Bernanke’s Jobs Estimate

Ben Bernanke at Jackson Hole:

If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, then econometric models can be used to estimate the effects of LSAPs on the economy. Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board’s FRB/US model of the economy found that, as of 2012, the first two rounds of large scale asset purchases may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred.

Bernanke’s estimate of two million jobs created as a result of his policy appears to be a stitched-together estimate based on two research papers: Fuhrer which estimated a gain of 700,000 jobs from QE1, and Chung et al which estimated 1,800,000 jobs.

The methodology here is interesting, to say the least. From the (unfortunately titled) Fuhrer paper:

Given the range of estimated effects on real spending (GDP), the translation to employment effects is accomplished by use of an Okun’s Law relationship that links GDP growth and changes in the unemployment rate. The typical relationship expressed in quarterly changes is summarized as: Change in unemployment = -0.125 (GDP growth – potential GDP growth).

GDP growth for one-quarter that exceeds potential GDP growth by 1 percentage point results in a one-eighth (0.125) percentage point decline in the unemployment rate. Equivalently, quarterly growth in GDP that exceeds potential growth by 1 percentage point for a year typically lowers the unemployment rate by about one-half percentage point.

Combining this simple Okun’s Law with the estimated effects on GDP discussed in the preceding section implies a decline in the unemployment rate of 30-45 basis points over the 2-year period it takes for the spending rate change to feed through the economy. With the U.S. labor force currently at just over 150 million people, this translates to an increase of about 700,000 jobs, a figure quoted by Boston Fed President Eric Rosengren in his speech of November 17, 2010.

The number of layers of uncertainty is problematic. First we have uncertainty over the level of GDP growth provoked by QE. Second we have uncertainty as to the reliability of the measure and concept of potential GDP growth. And third we have uncertainty as to the extent of the relationship between GDP growth, potential GDP growth and unemployment in this specific case.

Essentially, the equation assumes that because GDP growth has historically resulted in job growth, we should assume it will do so in the future. But this is a very different economy to the one we had fifty years ago. Today it’s possible for the financial sector to generate profits (and thus, GDP) by passing liquidity around the financial sector. And today, any American demand boom will create jobs in China and Mexico (etc), because that’s where the industrial and manufacturing jobs have been shipped to.

So Bernanke’s figure is a guess based on a guess based on a guess based on old data. Maybe 2 million. Maybe, maybe, maybe, maybe.

How do we know that after a big, painful bust that after a short burst of deflationary pain that job growth wouldn’t have come roaring back? After all that happened multiple times in the 19th century.

Hank Paulson might claim that he saved the world from a thousand year nuclear winter by bailing out his former employer Goldman at par on its credit default swaps. You can claim anything about what might have happened otherwise. Maybe, maybe, maybe. Such claims are junk science because they are unfalsifiable.

Yet the reality is very clear — either people have jobs or they don’t. That’s what the regime will be judged on.

The present policy of tripling the monetary base via monetary easing hasn’t solved the jobs problem, because we’re still in the woods. Trillions of easing — which we can say quite confidently has enriched the financial sector far more than any other sector of the economy — and yet we still have a jobs depression (of course, financial sector profits have come roaring back). This is the prime age employment-population ratio:

Quantitative easing hasn’t been about jobs. If this was about jobs or stimulating demand, Bernanke would have aimed the helicopter drops at the wider public, as many economists have suggested. This policy of dropping cash directly to the banks is bailing out a dangerous and morally-hazardous financial sector and too-big-to-fail megabanks that remain dangerously overleveraged and under-capitalised, needing endless new liquidity just to keep past debts serviceable. There has been plenty of cash helicopter-dropped onto Wall Street, but nobody on Wall Street has gone to jail for causing the 2008 crisis. Criminal banksters get the huge liquidity injections they want, and the rest get less than crumbs.

The Shape of 40 Years of Inflation

I have written before that there is no single rate of inflation, and that different individuals experience their own rate dependent on their own individual spending preferences. This — among other reasons — is why I find the notion of single uniform rate of inflation — as central banks attempt to influence via their price stability mandates — problematic.

While many claim that inflation is at historic lows, those who spend a large share of their income on necessities might disagree. Inflation for those who spend a large proportion of their income on things like medical services, food, transport, clothing and energy never really went away. And that was also true during the mid 2000s — while headline inflation levels remained low, these numbers masked significant increases in necessities; certainly never to the extent of the 1970s, but not as slight as the CPI rate — pushed downward by deflation in things like consumer electronics imports from Asia — suggested.

This biflationary (or polyflationary?) reality is totally ignored by a single CPI figure. To get a true comprehension of the shape of prices, we must look at a much broader set of data:

Yet the low level of headline inflation has given central banks carte blanche to engage in quantitative easing, and various ultra-loose monetary policies like zero-interest rates — programs that tend to benefit the rich far more than anyone else. Certainly, lots of goods and services — especially things like foreign-made consumer goods and repossessed real estate — are deflating in price. But you can’t eat an iPad or a $1 burnt-out house in Detroit. Any serious discussion of monetary policy must not only consider the effects on creditors and debtors, but also the effects on those who spend a larger-than-average proportion of their income on necessities.

Another issue is that CPI leaves out both house prices as well as equity prices.

Below is CPI contrasted against equities and housing:

It is clear from this record that a central bank focused upon a price index that fails to include important factors like stock prices and house prices can easily let a housing or stocks bubble get out of hand. CPI can — as happened in both the 1990s as well as the early 2000s — remain low, while huge gains are accrued in housing and stocks. Meanwhile, central bankers can use low CPI rates as an excuse to keep interest rates low — keeping the easy money flowing into stocks and housing, and accruing even larger gains. However, because such markets are driven by leverage instead of underlying productivity, eventually the ability to accrue new debt is wiped out by debt costs,  hope turns to panic, and the bubble bursts.

Both of the above examples indicate that the contemporary headline price index measures of inflation are deeply inadequate. Attempts to measure the rate of inflation that ignore data like house or stock prices will lead to flawed conclusions (rendering any such notions of “price stability” as meaningless), which has tended to lead to failed policy decisions such as those which led to the bust of 2008.

Currency Competition

The greatest trouble with monopolies is what they take away — competition. Competition is a beautiful mechanism; in exercising their purchasing power and demand preferences, individuals run the economy — it is their spending that allocates, labour, capital, resources and brainpower. It’s their spending that transmits the information that determines what gets made, what doesn’t, which businesses succeed and which don’t. Individuals exercise a far greater political and economic power in a free economy when they spend, and when they work than when they vote. So without competition, the power of choice suffers, and businesses, markets and societies can become economically stagnant and rampantly corrupt; look at North Korea and the myriad other examples of once-prosperous societies impoverished within the context of a lack of competition.

In a free market, monopolies are potentially less problematic because without competition a monopolist can become complacent and inefficient, allowing competitors a foothold to grab market share; consider the near-monopoly of Microsoft Windows and Internet Explorer in the 1990s, which began to melt away via the rise of Apple, Google, Firefox and the poorly-received Windows Vista in the 2000s. While a free market is not a foolproof guarantee of a competitive market — and sometimes regulation is necessary to prevent the formation of cartels — it is the closest thing to such a thing.

Monopolies can become much more problematic when a monopoly develops and the holders of that monopoly utilise the power of the state to protect their dominance. Whether their business is food, or clothes, or computers, or money, a state-protected monopoly limits competition and distorts the process of allocating of resources, capital and labour.

If we are for competition in goods and services, why should we disclude competition in the money industry? Would choice in the money industry not benefit the consumer in the manner that choice in other industries does? Why should the form and nature of the medium of exchange be monopolised? Shouldn’t the people — as individuals — be able to make up their own mind about the kind of money that they want to use to engage in transactions?

Earlier, this year Ben Bernake and Ron Paul had an exchange on this subject:

Bernanke contends that it is possible to transact in a competing currency like Yen, or pesos or bitcoin. This is technically correct. But, as Ron Paul points out, there are still a number of laws which are arguably preventing a level playing field:

The first step [to real currency competition] consists of eliminating legal tender laws. Article I, Section 10 of the Constitution forbids the States from making anything but gold and silver a legal tender in payment of debts. States are not required to enact legal tender laws, but should they choose to, the only acceptable legal tender is gold and silver, the two precious metals that individuals throughout history and across cultures have used as currency. There is nothing in the Constitution that grants Congress the power to enact legal tender laws. Congress has the power to coin money, regulate the value thereof, and of foreign coin, but not to declare a legal tender. Yet, there is a section of US Code, 31 USC 5103, that purports to establish US coins and currency, including Federal Reserve notes, as legal tender.

The second step to legalizing currency competition is to eliminate laws that prohibit the operation of private mints. One private enterprise which attempted to popularize the use of precious metal coins was Liberty Services, the creators of the Liberty Dollar. The government felt threatened by the Liberty Dollar, as Liberty Services had all their precious metal coins seized by the FBI and Secret Service in November of 2007.

The final step to reestablishing competition in currency is to eliminate capital gains and sales taxes on gold and silver coins. Under current federal law, coins are considered collectibles, and are liable for capital gains taxes. Coins held for less than one year are taxed at the short-term capital gains rate, which is the normal income tax rate, while coins held for more than a year are taxed at the collectibles rate of 28 percent.

This is not a radical change. In this age of cashless payment people can simply load their alternative currency onto a debit card and spend it — similar to the gold-denominated debit card currently available to non-Americans from Peter Schiff’s EuroPacific Bank. In this age of Google and ubiquitous computing, exchange rates can be calculated instantaneously.

If people and businesses choose to stick to government-backed fiat money and refuse other currencies, that is their prerogative. It is possible that other media of exchange would not become popular; but at least there would be a more level playing field. Under the status quo, there is no level playing field.

It is often said in interventionist circles that Bernanke is too tame a central banker, and that right now the people need a greater money supply. Well, set the society free to determine their own money supply based on the demand for money; let the people decide.

Whitewashing the Economic Establishment

Brad DeLong makes an odd claim:

So the big lesson is simple: trust those who work in the tradition of Walter Bagehot, Hyman Minsky, and Charles Kindleberger. That means trusting economists like Paul Krugman, Paul Romer, Gary Gorton, Carmen Reinhart, Ken Rogoff, Raghuram Rajan, Larry Summers, Barry Eichengreen, Olivier Blanchard, and their peers. Just as they got the recent past right, so they are the ones most likely to get the distribution of possible futures right.

Larry Summers? If we’re going to base our economic policy on trusting in Larry Summers, should we not reappoint Greenspan as Fed Chairman? Or — better yet — appoint Charles Ponzi as head of the SEC? Or a fox to guard the henhouse? Or a tax cheat as Treasury Secretary? Or a war criminal as a peace ambassador? (Yes — reality is more surreal than anything I could imagine).

The bigger point though, as Steve Keen and Randall Wray have alluded to, is that DeLong’s list is the left-wing of the neoclassical school of economics — all the same people who (to a greater or lesser extent) believed that we were in a Great Moderation, and that thanks to the wonders of modernity we had escaped the old world of depressions and mass unemployment. People to whom this depression — judging by their pre-2008 output — was something of a surprise.

Now the left-wing neoclassicists may have done less badly than the right-wing neoclassicists Fama, Cochrane and Greenspan, but that’s not saying much. Steve Keen pointed out:

People like Wynne Godley, Ann Pettifors, Randall Wray, Nouriel Roubini, Dean Baker, Peter Schiff and I had spent years warning that a huge crisis was coming, and had a variety of debt-based explanations as to why it was inevitable. By then, Godley, Wray and I and many other Post Keynesian economists had spent decades imbibing and developing the work of Hyman Minsky.

To my knowledge, of Delong’s motley crew, only Raghuram Rajan was in print with any warnings of an imminent crisis before it began.

DeLong is, in my view, trying to whitewash his contemporaries who did not see the crisis coming, and inaccurately trying to associate them with Hyman Minsky whose theory of debt deflation anticipated many dimensions of the crisis. Adding insult to injury, DeLong seems unwilling to credit those like Schiff and Keen (not to mention Ron Paul) who saw the housing bubble and the excessive debt mountain for what it was — a disaster waiting to happen.

The most disturbing thing about his thesis is that all of the left-neoclassicists he is trying to whitewash have not really been very right about the last four years at all, as DeLong freely admits:

But we – or at least I – have got significant components of the last four years wrong. Three things surprised me (and still do). The first is the failure of central banks to adopt a rule like nominal GDP targeting or its equivalent. Second, I expected wage inflation in the North Atlantic to fall even farther than it has – towards, even if not to, zero. Finally, the yield curve did not steepen sharply for the United States: federal funds rates at zero I expected, but 30-year US Treasury bonds at a nominal rate of 2.7% I did not.

Yet we are supposed to take seriously the widely proposed solution? Throw money at the problem, and assume that just by raising aggregate demand all the other problems will just go away?

As I wrote back in August 2011:

These troubles are non-monetary: military overspending, political and financial corruption, public indebtedness, withering infrastructure, oil dependence, deindustrialisation, the withered remains of multiple bubbles, bailout culture, systemic fragility, and so forth.

These problems won’t just go away — throwing money around may boost figures in the short term, but the underlying problems will remain.

I believe that the only real way out is to unleash the free market and the spirit of entrepreneurialism. And the only way to do that is to end corporate welfare, end the bailouts (let failed institutions fail), end American imperialism, and slash barriers to entry. Certainly, cleaning up the profligate financial sector would help too (perhaps mandatory gladiatorial sentences for financial crimes would help? No more paying £200 million for manipulating a $350 trillion market — fight a lion in the arena instead!), as would incentives to create the infrastructure people need, and move toward energy independence, green energy and reindustrialisation.

Then again, I suppose there is a silver lining to this cloud. The wronger the establishment are in the long run, the more people will look for new economic horizons.

Liquidation is Vital

Many Keynesians really hate the concept of liquidationism. I’m trying to grasp why.

Paul Krugman wrote:

One discouraging feature of the current economic crisis is the way many economists and economic commentators — apparently ignorant of what went on over the last 75 years or so of macroeconomic debate — have been reinventing old fallacies, imagining that they were coming up with profound insights.

The Bank for International Settlements has decided to throw everything we’ve learned from 80 years of hard thought about macroeconomics out the window, and to embrace full-frontal liquidationism. The BIS is now advocating a position indistinguishable from that of Schumpeter in the 1930s, opposing any monetary expansion because that would leave “the work of depressions undone”.

Andrew Mellon summed up liquidationism as so:

The government must keep its hands off and let the slump liquidate itself. Liquidate labor, liquidate stocks, liquidate the farmes, liquidate real estate. When the people get an inflation brainstorm, the only way to get it out of their blood is to let it collapse. A panic is not altogether a bad thing. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.

In light of the zombification that now exists in Japan and also America (and coming soon to every single QE and bailout-heavy Western economy) — zombie companies, poorly managed, making all the same mistakes as before, rudderless, and yet still in business thanks to government intervention  — it is clear that the liquidationists grasped something that Keynesians are still missing. Markets are largely no longer trading fundamentals; they are just trading state intervention and money printing. Why debate earnings when instead you can debate the prospects of QE3? Why invest in profitable companies and ventures when instead you can pay yourself a fat bonus cheque out of monetary stimulus? Why exercise caution and consideration when you can just gamble and get a bailout?

Unfortunately, Mellon and his counterparts at the 30s Fed were the wrong kind of liquidationists — they could not heed their own advice and leave the market be. Ironically, the 30s Fed in raising interest rates and failing to act as lender-of-last resort drove the market into a deeper depression than was necessary (and certainly a deeper one than happened in 1907) and crushed any incipient recovery.

Liquidation is not merely some abstract policy directive, or government function. It is an organic function of the market. As the stunning bounce-back from the Panic of 1907 shows — especially when contrasted against the 1930s — a  market liquidation on the back of a panic avoids a depression. Prices fall as far as the market deems necessary, before market participants quickly come back in into the frame, setting the market on a new trail toward growth. For without a central bank, asset-holders who want to maintain a strong economy and growth (in 2008, that probably would have meant sovereigns like China and Arabia) have to come in and pick up falling masonry as lenders of last resort.

Under a central banking regime (especially a Bernankean or Krugmanite one committed to Rooseveltian Resolve) all expectations fall onto the central bank.

My own view is not just that liquidation is vital. It is that the market mechanism is vital. Without their own capital as skin in the game, central bankers are playing blind. The pace of the liquidation and the pace of the recovery should be dictated by market participants — in other words, by society at large — not by the whims of distant technocrats. Society has more skin in the game. The Great Depression was not a crisis of too little intervention — it was a crisis of too much well-intentioned intervention.

As we are learning in our own zombie depression, a central bank doing the opposite of the 1930s Fed and reinflating may solve the problem of debt-deflation, but it causes many of its own problems — zombie banks, zombie corporations, zombie markets, corporate welfarism, and the destruction of the market mechanism.

The World Before Central Banking

In today’s world, there are many who want government to regulate and control everything. The most bizarre instance, though — more bizarre even than banning the sale of large-sized sugary drinks — is surely central banking.

Why? Well, central banking was created to replace something that was already working well. Banking panics and bank runs happen, and they have always happened as long as there has been banking.

But the old system that the Fed displaced wasn’t really malfunctioning — unlike what the defenders of central banking today would have us believe. Following the Panic of 1907, a group of private bankers led by J.P. Morgan successfully bailed out the system by acting as lender of last resort. The amount of new liquidity disbursed into the system was set not by academics like Ben Bernanke, but by experienced market participants. And because the money was directed from private purses, rather than being created out of thin air, only assets and companies with value were bought up.

The rationale of the supporters of the Federal Reserve Act was that a central banking liquidity mechanism would act as a safeguard against such events, to act as a permanent lender-of-last-resort backed by government fiat. They wanted something bigger and better than a private response.

Yet the Banking Panic of 1907 — a comparable market drop to both 1929 or 2008 — didn’t result in a residual depression.

As the WSJ noted:

The largest economic crisis of the 20th century was the Great Depression, but the second most significant economic upheaval was the panic of 1907. It was from beginning to end a banking and financial crisis. With the failure of the Knickerbocker Trust Company, the stock market collapsed, loan supply vanished and a scramble for liquidity ensued. Banks defaulted on their obligations to redeem deposits in currency or gold.

Milton Friedman and Anna Schwartz, in their classic “A Monetary History of the United States,” found “much similarity in its early phases” between the Panic of 1907 and the Great Depression. So traumatic was the crisis that it gave rise to the National Monetary Commission and the recommendations that led to the creation of the Federal Reserve. The May panic triggered a massive recession that saw real gross national product shrink in the second half of 1907 and plummet by an extraordinary 8.2% in 1908. Yet the economy came roaring back and, in two short years, was 7% bigger than when the panic started.

Ben Bernanke, widely seen as the pre-eminent scholar of the Great Depression thought things would be much, much better under his watch. After all, he has claimed that he understood the lessons of Friedman and Schwartz who criticised the 1930s Federal Reserve for continuing to contract the money supply, worsening the Great Depression; M2 in 1933 was just 72% of its 1929 peak.

So a bigger crash and liquidation in 1907 allowed the economy to roar back, and continue growing. Meanwhile, in today’s controlled, planned and dependent world of central liquidity insurance, quantitative easing and TARP, growth remains anaemic four years after the crash. Have the last four years proven conclusively that central banking — even after the lessons of the 1930s — is inferior to the free market?

Certainly, Bernanke’s response to 2008 has been superior to the 1930s Fed — M2 has not dropped by anything like what it did from 1929:


Industrial production has not fallen by as significant an amount as 1929, nor has homebuilding. And there are many other wide-scale economic differences between 1907 and 2008 in terms of the shape of the economy, and the shape of employment, the capital structure, and the wider geopolitical reality. But the bounce-back is still vastly inferior to the free-market reality of 1907. I think there are greater problems to central banking, ones of which Friedman, Schwartz and Bernanke were unaware (but of which Rothbard and von Mises were acutely aware).

Does central banking retard the economy by providing liquidity insurance and a backstop to bad companies that would not otherwise be saved under a free market “bailout” (like that of 1907)? And is it this effect — that I call zombification — that is the force that has prevented Japan from fully recovering from its housing bubble, and that is keeping the West depressed from 2008? Will we only return to growth once the bad assets and bad companies have been liquidated? That conclusion, I think, is becoming inescapable.

The Face of Corporatist Hypocrisy

From Bloomberg:

“Retirement ages will have to move to 70, 80 years old,” former AIG CEO Robert Benmosche, who turned 68 last week, said during a weekend interview at his seaside villa in Dubrovnik, Croatia. “That would make pensions, medical services more affordable. They will keep people working longer and will take that burden off of the youth.”

Now, as a guy who is living in a taxpayer-funded villa after his bank-insurance-derivatives-hedge fund-ponzi company blew up, we know Benmosche is a hypocrite. In my view, management should be held personally liable a long time before taxpayers. That’s right, I believe in personal responsibility and that means no hiding behind limited liability and bailouts, no matter how “systemically important” you claim to be.

But let’s set aside disgust at government for first setting up this scenario via Gramm-Leach-Bliley, and then in 2008 throwing money at hypocritical grifters like Benmosche.

Is he wrong about social security and medical services?

Spending costs money. You can spend as much as you like so long as you have the revenues to do so. But the US government is failing to fund its current spending, let alone the $61.6 trillion (that’s a low-end estimate — the high end estimate is $127.5 trillion or 737% of GDP) of future welfare liabilities that the US government is mandated by law to spend.

So can America get the money to match future commitments without significantly raising the retirement age?

In theory.

In theory the Federal government can squeeze taxpayers. Perhaps Occupy will get their wish of raising taxes on the 1% to whatever figure they have in mind (though the way corporations and lobbyists have successfully colonised Washington, that seems exceedingly unlikely). But this is a globalised world, and the higher they tax the more activity will leave to lower-rate jurisdictions, and the less activity will be taxable. Tax evasion and avoidance will soar.

In theory America could have an organic recovery and start generating significant amounts of organic GDP growth. But right now, that’s a fantasy. Pinning your hopes to potential future economic miracles like 3D-printing, nanoengineering, widespread solar energy and synthetic petroleum is hardly good accounting practice, even if they are realistically the best hope of a rosy future.

In theory taxpayers could agree to accept less spending, as Benmosche suggests. But Americans overwhelmingly support social security and medicare, and politicians hawking cuts make themselves into political pariahs. Promises are promises, and politicians have suckered the electorate by promising so much for so little. If Greeks rioting over the retirement age seems raucous, wait ’til a politician tries to slash SNAP, medicare or social security.

Much more likely is the current trend of escalating deficits and printing money to pay the bills — and bail out washed-up corporatists like Benmosche (and his “systemically important” equivalents in Europe). Policy-makers can balance the budget and raise aggregate demand and GDP to whatever level they like (the “highest” level presumably being toilet paper) by throwing newly-printed money out of helicopters.

Trouble is, with the US dollar no longer functioning as the globe’s reserve currency it’s going to get harder and harder to hide the inflation overseas or on primary dealer balance sheets. Welfare recipients will keep getting welfare, but in the long run it may not buy much.

No, nations chose their paths long ago. America chose the path of big spending, big warfare, big bailouts and big welfare, and bailout-recipients like Benmosche who plead “systemic importance” are heavily responsible for that slide into fiscal irresponsibility. It won’t be the politicians, bankers and corporatists who created the mess who will have to deal with the fallout; they have foreign villas, foreign ranches, foreign bank accounts, and barbed-wire-shrouded EMP-proof survival retreats. It will be the average American who has done nothing wrong other than believing the words of politicians.

Debt is Not Wealth

Here’s the status quo:


These figures are staggering; the advanced nations typically have between three and ten times as much total debt as they have economic activity. In the United Kingdom — the worst example — if one year’s economic activity was devoted entirely to paying down debt (impossible — people need to eat and drink and pay rent, and of course the United Kingdom continues to add debt) it would take ten years for the debt to be wiped clean.

But the real question is why? Why are both debtors and creditors willing to build a status quo of massive unprecedented debt?


From the side of the creditors, I think the answer is the misconception that debt is wealth. Debt can be used as collateral, or can be securitised and traded on exchanges (which itself can become a form of shadow intermediation, allowing for a form banking outside the accepted regulatory norms). To keep the value of debt high, and thus keep the debt illusion rolling along (treasury yields keep falling) central banks have been willing to swap out bad debt for good money. But debt is not wealth; it is just a promise, and in today’s world carries huge counter-party risk. Until you convert your debt-based promissory assets into real-world tangible assets they are not wealth.

From the side of the debtors, I think the answer is that debt is easy. Why work for your consumption when instead you can take out a home equity loan or get a credit card? Why buy the one car that you can afford when instead you can buy two with debt?

But there is another side in this world: the side of the central planners. Since the time of Keynes and Fisher there has been an economic revolution:

Deflation has effectively been abolished by central banking.  And so we get to where we are today: the huge and historically unprecedented outgrowth of debt. Deleveraging necessitates economic contraction, which produces the old Keynesian-Fisherian bugbear of debt-deflation, which the central planners abhor. So they print. Where once deflation often made debts unrepayable, and resulted in mass defaults, liquidation and structural transformation, today — thanks to money printing — debtors get their easy lunch of cheap debt, and creditors get their pound of flesh, albeit devalued by the inflation of the monetary base. It has been a superficially good compromise for both creditors and debtors. Everyone has got some of what they want. But is it sustainable?

The endless post-Keynesian outgrowth of debt suggests not. In fact, what is ultimately suggested is that the abolition of small-scale deflationary liquidations has just primed the system for a much, much larger liquidation later on. Bad companies, business models and practices that might otherwise not have survived under previous economic systems today live thanks to bailouts and money-printing. This moral hazard has grown legs and evolved into a kind of systemic hazard. Unhealthy levels of leverage and interconnection that once might have necessitated failure (e.g. Martingale trading strategies) flourish today under this new regime and its role as counter-party-of-last-resort. With every rogue-trader, every derivatives or shadow banking blowup, every Corzine, every Adoboli, every Iksil, comes more confirmation that the entire financial system is being zombified as foolish and dangerous practices are saved and sanctified by bailouts.

With every zombie blowup comes the necessity of more money-printing, and with more money-printing to save broken industries seems to come more moral hazard and zombification. Is that sustainable?

Already, central bankers are having to be clever with their money printing, colluding with financiers and sovereign governments to hide newly-printed money in excess reserves and FX reserves, and colluding with government statisticians to hide inflation beneath a forest of statistical manipulation. It is no surprise that by the BLS’ previous inflation-measuring methodology inflation is running at a much higher rate than the new:

Worse, in the modern financial world, we see an unprecedented level of interconnection. The impending Euro-implosion will have ramifications to everyone with exposure to it, and everyone with exposure to those with exposure to it. Not only will the inflation-averse Europeans have to print up a huge quantity of new money to bail out their financial system (the European financial system is roughly three times the size of the American one bailed out in 2008), but should they fail to do so central banks around the globe will have to print huge quantities of money to bail out systemically-important financial institutions with exposure to falling masonry. This is shaping up to be a true test of their prowess in hiding monetary inflation, and a true test of the “wisdom” behind endless-monetary-growth fiat economics.

Central bankers have shirked the historical growth cycle consisting both of periods of growth and expansion, as well as periods of contraction and liquidation. They have certainly had a good run. Those warning of impending hyperinflation following 2008 were proven wrong; deflationary forces offset the inflationary impact of bailouts and monetary expansion, even as food prices hit records, and revolutions spread throughout emerging markets. And Japan — the prototypical unliquidated zombie economy — has been stuck in a depressive rut for most of the last twenty years. These interventions, it seems, have pernicious negative side-effects.

Those twin delusions central bankers have sought to cater to — for creditors, that debt is wealth and should never be liquidated, and for debtors that debt is an easy or free lunch — have been smashed by the juggernaut of history many times before. While we cannot know exactly when, or exactly how — and in spite of the best efforts of central bankers — I think they will soon be smashed again.

Enter the Swan

Charles Hugh Smith (along with many, many, many others) thinks there may be a great decoupling as the world sinks deeper into the mire, and that the dollar could be set to benefit:

This “safe haven” status can be discerned in the strengthening U.S. dollar. Despite a central bank (The Federal Reserve) with an avowed goal of weakening the nation’s currency (the U.S. dollar), the USD has been in an long-term uptrend for a year–a trend I have noted many times here, starting in April 2011.

That means a bet in the U.S. bond or stock market is a double bet, as these markets are denominated in U.S. dollars. Even if they go nowhere, the capital invested in them will gain purchasing power as the dollar strengthens.

All this suggests a “decoupling” of the U.S. bond and stock markets from the rest of the globe’s markets. Put yourself in the shoes of someone responsible for safekeeping $100 billion and keeping much of it liquid in treacherous times, and ask yourself: where can you park this money where it won’t blow up the market just from its size? What are the safest, most liquid markets out there?

The answer will very likely point the future direction of global markets.

Smith is going along with one of the most conventional pieces of conventional wisdom: that in risky and troubled times investors will seek out the dollar as a haven. That’s what happened in 2008. That’s what is happening now as rates on treasuries sink to all-time-lows. And that’s what has happened throughout the era of petrodollar hegemony.

But the problem with conventions is that they are there to be broken, the problem with conventional wisdom is that it is there to be killed, roasted and served on a silver platter.

The era of petrodollar hegemony is slowly dying, and the assumptions and conventions of that era are dying with it. For now, the shadow of that old world is still flailing on like Wile E. Coyote, hovering in midair.

As I wrote last week:

How did the dollar die? First it died slowly — then all at once.

The shift away from the dollar has quickly manifested itself in bilateral and multilateral agreements between nations to ditch the dollar for bilateral and multilateral trade, beginning with the chief antagonists China and Russia, and continuing through Iran, India, Japan, Brazil, and Saudi Arabia.

So the ground seems to have fallen out from beneath the petrodollar world order.

Enter the Swan:

We know the U.S. is a big and liquid (though not really very transparent) market. We know that the rest of the world — led by Europe’s myriad issues, and China’s bursting housing bubble — is teetering on the edge of a precipice, and without a miracle will fall (perhaps sooner, rather than later).

But we also know that America is inextricably interconnected to this mess. If Europe (or China or both) disintegrates, triggering (another) global default cascade, America will be stung by its European banking exposures, its exposures to global energy markets and global trade flows. Simply, there cannot be financial decoupling, not in this hyper-connected, hyper-leveraged world.

And would funds surge into US Treasuries even in such an instance? Maybe initially — fund managers have been conditioned by years of convention to do so. But how long  can fund managers accept negative real rates of return? Or — much more importantly — how long will the Fed accept such a surge? The answer is not very long at all. Bernanke’s economic strategy has been focussed  on turning treasuries into a losing investment, on the face of it to “encourage risk-taking” (or — much more significantly — keep the Treasury’s borrowing costs cheap).

All of this suggests a global crash or proto-crash will be followed by a huge global money printing operation, probably spearheaded by the Fed. Don’t let the Europeans fool anyone, either — Germany will not let the Euro crumble for fear of money printing. When push comes to shove they will print and fiscally consolidate to save their pet project (though perhaps demanding gold as collateral, and perhaps kicking out some delinquents). China will spew trillions of stimulus money into more and deeper malinvestment (why have ten ghost cities when you can have fifty? Good news for aggregate demand!).

So Paul Krugman will likely get something much closer to what he claims to want. Problem solved?

Nope. You can’t solve deep-rooted structural problems — malinvestment, social change, deindustrialisation, global trade imbalances, systemic fragility, financialisation, imperial decline, cultural stupefaction (etc, etc, etc) — by throwing money at problems. All throwing more money can do is buy a little more time (and undermine the currency). The problem with that is that a superficial recovery fools policy-makers, investors and citizens into believing that problems are fixed when they are not. Eventually — perhaps slowly, or perhaps quickly — unless the non-monetary problems are truly dealt with (very unlikely), they will boil over again.

As the devaluation heats up things will likely become a huge global game of beggar thy neighbour. A global devaluation will likely increase the growing tensions between the creditor and debtor nations to breaking point. Our current system of huge trade imbalances guarantees that someone (the West) is getting a free lunch , and that someone else (the Rest) is getting screwed. Such a system is fundamentally fragile, and fundamentally unstable. Currency wars will likely give way to economic wars, which may well give way to subterfuge and proxy wars as creditors seek their pound of flesh, and debtors seek to cast off their chains. Good news, then, for weapons contractors and the security state.

Paul vs Paul: Round #2

Bloomberg viewers estimate that Ron Paul was the winner of the clash of the Pauls (Ron Paul fans, of course, are very studious at phoning in their support him for). But that is very much beside the point. This wasn’t really a debate. Other than the fascinating moment where Krugman denied defending the economic policies of Diocletian, very little new was said, and the two combatants mainly talked past each other.

The first debate happened early last decade.

To wit:

And so, round two. Krugman wants more inflation; Paul is scared of the prospect. From Paul’s FT editorial yesterday:

Control of the world’s economy has been placed in the hands of a banking cartel, which holds great danger for all of us. True prosperity requires sound money, increased productivity, and increased savings and investment. The world is awash in US dollars, and a currency crisis involving the world’s reserve currency would be an unprecedented catastrophe. No amount of monetary expansion can solve our current financial problems, but it can make those problems much worse.

Or, as Professor Krugman sees it:

Would a rise in inflation to 3 percent or even 4 percent be a terrible thing? On the contrary, it would almost surely help the economy.

How so? For one thing, large parts of the private sector continue to be crippled by the overhang of debt accumulated during the bubble years; this debt burden is arguably the main thing holding private spending back and perpetuating the slump. Modest inflation would, however, reduce that overhang — by eroding the real value of that debt — and help promote the private-sector recovery we need. Meanwhile, other parts of the private sector (like much of corporate America) are sitting on large hoards of cash; the prospect of moderate inflation would make letting the cash just sit there less attractive, acting as a spur to investment — again, helping to promote overall recover.

Ron Paul believes that inflationary interventions into the dollar economy will have unpredictable and dangerous ramifications. Paul Krugman believes that a little more inflation will spur economic activity and decrease residual debt overhang. Krugman gives no credence to the prospect of inflation spiralling out of hand, or of such policies triggering other deleterious side-effects, like a currency crisis.

The prospect of a currency crisis is a topic I have covered in depth lately: as more Eurasian nations ditch the dollar as reserve currency, more dollars (there are $5 trillion floating around Asia, in comparison to a domestic monetary base of just $1.8 trillion — the dollar is an absurdly internationalised currency) will be making their way back into the domestic American economy. Will that have an impact?

I don’t really know how much of this is to do with the Fed’s reflationary policies, and how much is to do with the United States’ endangered role as global hegemon. I tend to think that the dollar hegemony has always been backed by American military force, and with the American military overstretched, the dollar’s role comes into question. If America can’t play the global policeman for global trade, why would the dollar be the currency on global trade?

However it must be noted that America’s creditors do believe that their assets are threatened by the Fed’s inflationism.

As the Telegraph noted last year:

There has been a hostile reaction by China, Brazil and Germany, among others, to the Federal Reserve’s decision to resume quantitative easing.

Or as a Xinhua editorial rather bluntly put it:

China, the largest creditor of the world’s sole superpower, has every right now to demand the United States to address its structural debt problems and ensure the safety of China’s dollar assets.

Of course, China may be totally bluffing, or getting it wrong on the danger of inflation to its assets.

If the reflationism is angering the exporter nations perhaps it is a cause for concern. After all, if America’s consumption-based economy is dependent on China’s continued exportation, and Krugman is advocating inflating away their debt-denominated financial assets, then to what extent do Krugman’s suggestions imperil the trans-Pacific consumer-producer relationship?

And this is a crucial matter — there is nothing, I think, more crucial than the free availability of goods and resources through the trade infrastructure. Getting into a fight with China is risky.

As commenter Thomas P. Seager noted yesterday:

[The situation today] is directly analogous to the first Oil Shock in 1973. In the decades prior, the US had been a major oil producer. However, efficiency gains and discoveries overseas resulting in an incrementally increasing dependence of foreign petroleum. Price signals failed to materialize that would caution policy makers and industrialists of the risks.

Then, the disruption of oil supplies from the Middle East caused tremendous economic dislocations.

Manufacturing is undergoing the same process. The supply chain disruption from the Japanese earthquake and Tsunami was merely a warning shot. Imagine if S Korean manufacturing were taken off-line for any length of time (a plausible scenario). The disruption to US industry would be catastrophic.

In the name of increased efficiency, we have introduced brittleness.

Time will tell whether Krugman’s desire for more inflation is wise or not.