer from PTSD arising from the Enron and Lehman crises. They can’t count on the credit markets or the banks to be there when they need cash in the next crunch. Hence, they are keeping bucketloads of cash on their balance sheets as a precaution against the next credit shock. This explains their high liquidity preference.

I’m not blaming anyone for the broken credit markets, but I would observe that a disintermediated financial system means that the commercial bankers at Chase and Citi are not sitting around hoping for the next opportunity to rescue GE. How often do Jeff Immelt or Keith Sherin play golf with their commercial loan officers? Answer: never. Instead, Immelt plays golf with the president. But can Obama offer GE a loan during the next credit crunch? CEOs never learn that their commercial bankers are more important than presidents, even if they don’t own a 747.

The foregoing explains why the amount of QE required to create X% of NGDP growth has become so high. The banks don’t want to create credit, and the private sector is still shell-shocked from the Crash.

However, both of these neuroses are abating as confidence slowly returns.

It is certainly very constructive that, at this juncture, the FOMC is debating when and how to end QE3. Nothing is more likely to restore confidence at this delicate moment than the prospect of the withdrawal of liquidity and a shrinking of the Fed’s balance sheet. This is precisely the mistake that the Fed made in 1937, which cratered the recovery and prolonged the Great Depression by another three years. Millions lost their jobs. Bernanke wrote about it. Let’s try that experiment again--maybe it will turn out differently this time!

To recap: the power of conventional monetary stimulus has been severely attenuated by the psychological trauma of the 2002 and 2008 financial crises. There is no reason to assume that this trauma will dissipate, since the credit machine remains permanently broken and can’t be fixed without massive reintermediation, which will never happen. Thus, ever greater stimulus will be required to push up NGDP. And the Fed is now debating how to retract QE3.

Of course, this doesn’t bother me because I am wealthy and retired; it only affects hopeless young people and terrified unemployed dads. Who cares about them?

The Cato Institute Excommunicates Milton Friedman

It is possible to be both an orthodox libertarian and an orthodox monetarist. I know this because the pope of both religions was the same person for almost half a century: Milton Friedman. And indeed Friedman remains a major saint in both churches. Friedman believed that there is no conflict between believing in limited government and in the prudent administration of a fiat money currency system.

While many libertarians reject fiat money and central banking, this is not a tenet of the religion, and membership the Anti-Central Bank Society is not mandatory.

I can understand, in a philosophical sense, why many libertarians reject central banking and embrace unregulated monetary arrangements involving “free banking” and competitive currencies. They view the central bank as an appendix of the state and, as such, an enemy of property and wealth. They believe that the state uses the central bank as a mechanism to engage in crypto-taxation, debt monetization and wealth destruction. Since libertarians want to minimize the state and to allow markets to operate, they prefer free banking and competitive currencies, including gold. Free banking and competitive currencies do not require a central bank, as the US demonstrated during the 19th century.

Philosophically, I can agree with the desire for a market-based, self-regulating monetary policy. As a student of economics, however, I see such an arrangement as impractical in the extreme. Friedman explained over fifty years ago that the gold standard caused repeated deflations, panics and depressions. He spent decades of his life arguing that economic depression is always and everywhere a monetary phenomenon. 

While Friedman did not live to comment on Market Monetarism, he is its godfather nonetheless.

He would be appalled at the idea that the libertarian movement would actively oppose the concept of an independent central bank pursuing policies intended to maintain moderate growth and inflation. Friedman understood that inept monetary policy could lead to Keynesian experimentation and the expansion of the welfare state.

It troubles me to see the "sound money" movement gaining influence within the libertarian movement and its  institutions. An example of this malign influence can be found today at the Cato Institute whose new president, John Allison, is described by Wikipedia as a “staunch opponent of the Federal Reserve”.

My discomfort was increased when I came across Mr. Allison’s latest dissertation in the May/June issue of the Cato Policy Report, titled “The Federal Reserve’s Unsound Policies”. I read his piece with mounting annoyance. Mr. Allison is a fine man and a sound commercial banker with an excellent track-record. But, like many commercial bankers, he does not understand monetary policy (and that includes many regional Fed board members). Mr. Allison proceeds from a set of a priori principles to make statements about Federal Reserve policy that betray an infirm grasp of basic monetary theory.

More in sorrow than in anger, I offer below Mr.Allison’s paper accompanied by my critical commentary (in italics):

The Federal Reserve’s Unsound Policies

The Federal Reserve is increasing the long-term risk in our financial system through both its monetary and regulatory policies. It is simultaneously redistributing wealth from moderate-income savers to high-income households and laying the foundation for another housing bubble.

From 1914 until 2007 the Fed’s balance sheet grew to $900 billion. Since 2007 the balance sheet has exploded to $3.2 trillion and is growing $80 billion per month. The Fed’s capital ratio is currently 1.3 percent, while the average capital ratio of the largest banks is 8.0 percent. The Fed fails its own stress test and should be forced to shrink by its own standards. The risk in the financial system is not large banks, but the Fed itself.

CM: The Fed poses no credit risk to the financial system because it can print whatever it owes. As a monetary authority whose liabilities are money, the Fed requires no capital, although its ability to print money out of thin air is an asset of unlimited value. If the Fed were a commercial bank, its Tier One Ratio would be very high because its assets are low-risk (treasuries and agencies). It is also extremely profitable.

The Fed’s balance sheet has been radically expanded to hold down interest rates by buying Treasury and Freddie/Fannie bonds.

CM: The Fed’s balance sheet has been expanded in order to prevent a contraction in the money supply, and in an effort to maintain nominal growth. Without the Fed’s efforts, M2 and nominal GDP would have sharply declined after the Crash, as they did after 1929. The Fed’s post-Crash policies have prevented another depression. For an alternative scenario, see the eurozone.

This has significantly expanded the lending capacity of banks. Increasing the level of bank reserves has the same effect as “printing money.” If the economy starts to grow, either inflation will increase as money velocity accelerates or the Fed will have to withdraw the excess reserves, which will result in rapidly rising interest rates and major losses for bondholders.

CM: The object of Fed policy is to induce economic growth, which has succeeded despite falling velocity. When velocity rises, as it will, the Fed will be able to withdraw reserves without high interest rates. If the Fed acts prematurely, we will have another recession.

If the Fed does not shrink its balance sheet, the economy could be stuck in very slow growth as the government consumes an increasing share of the economy, as has happened in Japan.

CM: The Fed’s goal is full employment and it policies are geared to create sufficient growth to meet that objective. The Fed’s balance sheet and the federal government’s share of the economy are unrelated phenomena. In fact, the government’s share of the economy has been shrinking as the Fed’s balance sheet has been growing. Federal outlays as a % of GDP have declined from 25% in 2009 to 22.5% in 2012, and this trend is likely to continue for some time.

Since the U.S. dollar is the world’s reserve currency, these actions have created a global currency trade war. This currency trade war causes misallocation of capital and lowers the global standard of living just like a trade war based on raising tariffs. Instead of production being driven by real competitive advantages and efficiencies, fluctuating currency values are causing a sub-optimization of resources. Every country wants the “cheapest” currency to make its export industries more competitive.

CM: Many of the world’s central banks are seeking to prevent deflation via QE, which is intended to grow the money supply and the economy, and thus to raise nominal incomes. If successful, such policies raise living standards, while deflationary policies lower standards (see: Spain). Growth-oriented monetary policies can result in exchange fluctuations versus other currencies. Generally speaking, the currencies of central banks pursuing deflationary policies will appreciate against the currencies of central banks pursuing growth-oriented policies. In a world of freely-floating exchange rates, growth policies resulting in currency depreciation do not constitute a “competitive devaluation”, and such policies are not a “trade war”. The best measures of the efficacy of a country’s monetary policies are its rates of economic growth and unemployment. By these measures, the Fed’s expansionary policies are substantially outperforming the ECB’s deflationary policies. Today, the eurozone is experiencing zero growth and 12% unemployment. If there is a central bank which seems bent on distorting markets and lowering living standards, it is the ECB and not the Fed.

The only reason the U.S. dollar has held its relative value is its status as the reserve currency. This allows the Fed and Congress to get away with printing money and incurring massive debt that the market would not otherwise permit.

CM: The reason that the US has substantial debt capacity, and the reason that its currency serves as an international reserve asset, is due to the country’s long track record with respect to both creditworthiness and price stability. By contrast, while the euro was intended to compete with the dollar as a reserve currency, it has failed due to concerns about its liquidity and viability.

Unfortunately, having the world’s reserve currency creates a huge temptation to overleverage and create an unsustainable level of debt. Someday the rest of the world may wake up and realize the United States is in poor financial condition — the emperor has no clothes.

CM: It is true that a country’s debt capacity may exceed what would be an economically optimal level of national debt, as is clearly the case in Italy and Japan. Going forward, the US authorities must act to control the country’s debt ratio. This will require: (1) deficit limitation; and (2) economic growth. The Fed’s current pro-growth policies help in both respects. Growth increases government revenue and thus reduces the fiscal deficit. Growth increases the denominator of the Debt/GDP ratio, thus helping to control indebtedness. Further, the Fed’s QE activities have reduced the national debt by over $2 trillion (via monetization). QE has not added to the nation’s debt; without it the national debt would be substantially higher. The greatest threat to the creditworthiness of the US would be the adoption of “sound money” policies such as are now being pursued in the eurozone.

Current Fed regulatory policy is also increasing the risk in the banking system. All large banks are being forced to use the same regulatory-driven mathematical risk management models. This means that all the major banks will have a strong incentive to take the same type of risk, which significantly increases the overall risk in the financial system.

CM: The purpose of the Fed’s bank “mathematical risk management models” is to reduce the risks taken by large banks. I am unaware of a better capital adequacy approach offered by Cato or anyone else. Certainly the alternative to regulatory-driven models, which is proprietary risk models, has been proven to be inadequate (see: 2008).

The significant expansion of the monetary base (printing money) is surely creating misinvestments in the economy. The combination of easy money, low long-term interest rates, and very liberal lending standards by the Federal Housing Administration could be igniting another housing bubble, while we are still trying to recover from the last one. These combined government policies are encouraging consumption (housing is consumption) when the U.S. economy has a negative real savings rate, when government deficits (including unfunded liabilities) are considered. The lack of real savings and capital will reduce our longterm ability to grow the economy.

CM: The expansion of the monetary base has only produced modest growth in the money supply. The Fed’s post-Crash policy has been designed to encourage the return of economic activity in the household and business sectors. As a result of the Crash, housing starts declined from 1 million units to 500 thousand units. The recovery to pre-Crash activity levels has taken five years. House prices and housing affordability levels are more healthy than in 2007, with no evidence of another bubble.

By holding interest rates below what the market would create, the Fed is punishing moderate-income savers, especially older individuals. Retired individuals with low to moderate net worth should not be making risky investments. However, the Fed has forced down interest rates so that low-risk investments have negative real returns. This means that many older individuals who hoped to live on their interest income are having to consume their principle [sic], which threatens their standard of living. On the other hand the extra liquidity created by the Fed is driving higher returns in risky investments, typically owned by high-net-worth individuals.

CM: The principal beneficiaries of the Fed’s pro-growth policies are the unemployed and young people entering the job market. The alternative, as we see in Europe is high unemployment and very high youth unemployment.

The primary beneficiary of the Fed’s low interest rate strategy is the U.S. government, the world’s largest debtor. The federal government’s annual deficit is at least $250 billion less than it would be if interest rates were normalized. It appears that the real purpose of the Fed is to obtain favorable financing for the U.S. government, at the expense of private savers.

CM: The primary beneficiaries of the Fed’s low interest strategy are those households which depend upon employment to maintain their standard of living. A secondary beneficiary is the taxpayer of today and tomorrow, who would otherwise have been burdened with a substantially higher national debt had nominal growth been lower than it was. While some private savers who made the decision to keep their savings in short-dated instruments have suffered, those who kept their savings in bonds, annuities or stocks have done well.

The good news is that the United States is experiencing an economic recovery. However, it is the slowest recovery in our history, and we still have three million fewer jobs than in 2007. If markets had been allowed to correct, if the Fed had maintained sound money, and if fiscal and regulatory policies were rational, our growth rate would be significantly faster and the U.S. government’s financial position much sounder. At Cato we are working hard to encourage less regulation, lower taxes, less debt, and sound money.

CM: If markets had been allowed to correct, quite a few of the big banks would have failed in October 2008 and would have defaulted on their liabilities including uninsured depsosits. This would have prompted a sharp decline in the money supply, in nominal GDP and in employment, as was experienced during the Hoover administration when such an experiment was first attempted.

I wish that Cato would stick to advocating less regulation, lower taxes and less debt, and would leave “sound money” to those who understand what that incantation really means.

Mariano Rajoy And The Great Spanish Depression

“We must all ask ourselves whether the ECB should have the same powers as the rest of central banks in the world. We need to give ourselves the instruments that are available in other regions.”

--Spanish PM Mariano Rajoy, Bloomberg, April 8, 2013

Spain is in a full-blown depression, which began five years ago. The economy is shrinking in real and nominal terms. Prices are falling in a Japanese fashion. M2 is the same today as it was in 2009. Even though government spending is falling, the fiscal deficit remains at an unsustainable 10% of GDP because government revenues are falling as fast as spending. Debt to GDP is headed for 100% in 2014. One out of four Spaniards is looking for work (27%). Half of all young people cannot find jobs. The insolvent banking sector is being propped up with cosmetic accounting and ECB liquidity. Credit to the private sector has dried up, which bodes ill for employment. The public sector is shrinking and the regions are bankrupt. Spain today is the US in 1932, with Mariano Rajoy playing the role of Herbert Hoover.

To his great credit, the prime minister has put his finger on the problem: the fact that Spain’s central bank does not have a growth mandate and--even worse--doesn’t want one. You can’t fix the problem until you have identified it, and Rajoy has identified the problem. What’s he going to do about it? Nothing, it would appear.

What always happens in a protracted economic depression? A banking crisis, which intensifies the deflationary spiral (see: Irving Fisher).

Spanish bank accounting and Spanish bank solvency are currently in separate universes*, which can’t last forever. The insolvency will ultimately become too big to cover up**. At that point, the ECB will demand another recapitalization in the EUR 100B range, which will push Spain’s debt ratio into the red zone. This will trigger a “rescue” by the troika who will force defaults on bank liabilities.***

Hence, a major crisis which will make things much worse (see: early 1933).

What should Rajoy do? He should do what Ambrose Evans-Pritchard at the Telegraph suggests (and what I have been suggesting), which is to form a solid Club Med bloc along with Portugal, Italy and France, and revolt against the deflationary policies of the ECB. 

The Club Med bloc needs to go to war. They must unilaterally end austerity and finance their fiscal deficits in the domestic banking system using ECB money. What could the North do about it? Cut them off and precipitate a disorderly exit? As AEP says, “The Commission bends to power, and will not move unless the rest of EMU mobilises superior counter-power.” Faced with a breakup of the eurozone, Germany may relent and allow the ECB to grow the economy. 

If not, the South should exit, default and redenominate, leaving Germany to pick up the pieces.

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*Moody’s:“Asset-quality deterioration is only partially reflected in reported NPLs, as banks have been exchanging loans granted to troubled borrowers for real-estate properties as payment-in-kind or via asset foreclosures. Moody’s estimated adjusted problem loan ratio – more specifically a “non- earning assets” ratio that incorporates the real-estate properties that banks have on their balance sheets – amounts to 13.1%14 as of year-end 2011. If non-earning assets increased roughly in tandem with the volume of problem loans since then, this ratio would be close to 16% as of June 2012.” (Banking System Outlook: Spain, August 2012.)

**The date of the eurozone’s next financial crisis was brought closer today (May 7th) when Jeroen Dijsselbloem, the head of the Eurogroup, said that there will need to be an in-depth asset quality review of eurozone banks as a preliminary to the chimerical “banking union”. An asset-by-asset review is very different and more granular than the discredited top-down stress tests administered in the past. Of course, such reviews can always be fudged, and I have no idea who in Europe would be qualified to conduct such a review. They would need to import some regulatory talent from the US if they want to be remotely credible.

***Moody’s: “The current recapitalisation effort heightens the risk that subordinated and possibly even senior debt holders are forced to incur losses (“bailed-in”) to reduce the cost to taxpayers of recapitalisation.” Ibid.

Bull Story Remains Intact

Last October when the Dow was at 13300 I wrote that the effect of QE3 would become visible by the spring of this year:

“The impact of QE3 will only be felt cumulatively, as the little bits start to add up over the next six months. Six times $40B is $240B, which would represent a 9% growth in the Fed’s balance sheet, which becomes more significant--but that’s next April.”

--- “QE3's Market Impact Will Be Visible by Next Spring”, Oct. 11th, 2012

In December when the FOMC stepped up the pace and the Dow was at 13100 I wrote:

“Assuming that the Fed implements QE3 as announced Wednesday ($85B/mo), I expect to see the Dow around 15,000 next Christmas. This is because the Fed’s balance sheet should grow by $1 trillion next year, a 36% increase over where it is now.”

--“2013: The Year Of Printing Money”, Dec. 15, 2012

In March when the Dow was at 14250 I wrote:

“In December, I predicted a 15000 Dow by yearend. My current view is that we will get to 15000 by mid-summer.”

--“Stocks Will Go Higher As Reflation Gains Credibility”, March 5th, 2013

The Dow hit 15000 on Friday. I called the 2013 bull market correctly, and I did it using a single indicator: expected growth in the monetary base.

Let’s look at the facts: When the Fed began* QE1 after Lehman in late 2008, the Dow was at 8450; when QE1 ended in March of 2010, the Dow was at 11000, a gain of 2500 points, or 30%. When the Fed began QE2, in January 2011, the Dow was at 11700; when QE2 ended in July, the Dow was at 12850, a gain of 1150 points or 10% in six months. When the Fed began QE3 in late December, the Dow was at 13000; four months later the Dow is at 15000, a gain of 2000 points or 15%. Since the Fed began its QE policy, the Dow has risen from 8450 to 15000, a gain of 77%. Lesson: Don’t fight QE.

It appears that there is (in the current macro-environment) a positive relationship between the size (or growth rate) of the Fed’s balance sheet and the market value of the Dow stocks. Explaining this relationship can be complicated, but here is mine (or, rather, Scott Sumner’s): the Dow reflects expected nominal growth. Nominal growth increases corporate profits which makes stocks more valuable. QE increases nominal growth if pursued with sufficient vigor.

Is there some econometric rendering of this relationship? I wouldn’t know, but it looks to me to be more directional than proportional. The mediator is of course the two velocities: the M2/MB ratio**, and the GDP/M2 ratio, both of which have been falling, thus requiring ever greater doses of QE.

I said that my predictive tool is expected growth in MB, but perhaps I should really say expected nominal growth (or maybe I should say the expected real short-term interest rate). After all, growth in MB in and of itself doesn’t make companies more profitable; what makes companies more profitable is growth in nominal GDP (the product of M x V).

When I say “in this macro-envirnonment”, what I mean is “when inflation expectations are very low”, such that the market interprets growth in NGDP to be mostly real. It would have been a different story in the seventies, when the Fed had no credibility and expected nominal growth would have been discounted as inflation.

Since QE3 began, the MB has been growing at about $100B/month or 40% annually. The plan is to maintain this pace at least until unemployment falls another 1% to 6.5%. The credibility of this commitment is less than 100%. Everyone knows that there are committee members who want to stop it now; and everybody knows that Bernanke is a lame duck.

Therefore, the market has not fully incorporated (in my opinion) the announced employment target. Any signal of hesitation by the FOMC would cause the rally to stop. The stock market has no basis for optimism about Fed policy after this year, when Bernanke will be replaced by a weaker, less authoritative person. But for now, Bernanke is in charge, the employment target has been repeatedly stated, and QE3 is going full bore.

There is, however, one worrisome datapoint: inflation and NGDP growth are falling, because velocity continues to decline (from 2.1 in 2000 to 1.5 now). If this is not a blip, this means that the Fed will need to step up the pace in order to hit its employment target. Monetarists have been saying that the Fed should vary the pace of QE in order to stay on track. The Fed appeared to concede this point last week when it said: “The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.” I hope they really mean that.

Investment Conclusion

The conditions for rising equity prices remain in place as QE3 continues (or  accelerates). The equity risk premium still favors stocks over bonds (which are highly risky at this point in the epicycle). Cash remains penalized, forcing the risk-adverse to creep back into the equity market. A crucial piece of market information will be the identity of Bernanke’s successor.***

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*M2 = the money supply; MB = the monetary base, the Fed’s balance sheet; V = velocity, the ratio of GNP/M2.

**I date the periods of QE based on the movement in the monetary base, not the FOMC statements.

**One can only hope that the Republican hard-money caucus does not prevent another dove, such as Janet Yellen, from being confirmed.

Southern Europe: Revolt Now Or Default Later

“The policy is being set by the AAA core. The Commission bends to power, and will not move unless the rest of EMU mobilises superior counter-power. All else has become irrelevant in the euro snake pit.”

---Ambrose Evans-Pritchard, Daily Telegraph, April 24th, 2013

There are two schools of thought emerging among the non-delusional community with respect to the future of the eurozone. One view is that the ECB can still, by heroic action, save the eurozone. The other view is that it is now too late for the ECB to save the eurozone, and that the Club Med bloc will need to resume monetary sovereignty.

I cling to the former view because the alternative is pretty awful. I find it hard to grapple with the idea of some of the world’s largest debt issuers defaulting on their debts. It’s a horrific prospect. Euro exit by Italy or Spain would eviscerate the European banking system and cause a Lehman-squared.

But is the ECB rescue scenario possible? First, we will need to dispense with current ECB politics. This scenario only works if the ECB comes to Jesus and executes a total policy reversal as a consequence of the imminent default of Spain or Italy. So it is a given in this scenario that either the ECB sees the light on its own, or the Club Med bloc somehow forces the ECB to reverse course.

So now we have Mario Draghi and his entire board including the Bundesbank on the side of the angels, willing to whatever it takes to save the euro. What should the ECB do? For starters, it should implement the plan outlined by Lars Christiansen:

• Target the level of NGDP that would have resulted had the eurozone been growing at a reasonable pace since 2007. That is a level maybe 10-15% above the eurozone's current NGDP.
• Commit to engage in asset purchases such that M3 growth will average 10% p.a. until the output gap has been closed.
• Suspend the 2% inflation cap until the target is met.
• The policy instrument would be a GDP-weighted basket of eurozone government bonds.

In addition to the Christiansen plan, I would add the following:

• Active use of the OMT to backstop Club Med bond issuance, so as to limit yield spreads and restore market-access.
• A eurozone-wide bank support scheme guaranteed by the ESM and funded by the ECB.
• A statement that no bank in the eurozone will be allowed to default on its deposits for the next five years.

Such a program would: (1) restore market access; (2) restore depositor confidence; and (3) ensure that all eurozone banks have full access to ECB liquidity. Both the sovereign and banking crises would be solved.

It is true that this plan would not fully address the real effective exchange rate appreciation which has made the Club Med countries uncompetitive. But it would help in that inflation would permit real wages to decline over time (if nominal wages were constrained, a big if). Not ideal, but better than the current deflation and better than catastrophic default.

If this scenario proves impossible (see: Bundestag), the next question is whether a “managed exit” scenario is possible, by which one or more Club Med countries would be allowed to exit in the least disruptive way. Here, the answer is no. That is because euro exit at a minimum will be accompanied by redenomination of all debts, which is a form of default. There is no way that the troika (EU, ECB, IMF) is going to countenance a massive debt default. Indeed, it is likely that the troika will want to wreak its vengeance on the first escapee, to scare the others from trying to leave.

Thus, Spain and Italy face a stark choice: force the ECB to relent, or exit unilaterally. For Spain and Italy to be in a posture of revolt will require conditions to get much worse, and will require new governments. As Ambrose Evans-Pritchard wrote recently, a successful revolt by the south will require Churchillian leadership, which means different leaders.

France: Socialism Meets Deflation

Much of European academia was captured by marxist thought in the postwar era, including many European economics departments. There are many European “economists” today who know quite a bit about the labor theory of value and the internal contradictions of capitalism, but know very little about money, banking, and monetary economics. Macro- and micro- economics were seen by the marxists as the obsolete texts of a doomed system. Studying them was like studying a dead language. Consequently, marxism and the marxist perspective are to a great extent the only tools that the European Left has to work with as it seeks to reverse the economic devastation wrought by monetary union.

The hapless products of the marxist economics departments of the past now find themselves in leading roles in the eurozone. Yesterday’s student radicals are today’s statesmen. Americans need to understand the importance of the socialist Left in Europe: in every European country, the Social Democratic party plays a major role in parliamentary politics; every European country has had one or more socialist governments; and many European countries currently have governing socialist majorities in parliament. These marxist members of the European political class now confront a problem for which they were not educated: disastrous monetary policy.

While Marx did indeed have a theory of money, it is not terribly useful in sorting out today’s travails:

“The general price level will move in medium and long-term periods according to the relation between the fluctuations of the productivity of labour in agriculture and industry on the one hand, and the fluctuations of the productivity of labour in gold mining, on the other.”

---Eric Mandel, “Marx’s Theory of Money”

Today’s socialist finds himself quite at sea when he looks to Marx for a solution to the eurozone crisis. This certainly hasn’t stopped many eurozone politicians from trying to fit Europe’s problems into a marxist construct. The recent president of Cyprus (and of Europe) was only able to understand the crisis in the comic-book terms of greedy capitalists and oppressed workers. This is what his own party had to say about the Cyprus bailout negotiations:

“We will not accept terms that will destroy the popular strata, abolish working peoples’ gains, and sell off for pittance public property to big capital. We shall stand on the side of the class-based trade union movement in the mobilisations it is planning if the Troika insists on its policies. We shall not enter into a procedure that will be in complete contradiction with our ideology and history.”

Takes you back to Petrograd, doesn’t it?

You might say, “Well, that’s just Cyprus”. No it isn’t. There is a sympathetic story in Monday’s New York Times about France’s new finance minister, Pierre Moscovici, and the many difficult challenges he faces. The headline is  “Steering France’s Economy, and Attacked From All Sides”. The headline should be “Socialism Meets Deflation”.

Mr. Moscovici is not a believer in free-market economics; he is a socialist. His iPhone cover is a picture of Leon Blum. He told the Times: “There is a mainstream view in the European Commission that is neoliberal. But I’m a socialist.” We also learn that Mr. M was a member of the Revolutionary Communist League until he was 27. In other words, he was a Stalinist* as an adult.

Mr. Moscovici’s boss, Francois Hollande, was elected on an anti-austerity agenda. The French people, confronted with a choice between “reform lite” and “no reform”, chose no reform. They voted to maintain the French social model, and to avoid the structural changes being imposed on the other members of Club Med. However, this won’t in practice be possible because France’s fiscal deficit exceeds the limit set by the eurozone’s “fiscal pact” which requires all eurozone countries to bring their deficits to 3% or below. Despite Hollande’s comforting election promises, France’s budget is on the chopping block.

Mr. M is in a tough spot. The French economy is shrinking and unemployment is now 11%. Hollande has promised Europe that he will reduce France’s fiscal deficit ratio from the current 4% to 3%, which will require an estimated  budget cut of EUR 5B.  It will be hard for Moscovici to cut government spending at a time when the economy isn’t growing and unemployment is at 11%. Mr. M explained: “We must reduce deficits to keep our sovereignty and our credibility.”

QED: the bankruptcy of socialist economics. Because no one taught them about monetary policy, all the European leftists understand is austerity versus deficits. They have drunk the German Kool-Aid and believe that if they just tax a little more here and cut a little more there, all will be well. That way, they will keep their “credibility”. Even though Hollande and Moscovici ran on an anti-austerity platform, they are implementing austerity because “there is no alternative”.

The tragedy is that the European Left see its only choices as austerity or the abyss. They appear satisfied with (or resigned to) the ECB’s Zero Growth Policy. Maybe they believed it when Mario Draghi proclaimed this week that “the ECB’s monetary policy has been extraordinarily accommodative throughout the crisis”. How would they know differently? Is there any official in the eurozone who has bothered to discuss ECB policy with a reputable anglosphere economist? Mark Carney is just across the Channel, and I’m sure he can be made available to talk to Mr. Moscovici.

I think it is unlikely that it will be the European Right that will force the ECB to end its Zero Growth Policy. This will have to come from the Left, if only it understood economics. Time is running out, and unemployment is already in the red zone.

Lars Christiansen, who seems to be the only economist on the Continent who understands the problem, has recommended that the ECB issue the following statement:

“Effective today the ECB will start to undertake monetary operations to ensure that euro zone M3 growth will average 10% every year until the euro zone output gap has been closed. The ECB will allow inflation to temporarily overshoot the normal 2% inflation. The ECB has decided to undertake these measures as a failure to do so would seriously threatens price stability in the euro zone – given the present growth rate of M3 deflation is a substantial risk – and to ensure financial and economic stability in Europe. A failure to fight the deflationary risks would endanger the survival of the euro.

“The ECB will from now on every month announce an operational target for the purchase of a GDP weighted basket of euro zone 2-year government bonds. The purpose of the operations will not be to support any single euro zone government, but to ensure a M3 growth rate that is comparable with long-term price stability. The present growth rate of M3 is deflationary and it is therefore of the highest importance that M3 growth is increased significantly until the deflationary risks have been substantially reduced.

“The announced measures are completely within the ECB’s mandate and obligations to ensure price stability and financial stability in the euro zone as spelled out in the Maastricht Treaty.”

Unfortunately, such a statement would have to be issued over the dead bodies of Jens Weidmann and a number of other ECB board members. It is not imminent because, after all, “the ECB’s monetary policy has been extraordinarily accommodative throughout the crisis”.

France won’t be the ultimate savior of the eurozone because it isn’t sick enough yet. The savior will have to be  Spain or Italy. It will fall to one of them to be the country whose imminent collapse forces the ECB to relent and flood the continent with money. It’s a shame that so many millions will have to lose their jobs before that fateful day comes. And it’s a greater shame that when all the dust settles, capitalism will be blamed and socialism, which offers no answers, will advance.
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*Correction: Mr. Moscovici was a communist as an adult, but not a stalinist. The RCL was Trotskyite.

Are The Hawks Screwing Up Bernanke's Signaling?

There is a lot of literature about the conduct of monetary policy at the zero bound, that is, when the policy rate is zero and can’t be lowered. Bernanke is the author of a lot of this literature; it’s one of his academic specialties and why he is uniquely qualified to be chairman at a time when the Fed is operating at the zero bound.

Bernanke has taught us that the monetary authority is not helpless at the zero bound, because the crucial policy tool is not the nominal short-term rate but rather the real short-term rate. The real rate is the nominal rate minus expected inflation. The higher the level of expected inflation, the lower the real rate will be at a zero nominal rate. As an extreme example: If we knew that Bernanke was a madman plotting to destroy the United States via hyperinflation, we would probably want to move our money out of M2 and into something more tangible, like a business or a machine or property. We would know that the real interest rate was about to become highly negative, and thus the cost of holding M2 was about to become very high.

Thus, the policy objective of the Fed today is not to merely increase the monetary base, but rather to make forward statements about the growth of the monetary base that are sufficiently shocking that our inflation expectation will rise. There are many things the Fed could say, such as “we plan to grow the monetary base by one trillion this year and one trillion next year no matter what”. Or they could say “we plan to double the dollar price of gold (or the euro)”. Or they could say, “we will target 5% inflation until unemployment falls below 6.5% on a sustained basis”. But they have said none of those things. They have said almost the opposite.

Remember, the policy objective is to raise inflation expectations in order to make the real funds rate sufficiently negative to change economic behavior; to make liquidity very expensive, and to make risk very cheap; to induce actors to invest in productive capacity instead of M2. Bernanke laid this all out for the Japanese in his inflation speech in Tokyo ten years ago this month.

The simplest measure of inflation expectations is the the long-term risk free rate: the 10-year treasury yield. If the Fed were to succeed in raising inflation expectations, we should expect to see the market demand a higher rate of interest on the 10-year. But the FOMC says that an intended result of QE3 is lower bond yields. I cannot reconcile heightened inflation expectations with lower bond yields.

Today, the FOMC released its monthly statement, and it included the following language:

Longer-term inflation expectations have remained stable.

The Committee anticipates that inflation over the medium term likely will run at or below its 2 percent objective.

These actions should maintain downward pressure on longer-term interest rates.

This exceptionally low range for the federal funds rate will be appropriate at least as long as ...inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

In other words, “we are rapidly expanding our balance sheet, but don’t conclude from this that we wish to lower the real short-term rate”.

I may be missing a crucial element here, but on the face of it I see a glaring problem. And I think I know what the problem is: Bernanke was only able to get the hawks on the FOMC to agree to QE3 on the condition that this silly language be included. Perhaps he even got them to believe it. But if I wanted to raise inflation expectations, I would cross out all of this contradictory nonsense in the next release.

Investment Conclusion

Notwithstanding the foregoing, there is no doubt in my mind that QE3 is bullish for stocks and bearish for bonds if pursued until unemployment comes down to 6.5%. To my mind, a bond sell-off would be a strong signal that QE3 is really working. Once the “conservative” bond investors get clobbered, stocks should benefit from the run out of bond funds.