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.

Households

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.

Business

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.

Government

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.

Finance

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.

Inside The Mind Of Mario Draghi

“The ‘leave it alone’ liquidationists were headed by Secretary of the Treasury Mellon, who felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: ‘Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.’ He said: ‘It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people’...”

--Herbert Hoover, “The Great Depression”

Another Draghi press conference*, another iteration of Mellonist Thought. Draghi’s basic position, which has been iterated and reiterated for four years, is that Southern Europe must continue to go through purgatory in order to atone for its original sins of greed and indolence:

“Fiscal consolidation is and remains unavoidable. It should be clear to everybody that you cannot have growth with endless debt creation. Sooner or later, you are going to be punished and the whole thing stops.”

The ECB is not to blame for zero growth and high unemployment: that is the fault of the defective countries and their lazy people:

“You also have to ask yourself why these countries were not competitive. Why did they have to rely for growth in the good times, or “fairyland” times, on the protected sectors that were shielded from international competition?

It appears that there is more than a bit of Savonarola in Mr. Draghi. Although a Roman Catholic, he has a Puritan heart. 

A bit of psycho-biography: Draghi has spent his entire professional life apologizing for Italy. Imagine his life, traveling around the world in order to explain and excuse his country’s medieval politics and ungovernability. Try to imagine for a moment the depths of Draghi’s contempt for Italian politicians (and voters), with their Byzantine disinterest in anything but power, family and money.

Could Draghi be unconsciously (or even consciously)  seeking revenge on his country’s unmodern and undisciplined political culture, the succession of Andreottis, Fanfanis and Berlusconis and all of their satraps and corrupt henchmen? Does he perhaps think, like Lincoln, that only by going through a cauldron of fire can his country atone for its sins and enter the modern era? Does he, in other words, think that his utopian ends justify his brutal means?  Certainly the tone of his monthly Q&A would suggest impatience if not contempt for the complaints of those who would question his disastrous policies.

He explains to the doubting that near-zero inflation is a good thing:

“The fact that inflation is low is not, by itself, bad; with low inflation, you can buy more stuff..low inflation is increasing people’s purchasing power.”

Yes, it would if they were employed.

Why is aggregate demand so weak?

“You have a quite broad weakness in domestic demand and consumption, particularly because of the high levels of unemployment.”

So the unemployed are the cause of unemployment. QED.

Is the ECB’s Zero Growth Policy causing high unemployment? No, the problem lies with the occupied countries themselves:

"The Governing Council is of the persuasion that the present levels of unemployment are the result of a combination of cyclical factors, as well as structural factors. As of cyclical factors, there is no doubt that the labour market in general is experiencing the combined effects of a credit crunch and the unavoidable fiscal consolidation that many of these countries have had to undertake. It is also true that some structural factors are blocking the labour markets."

The people to blame for the eurozone’s high level of youth unemployment are the unemployed youths themselves:

"A fast-moving world, in other words globalisation, requires new skills and investment in human capital, meaning that youth unemployment can also be explained on the basis of a mismatch of skills and human capital."

Are the ECB’s policies responsible for the fact that business credit growth is shrinking and credit has been withdrawn from small businesses in the South? No, these are autonomous decisions being made by the banks:

"When you talk to healthy banks that do not need to be recapitalised, you ask them why they are not lending more. The answer you get is that the net rate of return, adjusted for the risk of lending, is not high enough for them to lend...(Another) reason why banks do not lend is risk aversion, which is both micro, with respect to their clients, and macro, with respect to the general economic environment and the high uncertainty that still prevails in some parts of the euro area."

Please don’t hold the central bank responsible for negative credit growth.

After four years of zero nominal growth and with over 12% unemployment, might it not be opportune to change from a zero-growth policy to a policy of robust nominal growth? No, it wouldn’t make any difference. The problems are cyclical and structural, and the solutions rest within the countries themselves:

“Ask yourself what should these countries change to become more competitive? And what adjustments are needed in order to achieve this objective?”

Have the ECB’s deflationary policies been effective? Is rising unemployment a signal of policy failure? Not at all, in fact our policies have been very successful:

“When we all look back at what OMT has produced, frankly when you look at the data, it’s really very hard not to state that OMT has been probably the most successful monetary policy measure undertaken in recent time.”

So there you have the evidence. Draghi is not unfamiliar with the relevant literature. He studied at MIT under Modigliani and Solow. He knows all about Fisher, Keynes, Friedman, Eichengreen and Krugman. I’m sure he even knows about Market Monetarism (perhaps Mark Carney has mentioned it to him). He understands how the modern semi-capitalist economy functions. What he is doing is conscious, deliberate, sincere and not an act of misfeasance. It is true that he is bound by his single mandate and by the politics of his Governing Council. But that does not explain the evident sincerity of his monthly testimony. He is a true Mellonist, as Krugman would say. He wants to purge the rottenness out of the system. He wants people to work harder and live a more moral life.

Savonarola was tortured until he recanted, and then hanged and burned. I just want Draghi to recant.

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*Draghi press conference, 6 June 13.

The George W. Bush Institute’s Contributions To Monetary Thought

A week ago, I criticized* the Bush Institute’s “Four Percent Growth Initiative” because it made no reference to monetarist thought. It was subsequently brought to my attention that the Bush Institute has published a book** which contains a chapter on monetary policy. I bought the book and read the relevant chapter.

It is even worse than I expected. It is embarrassing and adds nothing to an informed discussion of monetary policy. I will not reiterate my earlier comments concerning the intellectual limitations of “Texas Commercial Bank Thought”, also known as “Dallas Fedism”, which is unsurprisingly the ideology espoused by the Bush Institute. I will simply provide excerpts from the chapter and allow the reader to draw his own conclusions concerning the intellectual value of the thoughts emanating from the Bush Institute in Dallas:

The starting point for 4% growth is a commitment to a sound dollar. In very simple terms, that means creating the expectation that the dollar will retain the value that it has now for the next twenty or fifty years.

It costs the government nothing to create new dollars to offset dollar weakness, and there’s no competitiveness gain because of the reduced investment, so the theoretical endpoint is hyperinflation.

We need a strong and stable dollar policy. To create such a policy, the president should state that a strong and stable dollar is part of U.S. growth policy and will be implemented by the Treasury and the Fed. The White House should then insist that the policy be evaluated regularly by measuring the dollar against the price of gold.

The Fed should follow up by using each FOMC statement to reinforce the policy of a strong and stable dollar. It can do that by using FOMC statements to measure the dollar against the value of gold and other currencies and also to discuss any inflation implications.

To emphasize its intention of putting a long-term floor on the value of the dollar, the Treasury should issue debt payable in dollars and payable in gold, as economist Judy Shelton has pointed out.

The United States is practically alone in pursuing a near-zero interest rate and letting its central bank to borrow short-term to buy up the national debt.

For those who can borrow cheaply, corporate proceeds often go abroad while most of the subsidized government borrowing turns into extra deficit spending.

Under the 2010 QE2 Fed bond-buying scheme, the more the Fed intervened in markets, the weaker GDP growth was each quarter.

Near-zero interest rates tag the dollar as the flight currency of choice for world markets.

There you have it. I won’t attempt to explain it. President Bush intends to have his presidential institute taken seriously in national policy discussions. Unfortunately, no one will take his institute seriously unless he does so himself. He really should ask qualified professionals to review his Institute’s publications before they are published. Had he done so, he might have been persuaded to have the chapter on monetary policy written by the man he appointed chairman of the Federal Reserve, or at least by someone who understands the monetary policy which was pursued during his administration.

Is President Bush aware that there is an unbridgeable gulf between Ben Bernanke’s views concerning monetary policy and those expressed in his institute’s book? I ask this because it has been reported that “Bernanke’s academic research hadn’t been discussed when President Bush was weighing his appointment to the Fed Chairmanship.” I wonder if Bush knows that Bernanke is a monetarist?

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* “A Critique Of The Four Percent Growth Project at the George W. Bush Presidential Center”

** “The 4% Solution”, George W. Bush Institute, 2012

What Happens If The Bond Bubble Bursts?

All the talk these days is falling bond prices and the possibility that this is the end of the thirty-year secular bull market in bonds. This “turn” has been called many  times over the past generation, and each time yields have ultimately fallen further, ultimately to unprecedented, almost Japanese lows. I remember when 5% was the floor, 4% was the floor, etc. Nobody knows anything in this business.

But now respected bond market experts are saying that this is it: rates will start rising from here. Personally, I’m not predicting that, although I do not expect to see rates go any lower, either. I’m looking at very weak numbers:  1.1% inflation, 3.4% nominal growth, and 7.5% unemployment. These do not constitute a strong predicate for rising bond yields. However, many believe that the QE has been artificially propping up bond prices, and that prices will fall as QE tapers off. Others believe that the economy has achieved escape velocity such that we will see a return to normalcy in growth, inflation and bond yields. I don’t see that either--not with the current economic telemetry. (Note: nominal growth of 3.4% has historically been considered recessionary; the economy has been stuck in second gear for the past three years.)


But let’s assume that I am wrong and that this really is the end of the secular bull market (for whatever reason) and bond yields will start to return to more normal levels. If by “more normal levels” we mean precrash yields, that would be around 4-5% for the 10-year, considerably above the current 2.1%. While that may sound modest in yield terms, it is big in price terms. Already, with the mild uptick in yields over the past month, some fixed-income hedge funds are reporting substantial losses.


So, what if we have a panic at some point this summer, and the fall in bond prices accelerates? What would that mean for the stock market? We’ve watched this movie before: when yields spiked in 1987 and 1994. In 1987 the impact on stocks was profound; in 1994 it was less so and quite transitory.


And what about now, in the summer of 2013? The key questions are: (1) how big is the carry trade (borrowing overnight to buy bonds); (2) how levered are the positions; and (3) how deep are the pockets of the most exposed speculators. I don’t know the answer to these questions, but nobody else does either: this is the stuff of rumor and “market intelligence”.


But there is little doubt that a rapid unwind of the carry trade will be at least temporarily bearish for equities, for financial stability and for confidence. Personally, I’m not very worried, but we could have a few bumps if this scenario plays out.


Just as was the case with LTCM in 1998, we do not know the other positions or the interconnectedness of the most exposed institutions. It’s not just which banks or hedge funds are exposed to falling bond prices: it’s what other asset classes they are in, on what scale, and how deep and liquid those markets are. You may recall that when LTCM’s “EMU convergence trade” went awry, the impact wasn’t on the bonds of the governments that were supposed to be converging, but rather on Russian domestic debt and those who owned it. Nobody could have predicted that. When the SIV meltdown occurred in 2007, nobody knew that it would most affect German banks.


When institutions are hit with redemptions or margin calls, they sell their sellable stuff first. So, for example, if a hedge fund is currently under redemption or margin pressure, that selling pressure could appear in a market that is otherwise stable. This explains why stocks have been gyrating as bonds have been falling: some people are being forced to raise cash, or are front-running those who will be forced to raise cash. As prices gyrate, VAR limits, counterparty lines, and advance ratios all decline together, forcing more selling.


We have seen this phenomenon many times, and it is a normal part of market cycles. Such unwindings are usually benign. As long as no major institution is critically  wounded, the markets will right themselves, as they did in both 1987 and 1994. We may see some carnage among hedge funds, but they are seldom systemically significant.


With respect to my own portfolio, I am expecting mild turbulence but still remain bullish on equities. I think that the equity risk premium is sufficiently large to absorb whatever happens in bonds (and I don’t expect much).

Only A Crisis Will Solve Europe's Youth Unemployment Problem

“President François Hollande of France called Tuesday for “urgent action” to tackle alarmingly high rates of youth unemployment across the European Union, saying that mounting disillusionment among the “post-crisis generation” threatened the very future of the European project. “We need to act quickly,” Mr. Hollande told a gathering of government officials, business leaders and students in Paris. “In this battle, time is the decisive factor.”--New York Times, May 31st.

Europe has scheduled a summit conference this month to focus on one of its most worrisome problems: youth unemployment, which ranges between 25% and 50% in the south. The solution, they will conclude, is a EUR 6B program of targeted government programs to improve the employability and mobility of young people. (That’s EUR1000 per unemployed youth.)

If there is one word that should be eliminated from any policy discussion these days, it is “targeted government program”. Targeting is what ignorant people do when they have chosen to ignore the consequences of their policy choices. Policy determines the level of youth unemployment, not the absence of targeted programs. Targeting is inherently aimed at symptoms and cosmetics, not policy correction.

Europe’s malady is caused by the lethal combination of inflexible nominal wages, a falling price level, and a strong currency. Effective labor costs in the eurozone periphery rose quite dramatically following EMU. Prior to EMU, these countries used inflation and currency depreciation to permit rising nominal wages. Post-EMU, nominal wages have risen faster than prices at the same time that the currency has remained strong, this resulting in real effective wage appreciation. Adam Smith would say “No problem: wages must fall, and those who are overpaid must be replaced by cheaper workers.” But Adam Smith never saw a European labor law.

Under European labor law and custom, nominal wages rise, wages increase with seniority not productivity, entry-level positions (including benefits) are priced much too high to make hiring economic, and overpaid unproductive labor at all levels of the enterprise is protected. The millions of young unemployed workers who would happily work for one denarius are priced by law at three denarii, and no one is buying at that price. If businesses hire at all, they opt for temps, contractors or employees off the books. Once you really hire someone, you have to pay them a lot of money, give them full social benefits, and promise never to sack them for any reason.

Is there a way for Europe to reduce real wages despite rigid nominal wages? Yes: by causing prices to rise faster than wages, i.e., real wage depreciation, plus a weaker currency. This is how Southern Europe was able to remain competitive prior to EMU despite labor market rigidities.

Now, if you were to ask the ECB or the Bundesbank about this problem, they would answer that the peripherals have all made substantial progress in reducing labor market rigidities through structural reform, which would be nice if it were true. But it isn’t true and in fact it wouldn’t even be necessary if the Southern Europeans could resume their time-tested inflation/depreciation regimes. Go to Barcelona and ask the owner of a factory about how labor market reforms have allowed him to hire more young people.

So what is the outlook for youth unemployment in Southern Europe? That is easy to forecast: it will rise until the political system cracks.

I would call your attention to the increasing hostility in Europe to non-European immigrants. These foreigners were welcome when the economy was booming, but now they are seen as alien parasites competing with native young people. The unskilled jobs that were once available to native youth have been taken by immigrants, who will work longer hours for less and have limited “rights”. 

The combination of rising youth unemployment and the growth of immigrant communities has resulted in rising civil disorder. Rising civil disorder will accelerate the cracking of the political system, which can’t come too soon. Ironically, the political legitimacy of Europe’s system of government is postponing the needed political crisis. Less legitimate regimes would have crumbled sooner.

The sooner Europe’s political system fractures, the sooner the authorities will be forced to reflate, which will solve the problem. The US underwent deflation for almost four years (1930-33) and lost a generation. How many generations can Europe afford to lose?

A Critique Of The "Four Percent Growth Project" at the George W. Bush Presidential Center

I learned today that the  conservative journalist, author and educator Amity Shlaes is the Director of the Four Percent Growth Project at the George W. Bush Presidential Center at SMU in Dallas. Shlaes wrote the “Forgotten Man” about the taxpayer during the Depression, and a timely bio of Calvin Coolidge, the Rand Paul of the 1920’s.

Until I read about it today in the NYT Sunday Review, I had not been aware of the Four Percent Growth Project, which struck me immediately as an excellent idea. If there is one thing the world needs today, it’s 4% growth, and a path to get there in less than a millennium.

In perusing the Project’s site, I could find no evidence of monetarist thought, which is surprising considering that Bush appointed a devout monetarist, Ben Bernanke, to be chairman of the Fed. The Project’s site seems to be devoted to conventional conservative thought, as found at your local Rotary or Chamber of Commerce. In other words: Bushism minus monetarism.

As the Bush Center is new, monetarist thinking may eventually make its way to Dallas, as it has to other conservative institutions such as the National Review. Unfortunately, the nearby Dallas Fed is not monetarist, and has always been hawkish and anti-QE, an avatar of orthodox Texas Commercial Bank Thought (TCBT). TCBT teaches that the only way to prosperity is a balanced budget, a sound currency, and an end to Too Big To Fail. This is not subject to debate in Texas. (Recall that Gov. Rick Perry charmingly promised Bernanke that if he ever came to Texas he would be lynched for treason. Rick Perry is a full communicant of the Church of TCBT.)

I am intrigued by the wisdom of the name given to the Project, and I happen to know that Amity Shlaes understands monetarism, even if W doesn’t. (His “Decision Points” do not include appointing Bernanke, even though this was the best thing he ever did.) I am intrigued because these three words cut right to the Holy Grail of politics and economics: moderate sustainable growth. It is annoying to look through all of the economic nostrums  on the Project’s website, which are well-meaning but completely irrelevant to achieving 4% growth.

I will generously offer to replace the thousands of words on the Project’s website with a single sentence: “The Fed’s mandate should be changed from price stability and full employment to 6% nominal growth.” My lay readers will by now be familiar with monetarist thought, the core of which is the Quantity Theory of Money, which holds that central banks control nominal growth. Once this theory, or as I prefer to say “law", is accepted, then a discussion of growth must quickly devolve into a discussion of monetary policy. Money matters and deficits don’t.

Monetarism is generally ignored by both the Right and the Left. This is because they fight on the ideological battlefield of the size and role of the state, and see growth as a derivative of that struggle. The Right says: “You can only get growth by shrinking the state”, while the Left says the opposite. Neither side is interested in a simple prescription which ignores their central ideological dispute. Hence, they argue over which of their irrelevant religions has more influence over the economy, which neither of them understand.

This is also why some smart liberals, such as Paul Krugman and Matt Yglesias, can be monetarists alongside such smart conservatives as David Beckworth, Scott Sumner, Ramesh Ponnuru, and Ben Bernanke. Monetarism, like Newtonian physics, has no ideology.

To return to the Four Percent Growth Project: I hope that down the road Ms. Shlaes will see fit to organize a debate about monetarism. The first speaker should be the man that Bush made chairman of the Fed. The responder should be Rick Perry, without his gun and rope.

Why Bond Prices Are Falling

“Yields on US government debt, which move inversely to prices, have surged during May and peaked this week, leaving holders nursing their worst monthly loss since December 2010. The immediate cause was concern that the Federal Reserve would soon start to “taper” its open-ended bond purchases – with far-reaching consequences for US debt markets and perhaps signalling a turning point in the 30-year Treasury bull market.”

--Financial Times, 31 May 13

Sometimes I think that I’m living in my own separate universe. Here is what I believe to be true:

1. The Fed has, for the first time in its history, adopted an explicit employment target.

2. The policy tool being utilized to achieve this target is the expansion of the monetary base (the Fed’s balance sheet) in order to expand the money supply (M2) in order to stimulate NGDP and business activity (which determines employment growth).

3. One way to express what the Fed is doing is that, because it cannot lower the nominal funds rate, it must reduce the real funds rate by raising inflation expectations from their current historically low levels.

4. Raising inflation expectations (which will require higher actual inflation, given the Fed’s low credibility) will raise bond yields, and rising bond yields are therefore an important measure of policy success.

5. If the Fed decides to prematurely end or to reverse QE, inflation expectations will not be raised, policy will lose its stimulative effect, and NGDP and employment growth will be lower. Bond prices will remain low.

The conventional wisdom in the financial media today is that QE, by buying Treasury bonds, has “artificially” raised their prices. The current wisdom is that ending QE would eliminate this bond price-support system, and bond yields would rise to their “normal” pre-Crash levels. Talk of ending QE is said to be bearish for bonds, which is 100% wrong.

Wouldn’t it be wonderful if money-printing had the by-product of lower bond yields? The more inflation we created, the lower bond yields would go. Even though prices would be rising at, say, a 4% rate, investors would only demand a 10-year bond yield of 1.5%. We could then inflate away the national debt.

But the world doesn’t work that way. Bondholders demand a real yield, and react negatively to fears of higher inflation. When the Fed was creating double-digit inflation in the late seventies, bond yields were also in the double digits; there was no free lunch back then.

It is said that the Fed has been creating “artificial demand” for bonds, driving their prices above where the market would otherwise have them. But the Fed, despite its “massive” purchases, only owns a small proportion of marketable long-term government securities. The price of bonds is still set by the market, not the Fed. Rates are low because the market hasn’t fully bought the story that QE will produce “normal” inflation in the future, perhaps because inflation is currently 50% below target.

My interpretation of the recent bond sell-off is that the market is beginning to see the glimmerings of higher growth sometime in the future, which would lead to higher short and long-term interest rates as the current “extraordinary accommodation” is withdrawn. In other words, QE3 has begun to work its magic, and as it does, bond yields should slowly rise to normal levels. This is consistent with rising stock prices, reflecting expected earnings growth, despite rising interest rates. As stocks go up and bonds go down, the equity risk premium should decline from its current historic highs.

There is a possible scenario in which inflation and growth resume their pre-Crash levels, the funds rate rises, and bond prices fall substantially. The size of the potential loss involved in a resumption of 3-4% bond yields is very substantial. Somebody out there would be clobbered, and there would be considerable financial turmoil. The key question is how big and how leveraged the carry trade is today, and who is doing it to excess.

Why Can't Europe Understand Basic Economics?

I came into economic consciousness in 1972, and was an observant witness of the break-up of Bretton Woods, and the subsequent Great Inflation of the late seventies. I watched as Paul Volcker and other central bankers went to war against inflation and, by controlling money growth, began the process by which global inflation was exterminated by the 1990s. That was the seminal monetary experience of my generation: the slow strangling of the inflation monster.  

The heroes of this era were the central bankers who had the sang-froid to stand up to the pleasure-seeking politicians and to impose recession on the masses in order to break the “wage-price spiral”, as it was known at the time. The measure of a central banker became his ability to impose pain in the face of popular hatred, and thus restore monetary discipline. These heroes won that war; they killed the snake.

Thus, the standard by which central bankers have been measured since the eighties has been their commitment to “price stability”, the most heroic version of which is zero inflation, the Holy Grail. Indeed, today all of the world’s central banks have an explicit price stability mandate. Mark you: not an inflation-targeting mandate, a price-level targeting mandate, a nominal growth mandate, or an NGDP-level mandate. No: price stability, in all its austere glory.

And so we have transitioned during my conscious economic life from a world in which 5% inflation was tolerable to a world in which 2% is the absolute ceiling, and lower is just fine. We now live in a world in which two of the most important central banks have been targeting ultra-low inflation for years, the ECB and the BoJ, and in which the other important central bank harbors a large faction of “inflation hawks” on its policy committee.

And then, in 2008, came Lehman and the shutting down of the global credit system. The world’s central bankers, with their generational commitment to disinflation, were confronted by: deflation! And what did they do? Nothing. They stood back and allowed the price level, NGDP and RGDP to fall. They had long ago locked the storeroom where the reflationary tools were kept. And they had never seen or used those tools, either. They fell right into the same complacent psychology that their official predecessors fell into in 1931: they opened the credit spigots and offered an “accomodative” monetary policy: “We’ve done all we can.” Not the slightest attempt to raise an army to fight deflation and negative growth. Raised to fight inflation, they were stupefied by the challenge of deflation. (None of this applies to Bernanke, but he was a lone voice in a wilderness of stupidity and denial.)

So, the FRB, the BoJ, the ECB, and the BofE all stood back and watched as prices, nominal growth and real growth went negative. The wise and experienced central banks of Southern Europe had been silenced, having surrendered monetary sovereignty to Germany a decade earlier. (Banca d’Italia, once a highly sophisticated central bank, would never have permitted the post-crash deflation, but it’s been only a posh Italian think tank since 1999.)

Since the deflation of 2008-09, global growth has downshifted permanently into second gear. We now live in a world of low inflation, low nominal growth, and low real growth. Salt has been sown over the grave of the inflation monster.

True, millions of young people are now facing a lifetime of unemployment, but isn’t that the price we must pay to create a world without inflation? Won’t workers over time redevelop the psychology of the nineteenth century, when wages rose and fell with the business cycle? Why should nominal wages be sticky? Once people have been unemployed long enough, and once their unemployment benefits have run out, they will happily return to the labor force at lower wages, and the neoclassical equilibrium will be restored. It will be 1913 again.

I love the neoclassical equilibrium as much as the next guy, but we now know that it cannot co-exist with universal suffrage. The masses always vote for full employment at higher wages. Neoclassicism can only succeed in a plutocracy, which we gave up in the 19th century. Today we must devise a monetary policy that does not depend on the “reserve army of the unemployed” to discipline wages. We allow the unemployed to vote.

The High Priests of the new religion of extreme price stability are Jens Weidmann, president of the Bundesbank, and his subordinate, Mario Draghi of the ECB. The collected works of these men will someday be titled “Growth Was Not Our Mandate”. These men have assumed the roles of the central bankers of the Depression, who believed that the “purging of the system” and a reduction in wages was the only way to restore growth.

They are actively pursuing what Irving Fisher characterized as the “natural” way out of a depression:

“Unless some counteracting cause comes along to prevent the fall in the price level, a depression tends to continue, going deeper in a vicious spiral for many years. There is no tendency of the boat to stop tipping until it has capsized. Only after almost universal bankruptcy will the indebtedness cease to grow. This is the so-called "natural" way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.”

---Irving Fisher, “The Debt-Deflation Theory of Great Depressions”, 1933.

Professor Fisher (Yale) not only invented the debt-deflation theory, he also invented the quantity theory. He stands as a monumental figure in 20th century economics, along with Keynes and Friedman. You can’t be an anglophone economist and not know his work. Of course Draghi, the smartest man in Europe, knows all about Fisher and his theories. But does anyone else in the eurozone read Fisher? Is this all new to them? Is the deflationary catastrophe of the early thirties not part of their fundamental curriculum?

I dare say that it is not, at least in the Fatherland. Germans remember selectively their country’s monetary history. They choose not to remember the deflation of 1930-33, nor do they want to remember the successful post-1933 reflation under Hjalmar Schacht. They only remember the postwar hyperinflations, which were indeed awful but are absolutely irrelevant today.

Today, the world needs a new generation of central bankers who are not students of the Great Inflation, but are instead students of the Great Deflation and of Irving Fisher, Milton Friedman and Barry Eichengreen. The lesson of the past five years is that the world needs inflation, and some economies need it more than others. While Northern Europe can discipline itself to live with low inflation, Southern Europe never has and never will. Starving them won’t change their national character, it will only lead to chaos, which we are already beginning to see.

The following editorial appeared in El Pais (Madrid) earlier this month:

The consolidation of a fascist party in Greece. The success of Beppe Grillo and Silvio Berlusconi in Italy. The 6.2 million unemployed in Spain, its highest since the year after Franco's death, and the 26.5 million in the EU. The collapse of the French hope for François Hollande. The rise of anti-European parties in Greece, France, Finland, UK, Germany. The dismantling of the welfare state and the return of starvation wages in Southern Europe. None of this seems to move the Germans. With her hard countenance and furrowed brow, Chancellor Angela Merkel observes the perfect storm on the Continent without raising an eyebrow.

The risk to Europe today is what Fisher said about America under Hoover:

“If our rulers should still insist on "leaving recovery to nature" and should still refuse to inflate in any way, should vainly try to balance the budget and dis- charge more government employees, to raise taxes, to float, or try to float, more loans, they will soon have ceased to be our rulers. For we would have insolvency of our national government itself, and probably some form of political revolution.”

The Enigma Of Japanese Monetary Policy

The Nikkei index fell sharply today. Paul Krugman analyzed the various explanations and concluded that the sell-off was due to a lack of faith in the BoJ’s 2% inflation target. Krugman is correct. Readers will recall that I have never bought into Abenomics and the BoJ’s overnight conversion from deflation-targeting to inflation-targeting.  Why?  Because the BoJ is a deeply confused and intellectually incoherent organization unable and unwilling to obey its democratically-elected masters.

If you are a monetarist (which Krugman sort of is) you will know that the stock market is about monetary policy and little else (besides creeping marxism, which is what’s wrong with Krugman).

Only someone ignorant of Japan would ever believe that the BoJ will do whatever  it takes to achieve 2% inflation on any non-Oriental timeframe. The BoJ is guilty of the twin monetary sins of  input-only focus and dogged  incrementalism: “If I turn the hot water faucet by one centimeter a month, I will be able to take a hot shower at some time in the future.”

The BoJ is right on track, Japanese-style,  because it is indeed expanding the monetary base; it is turning the hot water faucet at one centimeter a month. The water will someday get hotter. But unfortunately, right now the water is getting colder. Hot shower a few years off.

In Japan today, inflation is not 2%, it is minus 1%, popularly known as deflation. That makes real debt bigger. Despite 23% growth in the Monetary Base, money growth has declined  from 3% before QE to 2% now. And NGDP (not NGDP growth) continues to decline, an honored Japanese tradition.

I would be interested to know who exactly have been buying up the moribund Japanese stock market, the goldmine of growth stocks. Are they monetarists who believe in the BoJ’s statements? If so, they were uninitiated gaijin who don’t understand that in Japan there are official statements and understood statements.

If you have read the “Enigma of Japanese Power” by Karel van Wolferen, you will understand that the Japanese power structure exists independently of the Occupation-imposed MacArthur constitution, and of Western democracy itself. Since the end of military rule, Japan has been  ruled by Big Business and Big Finance, which control their respective mandarins (and vice-versa) . The cabinet advises, but the mandarins rule. The BoJ mandarins are ultimately captives of the banks. The tradition of amakudari ensures that the mandarins and the banks are always on the same page, and that harmony prevails. This system dates from the gumbatsu coup in 1937.

Japanese banks are fatally exposed to JGB prices. If Japanese bond yields returned to terrestrial levels (say 3%), the banks would all be rendered hopelessly insolvent. The banks don’t want that, and the government does not really want it either. Hence, the BoJ is supposed to raise the rate of inflation without hurting bond prices. Totemo muzukashii desu. “It is a bit difficult.”

Gaijin economists have proposed ways of immunizing the banks from rising bond yields, such as swapping floating-rate bonds for fixed-rate JGBs. These ideas haven’t been discussed in Japan because they were proposed in English by American economists “who don’t understand Japan”, such as Ben Bernanke in 2003. “Ah, Professor Bernanke, your speech was very interesting. Is this your first trip to Japan?”

Until Japan can think up a way to protect its banks from 3% bond yields, Abenomics will remain a “difficult challenge that may take a few more years”.

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Friday Addendum:

May 23, 2013

BOJ Kuroda Says Will Strive to Ensure JGB Market Stability

REUTERS

TOKYO — Bank of Japan Governor Haruhiko Kuroda said on Friday the central bank will make efforts to avert volatility in bond markets through flexible market operations and enhanced communication with market participants.

"We don't have specific targets for stock prices or currency rates, and I won't comment on daily moves," Kuroda said at a seminar in Tokyo.

"As for the bond market, where the BOJ is directly involved in through market operations, stability is extremely desirable," he said.