Resuming this two-part series, after describing the primary features of the ABCT, I am now going to dwell on the secondary ones, as well as the role of government, finishing off with the proper course of action. Accordingly, some secondary features may develop. One of them is the deflationary credit contraction, although it is not a certain condition throughout a bust. The contraction phase begins with the end of the inflation, as you saw in the first installment, and can carry on without any further changes from the monetary camp. Nevertheless, deflation has almost always set in. Undeniably, after bankruptcies and financial woes amongst borrowers pervade the economy due to the excessive credit creation, the money supply starts to contract. However, there is no need for deflation to arise. Understandably, it is often posited that seeing that entrepreneurs can find few viable projects in a depression, business demand for loans plummets and, consequently, loans and money supply will shrink. Regardless, this argument overlooks the fact that banks, if they are willing, can purchase securities, thereby sustaining the money supply by increasing their investments to compensate for dwindling loans. Needless to say, this condition brings about some important implications that I am going to elucidate afterwards. Having said this, contractionist pressures always stem from banks and not from business borrowers. Be that as it may, the terrible economic landscape that is accompanied by widespread business failures could lead to questioning the banks' health and solvency state. Therefore, the money supply will decrease because of bank runs or "shadow bank" runs - like I showed previously. Even just the fear of such runs, owing to banks being inherently bankrupt in a fractional reserve system (or in sort of one), is enough for banks to tighten their positions. Furthermore, another common secondary trait of the bust is the surge in the demand for money. This "scramble for liquidity" as is frequently referred to, is provoked by three factors: i) people expect falling prices on account of the flagging economy and the emerging deflation, causing them to save more money and spend less, awaiting the drop in prices; ii) borrowers will try to pay off their debts, which are being promptly called by banks and other creditors, by liquidating other assets in exchange for cash; iii) the torrent of business losses and insolvencies makes businessmen wary of investing until the financial distress and the liquidation process cease. With the supply of money waning, and the demand for it rising, general falling prices are a consequent attribute of most busts, chiefly in its most gruelling stage. Notwithstanding, declining prices overall is precipitated by the secondary, rather than by the inherent, features of busts. In spite of regarding that the readjustments induced during the contraction phase should be permitted to unwind, almost all economists (not just the Keynesians) take the rather unfavourable view that the deflation and the general price fall that derives from it unnecessarily aggravate the severity of recessions. Despite that, this notion is incorrect for they have beneficial effects and definitely do not exacerbate the economic contraction. Firstly, on account of the general subside in prices, the demand for money can more easily be fulfilled because lower prices mean that the same total of cash balances have greater command over goods and services. As a result, the desire for increased real cash balances has now been satisfied. In the end, the demand for money will decline as soon as the liquidation and adjustment processes are finished. Once the liquidation is completed, the uncertainties surrounding the lousy financial panorama vanish and the scramble for liquidity terminates as well. So, a quick unhampered drop in prices, both in general (adjusting to the credit reduction) and especially in goods of higher orders (adjusting to the malinvestments of the boom), will speed up the recovery processes and remove expectations of further downturn. In defiance of prices waning as a whole, the important characteristic to note of the primary adjustments is that the prices of producers' goods plunge more rapidly than do consumer goods' prices. Secondly, the deflationary credit contraction is tremendously helpful to the recovery processes in the accounting of companies. Considering that firms record the value of assets at their original cost, when prices increase altogether, what seems to be a large profit may only be just sufficient to replace the now higher-priced assets. During an inflation, business profits are greatly overstated, with consumption of capital being greater than it would be if the accounting illusion were not operating - perhaps capital is even consumed without the entrepreneur realising it. On the flip side, in a period of deflation, the accounting illusion is reversed since what seem like losses and capital consumption, may actually mean profits for the firm due to assets now costing much less to be replaced. By merely thinking that he is replacing capital, the businessman is in reality incrementing the investment in his company. Thus, this overstatement of losses encourages saving, while restricting consumption. Finally, credit contraction will have yet another beneficial effect in promoting the recovery. Since credit expansion distorts the free-market by lowering price differentials between stages of production (lower differences between selling prices and costs), the curtailment of credit, au contraire, mangles the free-market in the opposing direction by diminishing the amount of funds in the businesses' hands, distinctly in the higher stages of production. Specifically, in view of the demand for factors in the higher stages dwindling, factor prices and incomes follow suit, increasing price differentials. Ergo, it encourages the shift of factors from the higher to the lower orders. Despite being abhorred by most economists, credit contraction returns the economy to (true) free-market proportions much sooner than otherwise. The more the government intervenes to delay the market's adjustment, the longer and more gruelling the depression will be, and the more difficult will be the road to complete recovery. Government hampering aggravates and perpetuates the depression." What is then the correct course of action that governments ought to pursue? If governments wish to see the economy actually recovering, breaking the shackles of the deflationary constraints and return to the suitable productive structure that respects society's time preferences, as quickly as possible, the first and clearest prescription, albeit very broad and basic, is not to interfere with the market's correction processes. Basically, the more the government intervenes, aiming at curing the economic malaises of the bust, those much-needed corrections are simply deferred. As a result, the deflationary/disinflationary environment will linger for longer, hindering "the road to complete recovery". As a matter of fact, were we to list the several ways that governments can hamper market adjustments, we would find that we had precisely catalogued the favourite measures of curbing recessions that make up the governments' fiscal and monetary arsenals. To wit, here are the ways the adjustments can be hobbled: 1. Preventing or retarding liquidation by keeping the credit spigots open, such as putting up a credit facility or guaranteeing loans backed by government; 2. By inflating further, the necessary fall in prices, mainly in the higher order goods, is blocked, thus delaying the corrections and prolonging the recession. The expansionary fiscal policies carried out by profligate governments that resort to debt and the accommodative monetary policies of central banks, in case they are actual "money printers", preclude the required structural reshaping to beget the recovery; 3. Keeping wage rates up insures permanent mass unemployment. In addition, when prices are declining because of deflation, trying to peg the rate of nominal wages results in pushing real wage rates higher. In the face of plummeting business activity and, accordingly, demand for labour, this aggravates immensely the unemployment problem; 4. Keeping prices up, above their true free-market levels, will create unsalable surpluses and prevent a return to adequate and sustained growth; 5. Stimulating consumption and discouraging saving worsen the shortage of saved funds even further, which is of course not conducive to a speedy recovery, being in fact a colossal drag. So as to encourage consumption, governments can provide all kinds of "helicopter money" payments, from food stamps to "stimmy" checks. Conversely, it can discourage saving and investment by increasing taxes, particularly on the wealthy, on corporations and estates. In case you do not know, any increment in government spending will discourage saving and investment, while spurring consumption, since government spending boils down to consumption. Although some of the private funds would have been saved and invested, all of the government funds are consumed (or rather wasted). Therefore, any amplification in the relative size of government in the economy, among other consequences, shifts the societal consumption/saving ratio in favour of consumption, extending the recession; 6. Subsidising unemployment via "insurance" payments or any other welfare programme will protract joblessness indefinitely, deferring the reshuffle of workers to the sectors where jobs are available. It is indeed probable that more harm and misery have been caused by men determined to use coercion to stamp out a moral evil than by men intent on doing evil." To conclude, credit expansion sets into motion the business cycle in all its phases. Beginning with the inflationary boom, marked by the swelling of the money supply and by malinvestment, then the crisis comes into light when the credit origination ceases, exposing the malinvestments, and reaches its finale when the corrections of the production structure are carried out. Ultimately, the economy gets back to the most efficient ways of satisfying consumers' wants and needs. Nevertheless, there is one huge caveat. Seeing that in the real world governments always feel the urge to save the day and rescue its constituency from the distress that crises generate, mainly for the public wanting a paternalistic State, the recovery phase is always restrained. Hardly ever does economic activity recover swiftly from its trough, at the full potential growth of a true free-market regime. Hence, government interventionism with the mission of combating the downturn and restoring the upward trajectory of the economy as fast as possible, will emphatically have the opposite effect. Bearing in mind that the banks, while reducing loans to businesses during the crisis phase, they stock up on securities, because of liquidity preferences. As you know, in times of outright financial panic or just meagre growth, the most liquid, meaning the safest, assets are the most sought after. These assets happen to be the debt securities issued by the governments of the most predominant and developed economies, such as the US, Germany, Japan and so on. For that reason, the prices of these government bonds (and notes and bills) skyrocket due to being in high demand, causing their interest rates (yields) to plunge. Despite becoming more prevalent since the inception of the eurodollar system, with its Markowitz foundations, these processes have abided by these methods, vis-à-vis liquidity preferences, since long before then (as the next graphs demonstrate). Consequently, noticing the low cost of servicing their debts, governments feel compelled to act. Obviously, they cannot refuse this invitation of profligacy. How could they? It is simply too tempting. Thus, the adjustments required to bring about a rapid recovery will be inhibited. Moreover, even though banks are able to trigger another boom by resuming their inflationary proclivities, if they perceive that economic conditions and their prospects are grim, they are not going to return to the prior "easy money" ways, owing to the outlook not being fitting to do so. Taking into account that banks are always looking for opportunities to lend to businesses in order to improve their profits, the fact that they refrain from doing so - the more governments butt in, the more they shy away from lending -, it really tells you a lot about the harm that government interference engenders.
Ergo, the best thing that governments can do is to essentially get out of the way and enact policies that adhere to the principles of laissez-faire capitalism. Fundamentally, let entrepreneurs find the best manners to satisfy the desires of the people, by getting rid of all kinds of arbitrary rules and regulations that erect barriers and hindrances which prevent the smooth functioning of the free-market system. To cap it all off, applying this philosophy to the banking industry and the monetary system, in general, is of the utmost importance to prevent the endless recurrence of the boom and bust cycle. On that account, only then can we grow and develop at the maximum rate imaginable, lifting along the way the standards of living at a pace never before witnessed. Above all, it would be done in a sustainable fashion, in view of conforming to the societal time preferences and the actual amount of savings. Otherwise, the governmental meddling acts as a tremendous drag on economic growth and all the things associated with it. Evidently, technological progress, social advance and rising living standards become gradually constrained. Therefore, the do-gooding politicians and technocrats that claim to know what is best for us, the commoners can very well, though unwittingly, turn a run-of-the-mill bust, a mere recession if you will, into a prolonged and dreadful depression.
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In this day and age, the most widely held belief on the cause of the business cycle is that it is endogenous to the capitalism system. In plain English, this means that the free-market is intrinsically unstable and fallible, though creating growth and progress, it also begets its own demise. In the turn of the 20th century, Ludwig von Mises presented his theory to the world explaining the puzzling and all-encompassing fluctuations in the economic landscape. Picking up where the Currency School of British classical economists left off in the early 19th century, his view holds that business cycles stem from disturbances generated in the market by monetary intervention. This monetary theory contends that money and credit - will be interchangeably mentioned - expansion, launched by the banking system (including all sorts of credit originators), triggers booms and busts. Because a cycle takes place in the economic realm, a valid cycle theory must be integrated with general economic theory, or as it is more commonly known, macroeconomics. Despite the followers of Keynes being the presumed superior economists owing to dominating economic thought worldwide, across academia, media and government agencies, the theory engendered by Mises is one of the only two (the other being Schumpeter's) that has been integrated into general economics. In fact, various neo-Keynesians have advanced cycle theories. However, they are integrated not with general economic theory, but with holistic Keynesian systems, which are very partial. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved." To begin with, I ought to describe the theory credited to Mises, the Austrian business cycle theory (ABCT). This theory came about because Mises detected that a cluster of business errors would suddenly emerge, causing an economic contraction. Clearly, such widespread failures cannot be provoked by business fluctuations due to changes in consumers' preferences or by entrepreneurs out of the blue becoming terrible at their jobs, which is to anticipate future economic conditions. Regarding business fluctuations, these are not the same thing as business cycles. On account of shifts in consumer tastes, in time preferences, in the labour force's quantity, quality and location, in natural resources' availability and in technologies, business activity is constantly mutating. Thus, we may expect specific business fluctuations all the time. Be that as it may, a special "cycle theory" is not necessary to account for them, being instead products of changes in economic data and are fully explained by economic thinking. Despite many economists attributing general business slump to weaknesses effected by a reduction in one or a few sectors of the economy, declines in specific industries can never ignite a general contraction, either a recession or a depression - the latter being an acute and/or a long period of substandard growth, stagnation or even continuous plunge of output. In view of shifts in data that will result in surges in activity in one field and declines in another, there is nothing here that points to general economic contraction, which is a phenomenon of the actual "business cycle". In relation to the pervasive mistakes made by the entrepreneurial class, this can only occur due to some external factor from the free-market. Since we live in a society of constant and unending change, this can never be precisely charted in advance. Although people try to forecast and anticipate changes as best as they can, such forecasting can never be reduced to an exact science. Nevertheless, entrepreneurs are in the business of foreseeing variations on the market, both for conditions of demand and of supply. While the more successful ones make profits, insofar as their judgements are accurate, the unsuccessful forecasters fall by the wayside. Hence, the successful entrepreneurs will be the ones most adapt at anticipating future business conditions. Needless to say, the forecasting is always imperfect, leading entrepreneurs to continuously differ in the success of their assessments and choices. Indeed, if this were not so, no profit or losses would ever be made in business - that is, they would operate in a market of perfect competition, which never transpires in the real world. Therefore, the market provides a training ground for the reward and expansion of successful and shrewd entrepreneurs, while weeding out the failed and unperceptive ones. In order to uncover the origin of the bust part of the business cycle, one must explain why there is a sudden cluster of business errors. This is the first and foremost peculiarity any cycle theory must account for. In spite of business activity moving along nicely with most businesses turning a profit, without notice, conditions change and the bulk of companies begin experiencing losses, revealing to have made grievous mistakes in their projections. On that account, a general review of entrepreneurship is now in order. As a rule, only some businessmen suffer losses at any other time; with the large majority either breaking even or making a profit. How, then, to justify the curious phenomenon of the crisis when almost all entrepreneurs accrue losses or simply earn less than they were expecting? How did these astute businessmen come to make such miscalculations together? And why were they all promptly unveiled at this particular time? Seeing that it is the duty of entrepreneurs to forecast future conditions, some of which being abrupt, it is then not legitimate to reply that instant changes in the data are responsible. Accordingly, you have to wonder why their analyses failed so abysmally. Another common feature of the business cycle calls for an explanation as well. Interestingly, throughout the cycle, capital goods industries oscillate more widely than do the consumer goods industries. Comparing to the latter group, the former one, chiefly the industries supplying raw materials, construction and equipment to other industries, scale up much further in the boom, being ultimately hit far more drastically in the bust. Lastly, a third feature of every boom that needs explaining is the expansion in the quantity of money in the economy. On the flip side, there is generally, though not universally, a decrease in the money supply during the bust. Bearing in mind those considerations, what immediately springs up as the explanatory element for the general movements in business is the general medium of exchange, money, for it is the mechanism of exchange (a.k.a., money) that links all economic activities. If one price of a particular good goes up and another one goes down, one may conclude that demand shifted from one industry to the other (with supply remaining the same). Having said this, if all prices, by and large, move up or down together, then something must have happened in the monetary sphere. In a nutshell, general price fluctuations are driven by changes in the supply of and demand for money. On the one hand, an increase in the money supply, with demand for it remaining constant, will cause a fall in the purchasing power of each monetary unit, occasioning a general rise in prices; vice versa, a drop in the money supply, ceteris paribus, will precipitate a general decline in prices. On the other hand, an increase in the general demand for money, the supply staying the same, will cause lead to the purchasing power of the currency to climb and, consequently, prices to wane overall; while a fall in demand will cause a general surge in prices. Ergo, when people are willing to hold in their cash balances (demand for money) the exact amount of money in existence, the purchasing power of money will remain constant. If the demand for money exceeds the stock, the purchasing power of money will soar until the demand is no longer excessive, clearing the market. Conversely, a demand lower than supply will subdue the currency's purchasing power, raising prices on average. Even though it has to be the case that any cycle in the economy as a whole must be transmitted through the mechanism of exchange, this relation between money and prices alone does not give the grounds for the business cycle. In short, why should this generate a business cycle? More importantly, why should it bring about a depression? According to the ABCT, it is due to the total disregard shown the banking institutions (including all types of credit originators) towards the people's time preferences. As we learned on the last couple of posts (parts I and II), time preferences give us the pure interest rate and its mirrored consumption-to-saving/investment ratio. Succinctly, a lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production and a building-up of capital, and vice versa. Moreover, the market rates of interest consist of the pure interest rate plus entrepreneurial and inflation risks. What is crucial to understand is that the resulting rates manifest themselves as the interest rates on the loan market. In practice, the interest rates are derived from the price differentials between businesses' selling prices and costs of production, that is the profit rate. Unsurprisingly, as banks expand credit to companies, giving the impression the supply of saved funds for investment has increased, the money enters the loan market, perhaps lowering or not the loan rates of interest - whether or not that happens is totally irrelevant. However, price differentials are, as a result, reduced. This occurs on account of businessmen being misled by the bank inflation into believing that the savings are greater than they actually are. Hence, when saved funds, are perceived to have increased, entrepreneurs invest in "longer" processes of production. In other words, the capital structure is lengthened, especially in the "higher" orders, most remote from the consumer. Essentially, entrepreneurs, using their newly acquired funds, bid up the prices of capital and other producer's goods, stimulating a shift of investment from the "lower" (near the consumer) to the "higher" (furthest form the consumer) orders of production. All in all, an "artificial" shift of investment from consumer goods to capital goods industries ensues. Soon, the new money percolates downward from the business borrowers to the factors of production: in wages, rents and interest. Unless time preferences moved lower, people will spend their higher incomes in the old consumption/investment proportions. In sum, capital goods industries, to a greater extent than the consumer goods sector, will find that their investments have been in error. What they thought profitable really fails for lack of demand by their entrepreneurial customers in the lower orders. Therefore, the higher orders of production have turned out to be highly wasteful (not all of it, of course) and the malinvestment must be liquidated. Owing to the credit expansion, beyond the true level of savings, ubiquitous bad decisions are committed. Naturally, the crisis arrives when the consumers come to reassert their desired proportions. The bust is for that reason the process by which the economy adjusts to the wastes and errors of the boom, re-establishing (or at least trying to) the efficient service of consumers' wants and needs. . . . additional investment is only possible to the extent that there is an additional supply of capital goods available. . .. The boom itself does not result in a restriction but rather in an increase in consumption, it does not procure more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in wrong lines, i.e., malinvestment on a scale for which the capital goods available do not suffice. Their projects are unrealisable on account of the insufficient supply of capital goods. . .. The unavoidable end of the credit expansion makes the faults committed visible. There are plants which cannot be utilised because the plants needed for the production of the complementary factors of production are lacking; plants the products of which cannot be sold because the consumers are more intent upon purchasing other goods which, however, are not produced in sufficient quantities. . .. The observer notices only the malinvestments which are visible and fails to recognise that these establishments are malinvestments only because of the fact that other plants - those required for the production of the complementary factors of production and those required for the production of consumers' goods more urgently demanded by the public - are lacking. . .. The whole entrepreneurial class is, as it were, in the position of a master-builder [who] . . . overestimates the quantity of the available supply [of] materials . . . oversizes the groundwork . . . and only discovers later . . . that he lacks the material needed for the completion of the structure. It is obvious that our master-builder's fault was not over-investment, but an inappropriate [investment]." In view that the inflationary boom precludes the efficient allocation of resources that a real free-market would generate by satisfying voluntarily expressed consumer desires, including the public's relative preferences for present and future consumption, the productive structure gets distorted, no longer serving consumers properly. Thus, the crisis signals the end of this inflationary distortion, and the contraction is the process by which the economy returns to the efficient service of consumers. Undeniably, far from being an evil scourge, the ensuing economic contraction is the necessary and beneficial return of the economy to normal. As a result, the boom plants the seeds for its future bust. Whether it becomes a garden-variety recession or a profound depression depends solely on the degree of government meddling, as I am going to demonstrate later on. Furthermore, the boom can last for a longer period than one would reasonably expect because banks tend to delay the day of reckoning. Seeing factors bid away from them by consumer goods industries, finding their costs surging and themselves short of funds to boot, the capital goods firms turn again to the banks. If the banks keep the credit spigots open, the borrowers are kept afloat. Once more, the new money pours into businesses and they can again bid factors away from the consumer goods industries. On the whole, as credit is relentlessly expanded, the wasteful enterprises can be shielded from consumer retribution. Clearly, the greater the credit swelling and the longer it goes on, the longer will the boom last. Without surprise, the boom will end when the inflationary credit expansion ceases at last. The longer the boom proceeds or the more intense it is in originating credit, the more imprudent errors are perpetrated, requiring more rigorous corrections and readjustments of the productive structure. On that account, some key features of the bust-recovery phase are going to emerge inevitably. For one, wasteful projects must either be abandoned or scaled down, with inefficient companies liquidated, completely or just partially, or turned over to their creditors. In addition, prices of producers' goods must dwindle, particularly in the higher orders of production, including capital goods, lands and wage rates. Just as the boom was marked by an illusory fall in the pure interest rates, although not necessarily in the market rates of interest, entailing that the price differentials between stages of production were too subdued, the bust consists of a rise in this interest-differential. This means that the prices of the capital and producers' goods must drop relative to prices in the consumer goods industries. Besides the indispensable price decreases of certain machines, whole aggregates of capital such as the stock market and real estate have to see their values contract. Finally, since factors of production must journey from the higher to the lower orders of production, some "transient" unemployment will materialise during the contraction phase, even though it does not have to be any greater than the unemployment corresponding to the shifts in production. In practice, the level of joblessness will be aggravated by the numerous bankruptcies and the vast malinvestments laid bare. Albeit it still needs to only be temporary. Simply put, the speedier the adjustment, the more fleeting will the unemployment be. Notwithstanding, if wage rates are kept artificially elevated, preventing them from falling, the unemployment will progress beyond the "transient" stage, assuredly becoming very alarming and harmful for the prospects of recovery. Due to being extensive and having still much to unravel, I will continue this discussion another day. Meanwhile, I would invite to read the other articles in this blog, if you have not already read them.
Let us get right down to business and resume where we left off in the first installment of this two-part series. Owing to functioning efficiently, the financial firms operating in the eurodollar markets were crushing their rivals in the New York (on-shore) money markets. Following the amplification of Regulation Q, which capped the interest rates payed on time deposits, in 1968, a very large flow of deposits started to move from New York City to London (for the most part) in the form of large-time deposits. This, coupled with the collapse of the London Gold Pool in March 1968, pushed NYC banks to send those deposits off-shore, to their overseas subsidiaries, and then borrowing them back to the head offices in NYC. In many cases, it was far easier than that. Usually, there would not even need to be any bank customer leaving the bank at all. The transactions could all occur physically in NYC, where, as Milton Friedman affirmed in 1969, the "bookkeeper's pen" could accomplish the round trip by itself. Unsurprisingly, these developments caught the eye of the Federal Open Market Committee (FOMC), inspiring bewilderment and unease among its members. Moreover, these innovative funding setups allowed banks to easily circumvent external constraints, including monetary policy and regulations, by using the wholesale techniques exposed in the first part. However, wholesale processes greatly favoured the larger banks that could, apparently, use their influence and superior expertise, both in technical and legal terms, to broker funding markets on- and off-shore to boot. Hence, the liaisons for these wholesale flows (primarily repo, or securities financing transactions, as they are sometimes called now) would be the biggest banks which were very keen on abandoning the traditional banking formats. As a matter of fact, this is what led to the S&L crisis of the 1980's (which left its mark as I am going to show later on), as many smaller banks and even thrifts sought to emulate what those large commercial banks discovered in the late 1960's. Because of this, the new forms of money, fuelled by the eurodollar markets, were confounding the monetary officials in charge of keeping track of the money supply so as to accomplish their mandate of price stability - do not forget, "inflation is always and everywhere a monetary phenomenon", as Friedman asserted). Using the measurements available at that time, M1 and M2, Fed staffers and economist just could not make sense of them. Curiously, these monetary aggregates could not keep up with the money demand depicted in their statistical models. To be more specific, the estimated demand for liquid deposit balances, for one, would regularly come in six, seven or even eight percentage points greater than the actual growth in money demand for those money forms. Something was amiss. As a result, this was exactly what led Princeton economist Stephen Goldfeld, in 1976, to make the case for the "mising money". Notwithstanding, that money was never missing; just operating in the shadows, with the officials at the Fed and at other central banks never really bothering to look for it. In September 1979, Norman Bowsher of the Federal Reserve bank of St. Louis elaborated a synopsis of this money demand issue, founding that repo was a big part of that "missing money". According to his estimates, the volume of the repo market at the end of 1970 amounted to roughly $2.8 bn. By 1975, that had turned into more than $15 bn, then reaching in June of 1979 an astonishing $45 bn. Interestingly, these advancements were taking place while prices were skyrocketing across the board (Great Inflation). Likewise, as the eurodollar markets were revolutionising the realm of banking, as well as finance in general, researchers Günter Dufey and Ian H. Giddy from the University of Michigan and Columbia, respectively, published a paper in February 1981 (right around the climax of the Great Inflation and the apex of the eurodollar system). In here, they detail several of the financial procedures and instruments experimented throughout the two previous decades. …the general principle is that the currency of denomination of an asset can be “converted” by contractually selling the future cashflows from that asset for another currency. Similarly, the currency denomination of a liability may be altered by contractually purchasing the foreign currency necessary to liquidate that obligation. The remarkable feature of this use of forward contracts in the Eurocurrency market, for example, is that it enables banks to offer deposits or loans in any currency for which there is a forward exchange market, even if no external money market exists in that currency. The result is that the Eurodollar is the only full-fledged external money in existence; other Eurocurrencies are often simply Eurodollars linked to forward exchange contracts. On account of feeling the urge to document the financial bacchanal, Dufey and Giddy listed all sort of newfangled products; not jusy those who caught on, but also those that failed to do so, like floating-rate notes. In a nutshell, what they demonstrated was that all of this financial innovation had turned the monetary system into a virtual, reserve-less and cash-less, currency-like system, as is styled by Jeff Snider, which operates on risk calculations to assess balance sheet capacities, as I expounded in the first segment. Besides the US dollar, they noted every other currency, insofar as there were forward exchange markets, was part of this monetary apparatus for being, in fact, "simply Eurodollars linked to forward exhange contracts". Thus, the actual monetary system had become even more derivative, although it kept its monetary essence. Essentially, it moved from a system where money in possession was that system's primary constraint (traditional fractional reserve banking) to one in which the balance sheet factors balancing "future cash flows from that asset" have reigned supreme. Ergo, real world bank liabilities could be liquidated or cleared based upon external - virtual, as opposed to real (having nothing to do with computers and the internet) - exchange markets of potential future transactions. Needless to say, such transfigurations stupefyed monetary policy-makers and regulators. Similar to Bowsher's efforts, Morgan Guaranty Trust, the precursor of the current JP Morgan Chase, used to provide estimates for the size of the whole Eurocurrency marketplace. In the middle of 1980, the eurodollar system mounted up to grossly $1,310 bn. Comparing to the US domestic system, the Fed's M2 aggregate, which included Eurodollar deposits held by US citizens at Caribbean branches, totalled in the same period $1,587 bn, with the Eurodollar deposits at a mere $2.9 bn. In addition, the M3 aggregate was about $1,850 bn. Remarkably, in 1980, the gross size was already two-thirds of the broadest monetary bundle of domestic money supply. Since the early 1960's, the eurodollar system had mushroomed tremendously, with the estimates from Morgan Guaranty numbering approximately a paltry $50 bn at that time. Then, by March 1988, which happended to be, for whatever reason, the last year Morgan Guaranty produced these estimates, the gross size of the eurodollar setup was worth $4,561 bn, while M2 in May 1992 added up to $3,396 bn, with the Eurodollar component being at $17.8 bn. Hence, the gross magnitude of the eurodollar regime was a third, or thereabouts, greater in 1988 than the M2 aggregate would be three years afterwards. As I mentioned before, the S&L - Savings and Loans institutions - crisis of the late 1980's was precipitated by these small entities taking a bigger step than their legs (as we say in Portugal) by following the larger banks, in a quest for higher returns. Accordingly, when the 1990's broke out, the shadow banking system took over, making the risk quantification calculations, such as VaR, pervasive in every major firm. Furthermore, a big break came in 1995, which interestingly coincided with the rise of excessive speculation and enormous credit creation. In short, a series of bubbles started to emerge. By allowing absolute public access to its thorough database on variances and covariances for a myriad of securities and financial instruments of all types, known as RiskMetrics, JP Morgan (the old Morgan Guaranty) was, inadvertently, the instigator of the heyday of the eurodollar system, where the "proliferation of products" spiraled out of control. The problem is that we cannot extract from our statistical database what is true money conceptually, either in the transactions mode or the store-of-value mode. One of the reasons, obviously, is that the proliferation of products has been so extraordinary that the true underlying mix of money in our money and near money data is continuously changing. As a consequence, while of necessity it must be the case at the end of the day that inflation has to be a monetary phenomenon, a decision to base policy on measures of money presupposes that we can locate money. And that has become an increasingly dubious proposition. In spite of sounding odd to some, the regulatory framework contributed immesely to the expansion of this banking modus operandi. The Basel Accords that were enacted in that decade were derived from these kinds of mathematical concepts, joining the "bucket" approach first introduced by the UNCR (see Part I). Due in large part to this new regulatory format, the quantification of risk became money-like. Therefore, regulatory bodies, both national and international, for being complaisant, emboldened banks to adhere to these practices. Hence, banks kept on expanding credit (the true "printing press") and, consequently, the money supply, as long as volatility and loss probabilities measurements, chiefly, permitted. Speaking of "printing press", contrary to popular belief, monetary policy is not, in the current molds, "money printing", in view of the fact that bank reserves (which are the byproduct of asset purchase programmes by central banks) do not factor in these calculations. Seeing that the pigheaded central bankers are guilty of negligence for not grasping the importance of these shadow off-shore markets, it merits a few articles on its own, if not a whole compendium. For that reason, I am not going to dwell on it here. Despite the utter irrelevance of bank reserves, combined with the undeserved faith in central bank mastery (the Greenspan put), these aspects managed to suppress risk perceptions, resulting in colossal balance sheet space. Moreover, this ultimately induced the relentlessly growing of the eurodollar system, up to that fatidic day of August 9, 2007. From then onwards, as the charts above show (using data only from banks operating in the US as a proxy for the entire eurodollar system), after the GFC, the expansion of money turned substantially tighter. Surely, it seems as if it had not been for the benevolent politicians and bureaucrats (in those graphs represented solely by the US government) credit origination would have practically stopped in its tracks, meaning that economic growth would have been almost inexistent. However, that is far from the truth, though unfortunately I have to defer that discussion for another day. As the graph above demonstrates, there is a huge variety of interest rates, at various levels, moving in distinct directions and transmitting different informations. Let us not forget, interest rates are simply prices and the price system is nothing more than a mechanism to convey information about the economic landscape and all of its elements. Looking at the chart, notice how the riskiest kinds of credit, like consumer and personal loans, have not kept the pace of descent of, or even diverged completely from, the safest (most liquid) forms, such as corporate and government yields, since the top of the Great Inflation. Although signaling that money creation is in the doldrums, some assets and sectors, as is exhibited by the next couple of charts, benefit with the low interest rate environment (e.g. bonds, real estate, large-cap and growth stocks, etc) Therefore, this entails that every asset class and industry are not hit by the economic "malaise" (tight money) equally, for some of them, albeit a small group, gain considerably. To conclude, how do we reconcile and relate the interest rate fallacy and classical/Austrian theory of interest? Evidently, it has to be the case that perceptions on entrepreneurial and inflation risks, besides the time preferences, are not sufficient to explain interest rates. Even if they denoted the most favourable conditions (i.e., no risk), interest rates could not possibly be zero, not to mention negative, on account of null and negative time preferences are an imposibility given our nature (i.e., human action). Hence, another component is necessary: liquidity risk.
Back in the day, prior to Markowitz unwittingly shifting the monetary and financial paradigm, the liquidity risk, albeit already a factor, was not as relevant as today. In fact, I posit that, in this day and age, the liquidity risk is all that matters. Since zero and negative interest rates (mostly on government bonds of advanced economies) are an outlandish reality, this must mean the liquidity risk completely overpowers the other components. Undeniably, owing to volatility and liquidity being opposite sides of the same coin, and that volatility is infered from all kinds of risk, it is then clear that liquidity risk encompasses entrepreneurial and inflation risks already. Merely time preference (the pure interest rate) is left as an element constituting interest rates. By looking at the sovereign bonds, for example, through the perspective of a typical investor, it is normal to reject them, not even touching them with a 10-foot pole, as Jamie Dimon, who is JP Morgan Chase's CEO, declared. Indeed, he fears high inflation is on the cards and, ergo, demands higher compensation, which should be reflected in a higher pure interest rate. Yet, in the reign of the eurodollar system, time preferences have little to no influence. During periods of financial distress, like the one encountered on March of last year, while the most liquid assets experience soaring prices, such as USTs with their yields dwindling, the riskiest securities and businesses will be priced accordingly, which will be reflected in their interest rates. This emphatically explains the intransigence of interest rates on those illiquid consumer and personal loans to join the others at the bottom (shown on the FRED chart above). By the same token, due to banking regulations that are designed to protect depositors, especially small ones, largely the schemes of deposit guarantees, the "retail" deposits have become after all risk-less assets (for the holders of these deposits). Accordingly, they yield the same as those risk-free assets, the sovereign bonds - in the case of Europe, banks refuse to impose negative rates just because their clients would immediately vanish. In view of the nature of the eurodollar beast, as uncertainty rises, the more liquid a security, the more will be requested in order for banks to maintain their balance sheets at maximum possible capacity. In the end, the conditions in the economy, validly appraised or not, in tandem with expectations of those conditions in the future are determinants of the rates of interest. Undoubtedly, for living in the era of the eurodollars, interest rates have no interest in the mainstream (keynesian) economists' explanations, whether it is Ben Bernanke's "global savings glut" or Larry Summers' "secular stagnation", rendering them absolutely laughable, if this situation was not so dreadful. In the midst of the enigmas pervading the enormously important, though puzzling, study of the economy, none other causes as much perplexity as interest rates. In spite of being the ones that pop up outright in people's minds when they think of them, in reality, there is a myriad of interest rates across different asset classes and geographies. Unsurprisingly, throughout the ages, interest rates have been the subject of immense scrutiny and discussion. However, it seems the level of understanding has not been improving. In fact, I contend it has actually regressed. The reasons for such growing mystification lies on i) the evolution of the monetary system (eurodollar), ii) academic obstinacy, iii) bureaucratic inertia and iv) reverence towards the so-called experts. To make long story short, due to technological progress, combined with the inauguration of new banking configurations brought about by methodological advancements, the banking industry started to mutate into a wholesale deposit system, increasingly burying the traditional retail banking arrangement. Following the inception of the eurodollar regime, banks, in lieu of compensating depositors acording to their time preferences, began to, on the whole, pay them interest based on the risk factors of their balance sheets' makeup. Owing to the developments of money and financial intermediation, credit expansion ballooned, particularly in the first few decades - Great Inflation -, regardless of the ostensible high interest rates and "missing money". Evidently, economists became confounded by this assumed dissonance for not being attentive to changes in the monetary system, having been stuck with an ancient worldview; an era that is no more. Overall, interest rates are determined by the participants in the financial system (predominantly banks) insofar as the economic and financial conditions forge their assessment. Moreover, credit is provided on the basis of balance sheet constraints and its various risk metrics. To begin with, the accepted view on interest rates, the one you are taught in college, is that interest rates reflect the time preference of society, which gives us the pure interest rate as Murray Rothbard dubbed it, plus entrepreneurial risk and inflation risk - the former one accounts for all the idiosyncratic forms of risk particular to any enterprise, while the latter one is an unanticipated loss in the purchasing power of money (PPM), since the expected loss in PPM is already reflected in the time preference and, therefore, the pure interest rate. In the classical and Austrian views, people's time preferences are what shape the production structure. The proportion of consumption to saving on investment is determined by the degree to which people prefer present to future satisfactions. The less they prefer them in the present, the lower will their time-preference rate be, and the lower will, obviously, be the pure interest rate. On the one hand, a lower time-preference rate will be reflected in greater proportions of investment to consumption, a lengthening of the structure of production and an accumulation of capital. On the other hand, higher time preferences will be expressed in higher pure interest rates and a lower proportion of investment to consumption. Because of varying degrees of entrepreneurial risk, along with loss of PPM risk, a structure of interest rates is established instead of a single uniform one. Nevertheless, seeing that it is the basis for the structure of production, and being a key aspect of the Austrian business cycle theory (ABCT), the crucial ingredient is the pure interest rate. According to the ABCT, when banks swell their credit balances to the economy, this new money pours forth on the credit market and lowers the rate of interest. Albeit this condition is not vital to the process, as Mises posited: If a bank does not expand circulation credit by issuing additional fiduciary media…it cannot generate a boom even if it lowers the amount of interest charged below the rate of the unhampered market….The inference to be drawn from the [Austrian] monetary cycle theory by those who want to prevent the recurrence of booms and of the subsequent depressions is not that the banks should not lower the rate of interest, but that they should abstain from credit expansion." In summary, while banks could arbitrarily lower the interest rate on loans, this would not initiate an inflationary boom. By the same token, even though banks could leave the interest rate unchanged, they could still lend out newly-created bank reserves by lowering the criteria of credit origination, which would ignite a boom and asset price inflation. Ergo, the concept that a low interest rate would spur credit expansion has been nebulous for a very long time. Yet, this tenuous link is still "taken for granted", even though Milton Friedman demolished this belief as far back as 1967 with its interest rate fallacy, as Jeff Snider coined it. As an empirical matter, low interest rates are a sign that monetary policy has been tight - in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy - in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted." In order to comprehend the current predicament, our journey starts in Chicago in the late 1940's. Although the ideas for quantification of economic factors have risen in the 19th century, technology and theoretical proficiency made way for those ideas to be expressed more coherently. Due to turning out so revolutionary, Harry Markowitz had, to all intents and purposes, established a completely new branch of economics: portfolio theory. By applying probability theory to equity behaviour, Markowitz would unwittingly change the world. Using variance (and covariance) to measure the risk of a portfolio, an investor could select a point from the set of Pareto optimal expected returns and variances of return combinations, known as the efficient frontier. In view of the intuition in this intellectual framework, it has been widely adopted. To the purposes of our discussion here, this theoretical breakthrough provided the technical tools to the overarching monetary tranfigurations that commenced in the 1950's. Naturally. this reduced the relevance of not just prior concepts, but actual operative workings. Owing to its fractional reserve nature, risk management had always been concentrated far more so on the liability side. As a consequence of the portfolio theory, this style was adopted instead into the asset side to hopefully produce enough knowledge and foresight about the risks involved. Basically, the rise of the eurodollar standard, besides prompting the demise of the faulty gold standard under the Bretton Woods (BW) edition, introduced a vast array of variables upon which the concept of risk would have to apply. The monetary sea change that ensued, because of the introduction of floating currencies and the parallel rise of derivative markets, led the US Securities and Exchange Commission (SEC), in 1975, to issue the Uniform Net Capital Rule (UNCR), which sought to crystallise risk management through standardised quantification, placing bank assets into twelve classes. Before moving on chronologically, I had better clarify this further. This eurodollar system is not a proper currency system, having indeed more in common with a computer network. For the "medium of exchange" function being the most important one for global trade, money has had to satisfy this need primarily, throwing the "store of value" function to near oblivion. For instance, a company in Portugal was not - and still is not - interested in attaining US dollars for their possession per se, but only so far as dollars would mediate trade across different jurisdictions. If exporting, the Portuguese business could convert whatever currency that might be coming back easily into escudos. Vice versa, if importing, the company would exchange escudos into dollars to be further converted into whichever currency of the ultimate destination of the goods. Seeing that it operates off-shore of the US, outside of the American regulating authorities' purview, this eurodollar setup has been extremely advantageous. In addition to the lack of government rules and regulations, there was no need for reserves properly regarded as currency. Suitable for a Twilight Zone episode, global trade did not - and till this day does not - require payment in physical, nor digital, Federal Reserve Notes at each node of a transaction, needing exclusively the methods and systemic capacity to bridge disparate financial and currency regimes under a common standard. By giving a blow-by-blow hypothetical, I am going to expound on how this system operates. Using that same Portuguese company as our example, though we can go forward in time to today, this business is now seeking for a loan in dollars and so it asks a local bank for one. Lacking the sufficient capacity to make that loan, this bank in Portugal gets in contact with a bank in the City of London that claims to be able to source those dollars. With no actual dollars ever exchanging hands, a claim was all that was required and everyone lived happily ever after. The end. Not quite, though. This is hardly the end. How exactly do they perform this modern financial alchemy? Through digging deeper, we realise they put into practice the concepts of portfolio theory, building on those ideas introduced by Markowitz. For the bank in the City to extend the loan to its Portuguese counterparty, it has to overcome a series of constraints. So as to pull this off, banks and financial institutions in general came to use, essentially, Markowitz foundations to describe mathematical properties, via probability statistics, of quantifying risk . Among them was Value-at-Risk (VAR), which set the world on fire in the 1990's and 2000's, being of more limited use before then. As Darryll Hendricks detailed in his paper titled Evaluation of Value-at-Risk Models Using Historical Data, by aggregating "the several components of price risk into a single quantitative measure of the potential losses over a specified time horizon", the VaR models "convey the market risk of the entire portfolio in one number", making it very appealing. Thus, the ability to make that loan is going to depend on volatility measures (variance and covarience) and loss probabilities, of which VaR is just one of them. As a result, the bank in the City will only lend balance sheet space (i.e., make the loan) to the one in Portugal if it does not disrupt internal (and external, such as regulations) balance sheet guidelines. Likewise, the Portuguese bank will have to run its share of calculations to maximise the efficiency of its balance sheet. Nowadays, these procedures, where the notions of financial risk, expected return and projected usage are respected, have become common practice and near instantaneous. To add some complexity to the example to approximate it with the real deal, we have to add collateral to the mix. Although in the pre-GFC era there were a lot of unsecured loans being made and the resort to exotic instruments like credit default swaps was recurrent, loans secured by collateral became the almost exclusive form. Hence, in order to make this scenario more realistic, the City bank will most likely only manage to make the loan if the bank in Portugal submits a security as collateral first. As you may have already figured out, the higher the risk of a particular deal (either with another bank or non-bank entity, whether secured or unsecured), the more balance sheet capacity it is going to consume. Notwithstanding, there is more to it still. That collateral has presumably come from some entity who has a sizable inventory like any major US-based bank operating as dealer in global repo and interbank markets. If both of those counterparties decide to take the least amount of balance sheet space, by hedging against risk as much as possible, then the Portuguese bank will post the highest form of dollar collateral, US Treasury securities (USTs), of which the short-tenors, T-bills, are the crème de la crème, for being the most liquid (less volatile) securities. Want more complexity? That collateral provided by the dealer is possibly being repledged. This means that the dealer has obtained the UST through its prime brokerage business, for instance, where customers allow consent for their securities to be re-used by their brokerage firms ( in this case, part of this US-based dealer), in exchange for some compensation of course. Alternatively, it can borrow from an insurance company or pension fund, or even from other dealers. Despite this example appearing monumentally intricate, the real world makes this entanglement seem like kid's stuff. In reality, those banks have many clients and relationships with many other banks and dealers. These latter ones being at the center of this financial web. Due to having many companies looking for dollar-denominated funding, the Portuguese bank creates a portfolio of mainly longer-term dollar loans which are sourced from arrangements with several banks worldwide, falling back on the simplest means, like our example, and also on currency swaps and other derivative instruments so as to devise the optimal liquidity strategy for the balance sheet. On account of being naturally short-run, the Portuguese bank has to keep on rolling over these liabilities to continue to fund its portfolio without a bump in the road. Since the assets have longer maturities than the obligations, a dangerous maturity mismatch ensues. Be that as it may, this bank buys access to large pools of collateral, engendered by the dealers, by posting a small margin of collateral. Thus, the bank has now secured enough collateral to fund all its dollar needs. All in all, this is the essence of the eurodollar system or, as some would call it, shadow banking. Bearing in mind that balance sheet capacity is governed by volatility and, consequently, judgements about risk, then anything in the world that could disturb risk perceptions will take its toll on balance sheet capacities of all the players in this system. Therefore, and remembering that those behemoths that act as dealers have a fundamental and pivotal role in all of this, were something to interfere with the collateral chains (worsening risk judgements), this house of cards would collapse, kicking off a shadow bank run.
Finally, this run does not entail that the lenders, either of "cash" or collateral, will demand the borrowers to liquidate their positions. Instead, they could get hit with more collateral calls - i.e., simply asking for more collateral or of better quality (more "pristine" ones). Considering that the less risky a security is, the less volatile it is and, ipso facto, the more liquid it is. Accordingly, the safest and most liquid securities are massively sought after during periods of financial distress, thereby precipitating a surge in their prices and a drop in their yields (interest rates). Because of already being extensive and having still much to say about this, allow me to take a breather and we will carry on with this analysis another day. So, be patient. In spite of not knowing the origins of this holiday, the customs have spreaded worldwide, being celebrated with hoaxes and pranks, especially by the media. As you may be aware, today is April Fools' Day, though I am not going to do any practical joke. Instead, I am dedicating today's post to my favourite fools: central bankers. To be fair, it is not just the technocrats in the monetary domain that, in my book, have earned the right to be labelled this way. Be that as it may, and having already discussed other domains, particularly the shamans of public health, this post is about the plan that the monetary wizards have been adopting recently, which is ostensibly gaining traction across the globe. On August 27 2020, during the annual gathering at Jackson Hole, Wyoming, Chairman Jay Powell unveiled the Fed's updated blueprint. As part of its November 2018 announcement of a grand strategy review, the Fed hosted 15 Fed Listen events which "engaged a wide range of organizations - employee groups and union members, small business owners, residents of low- and moderate-income communities, workforce development organizations and community colleges, retirees, and others - to hear about how monetary policy affects peoples' daily lives and livelihoods". While those were taking place, a conference was organised on June 2019, where some of the most prominent (keynesian) economists presented their econometrics-filled papers. Then, on the following month, July 2019, the FOMC arranged 5 individual working groups, each consisting of teams of the brightest mainstream analytical staff, grinding away over arrays of data in order to supply the FOMC with every bit of information they managed to process. As a result of all this arduous labour, the new policy framework would have been devised in the most unassailable manner possible. Given away by the title of this post, the novel strategy revolves around the advanced mandate of average inflation targeting (AIT), as opposed to the ancient and outdated inflation targeting, which was typically a 2% annual rate. Firstly, this is not at all ground-breaking, not even in the US. As is usually the case, the Bank of Japan (BoJ) was the first central bank to introduce this policy, naming it "inflation-overshooting commitment". On Sptember 21 2016, the BoJ announced its newfangled plan, Quantitative and Qualitative Monetary Easing with Yield Curve Control (QQE with YCC). In this revised framework, besides aiming at fixing the yields of the JGB's market - which they cannot do; it is simply a trickery -, "[t]he Bank will continue expanding the monetary base until the year-on-year rate of increase in the observed CPI (all items less fresh food) exceeds the price stability target of 2 percent and stays above the target in a stable manner". Despite the belief that this development in monetary policy, combined with the expansionary fiscal policy carried out by Shinzo Abe's government, was going to navigate Japan's economy toward overcoming deflation and achieving sustainable growth, the reality is that this was an absolute failure. Moving over across the Pacific, although it was not dubbed average inflation targeting, on May 2018, the Fed released a statement claiming to be following a new mandate for inflation, which consisted of running the annual inflation rate "near the Committee’s symmetric 2 percent objective over the medium term". Obviously, a long run average inflation target is no different than the medium-term inflation symmetry. Nevertheless, you may be wondering why are they splitting hairs? In short, they have to make you believe they have various tools in their monetary kit so that you keep trusting their words and regarding them in high esteem to boot. Long ago, sometime during the 1960's or 70's, central bankers realised they were not central to the monetary system due to not being the ones producing the money. In fact, they were (and still are) not able to find a big chunk of it. Therefore, they resorted to inflation expectations management, in lieu of expanding the actual money supply. Hence, what all of this nonsense comes down to is a desperate attempt to prevent the illusion from shattering. Owing to coming up short for more than a decade (and in Japan for two decades now), these wizards are pinning the blame on the zero- or effective-lower bound (ZLB or ELB - same thing). Allow me to explain. The Great Recession was so bad because of the Global Financial Crisis (GFC), which demanded an immensely forceful monetary policy response. In nominal terms, it would have meant interest rates being pushed down much further than they could have been if the ZLB was not standing in the way. Having only 525 basis points (bps) to work with at its onset, looking back on it, maybe the Fed needed 750 bps or a 1000 bps to properly offset the GFC and the Great Recession. Seeing that accommodative monetary policy, if you believe these things, is what contributes to recovery, not being able to introduce the right amount of it from the start put the economy into a sort of policy deficit. This is the moment QE enters the picture, with the mission of circumventing the ZLB by targeting real rather than nominal rates. In other words, to manage inflation expectations. This is precisely what the Fed's Vice Chairman Richard Clarida meant to convey on a speech delivered for the Peterson Institute for International Economics, on August 31 2020. In addition, he went on to affirm, encapsulating the rationale behind the BOJ's decision to do this "inflation-overshooting", that inflation expectations were of limited use because the Fed had spent decades positioning itself as an inflation fighter. On account of the public and the markets, he implied, regarding the central bank in that way, the 2% inflation target has come to be viewed as an inflation "ceiling". Once the economy generates 2% inflation, everyone presumes the Fed will come in and take away the punch bowl (even if it might still be needed). Ergo, the Fed had to steal from the page of the BoJ's playbook where it is defended that a commitment has to be made "that allows inflation to overshoot the price stability target so as to strengthen the "forward-looking mechanism" in the formation of inflation expectations." Secondly, although the focus has been on the inflation rate target, there was another monumental reassessment in this grand strategy review, which also considers a key rate that indicates the soundness of the economy. Not only is the absence of recovery implicit in this symmetry and average inflation targeting nonsense, the strategy document also spells out the most important part of it all: the unemployment rate conundrum. In view of being guided by a dual mandate (inflation and employment), "deviations of unemployment from the Committee’s assessments of its maximum level" set the course of action. As you will notice here, that part was stricken and, in its place, "shortfalls of employment" from the estimated maximum level made the entrance. By dropping "deviations" - plural - and replacing it with the term "shortfalls", the idea that employment could be "too much", therefore requiring the Fed to raise rates (and other "tightening" hocus-pocus) to cool off an overheated labour market, is apparently no longer maintained. According to the Phillips Curve, a labour market running too hot can be inflationary. Clearly, they still hold this belief, though they are making it clear that such a scenario is far from their minds so as to reinforce their goal to manage inflation expectations. Moreover, the grounds for making this change is one that have left first Janet Yellen's and then Jay Powell’s central bankers scratching their heads. Time and time again, the estimates for what they call maximum employment (i.e., full-employment) had been reduced, because in late 2014 and early 2015 the actual unemployment rate would have dropped underneath the lowest long run calculation (top graph). With no inflation in sight, and expectations for it falling hard (bottom graph), the Fed’s statisticians had no choice but to go back to the drawing board and redraw their picture for full-employment. So they did, a laughable 12 times in all. If you are left with the impression they are really not cut out for their jobs, having no clue of what they are doing, then welcome to the club. Unsurprisingly, the headline unemployment rate (U-3 in the US) must have been flawed and, consequently, extremely misleading. The flaw of this statistic lies in the labour force participation, rendering this rate to be enormously deceptive all the way from 2008 to today. Basically, the unemployment rate’s denominator, the labour force, had all along left way too many out of it (meaning it had been, and still is, a mathematical problem for both the numerator and the denominator). As the next couple of charts demonstrate, the proportion of people that left the labour force remained subdued after plummeting as a consequence of the brutal shock derived from the GFC and the decaying economic landscape engendered by government interventionism to curb that shock. Hopefully, the corona-phobia-induced recession may still resolve itself differently, recovering to the employment and participation levels, as well as the growth trend, of the pre-kung-flu era. However, the prospects do not bode well for the future like I explained last week. What had moved inflation expectations if not full-employment or even favourable views on the faulty unemployment rate? The obvious answer was available the whole time and not just in the TIPS market. From nominal rates to swap spreads to the dollar’s exchange value, and several others, the Eurodollar system is shown to be in charge of everything. As a matter of fact, the direction of financial markets (even stocks at times) in addition to the global economy are dictated by the overriding condition in the global monetary regime and its true reserve currency. Finally, it seems this central banking "novelty" has crossed the pond and reached the European shores (oh boy!). In an interview with Philip R. Lane, member of the Executive Board of the ECB, for the Financial Times, he stated that, and bearing in mind that a strategy review is in the making at the ECB (which was announced in January 2020), "if there is a strategic commitment that following a period of undershooting you signal that the correction phase is not just going to the target but going moderately above the target for a period (...) I think there is a very strong logic to that." Evidently, logic is one of their strengths. Notwithstading, all options (whatever they are) are on the table. Although "[t]here is a very strong analytical case for flexible average inflation targeting, (...) there are other options that may also be successful in anchoring inflation expectations." Thus, AIT is still not guaranteed to be implemented here in Europe, though between you and me, we know it will since they have nothing else up their sleeves. Sadly, we also know that nothing will change, with the deflationary/disinflationary environment continuing to haunt us. To conclude, despite the efforts made to elaborate the strategy review and the scientific appearance of its conclusions, the central bankers' mandates and tools have been the same since (at least) the advent of the Eurodollar system. Whether they create more bank reserves (the actual "money printing") or less, or make ever more grandiose promises and more creative labelling, it is the global monetary regime that has the final saying, no matter how many times and how many of them swear to "never gonna give you up, never gonna let you down" - you really have to watch this; it will make your day.
Therefore, for being extraordinarly pig-headed about the inner workings of the monetary system and the scope and efficacy of their mandates, central bankers have merited to make this day all about them. Congratulations! |
AuthorDaniel Gomes Luís Archives
July 2023
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