Inside The Mind Of Jens Weidmann

Jens Weidmann is the president of the Bundesbank and a member of the ECB Governing Council. He is seen as the leader of the Hawkish Group  at the ECB. He holds views that are diametrically different from mine (not that he knows or cares). But it is crucial to understand how he thinks, because he holds an effective veto over ECB policy. That makes him one of the most important central bankers in the world. His views cannot be ignored.

Weidmann has provided us with two recent insights into his thinking: a speech today (7/7) in France, and a recent interview (6/24) with Suddeutsche Zeitung.  Helpfully,  both documents are available in English on the Bundesbank website.

Weidmann speaks in plain language and doesn’t mince words, or at least no more than he must. It appears that he regrets EMU, although he denies that (as he must as a board member of the ECB). His official posture is: effective monetary union will require greater fiscal discipline and structural reform; easy money is not the answer. His views about EMU can be summed up as: In the absence of fiscal union, EMU remains a looser grouping of countries that will face the discipline of the financial markets if they fail to produce economic convergence.

With respect to monetary policy, Weidmann adheres to a  strict interpretation of the ECB Treaty which provides for a single mandate, price stability, and which excludes “monetary financing” or deficit monetization.

Weidmann’s attitude is: EMU was founded on the explicit understanding that the ECB would be as single-minded as the Bundesbank in its focus on the single mandate. His view is that not only does the ECB lack a growth mandate, it should not have one (and nor should any central bank). He is a supply-sider: growth results from sound fiscal, structural and monetary policies, not from “artificial stimulus”.

There is nothing radical or heterodox about Weidmann’s views. They are shared by a number of members of the FOMC. Indeed, his views are orthodox. I think that his true desire is a federal eurozone, modeled on the dollar zone. This would be a eurozone without national central banks and without national banking systems. South Dakota does not have a central bank, nor does it have a financial system. The Fed and the FDIC could not care less if South Dakota defaulted on its muni bonds.

Here are his words:

“We need to make sure that in a system of national control and national responsibility [federalism] , sovereign default is possible without bringing down the financial system. Only then will we really do away with the implicit guarantee for sovereigns. To achieve this, we have to sever the excessively close links between banks and sovereigns. Currently, European banks hold too many of their own governments’ bonds.”

Weidmann desires a eurozone where governments can default without collapsing their financial systems. He also desires a eurozone where banks can fail without becoming contingent liabilities of their governments:

“Getting to grips with the implicit guarantee for sovereigns would be a big step towards eliminating the inherent tensions in the monetary union’s structure. Removing the implicit guarantee for banks would be another one. To make that happen, we have to ensure the resolvability of banks. Defining a clear hierarchy of creditors is crucial. Shareholders and creditors will have to be first in line when it comes to bearing banks’ losses – instead of taxpayers.”

This is American federalism: states can go bankrupt without destroying their financial systems, and banks can fail without having any claim on their state. (Washington State did not shudder when WaMu failed.) We know that such a system could work because the dollar zone has worked for a couple of centuries.

But next we come to the crux: eurozone monetary policy. As a monetarist, I adhere to the view that the quantity theory operates, and that real growth is a derivative of money growth. In a nutshell: you can’t have 4% real growth with 1% nominal growth, and you can’t have 6% nominal growth without some inflation. That’s Market Monetarism, although it is really both Fisherian and Keynesian.

Here is Weidmann’s view: “The best contribution a central bank can make to a lasting resolution of the crisis is to fulfil its mandate: that of maintaining price stability.” In other words, there is no reason why the eurozone periphery cannot resume strong growth with 0% inflation and 0% nominal growth. I don’t mean to caricature his view, but it comes pretty close to that.

Has Weidmann read Fisher lately (or Bernanke, or Sumner)? To my knowledge he has not refuted the necessity of reflation in ending a depression. Indeed, I think that he is a sincere liquidationist, who views depressions and defaults as prophylactic. He wants to remake Southern Europe in the image of Northern Europe. He believes that, in the long run, it is in their own interest. He should read a financial history of the last three years of the Weimar Republic.

The Seduction Of Ben Bernanke

FDR was elected to correct Hoover’s budget deficits. Kennedy was elected to close a missile gap. Nixon was elected to end the Vietnam war. Obama was elected to restore civil liberties. Ben Bernanke ran for Fed Chairman on a platform of price-level targeting. In DC, you never get what you bargained for.

Bernanke ran for office as a radical, but has run the Fed like a Fairfield County Republican. As Krugman, Romer, Ball and others have observed, Chairman Bernanke acts like he never met Prof. Bernanke, that crazy “helicopter” guy at Princeton.

In his wilderness years in academia, Prof. Bernanke demanded that central banks think outside the box to prevent deflation and stagnation when conventional policies fail. However, when Bernanke took office as Chairman in 2006, nominal growth, inflation and inflation expectations were substantially higher than they are now, as he leaves office. The US economy is once again balanced on the cliff  of deflation. The economist with the Christmas list of outside-the-box policies has implemented only two of them and not very successfully. Prof. Bernanke would give Chairman Bernanke a C+.

Bernanke has gone from being the Prophet of Doom in 2002 to being the Bartender of Doom in 2013. He changed his monetary philosophy, or failed to persuade the FOMC, or perhaps was “captured” by the Fed’s policy staff, as Laurence Ball has argued. They serve a strange kind of Kool-Aid at the Eccles Building; one sip and a wild-eyed radical becomes “responsible” and a guardian of “institutional credibility”. 


Why Ben Bernanke changed his mind about monetary policy we may never know; that he changed his mind is a matter of public record. It appears that radicalism cannot survive high office.

Permit me to take you back to the early years of this century. A number of bad things happened in succession: the World Trade Center was destroyed by passenger aircraft, killing thousands and  paralyzing the financial system; Enron was revealed to be an accounting invention; WorldComm had gone bankrupt; and both the telecom and merchant energy sectors were under massive creditor attack. The US experienced a brief but sharp financial crisis, due to disruptions in the credit markets. In 2002 a lot of companies went bankrupt or almost did. Everything was falling: stock prices, growth, inflation. Nominal growth fell to its lowest level since 1937, and real growth stalled out completely.

For the first time since 1937, people were using the D-word: deflation. A prominent scholar on the subject was a Princeton professor named Ben Bernanke. Bernanke was a student of Fisherian debt-deflations and of monetary policy at the zero bound, and had devoted his attention to the Great Depression and to Japan's deflation problem. 

He accused the BoJ of intellectual paralysis.

He was vocal about the need for Japan to aggressively reflate, recommending that the BoJ experiment with unorthodox policies. At this time, he also began to express concerns about the outlook for deflation at home, and he pushed the FOMC (which he joined in 2002) to begin to think about the conduct of monetary policy at the zero bound.

In 2002, the newly-appointed Governor Bernanke gave his famous “Helicopter Speech” in which he outlined what a central bank can do to fight deflation after the funds rate has fallen to zero. The speech included this often-quoted passage:

“The U.S. government has a technology, called a printing press, that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. Under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

Bernanke’s reflationary preachings served him well: Bernanke and Bernankeism were much in favor at the Bush White House. Bush serially appointed Bernanke  to the Board of Governors in 2002, to head the CEA at the White House in 2005, and to replace Greenspan as chairman in 2006.

Shortly after Bernanke’s accession to the chairmanship, the subprime crisis exploded and blew a big hole in the financial system; the economy staggered. Prices actually fell, as did both nominal and real growth. It certainly looked fortuitous that the man in charge at the Fed was a world-renowned expert on unconventional monetary policy.

In his academic work, Bernanke had criticized the Fed's policies during the Great Depression, and the BoJ’s policies during Japan’s Great Deflation. Bernanke's answer to the challenge of rates at the zero bound was aggressive unconventional policy to prevent deflation, such as price-level targeting. In other words, forget about conventional levers such as interest rates and money growth, and instead focus on a nominal target, the price level.

Bernanke learned about price-level targeting from President Franklin Roosevelt. FDR, with no formal economics training (an advantage, as it turned out),  chose to ignore economic orthodoxy, and decided to target a price level closer to that which had prevailed before the 1930-33 deflation. It worked like magic, and laid the groundwork for Fisher’s “Debt-Deflation Theory of Great Depressions”, which remains the basis for understanding the importance of reflation in an indebted economy.

Bernanke on Roosevelt:

A striking example from U.S. history is Franklin Roosevelt's 40 percent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation. The devaluation and the rapid increase in money supply it permitted ended the U.S. deflation remarkably quickly.

Bernanke was highly critical (1999) of the Bank of Japan for its complacent acceptance of a decade of monetary and economic stagnation after the bursting of the Bubble Economy:

“Bank of Japan officials would not necessarily deny that monetary policy has some culpability for the current situation. But they would also argue that now, at least, the Bank of Japan is doing all it can to promote economic recovery. For example, in his vigorous defense of current Bank of Japan policies, Okina applauds the “BOJ’s historically unprecedented accommodative monetary policy”. He refers, of course, to the fact that the BOJ has for some time now pursued a policy of setting the call rate, its instrument rate, virtually at zero, its practical floor. Having pushed monetary ease to its seeming limit, what more could the BOJ do? Isn’t Japan stuck in what Keynes called a “liquidity trap”?

“I argue, to the contrary, there is much that the Bank of Japan, in cooperation with other government agencies, could do to help promote economic recovery in Japan. Most of my arguments will not be new to the policy board and staff of the BOJ, which of course has discussed these questions extensively. However, their responses, when not confused or inconsistent, have generally relied on various technical or legal objections—-objections which, I will argue, could be overcome if the will to do so existed. My objective here is not to score academic debating points. Rather it is to try in a straightforward way to make the case that, far from being powerless, the Bank of Japan could achieve a great deal if it were willing to abandon its excessive caution and its defensive response to criticism...

“There is compelling evidence that the Japanese economy is suffering from an aggregate demand deficiency. If monetary policy could deliver increased nominal spending, some of the difficult structural problems that Japan faces would no longer seem so difficult.”

Bernanke offered the BoJ (and later the Fed) a menu of unconventional policy options including:

1. Price-level targeting.

2. Conventional and unconventional asset purchases.

3. Explicit and direct deficit monetization.

4. Pegging long-term rates.

5. Forward guidance about the path of the funds rate.

6. Currency depreciation.

7. Government purchases of private assets financed by the Fed.

Once in power, that long list of unconventional policy options got chopped down to this:

1. Forward guidance.

2. Conventional asset purchases.

All the other options were gone. And Bernanke has never explained why.

I think Bernanke should be judged by the yardstick of his mandate: full employment and adequate inflation to achieve it. I’d feel better about his legacy if he left office with 2% inflation; at least you could say he was trying. But with 1% inflation, he has given up.

Larry Summers For Chairman

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

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

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

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

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

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

The Bond Market Is Not Our Friend

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

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

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

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

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

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

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

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

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

Buy Stocks Now!

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

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

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

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

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

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

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

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

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

The Stock Market Doesn't Understand Monetary Policy

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

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

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

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

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

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

Bernanke Gives Up

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

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

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

This is what I see in terms of interpreting the Fed’s policy stance:

1. Moderate (5-7%) money growth.

2. The lowest inflation since the Crash (.7%).

3. Very low inflation expectations.

4. Very low LT interest rates.

5. Very low and falling (3.4%) nominal growth.

6. Low real growth (1.8%).

7. High (and rising) unemployment (7.6%).

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

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

Stop Worrying About China

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

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

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

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

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

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

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

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

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

Charles Plosser’s Monetary Offenses

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

Now, here is what Plosser recently said in an interview on Bloomberg TV:

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

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

But what exactly is Plosser saying? I would translate his remarks as follows:

“The goal of economic policy should be to maximize the ability of markets to function. Rigidities and frictions must be demolished. Governments should balance their budgets and then get out of the way. The best way to allow markets to work is to stop manipulating them, and provide price stability and nothing more. The magic of the marketplace will take over from there and create prosperity without inflation or deflation.”

How could anyone who is not a socialist not agree with that? Isn’t it almost axiomatic if one is a follower of Adam Smith or Milton Friedman? Yes, it’s almost axiomatic but it’s not axiomatic. There is still room in the capitalist house for monetarism.

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

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

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

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

Monetarists say that not only does money matter, it’s all that matters. Plosser disagrees. He’s a Mellonist who would fit right in at the ECB. But he is 100% wrong. It was Mellonists like Plosser who Irving Fisher was talking about in 1933:

"If even then our rulers should still have insisted on 'leaving recovery to nature' and should still have refused to inflate in any way, and should vainly have tried to balance the budget and discharge more government employees, to raise taxes, to float, or try to float, more loans, they would soon have ceased to be our rulers."

The Fiscal Crisis Is Not Over

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

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

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

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

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

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

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

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

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

Reserve currency status is not only a subsidy to our living standard, it is also a subsidy to our national security. Once we lose it, we can never get it back, and America will be just another country.
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* CBO estimates that Obamacare will cost $160-170B per annum, roughly twice the savings from the sequester. http://www.cbo.gov/publication/44176