Archive for the ‘macroeconomics’ Category

Federal Reserve should place itself on auto-pilot

March 29, 2012

A single goal of long-run price stability should be supplemented with a requirement that the Fed establish and report its strategy for setting the interest rate or the money supply to achieve that goal.  If the Fed deviates from its strategy, it should provide a written explanation and testify to Congress.  To further limit discretion, restraints on the composition of the Federal Reserve’s portfolio are also appropriate, as called for in the Sound Dollar Act.” John B. Taylor, ‘The Dangers of an Interventionist Fed’, The Wall Street Journal, March 29, 2012

The history of the Federal Reserve System, since its inception in 1913, has been poor from the standpoint of economic stability. During the 1920s, the money supply grew too quickly, promoting the stock market boom of 1929. Excessive tightening in 1929 induced the Great Crash. Bank failures and a contraction of the money supply through much of the 1930s, played a major role in prolonging the Great Depression in the United States.

Between 1960 and 1980, the Fed intervened unpredictably with stop-go changes in money growth, inducing frequent recessions, high unemployment and fluctuating rates of price inflation. The resulting stagflation of the late 1970s encouraged Paul Volcker to usher in an era of rules-based monetary policy designed to squeeze stagflation out of the U.S. economy.

Between 1980 and 2000, the Fed followed monetary rules that led to low unemployment, low inflation, stable interest rates and stronger economic growth. Unfortunately, after the dot-com collapse of 2000, andthe  September 11, 2001 attack, the Federal Reserve succumbed to populist pressures as Chairman Alan Greenspan seized the controls with uncontrollable zeal. From 2003 through 2012, the Federal Reserve has behaved in a manic fashion, creating the financial crisis of 2008 and plunging the U.S. economy into a 1930s style recession that shows no sign of ending.

The potential stagflation confronting the United States is of immense proportions. Let me focus on reserve balances credited by the Federal Reserve and deposited in  U.S. banks. This is base money,which eventually expands through the money multiplier into the broader M2 money supply (or its equivalent)  that, in turn,  determines the aggregate level of prices across the economy.

Prior to the 2008 panic, reserve balances held steady at approximately $10 billion. In its own post-2008 panic,  including its mindless initial money injections, followed by QE1 and QE2 stimulus injections, the Federal Reserve has  pumped up those reserve balances to $1,600 billion – a 16-fold increase. 

 So far the impact on M2 has been relatively small. But once the recession eases, the scope for expansion in M2 will be dramatic. In the absence of base money contraction,  M2 money balances will soar, inducing significant inflation. The economy will be severely disrupted, most likely  by inflation, or stagflation, but alternatively by a Fed-induced  major recession.

If the Federal Reserve attempts to claw back base money by selling off its enormous portfolio of mortgage securities, long-term interest rates will soar and the housing market will tank. If it sells short term Treasuries, the credit market will dry up and with it, consumer expenditures. If it leaves base money alone, the U.S. will lurch back to double-digit rates of price inflation.

In essence, the Federal Reserve has replaced the entire interbank money market and large segments of other markets with itself.  It determines the interest rate without regard for the demand and supply of money.  In so doing, it has socialized financial markets, replacing decentralized markets with centralized bureaucratic control. Ben Bernanke has morphed into V.I. Lenin as the  autocratic leader of an increasingly socialist country.

Off with his head!

The English snail should not join the French whiting at the dance

December 19, 2011

” ‘Will you walk a little faster?’ said a whiting to a snail.

‘There’s a porpoise close behind us, and he’s treading on my tail.

See how eagerly the lobsters and the turtles all advance!

They are waiting on the shingle – will you come and join the dance?

Will you, won’t you, won’t you, will you join the dance?

You can really have no notion how delightful it will be

When they take us up and throw us, with the lobsters out to sea!’

But the snail replied ‘Too far, too far!’ and gave a look askance -

Said he thanked the whiting kindly, but he would not join the dance.

Would not, could not, could not, would not join the dance.

‘What matters it how far we go?’ his scaly friend replied.

‘There is another shore you know, upon the other side.

The further off from England, the nearer is to France  -

Then turn not pale, beloved snail, but come and join the dance.

Will you won’t you, will you won’t you, will you join the dance!’

Lewis Carroll, ‘The Lobster Quadrille,  Alice’s Adventures in Wonderland, 1865

And the answer must always be NO!

The explanation for that answer is central to the current angry debate, generated by fearful French government ministers, as to which of two government securities – the British or the French – should be downgraded by the major credit agencies. Let me explain.

Suppose that Britain and France confront an exactly equal government debt crisis. Let us further suppose that their economies are in roughly equal condition. Let us further suppose that the two governments have put in place equally conservative fiscal policies designed to reduce annual fiscal deficits. In such circumstances, Britain enjoys a significant potential economic advantage over France, as a direct consequence of remaining outside the eurozone.

Both countries will be committed to pursuing programs of extreme pro-cyclical fiscal austerity. They will be tilting government spending negatively into the teeth of an economic recession. Britain retains two additional instruments, should a serious  Irving Fisher-style debt-deflation ensue, that France simply does not possess.

The first is flexible exchange rates – a double-edged sword to be sure –  but one that Greece would give up several of its tourist islands to possess at the present time.  Beggar-thy-neighbor policies are not exactly poster- boys for good behavior. But they can make an impact when no one else is motivated or able to use them.  Britain can drive down the value of the pound sterling in a manner that France has no power to match in the  extended eurozone.

The second enormous advantage possessed by Britain, should depression threaten, is that it is a sovereign nation, with its own independent central bank. And that bank possess a lender-of-last-resort facility. In contrast, France is now a sub-sovereign state,  without its own central bank, and devoid of any lender-of-last-resort mechanism. The eurozone itself is bereft of a eurobond and devoid of a central bank with full lender-of-last-resort mechanisms.

As one confronts an immediate future in which Britain and the entire eurozone tilt fiscal policy pro-cyclically into the teeth of recession, which of the two countries, equally placed in terms of debt crisis and debt response, would you downgrade, given that a choice must be registered?

The three major credit agencies are currently poised to downgrade France and to reaffirm Britain’s triple A  rating. And such a decision will be well-justified.

No amount of pleading  and threatening by the French whiting should change the decision of the British snail. Remember that those global market lobsters are not hanging around offshore for nothing!

Of loose money, money illusion, and stagflation

June 24, 2011

“The Federal Reserve is ending its second round of quantitative easing this month, and Chairman Ben Bernanke was asked recently if he thought the $600 billion in bond purchases had worked. Yes, he replied, because the stock market had risen sharply in value.  Then this week Mr. Bernanke was asked why the economy was lagging. ‘We don’t have a precise read on why this slower pace of growth is persisting,’ he said, in a rare and revealing case of modesty.’ Review and Outlook, ‘Of Wealth and Incomes’, The Wall Street Journal, June 24, 2011

A prescient reporter should have asked Mr. Bernanke a follow-up question, why the United States stock market is now in a process of correction, eliminating all the gains achieved earlier in 2011.  No doubt the complacent Mr. Bernanke would have pulled out another fraudulent ace concealed under his sleeve.  Whether or not his answer would have persuaded a gullible reporter is really beside the point.

Because in truth, Ben Bernanke now holds a poker hand consisting of the Ace of Spades, the Ace of Clubs, the Eight of Spades, the Eight of Clubs, and the Queen of Diamonds. Yes, that self-same Dead-Man’s-Hand held by Wild Bill Hickock when gunned down playing five-card poker in Deadwood, North Dakota.

The problem with Ben Bernanke’s poker strategy is that loose money cannot be focused like a laser beam on specific economic targets.  The Federal Reserve surely can create new dollar bills. But it cannot dictate where those dollar bills will end up in a global economy that still runs mostly on a dollar standard:

“with QE2 piling on near-zero rates, dollars flooded into assets other than stocks.  In particular, they flowed into emerging markets like China and Brazil and into commodities nearly across the board…One result has been a sharp increase in food and energy prices that took gasoline up to $4 a gallon.  These have produced…income effects, or a change in consumption resulting from a change in real income.  People who pay $4 for gasoline or $30 more for groceries, have less money to spend on other goods.  They also tend to feel poorer, which can influence their overall confidence in the economy.” ibid.

 The wealth effects unquivocally have helped the affluent and the financially savvy.  The income effects are felt most acutely by the middle class and the poor. The artificially low interest rates have helped the bankers and hedge funders. They have harmed the less-affluent elderly who rely disproportionately. on fixed interest returns on their limited asset portfolios.  So Ben Bernanke has abused his responsibility to maintain sound money in order to behave as a reverse Robin Hood – stealing from the poor to give to the rich. In so doing, his behavior conforms to a long line of Liberal -Democrat, Limousine -Progressives across the United States.

Loose money can create an illusion of economic recovery. Rational expectations quickly kick in, and the sun shines on the trickery, exposing the magician to the scorn of the multitude. Sadly, however, the loose money itself ultimately ends up in inflation, stagnating unemployment and retarded economic growth. That condition is known as Stagflation. We know stagflation well. We thought that Paul Volcker had conquered it during the Reagan administration.  Unfortunately, a singularly stupid or malevolent Chairman of the Federal Reserve has let the genie out of the bottle once again.

May God damn you, Ben Bernanke, for the harm that you have done!

Harvard political economist favors tax cuts and spending reductions

September 16, 2010

“The evidence from the last 40 years suggests that spending increases meant to stimulate the economy and tax increases meant to reduce deficits are unlikely to achieve their goals.  The opposite combination might.” Alberto Alesina, ‘Tax Cuts vs. Stimulus: The Evidence Is In’, The Wall Street Journal, September 15, 2010

Alberto Alesina is a leading political economist of his generation. Born in Italy in 1957, he is one of a small group of Italian economists who are leading a second revolution in empirical public choice, building on theoretical foundations  provided by such first generation scholars as Duncan Black, Anthony Downs, James Buchanan, Gordon Tullock and Mancur Olson.

Alesina obtained his doctorate in economics from Harvard University in 1986, joined the Harvard faculty in 1988, and advanced  to a full professorship in 2002. Currently, he occupies the Nathanael Ropes Chair of Political Economy. For the most part, Alesina is apolitical, focusing on positive rather than normative political economy.  At the relatively young age of 43 years, he has already published several books and some 130 papers in the foremost scholarly journals in economics and public choice.  In short, he is a force to be reckoned with.

In the above-mentioned column, Alesina draws upon an empirical paper, co-authored with his colleague Silvia Ardagna,  that evaluates the 107 large fiscal adjustments that occurred in 21 OECD countries between 1970 and 2007.  The authors define as ‘large’ any cyclically adjusted deficit reduction of at least 1.5 percent in one year.

According to their model, a country experienced an expansionary fiscal adjustment so defined when its rate of GDP growth in the year of adjustment and the following year was in the top 25 percent of the OECD.  A recessionary adjustment, thus occurred when a country’s rate of growth of GDP was in the bottom 75 percent of OECD.

The Alesina/Ardagna results are striking.  Over a period of almost 40 years, expansionary adjustments were based mostly on spending cuts, while recessionary adjustments were based mostly on tax increases.  Moreover, adjustments based on spending cuts were accompanied by longer-lasting reductions in ratios of debt to GDP.

In the same paper, Alesina and Ardagna examined years of large fiscal expansion, defined as increases in the cyclically adjusted deficit by at least 1.5 percent of GDP.  Over 91 such cases, they determined that tax cuts were much more expansionary than spending increases.

On the basis of this evidence, Alesina concludes that Europe has learned the right lessons in focusing attention on spending cuts rather than tax hikes in its approach to deficit reduction. In contrast, the United States currently is set on an inappropriate course of tax increases as a mechanism to offset rising federal spending.

The evidence is in. Europe listens and learns. The United States buries its head yet further in the sand.

The Demise of Chicago Economics 3: World-Class Technique Alone Does Not Cut the Mustard

April 26, 2010

The Chicago School of Economics did not arrive fully grown in 1946 and 1950 with the arrivals of Milton Friedman and Friedrich von Hayek.  Strong foundations had been laid during the inter-war years by the deep-thinking  Frank Knight and the analytically brilliant  Jacob Viner, together with the strong (though not unequivocal) support of Paul Douglas and Henry Simons.  The soil was fertile for Hayek and Friedman to carry the baton of free market economics on its second lap.

For an economist to make a real impact, in my opinion, four ingredients are necessary.  The first ingredient is genius, the ability to see through the fog of a complex world and identify new insights of true significance for the discipline. The second ingredient is an understanding that economics is about economizing, and that economizing requires that economic models themselves must be economical: they must produce a lot from a little, not a little from a lot. The third ingredient is communication skills. Writing in simple clear sentences is the art of good communication. If an economist uses mathematics and econometrics as a crutch rather than as a tool, he is lost in translation, just as an attorney is lost before a jury if he has to resort to a blackboard to make his point. The fourth ingredient is relevance. Great economists do not waste their talents on the third order of smalls. They direct their energies exclusively to issues of the highest contemporary importance.

Hayek was endowed in full measure with these four ingredients, and used them well. Hayek’s early career focused on the role of knowledge and discovery in market processes and on the methodological underpinnings of  Austrian economics, notably subjectivism and methodological individualism. Throughout a long career, Hayek  focused attention on economics as a coordination problem, and on the role of markets as spontaneous orders  that, to a greater or a lesser degree,  resolve that problem of coordination, not least by signaling inconsistency among the plans of individuals and by providing incentives for the resolution of such inconsistencies.  Hayek was no Utopian.  He fully recognized that market economies periodically experience profound failures of coordination, that panics and recessions, even depressions do occur. He explained, better than anyone else, just how those failures occur, who and what is primarily responsible, and how the process of regeneration can and will occur in a well-functioning market economy.  How much his wisdom would be missed in September 2008 by the fatal conceit of an economics profession that rushed to constructivist rationalist solutions that he had long abjured!

Friedman also was well-endowed with those four ingredients, though in a different balance.  Friedman was less philosophical  than Hayek, better trained in advanced economic theory and econometrics, more narrowly focused on economics, and much more aggressively brilliant in debate. In my judgment, Hayek ranks first, and Friedman second, as the two most influential economists of the second half of the twentieth century. Friedman had a wonderful sense of what was important in the debate between mercantilism and free markets. His work on the consumption function embraced the economics of Keynes while invalidating the Keynesian theory of a powerful fiscal multiplier.  His reformulation of the quantity theory of money and his rigorous testing of its predictions,  laid the foundations for the 1980s re-emergence of monetary policy from its long dangerous sleep throughout the Western World.  His insights on flexible exchange rates provided a crucial basis for the worldwide globalization that surely followed its implementation.  His influential critique of the military draft saved countless Americans from temporary enslavement by the state. Most important of all, his consistent application of high-quality price theory to an understanding of economic issues provided a beacon of light to the economics profession thus transforming the discipline world-wide.

Inevitably, the presence of two such towering intellects drew the brightest and the most ambitious young  (and older)economists to Chicago like moths to the flame. Those economists, for a time,  at least, inspired by what they believed to be the ‘fire of truth’, worked wonders on economics, literally forcing back the powerful divisions of progressive socialism that swamped out the US economics profession during the middle years of the century. Among these eager scholars, were Ronald Coase, Harold Demsetz,  Harry Johnson, Gary Becker, Sam Peltzman, Reuben Kessel, Richard Epstein, Richard Posner and William Landes, names that are now renowned (if not always revered) for the contributions that they made to free market economic thinking.

Unfortunately, this beautiful program would not last, in fact would not long survive the departure of Milton Friedman from Chicago. Some attrition came through premature deaths, some through departures to sunnier climes, some through eventual changes in economic philosophy. Most important, however, was the fault-line that developed when Chicago faculty determined to emulate their Saltwater rivals and to substitute high technology for human capital, complex modeling for simple modeling, impressive incoherence for simple communication skills, and third order of smalls for relevance, in order to attract mathematicians to the doctoral program and to publish in journals whose editors had lost all sense of what is important and what is not. As one renowned faculty member listed above advised me just a few years ago:  ‘Charles, I would never have graduated through the Chicago program as it now is. I am not a world-class mathematician, and I do not emanate  from the People’s Republic of China.’

When an economist substitutes technique for quality-thinking, writes in jargon rather than in good prose, directs his attention to problems where data sets exist for mining, rather than because the problems are of substantive importance, and focuses attention on making marginal contributions to a well-researched field rather than redirecting economic research through discrete innovative steps, he downgrades his impact and renders himself vulnerable to irrelevance when a crisis truly emerges. Too many Chicago economists fell for such low-hanging fruit over the past quarter century.  As I shall demonstrate in tomorrow’s column, this would cost them dearly in September 2008.

US Economic Recovery is Retarded by the Fiscal Stimuli

April 14, 2010

Two recent newspaper columns confirm that US economic recovery will be much slower over the period 2009  to 2011 than was the case over the period 1982 to 1984:

Neil Irwin, ‘Jubilation exceeds economic reality: reasons for caution’ The Washington Post, April 13, 2010


Joseph Curl, ‘Personal income falls 3.2% during Obama’s 15 months’, The Washington Times, April 13, 2010

Economic recovery in the United States began in June 2009 with an upturn in gross domestic product.  Over the following three quarters, ending in March 2010, the cumulative percentage increase in gross domestic product was barely 5 per cent, while the cumulative percentage growth in employment was -0-6 per cent.  Economic recovery was significantly more brisk following the initial upturn in November 1982  from the equally deep recession that started in 1980.  In that  earlier case, over the following three quarters,  gross domestic product increased  cumulatively by 8.3 per cent, while the cumulative percentage growth in employment was 1.5 per cent. In my judgment, the major difference between these two events was the  unwillingness of  President Reagan and the Congress to flush stimulus monies down the toilet and to nationalize significant sectors of the economy in 1981-1982 and the eagerness of Presidents Bush and Obama and Congress to impose such solutions in 2008-2009.  As modern economic theory predicts, government supplied uppers become downers, stimulants become depressants, in any economy blessed with good economic information.

In any event, the statistics define a depressing, if not exactly a depressed, picture for America’s national economy. The stock market surely has recovered well from its March 2009 low.  But it is still functioning only at 79 per cent of its 2007 peak. The growth in gross domestic product has barely caught up with its decline during the 2008-2009 recession. The turnaround in employment during the first quarter of 2010, listed at 162,000 additional jobs, is something of a mirage, partly a result of temporary hirings by the Census Bureau, partly a result of a rebound from February snowstorms.  The underlying employment growth was only some 50,000 jobs, well below the 130,000 new jobs required just to keep pace with population growth. Real personal income for Americans – excluding such government payouts as Social Security – has fallen by 3.2 per cent since President Obama took office in January 2009.

Douglas Holtz-Eakin, former director of the nonpartisan Congressional Budget Office, has noted that, under President Obama, only federal spending has increased. Jobs, business start-ups, and incomes are all down. In his judgment, this is proof that the government cannot spend its way to prosperity.  The CBO reports that per capita income  (which includes government transfers) increased during President Bush’s two terms in office from $29,159 to $32,632, whereas it fell by nearly one per cent to $32,343 (all in 2005 prices) during the first 15 months of President Obama’s term.

Prognosis for the short-term future of the US economy is no less depressing. The US economy is expected to grow at 3.1 per cent during 2010, according to a consensus of forecasters surveyed by the Blue Chip Economic Indicators. That growth rate is close to the long-term trend, and well below past growth rates during  initial upturns from deep  recessions. Such a growth rate, in an expanding labor market,  will barely dent the  current 9.7 per cent rate of unemployment, which itself is at least two percentage points above the level predicted a year ago by President Obama’s over-optimistic, hydraulic Keynesian,  economic advisors, Lawrence Summers and Christina Romer.

There are many reasons for this anaemic growth rate in the US economy. Total household debt, at 94 per cent of gross domestic product in December 2009, is down only two percentage points from 96 per cent when the recession began in 2008.  By contrast, in 2000, the ratio of household debt to GDP was only 70 per cent. To return to that ratio, US households would have to pay down $3.4 trillion of debt, and that must impose a drag of economic recovery. As the federal government’s stimulus packages wind down during 2010 and 2011,  transient government jobs will disappear. The overhang of the federal debt will choke private investment.  Pending increases in the level of federal taxation will constrain consumption outlays by prudent households (certainly among the 50 per cent that actually pay income taxes, and perhaps among some of the remaining 50 per cent that shortly will pay consumption taxes). An excessive supply of high-powered money, once bank-lending picks up, will generate stagflation of an unwelcome 1970s vintage.

My prediction is that the debt crisis and stagflation together will lower the long-term growth rate of the national economy to its 1970 magnitudes, and that Presidents Bush and Obama, together with Alan Greenspan and Ben Bernanke,  will have raised the natural rate of unemployment by at least three percentage points, from 5 to 8 per cent, by their fiscal imprudence and socialist policies.

A Progressive Socialist Takeover at the Federal Reserve?

March 12, 2010

“Hundreds of thousands of rouble notes are being issued daily by our treasury.  This is done, not in order to fill the coffers of the State with practically worthless paper, but with the deliberate intention of destroying the value of money as a means of payment.  There is no justification for the existence of money in the Bolshevik state, where the necessities of life shall be paid for by work alone. Experience has taught us it is impossible to root out the evils of capitalism merely by confiscation and expropriation, for however ruthlessly such measures may be applied, astute speculators and obstinate survivors of the capitalist classes will always manage to evade them and continue to corrupt the life of the community.  The simplest way to exterminate the very spirit of capitalism is therefore to flood the country with notes of a high face-value without financial guarantees of any sort.  Already even a hundred-rouble note is almost worthless in Russia.  Soon even the simplest peasant will realize that it is only a scrap of paper, not worth more than the rags from which it is manufactured.  Men will cease to covet and hoard it so soon as they discover it will not buy anything, and the great illusion of the value and power of money, on which the capitalist state is based will have been definitely destroyed.  This is the real reason why our presses are printing rouble bills day and night, without rest.” Vladimir Ilvich Ulianoff Lenin, ‘Interview’, Daily Chronicle (London) and  New York Times, April 23, 1919.

“Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency.  By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.  By this method they can not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some.  The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the existing distribution of wealth.  Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become ‘profiteers’, who are the object of hatred by the bourgeoisie, whom the inflation has impoverished, not less than of  the proletariat.  As the inflation proceeds and the value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.  Lenin was certainly right.  There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.  The process engages all the hidden forces of economic law on the side of destruction, and it does so in a manner which not one man in a million is able to diagnose.” John Maynard Keynes, The Economic Consequences of the Peace, London: Macmillan, 1919.

“President Barack Obama plans to nominate Janet Yellen as vice chairman of the Federal Reserve Board, a person familiar with the matter said.  Ms. Yellen, president of the Federal Reserve Bank of San Francisco since 2004, has been a strong supporter of Fed Chairman Ben Bernanke’s policies to fight the deep economic downturn.  One of the more dovish policy makers among the fed’s 12 regional bank presidents, Ms. Yellen has been a key advocate of the Fed’s policy of near-zero interest rates and a massive expansion of the central bank’s balance sheet, even as some regional Fed officials advocate for pulling back the monetary stimulus more quickly….Ms. Yellen has been especially concerned about high unemployment and sees little risk of inflation.” D. Paletta, S. Reddy and J. Hilsenrath, ‘Obama to Tap Yellen for Fed Vice Chair’, The Wall Street Journal, March 12, 2010.

These quotations speak pretty much for themselves. As readers of this column are aware, President Obama has the opportunity to fill two additional vacancies on the Fed’s Board of Governors. A judicious choice of nominees will provide him with a clear majority on the Board. Janet Yellen is a progressive socialist, Ben Bernanke has sold out to that cause in return for a coveted second term in the Chair. President Obama is a progressive socialist, Speaker Nancy Pelosi is a progressive socialist, and Senate Majority Leader, Harry Reid is a progressive socialist. A large  majority of Democratic members of both the House and the Senate vote as progressive socialists.  A majority of the electorate is not progressive socialist, at this time.

However, once their hard-earned wealth has been  wiped out by high and volatile rates of price inflation, where do you think that an electoral majority may stand in November 2012, Dear Readers?  More important, where do you think that Obama, Pelosi and Reid (if he is still in office) think that such a financially ruined electoral majority will stand? 

Whatever else they may have been, Lenin and Keynes were not fools.  Like Professor Moriarty and Sherlock Holmes, they were endowed with intellectual genius, just like those characters in the novels by Conan Doyle,  plotting on opposite sides of the spectrum.  The Republican Party minorities in the House and the Senate, unfortunately, score much closer to Lenin’s evaluation of the brain-power of the Russian peasant, than to the genius of Lenin and Keynes.  So, we must continue to enjoy life  in dangerous times.

Why US Banks Are Not Lending

February 16, 2010

This posting responds to a lively and insightful commentary on my Column (February 15, 2010) on Paul Krugman and the liquidity trap.  Let me start by outlining some relevant statistics.

1.  The debt overhang: Since Irving Fisher’s famous 1933 paper, it has been well known that high and rising levels of debt in an economy impact adversely on economic growth.  In the third quarter of 2009, the total amount of debt in the United States (private as well as public)  amounted to $3.70 for every dollar of gross domestic product (370 per cent).  This reflects an exponential rate of growth from $1.60 per dollar of gross domestic product (160 per cent) in 1980. The growth rate accelerated dramatically from 2001 under the administrations of George W. Bush and Barack Obama. 

2. The  expansion of high-powered money:  Since Irving Fisher’s famous 1911 paper, it has been suspected that a significant increase in the quantity of high-powered money will generate price inflation within an economy.  Since September 2008, the Federal Reserve has engaged in a massive expansion of Federal Reserve Bank credit from $1 trillion to $2.2 trillion.  Under normal circumstances, the money supply (M2) might well have expanded to this increase in reserves by $4 trillion, or 96 per cent, triggering an extremely high rate of price inflation. Milton Friedman’s research certainly would predict such a response.   Many economists, myself included, expect a significant hike in the inflation rate unless, somehow, the Fed can stem the impact of excess bank reserves.  This expectation can be seen in the rising price of gold on world markets.  As yet, however, the link between an increase in M and an increase in P has not manifested itself.

3.  The stagnation of M2: The money supply (M2) has manifestly failed to increase  at a rate consistent with the monetarist model.  Instead, through 2009, M2 rose only 3 per cent, less than one half its average growth rate over the previous 50 years.  If as Friedman assumed, the income velocity of circulation of money is stable (MV=GDP) then nominal GDP expansion through 2010 can be expected to grow at approximately 3 per cent.  With the inflation rate hovering around 1.5 per cent, the real rate of growth of GDP would also hover around 1.5 per cent, way below the level necessary to restore the US economy to anything approaching full employment.  In fact, during the last two quarters of 2009, the growth rate of M2 slowed to zero.  This implies that, by early 2011, the growth rate of GDP in the United States will fall to zero, with no change in the price level  (Hoisington. Quarterly Review and Outlook, Fourth Quarter 2009).

What has happened?

Let me outline two alternative theories that attempt to explain this unusual phenomenon.  The first relies upon the debt overhang statistic and the associated fear of  price deflation.  In their 2009 book – This Time is Different-Eight Centuries of Financial Folly – Reinhart and Rogoff  analyze the role of debt in creating financial crises in 66 countries over a period of 800 years.  They demonstrate that the principal factor that explains more than 250 crises was excessive debt relative to national income.  They  conclude that this time is no different, that excessive debt  has led to   major economic contraction and deflation as individuals and governments seek to pay down their debts.  If this theory indeed is accurate, then the deficit spending by Bush and , especially, by Obama,  in the United States and by Gordon Brown in the United Kingdom, is simply disastrous, prolonging and deepening the deflationary phase.  Just as in the case of Hoover and FDR, presidential policies turn a limited  recession into a Great Depression. Under this theory, the banks do not lend because there are few customers for fixed interest  loans in a climate of pessimistic, deflationary expectations.

The second explanation focuses attention on the relationship between the Federal Reserve and the banks, upon monetary rather than fiscal policy, and suggests that flooding the system with excess liquidity has been a serious mistake of policy.  The policy error, it is suggested, occurred because the Fed wrongly focused on the shortfall in aggregate demand rather than on the underlying supply constraint of credit availability (Ronald McKinnon,  ‘Why Banks Aren’t Lending’, The International Economy , Fall 2009). By driving short term interest rates down to zero, the Fed provided incentives for risk-averse banks to borrow virtually for nothing and to invest in low yield Treasury notes, rather than running the risk of a repeat of September 2008, by purchasing higher- risk assets.  The solution to this credit rationing, McKinnon argues, is to elevate very short term borrowing rates on the banks, without disturbing (much) longer-term rates on Treasury notes, thus forcing profit-seeking banks to invest in riskier waters, thereby expanding M2 in the usual manner.

In my judgment, both theories are relevant. For Ben Bernanke, they combine to bring to the fore his worst nightmare. If he jacks up short-term rates, and forces the banks to lend, up jumps the money multiplier and, with it, the risk of inflation.  If he reverses course and pays the banks not to lend, then he generates price deflation. Bad luck, Bad Ben!

Now if only he could mop up the excess reserves while forcing the banks to lend, he would be in Monetary Paradise.  But,  for Bad Ben,  Monetary Paradise is Lost.  His balance sheet is highly leveraged,  saddled with toxic assets rather than Treasury notes.  Like Old Mother Hubbard, his cupboard is all but bare.  He cannot give his presidential dog its much needed bone.


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