Image by jscreationzs
The main problem with having discussions about economics and financial markets is this: People look at these complex phenomena through entirely different prisms; they use vastly dissimilar – even contrasting – narratives as to what has happened, what is going on now, and what is therefore likely to happen in the future. Citing any so-called “facts” – statistical data, or the actions and statements of policymakers – in support of a specific interpretation and forecast is often a futile exercise: The same data point will be interpreted very differently if some other intellectual framework is being applied to it.
Blue pill or red pill?
There is what I call the mainstream view, the comforting view. That is the world in which the majority of commentators and almost all policymakers live. If you want to be part of this world, you have to take the blue pill.
In the words of Morpheus: “You wake up in your bed and you believe what you want to believe.”
Or, if you don’t want to take the blue pill, you can simply continue reading the main newspapers and watch CNBC – it’s the same thing. The perspective from inside the Matrix is this: We are facing cyclical challenges. The economy is an organism, and it is presently not performing to its full potential. It is still weakened by a terrible disease (financial crisis), but luckily it is now recovering. But because the disease was so severe, the recovery is slow. Thankfully, the doctors – the governments and central banks – have learned from Dr. Keynes and Dr. Friedman and are providing ample stimulus to aid this recovery. The medicine is applied in such strong doses that many observers are afraid the treatment itself could cause damage to the patient. There is, however, no alternative to such drastic medication, and we have to trust that, as the recovery proceeds, the medication will carefully be reduced.
This is the comforting narrative. Comforting, because it’s the cyclical view, which simply means, “we have been here before.” It also contains, at its core, a naïve view on money: injecting money into the economy has only two effects: it boosts growth (that is positive) and it lifts prices (that is sometimes positive, sometimes negative). No other effects of money-injections do have to trouble us.
Alternatively…..you may take the red pill, and “I will show you how deep the rabbit hole goes.”
The economy is in reality not some organism or a machine that has a definitive performance potential. The acting parts are not some neat, statistically observable aggregates – – but individuals, or groups of individuals who form households or companies. All these actors have their own personal aims and goals, and they all use the decentralized market economy to realize their plans as well as they can. For those stepping outside the Matrix, with its comforting idea that everybody wants higher GDP and that when GDP is higher, regardless of how this was achieved, everybody will be happy – this appears scarily chaotic: No unifying objectives but a multitude of separate and often conflicting wishes and plans. Yet, on closer inspection, it is not chaos, as the actors can use market prices to plan their actions rationally and coordinate them.
Market prices are essential for this extended and decentralized division of labor to work. But sadly, market prices are constantly being distorted.
Most importantly, the constant injection of new money in today’s system of fully flexible paper money tends to depress interest rates and fool the market participants into believing that more voluntary savings are available than really are, and that resource allocations and asset prices are therefore justified that correspond with a very low time preference (=high propensity to save) by the public. These distortions have been going on almost continuously for the past 4 decades but in particular over the past 20 years.
Image by Salvatore Vuono
The result of such distorted market signals is the accumulation, over time, of a tremendous cluster of errors, visible in the form of unsustainable asset prices, excess levels of debt, and an under-collateralized pile of inflated paper assets.
For those outside the Matrix, the red-pill-crowd, there is only one solution: The printing of money and artificial lowering of interest rates has to stop. This allows the coordination of decentralized individual plans to make again use of correct market prices (importantly, that includes interest rates). The result will be the dissolution of the accumulated misallocations of resources and mis-pricings of assets – this is going to be painful for a while but necessary for markets to function properly again.
Those inside the Matrix can’t see it that way. For them, the recession is not the collective realization that a cluster of errors has piled up, and the drastic revision of a multitude of individual plans in response to this realization, but simply a drop in aggregate activity of the economic organism. This requires more money injections. More stimulus! More medication! Depressing interest rates further is an important part of the treatment.
The red-pill crowd knows that this will not work. It will slow the correction of past mistakes – which, ironically, the blue pill crowd will interpret as a sign of stability – and encourage new activities on the basis of wrong price signals, which must ultimately lead to an even bigger cluster of errors – but this activity will be interpreted by the blue-pill crowd as the green shoots of recovery.
With dislocations piling up, the creation of artificial growth becomes ever more difficult.
The red-pillers view money creation differently from the blue-pillers. The effects of money printing are not just higher growth and higher inflation but, much more importantly, the distortion of relative prices and, consequently, the misallocation of resources.
The present crisis is not a cyclical phenomenon – as the blue-pillers believe – it is a systemic problem. It is the process by which the paper money system approaches its endgame. The blue-pillers are in charge of the printing press and the government. They cannot but continue printing money.
*****
Last Exit?
How the world looks when one is under the influence of a healthy dose of blue pills, can be seen from this story in the Wall Street Journal about the Federal Reserve’s planned exit strategy. The deliberations at the Fed give the impression as if the problem is solved – the cyclical problem that is, as they are unable to perceive of the structural ones- and the Fed is now getting ready to shrink its balance sheet.
Exit strategy? Shrinking the balance sheet? – Well, here is a fact (for a change): The Fed has expanded bank reserves and base money by almost 24 percent (non-annualized!) since the start of this year. The Fed still has both feet firmly on the accelerator. It hasn’t even as much as paused in its aggressive policy of unlimited bank reserve expansion, and is already talking about balance sheet reduction?
At the same time, the Financial Times tells us about choppy trading in equity markets because of ‘recovery doubts’.
The Fed has pumped more than $1.6 trillion in freshly printed cash into the U.S. banking industry over the past two-and-a- half years and the mortgage industry has been nationalized – yet, the recovery is shaky? Of course, to us outside the Matrix this does not come as a surprise. The prime aim of the stimulus policy has been to underwrite headline growth by obstructing the market’s dissolution of past capital misallocations at all cost. Naturally, the capital misallocations are not gone and they are hindering a proper recovery – the only market that appears to be cleansing itself of past excesses is the U.S. housing market.
Exit strategy? – I believe it when I see it.
Many investors out there fear the end of QEII and the start of the tightening cycle. But: there will be no tightening cycle. Don’t let yourself be dragged into the comforting cycle story. The recovery is a statistical mirage created by aggressive market intervention – as soon as the market interventions are cut back, the problems come back to the surface. And the blue-pillers will ease again.
The Fed will soon be the largest single owner of US government debt. The ECB is already the largest owner of Greek government debt. How much balance sheet reduction is feasible, you believe?
Correct. Not much.
I remain of the view that a meaningful deflationary leg-down in commodity markets or in other so-called risk assets is unlikely as the blue-pill crowd cannot but continue to debase the paper money.
What if inflation moves higher? – Answer: Policymakers will still maintain easy policy. The Bank of England illustrates this nicely. With even officially reported headline inflation approaching 5 percent, the BoE can’t bring itself to tighten policy as it is beholden to some ridiculous “output-gap” model according to which weak growth will take care of inflation – good luck!
All these central bankers have, for more than two years, worked their printing presses around the clock to avoid a correction of the overextended financial system and to keep the public sector going. They will not pull the rug from underneath them just because inflation moves up.
***
Timely return to gold?
If one views the economy – correctly! – as a decentralized framework for the coordination of individual plans, then it is apparent that hard money of essentially inflexible supply is ideal as it is least disruptive to financial markets. Conversely, elastic money (paper money) must distort relative prices and destabilize the economy over time.
Recently, the idea of a return to some form of gold standard has found new promoters. Former Republican presidential hopeful Steve Forbes predicted a return to gold for the United States within the next 5 years. The idea also received support from a rather dubious corner. Zimbabwe’s notorious central bank chief Dr. Gideon Gono had this to say:
“The world needs to and will most certainly move to a gold standard and Zimbabwe must lead the way.”
And, of course, we remember that the idea that some link to gold be reconsidered was floated right from the very top of the global paper money bureaucracy, from World Bank president Robert Zoellick, last November.
I think the world will ultimately return to a gold “standard”, hopefully a proper gold-as-money system without any involvement of the state and NO central bank. But this will only occur after the complete collapse of the present paper money system. States and banks are presently the biggest beneficiaries of the paper money franchise. Does anybody really believe that people would continue to fund the inflated public sector and the overleveraged banking sector, or even put their savings on deposit at fractional-reserve banks with minimal capital, if it weren’t for the institutional support of these entities from the central bank and its printing press? The political elite and the finance establishment will fight a return to hard money tooth and nail.
In the meantime ….. the debasement of paper money continues.
10 Responses to Beyond Repair – This will not have a happy ending.
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The Matrix is a nice analogy. Good post.
I like that the red pills (in your accompanying photo) are larger than the blue ones, and hence intrinsically harder to swallow. But you gotta take your medicine sometime…
Mike Church has been using the Matrix analogy for current events on his Sirius-XM talk show for a long time.
uummm, minor point.
To say that the Fed has pumped $1.6 Trillion in cash into the banking system is, well, er, in error.
IF the Fed had pumped $1.6 Trillion in cash into the economy anywhere, it would be in the M1 and M2 parts of the money supply, actually driving up aggregate demand.
The problem with the debt-money system and fractional-reserve based money system is that it is not possible for the Fed, nor the government (at present), to put any actual money to work for the national economy.
See our vid on the impotent monetary policies of the Fed.
http://www.youtube.com/user/economicstability#p/a/u/4/Zliv3USGysM
There’s no such thing as high-powered money.
Thanks.
Sorry if the term ‘cash’ is somewhat inappropriate in this context. I meant reserve money; deposit money at the Fed. At the time of the Lehman collapse (September 2008) bank reserves and the monetary base (not M1 and not M2) were $871.9 billion. At the end of April 2011, this same monetary aggregate stood at $2,523.311 billion. The Fed thus created $1,651 billion ($1.6 trillion) in bank reserves. This is new money that the Fed created out of thin air and pumped into the banking industry (again, not the ‘economy’ or M1 or M2). Roughly, but not precisely, this is $1 trillion the Fed bought in mortgage-backed securities from the banks as part of QE1, and $400 billion it has thus far spent on buying Treasury securities as part of QE2, plus some change. These operations do not necessarily lengthen the balance sheets of the banks (who just exchange toxic mortgages on their balance sheet for fresh deposits at the Fed, which are not part of M1 or M2), but it is still a bail-out of the banks and it allows the banks to preserve capital and lend again. To the extent that the banks keep the money on deposit at the Fed and that loan demand stays low (your points, I assume) other aggregates will not increase. But, some of these reserves are definitely ‘leaking’ into the aggregates you mentioned: M1, M2 and the wider economy, and this is official Fed policy. M1 has expanded by $498 billion over the same time, and M2 by $1,154 billion. This is presently not enough to generate hyperinflation, just moderate inflation. But my points are these: Nothing is solved; the system is presently underwritten by the Fed, which cannot terminate ‘easy money’ or shrink its balance sheet. If more ‘aggregate demand’ is deemed necessary (and that will be soon) the Fed will stop paying interest on the deposits that the banks hold at the Fed. Then M1 and M2 will rise more meaningfully. Additionally, the Fed will have to support government spending as it did via QE2–and this is money that will be ‘put to work in the economy’ as you put it. That is my forecast. In any case, none of that is good for paper dollars.
I agree with a lot of what you wrote, most of it for sure, excepting maybe your point that the Fed supports government spending via QE2. To me, monetary easing merely supports the banking system. Except for inadvertent leakage it does nothing for the real economy. And I’m not sure what you mean by paper money in these days. Is it just fiat money without metal backing, or is it just fractional-reserve banking – creating money out of nothing, backed or not?
I totally agree the Fed’s policies are wrong-headed and ineffective, but perhaps not for the same reason that you do.
For instance, there can be no question that more aggregate demand is necessary. Again, pumping up reserves at the banks does little to nothing for the real economy.
The problem lies in the debt-money system itself. I assume you would be familiar with the infamous quote of Atlanta Fed credit manager Robert Hemphill with regards to our debt-money system.
If banks refuse to make loans, then we have no money. “This is a staggering thought”. This is our present reality in one sentence.
It matters not why the problem arises with the banks – the fact is that in a debt-money system there can be no economic activity (growth or increased aggregate demand) without the bankers saying so.
The Fed is not capable of meeting its two economic goals, that of promoting the fullest employment possible and a stable buying power of the currency with the debt-money system.
What we need is a new money system. Much like the Cobdenites, we promote the full-reserve banking system that is necessary to avoid the common fallacies of economic booms and busts. With full-reserve banking and a fiat money system, the question becomes by whom new money creation best manifests to meet those same goals.
We advocate the Dennis Kucinich plan.
http://www.economicstability.org/wp/wp-content/uploads/2010/12/NEED_ACT-12.2010.pdf
We advocate the 1939 Program for Monetary Reform of Fisher, Douglas, Graham, etc.
Check out this mp3 version – a little sketchy at the beginning.
http://k002.kiwi6.com/hotlink/169p578y94/A_PROGRAM_FOR_MONETARY_REFORMb.mp3
Thanks.
I don’t think the economy needs more “aggregate demand” and certainly not “aggregate demand” through the creation of fiat money. We are in this mess precisely because of dislocations that resulted from the fiat-money induced artificial booms of the past. My point is that any system of elastic money – including yours of 100-percent reserve banking where the expansion of the money supply is guaranteed and controlled by the Fed – must lead to economic instability. Creating money -whether created by the Fed or the fractional-reserve-banks (FRB) or both- leads to short-term booms, followed by busts. You want a fiat money system under control of the Fed (with the uncertainty of FRB removed). You want more government control of money and credit. I want no fiat money but proper commodity money completely outside the control of any government agency. In my system, there would be no Fed. What the economy needs is not “aggregate demand” delivered by some government agency and its clever injection of fiat money but a free market with uninhibited price formation. Lasting growth and wealth creation are not the result of fiat money creation but of saving, investing, capital formation and entrepreneurship. The money of the free market has always been an apolitical commodity of essentially inflexible supply, hard money –gold.
We had a commodity-backed money system that brought on the Big D.
So, ….???
Your criticism of “fiat-money” seems overwrought.
Merely removing the fractional-reserve part of the money system will provide all of the stability necessary to eliminate the boom-busts that you attribute to money in our present fiat-status.
You say that any fiat money system, “including yours of 100-percent reserve banking where the expansion of the money supply is guaranteed and controlled by the Fed – must lead to economic instability.”
First, in “mine”, the amount of money is not controlled by the Fed, but a legal metric.
Second, why would it lead to economic stability?
Where is your proof?
The elastic-money bogeyman is trivialized by the real fact of a permanent money system (money is not created and destroyed by issuing debts) that has a legal construct to maintain the stable buying power of the national currency.
That’s actually what people want and expect from their money system.
How can a money system that is legally required to be issued so as to eliminate inflation and deflation considered yet “ leads to short-term booms, followed by busts”?
I want government control of money.
I want zero control of credit.
Once money is created, it is in someone’s bank account and whomever owns it can hold it or lend it out at their pleasure.
All of your glorious qualities of free commerce – of saving, investing, capital formation and entrepreneurship – are all exactly what would happen if we had an adequate permanent money system with unvarying quantities of our medium of exchange.
I want less regulation of banking and credit. It will become unnecessary by removing the moral hazard attached to private credit creation that issues national-currency-denominated debts – creating taxpayer obligations for generations.
The only aggregate demand that any economy needs is that which is determined by its real potential for both creating and meeting that demand. In our country, with its volumes of inactive human and physical contributors to potential ‘growth’ in aggregate demand, providing a means of exchange to employ those unused resources is the job of the whole nation acting through our existing institutions.
Neither my, nor your, visions of the future are achievable by anyone’s ‘fiat’.
They will both take legislative changes. Mine are in the Kucinich Bill.
Where are yours?
Hope you don’t mind the debate here.
I don’t mind the debate and I am not surprised by your points. I am just not quite sure how far we can carry this debate in these comments pages.
1) Gold did not cause the Great Depression, which was not caused by tight money in the 1930s but by easy money in the 1910s and 1920s, mainly as a result of Fed-supported FRB. This should not be a point of contention between us.
2) Under a proper gold-standard, the supply of money is essentially inelastic. This leads to moderate secular deflation, which has many advantages. Rising productivity leads to falling prices; money has a positive return. Short-term changes in money demand are satisfied by swings in money’s purchasing power.
3) The notion that a form of money can be provided that remains stable in purchasing power is theoretically flawed and practically impossible. Apart from fundamental problems with the concept of the “price level” — it presupposes stable exchange-relationships between the various goods and services that constitute the price index, which is a fiction –even if the Fed tried to keep the purchasing power stable, it couldn’t anticipate any sudden changes in money demand. Even in your system, these will lead to swings in money’s purchasing power. But, more importantly,
4) in a productive economy there is constant pressure for prices to fall (secular deflation). If you want to avoid this, you have to constantly inject money into the economy to keep your “price index” stable. This must occur via financial markets where the money injections will depress interest rates on the margin. This in turn must upset the coordination between saving and investing, for which uninhibited interest rates are essential. As the Austrian business cycle theory explains in detail, this leads to a boom first, followed by a bust. The flaw in your concept is this: price level stability is not the same as economic stability!
Where is proof for this? In my book:
http://www.amazon.com/Paper-Money-Collapse-Monetary-Breakdown/dp/1118095758/ref=sr_1_1?ie=UTF8&s=books&qid=1306422214&sr=8-1
You can also find some information about the book on this site.
Listen, I am not in the monetary reform business. I have nothing to do with politics. I worked in financial markets and I love economics. I think the insights of the Austrian School –L.von Mises in particular– are superior to anything else I came across. I apply them to the question, can paper money work? I know my views are controversial but I am convinced they stand up to scrutiny.
“Most importantly, the constant injection of new money in today’s system of fully flexible paper money tends to depress interest rates and fool the market participants into believing that more voluntary savings are available than really are …”
I would put slightly differently. It is not so much that people are fooled. Everybody knows that interest rates are artificially low and do not actually reflect the availability of voluntary savings. Nevertheless it may be perfectly rational to take advantage of the low rates.The problem is that the investment is, by definition, socially unproductive.
An analogy might be Government subsidising the production of cars by agreeing to buy them at a rate twice the prevailing market. Productive resources would then be used to produce more cars. Nobody is fooled. The manufacturers know that the demand is not real demand. But it is still rational for them to make extra cars even though nobody wants them and resources are being diverted from more productive outlets.
It strikes me that articially low interest rates have a similar effect except that they even worse because they subsidise production across the board, rather than confining it to a single product.
Julius