deleveraging trap

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Why I Was Wrong About Inflation

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Back in 2007, I was much more interested in finance and trading than I was in macroeconomics. When the crisis — and the government’s macroeconomic response to the crisis — began in 2008 what was really needed to get a strong grasp of the situation was an understanding of macroeconomics, which I did not have as it was a topic I only really began studying in depth at that time. This led to some misconceptions, particularly about inflation. I mistakenly assumed — as did many at the time, and as do many today — that the huge expansion of the monetary base would lead to stronger inflation than the timid and low inflation we have seen in years since the programs began. While I strongly doubted the claims of individuals like Peter Schiff that hyperinflation might be nigh — as I understood that most historical hyperinflations occurred due to a collapse in production, not solely due to money printing — I thought a strong inflationary snapback was likely, Why? A mixture of real effects and expectations. If central banks are printing money at a higher rate, people will fear that money is becoming less scarce. If having more money in circulation does not begin to bid prices upward, producers will soon begin to raise prices to anticipate any such rise. Simply, I thought that central banks couldn’t print their way out of disaster without some iatrogenic side-effects. I assumed the oncoming pain was unavoidable, and that the onset of inflation was the price that would be paid. As Ludwig von Mises put it: “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 a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

So why did that not occur? After all, plenty of internet goldbugs — and very serious people following the advice of people like John Taylor, Eugene Fama, and Niall Ferguson — were talking about the potential for a strong inflationary shock. The gold price was soaring — hitting a peak above $1900 an ounce in September 2011 — as people anticipating inflation sought to buy insurance against it. Well, for a start it seems like the public did not really buy into the notion of an oncoming inflationary shock. Expected inflation as measured by the University of Michigan has remained very close to the post-1980 norm since the crisis:

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But above and beyond this, the real monetary effects were not the ones I first assumed them to be. The total money supply — most of which is generated not by the Fed but in the private sector through lending — has been stagnant, even while the Federal Reserve is expanding the monetary base. So while the financial sector is flush with cash and has bid the stock market up above its pre-recession nominal peak, other goods in other sectors just have not had enough of a bid behind them to send inflation strongly upward because other areas of the economy (for instance housing, consumer electronics and real wages) have continued to deflate in the context of continued deleveraging, accelerating offshoring driving down wages and the receding effects of the 2008 oil shock.

Yet even more importantly the supply of goods in the West — flowing as it does from East to West, from the factories of the Orient to the consumers of the West — has remained strong and stable. There has been no destabilising, chaotic Chinese crash or revolution, even though many wished there would be in the wake of the Arab spring. And for all the talk by the Chinese and Russians of bond vigilantism, starting a new global reserve currency and dumping the dollar, that has not happened either. And why would it? Certainly, the Asian bond-buyers might have suffered a few years of negative real interest rates. This might have pissed them off. But undermining the Western recoveries further (which have been quite pathetic thus far) when such a high proportion of their assets — dollars and treasuries and increasingly real assets like land and industrials — are related to the economic performance of the West would be to cut off their nose to spite their face, while simultaneously risking conflict with the American military, whose capabilities remain unmatched. The Chinese and Russian talk of de-Americanisation and a post-American world is all bluff and bluster, all sound and fury signifying very little. In the long run, America will have to accept a world where it is no longer the sole global superpower, but there is no incentive for America’s competitors to hasten that way with the kind of aggressive economic warfare that might cause an economic shock.

On the other hand, it is certainly true that much of the new money entering the system is sitting as excess reserves. Is that a symptom of the inflation simply being delayed? Until the middle of last year I thought so. Now I very strongly doubt it. The existence of excess reserves in the system is not a symptom of stored-up future inflation, but a symptom of the weakness of the transmission mechanism for quantitative easing. Simply, the system is in a depression. The banking system is infected with a deep paranoia, and would prefer to sit on risk-free cash instead of lending money to businesses. If the money was lent out, there would be an increased level of economic and business activity. Therefore there is no guarantee of any additional inflation as the money is loaned out.

So I was wrong to worry that inflation could become an imminent problem. But I was wronger than this. The entire paradigm that I was basing these fears upon was flawed. Simply, I was ignoring real and present economic problems to worry about something that could theoretically become a problem in the future. Specifically, I was ignoring the real and present problem of involuntary unemployment to worry about non-existent inflation and non-existent Asian bond vigilantes. The involuntariness of unemployment is a very simple fact — there are not enough jobs for the number of jobseekers that exist, and there hasn’t been enough jobs since the crisis began. Currently there are just over three job seekers for every job. So unemployment and underemployment are not simply things that can be dismissed as a matter of workers becoming lazy, or preferring leisure to work. Mass unemployment has insidious and damaging social effects for individuals and communities — people who are out of work for a long time lose skills. For communities, crime rises, and health problems emerge. And there are 25 million Americans today who are either unemployed or underemployed as a practical matter it is not simply a case of sitting back and allowing the structure of production to adjust to the new economy. And worse, with unemployment high, spending and confidence remain depressed as the effects of high unemployment create a social malaise. This is a mass sickness — and in the past it has led to the rise of warmongering political figures like Hitler. So while it may be preferable for the private sector to be the leading job creator under ordinary conditions, while the private sector is engaging in heavy deleveraging this is impractical. Under such an eventuality the state is the only institution that can break the depressionary trend by creating paying jobs and fighting back against the depressionary tendency toward mass unemployment. Certainly, centralised bureaucracy can be a troublesome and distortionary thing. But there are many things — like mass unemployment and underemployment, and the social problems that that can bring — worse than centralised bureaucracy. And no — this kind of Keynesianism was not the problem in the 1970s.

By worrying over the potential for future inflation or future bond vigilantism due to monetary and fiscal stimulus, I was contributing to the problem of mass unemployment, first of all by not acknowledging the problem, and second by encouraging governments and individuals to worry about potential future problems instead of real-world problems today. As it happened, a tidal wave of evidence has washed these worries away. It is clear from the economic data that inflation is not a concern in a depressionary economy, just as Keynesian-Hicksians heuristics like IS/LM suggested.

Of course, if the depression ends of its own accord then inflation could become a problem again.  If the United States were to experience a strong unexpected spurt of growth sustained over a year or so, pushing unemployment significantly down and growth significantly up, inflation could rise appreciably. The Federal Reserve would have to quickly taper both its unconventional policies and probably begin to raise rates. Of course, that is rather unlikely in the present depressionary environment. But certainly, it is a small possibility. That would be the time for the Federal Reserve to start to worry about inflation. A strong negative energy shock — like the one experienced by the UK in 2010 and 2011 — could push inflation higher too, yet that would be a transitory factor in the context of the wider depressionary environment, and would most likely fall back of its own accord.

If the Fed was engaging in actual helicopter drops — the most direct transmission mechanism possible — there would likely be a stronger inflationary response than that which we have seen thus far. Yet ultimately, this might prove desirable. After all, if the private sectors of the entire Western world have a very large nominal debt load which they are struggling to deleverage, some stronger inflation would certainly begin to minimise that. Yes, that is redistribution from lender to borrower. No, creditors will not be happy about this. But in the end, creditors may find it easier to take an inflationary haircut than face twenty years of depressionary deleveraging as Japan has done. Although the West certainly does not have the same demographic troubles as Japan, such an outcome is possible unless people — governments, entrepreneurs, individuals, society — decide that unemployment and a lack of demand in the economy must be tackled, and do something about it. Then can we confidently expect to climb out of the lip of the deleveraging trap.

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Why Does Anyone Think the Fed Will Taper?

Simon Kennedy of Bloomberg claims:

The world economy should brace itself for a slowing of stimulus by the Federal Reserve if history is any guide.

Personally, I think this is nutty stuff. In enacting QE3, Bernanke made pretty explicit he was targeting the unemployment rate; the “full-employment” side of the Fed’s dual mandate. And how’s that doing?

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It looks like its coming down — although, we are still a very long way from full employment. And a lot of that decrease, as the civilian employment-population ratio insinuates, is due to discouraged workers dropping out of the labour force:

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Moreover, of course, quantitative easing — substituting zero-yielding cash into the money supply for low-yielding assets — is about the Federal Reserve attempting to reinflate the shrunken money supply resulting from the collapse of shadow intermediation in 2008. And the broad money supply remains extremely shrunken, even after all the QE:

And the bigger story is that America is still stuck in a huge private deleveraging phase, burdened with a humungous debt load:

Japan, of course, tapered its stimuli multiple times at the faintest whiff of recovery. Bernanke and Yellen will be aware of this.

Much more likely than abandoning stimulus is the conclusion by the next Fed chair — probably Yellen — that the current transmission mechanisms are ineffective, and the adoption of more direct monetary policy, including helicopter money.

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Of Krugman & Minsky

Paul Krugman just did something mind-bending.

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In a recent column, he cited Minsky ostensibly to defend Alan Greenspan’s loose monetary policies:

Business Insider reports on a Bloomberg TV interview with hedge fund legend Stan Druckenmiller that helped crystallize in my mind what, exactly, I find so appalling about people who say that we must tighten monetary policy to avoid bubbles — even in the face of high unemployment and low inflation.

Druckenmiller blames Alan Greenspan’s loose-money policies for the whole disaster; that’s a highly dubious proposition, in fact rejected by all the serious studies I’ve seen. (Remember, the ECB was much less expansionary, but Europe had just as big a housing bubble; I vote for Minsky’s notion that financial systems run amok when people forget about risk, not because central bankers are a bit too liberal)

Krugman correctly identifies the mechanism here — prior to 2008, people forgot about risk. But why did people forget about risk, if not for the Greenspan put? Central bankers were perfectly happy to take credit for the prolonged growth and stability while the good times lasted.

Greenspan put the pedal to the metal each time the US hit a recession and flooded markets with liquidity. He was prepared to create bubbles to replace old bubbles, just as Krugman’s friend Paul McCulley once put it. Bernanke called it the Great Moderation; that through monetary policy, the Fed had effectively smoothed the business cycle to the extent that the old days of boom and bust were gone. It was boom and boom and boom.

So, people forgot about risk. Macroeconomic stability bred complacency. And the longer the perceived good times last, the more fragile the economy becomes, as more and more risky behaviour becomes the norm.

Stability is destabilising. The Great Moderation was intimately connected to markets becoming forgetful of risk. And bubbles formed. Not just housing, not just stocks. The truly unsustainable bubble underlying all the others was debt. This is the Federal Funds rate — rate cuts were Greenspan’s main tool — versus total debt as a percentage of GDP:

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More damningly, as Matthew C. Klein notes, the outgrowth in debt very clearly coincided with an outgrowth in risk taking:

To any competent central banker, it should have been obvious that the debt load was becoming unsustainable and that dropping interest rates while the debt load soared was irresponsible and dangerous. Unfortunately Greenspan didn’t see it. And now, we’re in the long, slow deleveraging part of the business cycle. We’re in a depression.

In endorsing Minsky’s view, Krugman is coming closer to the truth. But he is still one crucial step away. If stability is destabilising, we must embrace the business cycle. Smaller cyclical booms, and smaller cyclical busts. Not boom, boom, boom and then a grand mal seizure.

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Why Modern Monetary Theory is Wrong About Government Debt

I’ve taken some criticism — particularly from advocates of modern monetary theory and sectoral balances and all that — for using total debt rather than just private debt in my work.

The modern monetary theory line (in one sentence, and also in video form) is that government debt levels are nothing to worry about, because governments are the issuer of the currency, and can always print more.

This evokes the words of Alan Greenspan:

The United States can pay any debt it has because we can always print money to do that. So there is zero probability of default.

Of course, the point I am trying to make in worrying about total debt levels is not the danger of mass default (although certainly default cascades a la Lehman are a concern in any interconnective financial system), but that large debt loads can lead to painful spells of deleveraging and economic depression as has occurred in Japan for most of the last twenty years:

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Of course, before the crisis in America (as was the case in Japan at the beginning of their crisis) government debt was not really a great contributor to the total debt level, meaning that the total debt graph looks far more similar to the private debt line than the public debt line, which means that when I talk about the dangers of growing total debt I am talking much more about private debt than public debt:

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But what Japan empirically illustrates is the fact that all debt matters. Japan’s private debt levels have reset to below the pre-crisis norm, yet the economy remains depressed while public debt continues to climb (both in absolute terms, and as a percentage of GDP). If excessive private debt was the sole factor in Japan’s depression, Japan would have recovered long ago. What we have seen in Japan has been the transfer of the debt load from the private sector to the public, with only a relative small level of net deleveraging.

And high and growing public sector deficits often lead to contractionary tax hikes and spending cuts. This happened time and again during Japan’s lost decades. Peter Tasker of the Financial Times writes:

When Japan’s bubble economy imploded in the early 1990s, public finances were in surplus and government debt was a mere 20 per cent of gross domestic product. Twenty years on, the government is running a yawning deficit and gross public debt has swollen to a sumo-sized 200 per cent of GDP.

How did it get from there to here? Not by lavish public spending, as is sometimes assumed. Japan’s experiment with Keynesian-style public works programmes ended in 1997. True, they had failed to trigger durable economic recovery. But the alternative hypothesis – that fiscal and monetary virtue would be enough – proved woefully mistaken. Economic growth had been positive in the first half of the “lost decade”, but after the government raised consumption tax in 1998 any momentum vanished. Today Japan’s nominal GDP is lower than in 1992.

The real cause of fiscal deterioration was the damage done to tax revenues by this protracted slump. Central government outlays as a percentage of GDP are no higher now than in the early 1980s, but the tax take has fallen by 5 per cent of GDP since 1989, the year that consumption taxes were introduced.

A rise in debt relative to income has historically tended to lead to contractionary deleveraging irrespective of whether the debt is public or private.

The notion at the heart of modern monetary theory that governments that control their own currency do not have to engage in contractionary deleveraging remains largely ignored. Just because nations can (in a worst case scenario) always print money to pay their debt, doesn’t mean that they will always print money to pay their debt. They will often choose to adopt an austerity program (as is often mandated by the IMF), or default outright instead (as happened in Russia in the 1990s).

And what governments cannot guarantee is that the money they print will have value. This is determined by market participants. In the real economy people in general and creditors (and Germans) in particular are very afraid of inflation and increases in the money supply. History is littered with currency collapses, where citizens have lost confidence in the currency (although in truth most hyperinflations have occurred after some great shock to the real economy like a war or famine, and not solely as a result of excessive money printing).

And there has always been a significant danger of currency, trade and political retaliations by creditors and creditor nations, as a result of the perception of “money printing”. Many, many wars have been fought over national debts, and over currencies and their devaluation. One only has to look at China’s frustrated rhetoric regarding America’s various monetary expansions, the fact that many Eurasian creditor nations are moving away from the dollar as a reserve currency, as well as the growth of American-Chinese trade measures and retaliations, to see how policy of a far lesser order than the sort of thing advocated in modern monetary theory can exacerbate frictions in the global currency system (although nothing bad has come to pass yet).

Governments controlling their own currencies are likely to continue to defy the prescriptions of the modern monetary theorists for years to come. And that means that expansionary increases in government debt relative to the underlying economy will continue to be a prelude to contractionary deleveraging, just as is the case with the private sector. All debt matters.

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Gold, Price Stability & Credit Bubbles

John Cochrane thinks that central banks can attain the price-stability of the gold standard without actually having a gold standard:

While many people believe the United States should adopt a gold standard to guard against inflation or deflation, and stabilize the economy, there are several reasons why this reform would not work. However, there is a modern adaptation of the gold standard that could achieve a stable price level and avoid the many disruptions brought upon the economy by monetary instability.

The solution is pretty simple. A gold standard is ultimately a commitment to exchange each dollar for something real. An inflation-indexed bond also has a constant, real value. If the Consumer Price Index (CPI) rises to 120 from 100, the bond pays 20% more, so your real purchasing power is protected. CPI futures work in much the same way. In place of gold, the Fed or the Treasury could freely buy and sell such inflation-linked securities at fixed prices. This policy would protect against deflation as well as inflation, automatically providing more money when there is a true demand for it, as in the financial crisis.

The obvious point is that the CPI is a relatively poor indicator of inflation and bubbles. During Greenspan’s tenure in charge of the Federal Reserve, huge quantities of new liquidity were created, much of which poured into housing and stock bubbles. CPI doesn’t include stock prices, and it doesn’t include housing prices; a monetary policy that is fixed to CPI wouldn’t be able to respond to growing bubbles in either sector. Cochrane is not really advocating for anything like the gold standard, just another form of Greenspanesque (mis)management.

Historically, what the gold standard meant was longer-term price stability, punctuated by frequent and wild short-term swings in purchasing power:

In its simplest form (the gold coin standard), gold constrains the monetary base to the amount of gold above ground. The aim is to prevent bubble-formation (in other words, monetary growth beyond the economy’s inherent productivity) because monetary growth would be limited to the amount of gold dug out of the ground, and the amount of gold dug out of the ground is limited to the amount of productivity society can afford to spend on mining gold.

Unfortunately, although gold levels are fixed, levels of credit creation are potentially infinite (and even where levels of credit creation are fixed by reserve requirements, shadow credit creation can still allow for explosive credit growth as happened after the repeal of Glass-Steagall). For example, the 1920s — a period with a gold standard — experienced huge asset bubble formation via huge levels of credit creation.

In any case, I don’t think that the current monetary regimes (or governments — who love to have the power to monetise debt) will ever change their minds. The overwhelming consensus of academic economists is that the gold standard is bad and dangerous.

In a recent survey of academic economists, 93% disagreed or strongly disagreed with this statement:

If the US replaced its discretionary monetary policy regime with a gold standard, defining a “dollar” as a specific number of ounces of gold, the price-stability and employment outcomes would be better for the average American.

That question is skewed. A gold standard can also be a discretionary regime; gold can be devalued, it can be supplemented with silver, and it can be multiplied by credit. And the concept of “price-stability” is hugely subjective; the Fed today defines “price stability” as a consistent 2% inflation (which on an infinite timeline correlates to an infinite level of inflation — the only stable thing being the rate at which the purchasing power of a dollar decreases).

If anything, the events of 2008 — which I interpret as a predictable and preventable housing, securitisation, and debt bubble stemming very much from central bank mismanagement of the money supply under Greenspan — secured the reputation of central banking among academic economists, because the bailouts, low rates and quantitative easing have prevented the feared debt-deflation that Milton Friedman and Ben Bernanke postulated as the thing that prolonged and worsened the Great Depression.

The Japanese example shows that crashed modern economies with excessive debt loads can remain stagnant for long periods of time. My view is that such nations are in a deleveraging trap; Japan (and more recently the Western nations) hit an excessive level of debt relative to GDP and industry at the peak of the bubble. As debt rises, debt servicing costs rise, leaving less income for investment, consumption, etc.

Throughout Japan’s lost decade, and indeed the years that followed, total debt levels (measured in GDP) have remained consistently high. Simply, the central bank did not devalue by anywhere near enough to decrease the real debt load, but nor have they devalued too little to result in a large-scale liquidation episode. They have just kept the economy in stasis, with enough liquidity to keep the debt serviceable, and not enough to really allow for severe reduction. The main change has been a transfer of debt from the private sector, to the public sector (a phenomenon which is also occurring in the United States and United Kingdom).

Eventually — because the costs of the deleveraging trap makes organically growth very difficult — the debt will either be forgiven, inflated or defaulted away. Endless rounds of tepid QE (which is debt additive, and so adds to the debt problem) just postpone that difficult decision. The deleveraging trap preserves the value of past debts at the cost of future growth.

Under the harsh discipline of a gold standard, such prevarication is not possible. Without the ability to inflate, overleveraged banks, individuals and governments would default on their debt. Income would rapidly fall, and economies would likely deflate and become severely depressed.

Yet liquidation is not all bad.  The example of 1907 — prior to the era of central banking — illustrates this.

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.

Although liquidation episodes are painful, the clear benefit is that a big crash and depression clears out old debt. Under the present regimes, the weight of old debt remains a burden to the economy.

But Cochrane talking about imposing a CPI-standard (or Greenspan talking about returning to the gold standard) is irrelevant; the bubble has happened, it burst, and now central banks must try to deal with the fallout. Even after trillions of dollars of reflation, economies remain depressed, unemployment remains elevated and total debt (relative to GDP) remains huge. The Fed — almost 100 years old — is in a fight for its life. Trying to balance the competing interests of creditors — particularly those productive foreign nations like China that produce much of America’s consumption and finance her deficits — against future growth is a hugely challenging task. The dangers to Western economies from creditor nations engaging in punitive trade measures as  a retaliatory measure to central bank debasement remain large (and the rhetoric is growing fiercer). Bernanke is walking a tightrope over alligators.

In any case even if a gold standard were to be reimposed in the future, history shows that it is unlikely to be an effective stop against credit bubbles. Credit bubbles happen because value is subjective and humans are excitable, and no regime has proven itself capable of fully guarding against that. Once a credit bubble forms, the possibilities are the same — liquidation, inflation or debt forgiveness. Today, central banks must eventually make a choice, or the forces of history will decide instead.

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The Absurdity of Sandy Weill

I’m suggesting the big banks be broken up so that the taxpayer will never be at risk, the depositors won’t be at risk and the leverage will be something reasonable.

This from the guy who provided the impetus and the funds to end Glass-Steagall? Totally absurd — akin to Joe Stalin renouncing Marxism-Leninism and the gulag archipelago on his deathbed.

Glass-Steagall’s separation between depository and speculative institutions — especially during the Bretton Woods period — was a relatively robust system; there was never a large-scale banking calamity of the nature of 2008 or 1929 under its regime. Certainly, it had its imperfections — above all else that it never prevented bankers like Weill from chipping away at it up to the point of repeal — but the proof of the pudding is in the eating, and Glass-Steagall presided over a period of growth and stability.

While the data tends to show that the end of Bretton Woods in 1971 was the real catalyst of the financialisation, globalisation, deindustrialisation and debt buildup that ultimately flung the US into a depressionary deleveraging trap, the end of Glass-Steagall was profound.

Depositors’ funds became a medium for the creation of the huge and sprawling shadow banking and derivatives webs.

The blowout growth in shadow banking was presaged by the end of Glass-Steagall in 1999:

And the slow contractionary deleveraging of shadow banking has been a significant force in keeping the economy depressed since 2008. Any contrition on the part of Weill for his role in repealing Glass-Steagall might as well be an attempt to close the stable door after the horse has bolted. It’s like trying to uninvent the atom bomb after Hiroshima. Weill was the guy who — above anyone else — was responsible for the damage done.

Coming out and claiming that reimposing Glass-Steagall would fix the problem is inadequate. If he wants to be taken seriously he should match every dollar he spent trying to get Glass-Steagall repealed with new lobbying funds to reimpose a separation between banks that accept deposits and the shadow banking and derivatives casinos.

Beyond that, I think that this is very telling. The financial institutions will do anything to avoid the ultimate free market solution — the disorderly liquidation of the system they created via default cascade. If high-ranking members of the financial elite are willing to talk about reimposing Glass-Steagall, they must be seriously concerned that the system they built is getting dangerously close to self-destruction.