I like to say we injected cocaine and heroin into the system, and now we’re maintaining it on Ritalin.
- Richard Fisher, Former FOMC voting member, 9 March 2016
Here is the solution to the American drug problem suggested a couple years back by the wife of our President: “Just say no.”
Nancy Reagan died a little under two weeks ago, and one of the things she’ll be most remembered for is her campaign against drug use, and the famous slogan: ‘Just say no.’ Whether her efforts were effective are debatable. At the very least, they did ignite a national conversation about drug use that was useful.
In my personal opinion, drug addiction is closely related to a lack of hope, or a lack of appreciation for the future. If one doesn’t believe any sort of positive future is in the offing, it is more likely that drugs become appealing. Not only do they create an escape from that lack of future, they provide comfort in the present. Despite the destructive nature of drug abuse, it is understandable on some level.
Unfortunately, policy makers in the economic arena also share the drug addicts’ lack of hope when it comes to future prospects in recessions. When statistical metrics such as GDP, and projections such as the output gap begin to deviate from the plan, policy makers turn to the monetary drugs of interest rate cuts and asset purchases. They ultimately see no hope for economies in slowdowns, and must ease them away. As with the drug abuse, the high is only temporary, and it doesn’t change reality. To the extent the user continues, he or she only engages in self harm.
A few days after Nancy Reagan passed, the European Central Bank’s eschewed her pleas to ‘just say no,’ and chose to increase its version of Quantitative Easing, and to further reduce deposit rates. The full details of their monetary policy decision are below:
Monetary policy decisions
At today’s meeting the Governing Council of the ECB took the following monetary policy decisions:
(1) The interest rate on the main refinancing operations of the Eurosystem will be decreased by 5 basis points to 0.00%, starting from the operation to be settled on 16 March 2016.
(2) The interest rate on the marginal lending facility will be decreased by 5 basis points to 0.25%, with effect from 16 March 2016.
(3) The interest rate on the deposit facility will be decreased by 10 basis points to -0.40%, with effect from 16 March 2016.
(4) The monthly purchases under the asset purchase programme will be expanded to €80 billion starting in April.
(5) Investment grade euro-denominated bonds issued by non-bank corporations established in the euro area will be included in the list of assets that are eligible for regular purchases.
(6) A new series of four targeted longer-term refinancing operations (TLTRO II), each with a maturity of four years, will be launched, starting in June 2016. Borrowing conditions in these operations can be as low as the interest rate on the deposit facility.
As usual, the real fireworks came in the press conference after the decision was released, in which Draghi made his usual attempt to please everyone. The monetary doves who believe that the ECB hasn’t been loose enough with the monetary spigots got something to cheer in the announcement itself. The more hawkish who believe the ECB is being far too loose also got something when Draghi declared that this set of policy easing would be the last for the foreseeable future.
What interests me in all of this is the base attempt by yet another central banker to control an economic situation which is not going according to plan. Ever since the Great Recession, central bankers the world over have been engaged in a constant battle with the marketplace. The American version of this battle is as follows: the marketplace wanted to (and still wants to) effectively restructure the debts incurred during the go-go years of the housing bubble. Doing so would have resulted in a cascade of bank and corporate failures, asset price declines, layoffs, and defaults of various kinds. To be sure, a lot of that did happen, but it would have been a lot worse had central bankers not acted, as Draghi defiantly pointed out multiple times during his press conference.
This stance, that ‘the counterfactual’ would have been utterly devastating for Western Civilization as a whole stands as a blanket justification for mainstream economists, government officials, and commentators as to why the efforts of central bankers since 2008 were beneficial to the respective economies. The economy was a patient bleeding from a gunshot wound, the analogy goes, and the central bankers were the surgeons in the Emergency Room. Unfortunately, it relies on a bankrupt understanding of economics, which, as I will show, not only led us to pursue the wrong course of action in 2008, but will lead to the ultimate demise of the economy as we know it should it continue.
Economic Growth, and How Best to Attain It
Even though my contention is that the central bankers of the world have got it wrong, I will concede that at the very least, they have good intentions. They ostensibly want to achieve steady economic growth, and to do so with as little unemployment as possible. So where are they getting it wrong?
Let’s start from the beginning. Economic growth is a process by which the scarce resources on this planet are fashioned into goods and services which help to satisfy the many needs and wants of man. To the extent that these goods and services are better and/or more plentiful than before, the standard of living of those affected will rise. This process begins with a producer anticipating a future want or need, continues to the producer acquiring land, labor and capital, then producing the product or service, and delivering that product or service to the market. The last stage of the process is the consumption of the good or service. Reiterated for the more visual readers:
How Economic Growth Happens In A Market:
Identification/Anticipation of Unmet Want or Need
Gather Land, Labor and Capital
Delivery to Marketplace
At any given moment in time, resources are finite, thus how they are used becomes important. At the same time, there are many producers who are competing for those resources so they can attempt to satisfy the needs and wants of consumers which they have determined. The producers which get to realize their vision as opposed to those who don’t is largely determined by price. More specifically, the price of land, labor and capital, the price of the money which is borrowed to procure them, as well as the price at which those final goods can be sold.
As prices change in the market, the prospects for producers’ projects change with them. Policy makers understand this – which is why during recessions, they seek to stimulate investment by lowering the rate of interest. This lower cost of borrowing means that more of it can be done, which in theory leads to more investment and production. An unencumbered marketplace seeks to stimulate investment just the same. Its method is different from that of policymakers, in that it works via the reduction of prices and a rising rate of interest. When this occurs, the lower prices also bring costs down, which then means that the price a producer then has to command to clear a profit becomes easier to achieve.
A word here on the idea of a ‘deflationary spiral,’ the possibility of which was referenced by Draghi in his presser as ‘disastrous.’ The idea that ‘deflation,’ defined as falling prices in the mainstream, is to be avoided at all costs is a big part of Keynesian theory, some variant of which has been the dominant economic dogma for the last 80 years. This reticence among policymakers is because falling prices in recessions lead to falling profits, which lead to rising layoffs and liquidations, which lead to more falling prices, and profits, theoretically driving the economy into a ‘spiral’ like vortex. Therefore policy seeks to maintain a rising price level. This underscores the consistency among policymakers, and academics of all stripes in assigning a positive connotation to rising prices and a negative connotation for falling prices.
Taking the theory out and returning to the real world exposes this predilection for inflation for what it is – nonsense. Central bankers the world over are declaring that if the prices of goods and services economy wide go up by a certain amount each year, the economy will be in great shape. If the prices for rent, food and gas went down, however? Chaos must be lurking.
Of course, the fear of falling prices neglects the fact that humans have never ending needs and wants, such that the price level will never ‘spiral’ to zero. At some level of prices, there will be demand for goods, which means there will be an interest for producers to supply that demand. Once that price level is found, the engine of economic growth can begin anew.
Some Methods of Stimulus Are Better Than Others
Invariably, recessions happen. The short explanation for them is that humans make mistakes. To be slightly more detailed, the economic growth machine can stall for various reasons. Producers may misinterpret the need or want for their goods. Too much of them may be produced. They may be produced inefficiently. Consumers may have changed their tastes. Whatever the reason, slowdowns in economic growth are always going to happen, the same way any path to success will have blips or setbacks along the way.
The true measure of success, without being too cliché, is not how many times one is felled, but the response to each fall, and how and if one gets up. With respect to economies, how the inevitability of recessions are responded to is of utmost importance.
The difference between a policymaker and freer market method of restoring investment during recessions ultimately boils down to the following: Policy makers prefer lowering interest rates, combined with other measures, with a goal of propping up the price level. The market, left alone, would be inclined to higher interest rates with a falling price level. From the perspective of the producer the lower interest rates/higher price combo means that ultimately a higher price is required for their final goods to achieve a profit. The higher interest rate combined with a price level left to find its true means a lower price for final goods is then necessary to make a profit.
Prior to the Federal Reserve, recessions more or less played out via the market raising interest rates, dropping prices, and allowing the chips to fall where they fell. A clear example of this is the ‘Long Depression,’ a description ascribed to the period from 1873-1879. My analysis of this period comes from the work done by Milton Friedman and Anna Schwartz in their book A Monetary History of the United States, 1867-1960. I’ll start with the conclusion first: it is questionable that this period (Friedman and Schwartz start with 1869 in their analysis) really constituted a depression on the whole, given the economy improved in virtually metric over the course of the period. The following chart illustrates this:
A more qualitative description of the time period is given by Friedman and Schwartz below:
There are many other signs of rapid economic growth. This was a period of great railroad expansion dramatized by the linking of the coasts by rail in 1869. The number of miles of track operated more than doubled from 1867 to 1879, a rate of expansion not matched subsequently.
In New York State, for which figures are readily available, the number of ton miles of freight carried on railroads nearly quintupled and, for the first time since the figures began, exceeded the number of ton miles carried on canals and rivers…. The number of farms rose by over 50 per cent from 1870 to 1880 for the U.S. as a whole. The average value per acre apparently increased despite the sharp decline in the price of farm products—clear evidence of a rise in economic productivity. The output of coal, pig iron, and copper all more than doubled and that of lead multiplied sixfold.
Manufacturing shared in the expansion. The Census reported 33 per cent more wage earners engaged in manufacturing in 1879 than in 1869, though 1879 was a year containing a cyclical trough and one following an unusually long contraction, while 1869 was a year containing a cyclical peak. An index of basic production compiled by Warren and Pearson nearly doubled from 1867 to 1879.
The rapid progress of the United States in manufacturing was clearly reflected in international trade statistics. Despite a decline in prices, exports of finished manufactures were nearly 2.5 times as large in gold values and 1.75 times as large in greenback values in 1879 as in 1867.
Based on the chart alone, it is clear that 1879 America was superior to 1869 America. There was a robust increase in the value of the national product, both in absolute terms and per capita. This is despite the population increasing by 25% in a 10 year period. The money velocity, which is used as a proxy for investment and spending, remained about the same, showing that money flowed around the economy with no problem.
The quoted passage from Friedman and Schwartz provides more detail, describing the manner in which vastly improved productivity led to more product at a lower price, which is the mechanism through which economic growth is passed to the masses on the whole.
The following chart is a more visual representation of what happened over that 10 year period, and is particularly instructive with respect to the overall point made about downturns and recoveries:
The following description accompanies the chart:
Consider the velocity series on that chart. Velocity declines from 1869 to 1871, rises to 1873, and declines to 1875. So far, so good. June 1869 marked a cyclical peak, December 1870, a cyclical trough, and October 1873, a cyclical peak, so these movements conform to the cycle in the same direction as later movements. But then comes a serious discrepancy. Velocity rose some 17 per cent from 1875 to 1879, bringing the terminal velocity to a level 4 per cent higher than in 1869 and 8 per cent higher than in 1873, both cyclical peak years.
The relevant detail is the fact that while velocity fell in the initial portion of the depression, from 1873-1875, it quickly responded over the next four years to reach a high surpassing the prior peak years. This puts the lie to the deflationary spiral fears propagated by central banks and their ideological brethren, given that the price level declined during this period. Indeed, the lower price level induced spending and investment, which is evidenced by the increased national product in 1879 versus 10 years prior.
The only evidence that this period was some sort of devastating time in American history was the protracted decline in prices, which was a constant of the time. And it is only considered a negative because of contemporary misunderstanding of deflation and inflation. Even in Friedman and Schwartz’ writing, they describe the idea as money velocity responding positively to falling prices as ‘a serious discrepancy.’
The Keynesian influenced economic dogma suggests that as prices fall, humans are more inclined to hoard their money as opposed to spending it because of the anticipation that an even better deal awaits them. In reality, these decisions are governed by an individual time preference. We as humans ultimately desire goods and services, not money for its own sake. Thus a certain level of ‘natural demand’ exists, which is discovered as prices fall, shifting preferences to preferring goods versus money. It is the falling price that persuades the change of preference.
Friedman and Schwartz’ astonishment at their findings is captured in the following, emphasis mine:
…an unusually rapid rise in output converted an unusually slow rate of rise in the stock of money into a rapid decline in prices. We have dwelt on this result and sought to buttress it by a variety of evidence, because it runs directly counter both to qualitative comment on the period and to some of the most strongly held current views of economists about the relation between changes in prices and in economic activity.
…In the greenback episode, a deflation of 50 per cent took place over the course of the decade and a half after 1865. Not only did it not produce stagnation; on the contrary, it was accompanied and produced by a rapid rate of rise in real income. The chain of influence ran from expansion of output to price decline.
Modern recessions are different, in that central bankers believe that once the price level rises again, economic growth will follow. This hyper focus on the price level is backwards thinking, mainly because prices are the effects of real economic conditions, as opposed to the causes of them. Furthermore, the modern economy employs a debt based consumer spending model as its means to economic growth.
This method is particularly prone to stalling, because the impetus for spending (increasing levels of debt) cannot continue in perpetuity. At some point, markets can’t support prices at the high levels producers need to set, which in turn leads to prices falling, profits falling, trouble servicing debts, liquidations, and layoffs. Yet, the solution presented by mainstream economics is to guide prices higher again. Here’s Nobel Prize winning economist Paul Krugman, writing in reference to the recent machinations over the Federal Reserve raising interest rates:
So the Fed should not be eager to raise rates until inflation and wage growth are at least at, and preferably above, where they were before the bottom fell out.
Krugman, like most in the mainstream, do not fathom that the bottom fell out precisely because prices were already elevated beyond what the market could support in the first place.
A Rock and A Hard Place
The debt-driven, consumer spending method of achieving economic growth which has been employed in modern business cycles has ended up being wholly inadequate; this is proven by the fact that the result of it was the Great Recession. This model of economic growth ‘worked’ as long as debt continued to expand. As long as low interest rates enabled producers to borrow to increase output at elevated prices, and as long as consumers could borrow to pay further elevated prices for final goods, things ran smoothly. Asset prices rose on the back of all of this, which enabled further borrowing, as the rising valuations of assets provided more collateral.
This all came to a head when the debt machine came to a halt. As mentioned before, since incomes are finite at any given time, there is a limit to how much can be borrowed. Once that limit is hit, the impetus to spending, by consumers and producers alike, is no longer there. That removed impetus set in motion the slowdown leading to the Great Recession.
The Federal Reserve, the ECB, the Bank of Japan, Bank of England and the rest of the major central banks responded to the Great Recession in an unprecedented manner. In lowering the rate of interest to zero and creating trillions of dollars from nothing to buy trillions worth of bad debt and government bonds, the price level in major economies was prevented from falling further. The debt engine was restarted; assets stopped falling and summarily went higher – for a time.
The story differs depending on which constituency you are in, but the gist is that the central bankers have only been able to succeed in spurts. That is they are able to engineer prices higher, as evidenced by rising inflation, but as time goes on prices stop rising. They must then spring into action again in order to kick start inflation, or at the very least prevent deflation. This is behind the ECB’s decision on Thursday to further loosen its monetary policy.
It is a former central banker, Richard Fisher, who perhaps unintentionally, but entirely accurately, described the nature of the mission central bankers have undertaken. In speaking with CNBC last Wednesday, he described the actions of the Federal Reserve since the Great Recession as injecting cocaine and heroin into the system, which is now being maintained with Ritalin. Fisher went on to say the following:
It was a discussion about the cost-benefits of QE, and the major objective was to create a wealth effect. So we drove rates to zero, we actually drove rates to the lowest yields in 239 years of history. When you do that, what you do is you change the way you discount future yields and future earnings. The market took off the first week of March 2009 when we made it very clear, we had already doubled the size of our balance sheet, and we were gonna do more. And that was the trip wire, or at least the ignition of this great rally.
Even more instructive, towards the end of the exchange, CNBC anchor Simon Hobbes asked Fisher that, having created the wealth effect, was it imperative for the central bank to ‘protect the market,’ and to underwrite it so as to prevent the economy from suffering if and when financial markets decline. Fisher answered that it would be a ‘reckless thing to do.’
Unfortunately for central bankers, this sort of recklessness is the only option open to them. In holding deflation as an iron clad negative thing, central bankers have locked themselves into a position in which they are compelled to force prices higher no matter what. This involves printing money to expand its balance sheet as Fisher mentioned.
These printing exercises are not singular events. Prices naturally rise and fall, so if you have sworn to eliminate prices falling, you are always going to have to be on the job, because at some point down the road economic fundamentals necessitate a decline in prices. It is then you will have to print again, which in the short run boosts prices once more…until the next time.
The drug analogy brought up by Fisher is apt. In injecting large amounts of liquidity to the system, the Fed was effectively shooting up with cocaine and heroin. The ‘high’ of that drug took the form of increased asset prices, increased investment and consumption, and so forth.
Like drug use, the high doesn’t last forever. It dissipates, and whatever reality the drug user was trying to escape returns. Similarly, when the effect of one monetary loosening campaign wore off, the threats to the economy that originally plagued it resurface. The unsustainable debt burdens, rather than being cleared, remain. The inefficient companies which should have been liquidated also remain, and so forth.
The drug user can keep taking more hits of the drug, but eventually, the body will become acclimated to that dosage of the drug, and the desired high won’t be achieved. It takes larger and larger doses of the drug to achieve a high strong enough to escape reality. Since the drug is a poison, there is some amount of the drug which will prove too much for the body to handle, and it will succumb to an overdose.
The economic equivalent of this is the specter of hyperinflation. In order to maintain the ‘wealth effect,’ which entails ever rising levels of debt, rising asset prices, investment and production, central bankers will have to provide ever greater amounts of liquidity. This explains why there have been three Quantitative Easing programs in the United States, of increasing size and duration. Every time a QE program had been stopped, the economy subsequently threatened to roll back into a deep recession.
Maintaining the economy on Ritalin won’t work, it needs something much stronger. Yet, doing so will endanger the very viability of the dollar. No one knows exactly where the breaking point is, but it does exist. There is a point at which the US dollar will become worthless, as long as the Federal Reserve fashions to print its way out of recessions.
As such, the Fed is truly between a rock and a hard place. It cannot explicitly underwrite expansion of debt in perpetuity without destroying the dollar. On the other, it cannot stop the expansion of debt without destroying the impetus for appreciating prices, and therefore the recovery it engineered. The Fed, as well as all central banks, must choose between their (flawed) notions of engineering economic growth through debt based consumption, and the currency. Only one can survive.
Of course, central bankers can easily hop out of the box they’ve placed themselves in, but it requires them to change their thinking. It requires them to forget the notion that increases in asset prices can only be positive, regardless of the reason why the asset prices are rising. It is the same craving for an instant, better high which dooms the drug abuser. As drug users need not try to escape from the lows of life via the highs of drugs, central bankers need not attempt to escape the temporary blips in human progress – recessions – via the exuberance of stock market manias, tech booms and housing bubbles.
At the risk of sounding inhumane, the patient who ended up in the ER at the depths of the Great Recession wasn’t worth saving. Having said that, a more accurate medical analogy one can use is a cancer diagnosis. The Great Recession was the emergence of a large tumor which was threatening our well-being. After being diagnosed, the doctor told us we had two options: Undergo severe chemotherapy and radiation that might leave us bedridden for up to 18 months to two years, followed by a few more months of physical therapy. After that, the cancer would be completely gone. The other option would be to take a daily cocktail of medication, mostly to numb the physical pain and other symptoms of the tumor. We could physically go about our day as normal, but the tumor would remain, slowly entrenching itself in the body.
The latter option was chosen, as QE, TARP, and other programs constituted the cocktail of medication which numbed the pain and restarted the engine of growth from the prior cycle. Asset prices rebounded, job growth returned, and the economy looked to be on solid footing again.
However, the tumor is still with us, and thriving even. The ‘medication’ given to us by the Federal Reserve has meant that all sectors of the economy, from household to business to government, are now more saturated with debt than ever before. From the perspective of such a levered lot, the mere interest rate increase of 0.25%, let alone a proper normalization, borders on usurious. The fundamental truth remains that an economy which must have constant price increases to grow is an economy that will be prone to sudden, severe crashes as the general consumer base does not increase its income and take on debt at a fast enough pace to sustain demand at higher price levels.