Posted on 08/18/2008 2:18:45 PM PDT by djsherin
In the dozen or so years until 2007, it had become as close to a global orthodoxy in economic policy making as we ever see: Central banks should target a low and stable rate of inflation.
This replaced earlier orthodoxies -- such as that central banks should maintain a fixed exchange rate with an ounce of gold, which was abandoned in 1971. Though inflation targeting left far more latitude for government officials to expand the money supply, it too ultimately proved too great a shackle on the exercise of central bank wisdom.
The U.S. Federal Reserve, the European Central Bank, the Bank of England and other rich-country central banks have generally made 2% inflation, give or take a smidge, the touchstone of good performance. Fed officials have for 20 years paid public obeisance to their statutory "dual mandate," to maximize employment as well as stabilize prices. But in practice, until recently, they treated it much like a mildly embarrassing biblical injunction that could be safely ignored, if not repudiated.
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Interesting.
The Fed began tightening in 2005 to slow and then break the real estate bubble. Which worked - said bubble is comprehensively smashed. Rates peaked in the summer of 2007 as this became obvious, and all the major banks shifted into reverse. Debt liquidation has been gale force since then, and it is crazy to worry about too much money.
The Fed has not flooded the system with new high powered money in response. The cut in rates to 2% from 5.5% has only kept M1 *constant*. M1 hasn't moved in 3 1/2 years. The slander against the Fed is an ideological line and does not reflect the reality.
The source of that line is the fiction that banks and the ordinary credit cycle don't control the broader money supply, that it is all up to policy and ever the gubmint's fault. This is a stone cold lie.
The Fed didn't put a gun to anyone's head to force them to recklessly lend to deadbeats; it didn't put a gun to anyone's head to force them to take out a loan they couldn't afford, and it isn't putting a gun to anybody's head to hold dollar balances. All those actions are voluntary.
And the Fed isn't forcing unwanted money on the market. It is keeping the bank's present state of panic from collapsing the money supply at double digit annual rates, but that is quite completely all. Every ounce of accomodation since last July has been offset, dollar for dollar, by selling treasuries into the market in open market operations.
The reason the commodity bubbles are bursting, is speculators bought this ideological line that the Fed was reckless and inflating, but it flat isn't. None of these huge doubled prices are going to stick, any more than house prices twice what anyone could afford to pay stuck.
Dollars are holding their value in real terms, interest included. Speculators pretending hard assets are safer, on the other hand, have recklessly overbought assets to levels that won't be sustained and will only bring misallocation, loss, and distress. In real estate, in oil, and in gold, etc.
The Fed did not do those things. A million parrots repeating the lie that it did, will not make it true.
It's no coincidence that the prices of just about every commodity just happened to hit major peaks after the Federal Reserve stopped reporting M3 a few years ago.
The U.S. Treasury has been flooding the world with more dollars. It just hasn't openly admitted it.
It is disingenuous to ascribe to fed rate cuts no link to inflation simply because M1 hasn't moved much. It is like saying the increase in gas prices has not resulted in an increase in the price of goods and services because I still get my hair cut for $14.89. Fed rate policy is most strongly manifested in M2 (and M3, at least until its calculation by the fed became inconvenient of dubious utility). M2 has most certainly skyrocketed (to be fair, its increase has been much less dramatic as a percentage of the GDP, but still "too high"). The "broader" money supply to which you refer includes M1+M2, at minimum, and fed policy most certainly regulates M2.
Keynesian/Marxist stupidity aside, I think everyone agrees that inflation and the money supply are linked. The argument you are apparently making implicitly assumes that M2 (and M3) have nothing to do with with the "real" money supply, and thus inflation. Am I misinterpreting you?
The Fed didn't put a gun to anyone's head to force them to recklessly lend to deadbeats; it didn't put a gun to anyone's head to force them to take out a loan they couldn't afford, and it isn't putting a gun to anybody's head to hold dollar balances. All those actions are voluntary.
By that logic, the fed can set ANY policy it wants, and then wash its hands of the results borne by the ensuing behavior of the market. It wouldn't be the fed's fault that nobody wanted to take out a bank loan offered at 400% interest, right?
Actually, I'd tend to agree, if not for the fact that the fed actually REFUSES to wash its hands - it acts as a guarantor (using the tax dollars of those of mostly no party to said voluntary activities) for those individuals and entities engaging in the risky activities itself enabled. Same goes for taxation and spending policies (and their interplay with monetary policy) - when the government or a sufficiently large entity screws up, it is made sure that the losses/costs are socialized, and we are all forced to pay.
That is the law, and the reason for the law is also clear. Increased demand to hold money or near money for *savings* purposes, or for investment in a secure asset, does *not* represent an increased desire for *transactions* money forms. It cannot be expected to show up immediately as demand for other forms of spending. US banking law is therefore explicitly intended to *allow* broader, savings forms of money-substitutes to rise whenever there is both demand for such accounts by savers, and a willingness to borrow from them by banks.
The only limits banks face in expanding *savings* forms of money, are (1) do people want to hold higher savings balances? and (2) to a much smaller extent, their capital adequacy requirements from their whole-sheet size, on the asset size. Meaning, if a bank doubles its liabilities by borrowing on CDs, presumably it will increased its leverage and Basel II reserve capital. Although, if the proceeds are put into treasuries, it won't actually face even those limits, since Basel II capital requirements against low credit risk instruments, are essentially zero.
For the umpeenth time, the Fed does *not* control how much households or companies want to save, and it does *not* control how much money-substitutes banks create to satisfy that demand. It controls *currency* and *checking accounts* through the reserve requirement. It will not let banks "print money", in the specific sense of letting depositers withdraw balances as *currency*, nor as net shifts out of savings into checking to be spent. But it does not regulate the free credit decisions of banks and households. If you want to lend money to a bank at 3% for 6 months on a CD, the bank needs *zero* reserves to take you up on that offer.
What happened since 2005 is the Fed did *not* allow any new *transactions* money creation, net, but the banks went ahead and created $2 trillion in new *deposits*, anyway, extending their leverage to do so, through mid 2007. The banks immediately got into trouble doing that, however. They had extended their balance sheets and leverage levels at vanishing spreads, without the real economic activity to support it. That is why they hit a wall last summer.
And it is evaporating. Corporate paper ran off at half trillion annual rates, new borrowing has fallen 30%, huge write offs had to be taken as debts went south on mortgages, and now commodities from gold to oil are collapsing at rates of -50% per year. Why? Because everyone pretended there was a giant inflation, but somebody forgot to tell the Fed.
They aren't making new monopoly money for people to throw at every problem. The bubble-blowers are slandering them and pretending they are, but they aren't. Banks overextended themselves in the meantime, got caught out, and are retrenching violently. They wouldn't need to retrench violently if the Fed *had* created new *spendable* money at the 7% to 10% annual rates they anticipated.
The real story this cycle has been that the Fed went appropriately tight over 3 years ago, and the financial sector stepped into deep "trouble" precisely by ignoring it and pretending it wasn't happening and they didn't need to adjust to it, that more money would just rain down and make all their bubbles real increases in prices and sustainable.
The Fed has *not* obliged. That is why Fannie and Freddie are in the critical ward, oil has peaked, gold has peaked, the banks are being forced to deleverage and raise new capital - expensive capital, you think they'd need to do that if they could just print money at will? - and above all, why real estate prices are not increasing at double digit rates anymore, but are instead declining at double digit rates, right back to where they belong.
Above all, the speculation in real estate and other hard assets would have required a doubling of the general price level, including wages, along with actual spendable money. The Fed has not accomodated that pleasant inflationary fantasy. There are no more real dollars being spent today, than 3 1/2 years ago.
Someone may object, if a saver just decides to cash in his CD and spend it, then the narrow money supply will balloon. Ah no. The narrow money supply can't move unless the Fed lets it. If you turn your CD into a checking account deposit, preparing to pay Best Buy for a new TV, the bank has to reserve against it. It needs to force a cash flow in its favor, to do that. It needs to realize assets, get paid, net, not create new ones by paying out, net.
Banks are free to speculate about how far to extend themselves and what risks to take. The Fed doesn't stop them. But failure sure as heck does. If the Fed doesn't let M1 move, failure of all the bubble schemes is a certainty. They can't all be accomodated with only the same old narrow money supply and the same real income level.
That's how it is *designed* to work. It is working just fine. It doesn't abolish cycles, but it does enforce the conservative, restricted, downswing side of them, if the banks extend themselves too far. Which they did, and which the system is currently forcing them to correct.
That 2% federal funds rate is helping banks rebuild balance sheets, but it isn't fueling inflation. Because companies and consumers don't have access to it. Mortgage rates at over 6% for the highest quality credits - higher than last year. Corporate rates are 6.5% for A credits. Not things hyperinflations are made of.
The headline inflation numbers still reflect the past, and the oil bubble in particular. Also they do not accurately reflect the swing in housing costs, which are a third of real consumer costs. The commodity upswings are over, they are not going to be seen in future CPI numbers. The reverse, in fact. (Although the heating oil hit still won't fully arrive until this winter, so the absolute commodity peak won't all be "in" until spring 2009).
A year or two from now, the present low fed funds rate might support monetary expansion - but right now it is only preventing a strong deflation that would otherwise be occurring as banks deliberately reduce their leverage, in response to credit losses. By then the Fed will tighten somewhat.
Everyone is missing this real story because it doesn't fit their ideological hatred of everything government. The right thinks that way on principle, and the left thinks that way about the current incumbents, and is also ready to listen to any slander of anything capitalist. But in fact, the Fed has been quite good this cycle in a pure technocratic sense, and while it might be fairly criticized for being about a year late in the 2004-5 period, that is long past, and everything they've done since has been smack on the money.
That is the reality. It is not wanted ideologically so it is ignored. But it will out.
Yes, the government spends way too much money. I thought we were talking about the Fed?
By not letting M1 move. That is what banks actually need to reserve against, by law. Check.
By raising rates to kill the real estate bubble - accomplished 2005 to 2007. Real estate bubble, dead as a doornail. Check.
By making it far too risky to expand without its aid and support, in terms of real consequences for overexpanding banks. $1 trillion in lost market cap since last summer, anyone? A pile of wall street CEO heads in the trophy case, fired for credit losses? Fortunes wiped out?
That is *how* the Fed stops banks from expanding money too fast.
Is anyone else paying the slightest attention to the actual events, or is everyone just reading from an ideological script decades old, as though it were a hymnal?
I'd agree, if not for one party of those actions drawing me in at gunpoint. I'm not asking for the government to do anything FOR ME in fact - and that includes robbing me to pay for the mistakes of others. If Bob's Bank collapses, I'm fine with all of his clients losing everything - I just don't want to get stuck with a bill.
We are not talking about free men acting within a free market. We are talking about partially-free men interacting with eachother and the government. My asset values do not evolve according to a sum of products of interactions between free agents - if they did, I would be happy to deal with all that came my way. Your freedom does not include using the government to force me, at gunpoint, to subsidize your losses, underwrite your loans, or otherwise share your risks. It is a fiction that we have a free-market (I wish we did).
I find it strange to have to assert my own standing upon the side of liberty with an (apparent?) proponent of activist government monetary policies...
Excellent, so we are in agreement apparently! Except that I disagree that the above happened to the degree warranted, and disagree that the federal government would actually permit "sufficiently large" financial entities to suffer alone (i.e. without sending me a bill, one way or another, regardless of the lack of any voluntary link between myself and said entity) under any circumstances. If the taxpayer (by extension) is assumed implicitly to act as essentially an insurer (socialization of "large enough" losses), then monetary policy is necessarily partly to blame for reckless behavior.
You have completely sold me, not just the above (worth repeating) but all of it. I think you are dead on. People who disagree with you should at the very least re-read all of your posts on this thread and digest them before attempting to comment further. Then, let the floodgates fly. But people disagreeing with your conclusions should read them a second time, slowly and let the information sift against what they thought they knew. I think you have made many true statements in your posts. I think you have the current conditions analyzed accurately.
You are not sent a bill in the mail when a bank fails, such that your personal credit rating suffers if you don't mail in a check. So where does the allegation of your being robbed, come from?
I note in passing that it is needlessly inflammatory, a piece of libel even. Right up there with Proudhon claiming that property is theft or Marx claiming that profit is theft, many who (falsely, in my opinion) pretend to be libertarians in their principles, effortlessly pretend that finance is theft. They are just as wrong and for essentially the same reason.
There are two classic sources of the allegation. Use of public money, stemming especially from 19th century populist views associated with Andrew Jackson's fight with the Bank of the United States, for example. And allegations about inflation and its effects, stemming especially from Austrian economics, especially Mises (compared to Hayek e.g.). Sometimes they are conflated, as in our passing poster earlier who confuses the treasury and the Fed.
First to deal with the public money case, by far the less significant one. You aren't robbed when insured bank deposits are paid off at par. One, it is called insurance for a reason, two, the FDIC is profitable. But suppose as in the S&L crisis of the early 90s, funds from the US treasury are used. Does this mean you are robbed, on those occasions?
Hardly. Unless you are willing to plead guilty to bank robbery over the last 3 years and go to prison for it. Since just the top 5 US money center banks paid $78 billion in corporate income taxes over that period, and you drove on interstate highways funded out of general revenue.
By any conceivable accounting, banks are huge net payers to the US treasury. Directly through corporate income tax, secondarily through taxable dividends, thirdly through all of their salaries and expenses earned by their services and paid by their employees and clients, fourthly by the positive externalities of their role in the capital markets etc.
Nearly every item decried as a "bailout" and as "theft" by the ideologues, worthy successors to Proudhon and Marx, has been profitable for the bailing out federal entities. Leaving aside the billions in earnings the Fed pays to the treasury each year, and the self financing nature of the agencies, even the direct bailouts themselves frequently end up not losing the taxpayer a dime. And they certainly never even approach the taxes collected from profitable banks continually.
So are you a bank robber, because banks are net payers of more in taxes than they receive in bailouts? It is one entry accounting, and it is nonsense. Health care might claim to consume more in federal money than the value returned for it, since $700 billion a year is spent on it. Education perhaps, though it does have returns that simply pass to individuals. But banking is emphatically not a net drain on the US treasury, so your nose is utterly untouched by banking and federal banking policy, by this route at least.
As for their general economic role, it is even more valuable. Shut the banks down and see where you wind up, if you don't believe it. The experiment was very nearly tried in the early 1930s, the answer was "in deep trouble".
Banks are among the largest generators of uncaptured positive externalities in the whole economic system, indeed in history. You need only compare the poverty of a nation without a functioning banking system and one with such a system, and then ask what fraction of that difference falls to the banks themselves as their share of income. Try getting through the next week paying for everything you might require, solely by barter using blueberry scones, then tell me the monetary system is robbing you rather than benefiting you.
That leaves the claim derived from inflation, and supposedly you are robbed whenever the money supply is increased, whether it is to cover a mistake of others or not. And this was the target of my original comments about other men's freedom and exchange value of anything not being guaranteed.
It is not the Fed's actions that change the effective money in existence, it is the actions of other private bankers. The Fed *regulates* those actions, indeed it restricts them in the direction you claim to favor, compared to what banks could do and actually did without it.
If a private financier somewhere agrees to accept the IOU of some entrepeneur as an asset better than money, and increase his own leverage to fund said entrepeneur's projects and pays his bills for him, then this action will change the exchange value of other commodities you own. It will change the exchange value of money you hold, or any commodity the entrepeneur directly deals in. It will effect others indirectly, altering the price of everything under the sun, potentially.
Should you be entitled to demand that the government go put a gun to that financier's head and tell him he can't do that, because it is making the value of items you own, bounce around? No. If you did and others did likewise, all economic freedom would evaporate. There is *no* meaningful private economic action that leaves the value of all other goods unchanged.
The demand being unreasonable, the claim that financing is theft is an unsupported libel.
The one who got the principle of this right, incidentally, was not Mises but Hayek, and in the context of planning not finance. It is a mistake to pursue economic security to the point where economic liberty is lost. One, you can't have economic security. Full stop. And especially not in an adaptive system, and adaptive ones are the only ones that can increase wealth over time. Two, economic liberty you can have, and is worth more.
As Hayek said in Road, we should simply accept that freedom includes occasional hardship and that is simply part of its price, a price fully worth paying. Other men being free means they are also free to make mistakes. If they are large enough they may inconvenience me as well as themselves or their immediate counterparties. That cannot be prevented, full stop.
This doesn't mean there can't be better and worse monetary policy, conducted more skillfully in a technocratic sense, or less. It emphatically does mean there is no substitute for good finance, and there will unavoidably be consequences when men screw up in finance as in all other things. And it emphatically means finance is not theft, and the slander that it is should be dropped by all friends of liberty, and of capitalism.
Moreover, whether you are yourself in the position of a banker own, net of services you use from them and of any positive or negative cost they have, is your own free choice. If you think they have the greatest deal ever, be a banker tomorrow by buying bank stock, instead of lending to them on deposits. Both sides of an offered deal can't be unfair to you.
A cut is made by the realities of deposits and of bank ownership. You then get to choose, and are responsible for the side of that choice you pick. All the allegers of robbery (Proudhon, Marx, etc) avoid that simple commercial principle of justice, "making a market". They are all speaking for *one* side of a proposed trade, instead of offering either one to anyone who disagrees with their price.
If you think the Fed has set rates too low, go take out a loan. If you think banks have it easy, buy banks. If you don't do these things and instead slander bankers and demand different rates, but won't move which side of the trade you want to stand on - then no one should take seriously your claims to be concerned with the justice of the deals on offer.
When Marx said that profits are theft, he was insisting that capital be provided to his clients for free. But he wasn't thinking of providing that capital himself, just naming the price, zero. When the contemporary slanderers say that finance is theft, they are insisting that monetary services be provided to them, without moving the value of anything they own an inch. They aren't providing me with any service, nor are they bearing any risk on my behalf.
You’re welcome.
I’m still a little confused. I wouldn’t consider myself economically savvy, although I have been reading a lot lately and trying to understand. I guess while I try to let this digest, why exactly is a bailout of a financial institution desirable? By any means, isn’t this privatizing profits and socializing losses?
Also I get your point about these companies net paying more to the government than they are bailed out for, but I have 2 concerns:
1) Why is the government bailing people out at all? Plenty of businesses pay lots in taxes while providing useful services/products, but they aren’t bailed when/if they fail, and arguably they would have paid more in then the bailout was worth.
2) Regardless of what these companies have paid in, the government is already deficit spending. Is it really worth the cost to fall deeper into debt?
Again, these are just questions and concerns. I’m still trying to learn this stuff.
Excellent post!
However, when we talk about the money-in vs money-out of the FDIC (and the now defunct FSLIC), should we not compare that payout number to total SAIF and BIF (just DIF, circa 2006) premiums? I recall reading that the Indymac failure (less than $10 billion) last month alone sapped 11% of the total accumulated Deposit Insurance Fund. I would be thrilled to learn that the DIF (and its progenitors) have been operating in the black since Glass-Steagall.
I appreciate your well constructed posts on this topic, and am thinking about some of the issues you raised. I probably won't ever agree with you entirely on these things, but I think I can better appreciate some of the nuances involved.
bttt
The economy isn't a zero sum game. Widespread hardship and failure in the financial sector doesn't make everyone else any richer, quite the contrary. Moralists in soup lines don't pay taxes, they collect handouts.
The reason central banks act as a lender of last resort in crises, is stabilizing, countercyclical lending is both profitable and beneficial for those who engage in it and those it helps. It damps the cycle and it buys low.
Why don't private financiers do the same? Some do, but most do not or there wouldn't be a cycle in the first place. At cycle bottoms, most can't. They are overextended from mistakes made in the boom years. Bargains go begging.
Trying to save a few shekels for the treasury by bankrupting the populace is hardly "economy".
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