03 September 2011

About Those Falling Interest Rates and the Fallacy of Monetary Deflation at the Zero Bound

Liquidity Trap, Straight Up, with a Twist

I think we are all familiar with the recently popular viewpoint that as the financial economy crashed, what people called 'money destruction' would follow. Well actually the destruction of credit which some considered the same as money, as money itself. There were many detailed and complex thought experiments to explain why this must happen, involving monetary theories.

This would result in a much stronger dollar, since in fewer dollars would result in an outsized dollar demand, especially to pay off debt, a simple equation resulting from what might best be described as pidgin monetarism, favored heavily by non-economists, using what passes for common sense. Unfortunately these are uncommon times.

In this monetary deflation interest rates would fall, and commodities would be crushed, including gold and silver, falling before the almighty dollar.

The example most often cited was that of post-bubble Japan. America was doomed to decades of a stronger dollar and slack demand.

Well it didn't happen, despite the resurgent hope that the expected deflation will finally occur. There are even fresh definitions of what deflation really is, in Clintonesque manner, to accommodate it to the unexpected outcome we see today.   Unexpected at least by those theorists and their true believers.

When you have no model and are a little right by accident, it is fairly easy to adapt your forecast to what is really happening. But you simply cannot explain it. One might have successful investment results, and my congratulations to such flexibility, but it is the result of momentum following and not from a deep understanding of what is happening.

Let me give you three things to think about.

First, credit is NOT money. Money can be created from a number of sources throughout an economy. The expansion of credit at the business and banking level, often involving savings and fractional reserve leverage, is the major organic source of money, the point of its creation from economic activity or transactions themselves.   It is the most utilitarian form of money, because it is directly tied to what one might ordinarily expect to be productive investment and economic benefits.

Sometimes this mechanism is distorted and abused, in the case of fraud or reckless lending for speculation as an example, and then the money supply begins to decouple from the real economy.  It is the job of the regulators and the Fed to control this.

Like gold or any other asset or liability, credit must be transformed into a utilitarian form of wealth, or money, in order to effect the exchange. You may HAVE a million dollars in credit somewhere, but at some point someone must agree to transform that credit into actual money for you to use it. If an unused million dollar credit line expires, we do not see ourselves as a million dollars poorer.

When organic credit expansion fails to create money, the Fed or the Treasury can step in and create money non-organically, that is, not as the result of economic activity. In the case of an external standard, the Treasury can formally devalue the currency, as the US had done in the first half of the 1930s. Monetary authorities do not like to do this, because it makes their activity more transparent, and therefore more controversial.

By the way, Roosevelt did not have to take the US off the gold standard, or disallow the holding of gold by US citizens, in order to devalue the dollar as he did. This was a more complex arrangement designed to recapitalize the banking system, which I covered in some detail in an earlier blog.

Money is created from the assets on the Fed's balance sheet. These include various forms of credit, forex, and gold. The money as notes and reserves is held on the liability side of the balance sheet, in banking fashion.

The second thing to remember is that the extent of inflation or deflation is a policy decision in an otherwise unconstrained environment.

Greece does not have such a choice, for example, because the ECB controls their currency.  The US probably has the most choice of all, because it not only owns its currency, but the dollar is also still the world's reserve currency. While the audience is not captive, it is at a disadvantage.

The third thing is that the creation of money from the Fed or Treasury may result in more money, but it may not result in a sustainable recovery.    Money created by the Fed is high powered money, created as it were from the will of the monetary authority's policy.

Money creation, or monetary stimulus, works well in situations wherein the economy has fallen into a temporary slump, especially because of some exogenous shock or a slack period that is cyclical in nature, such as seasonal variation.

But in the event of a secular crisis or problem, monetary stimulation is a palliative, but no cure.   The remedy lies generally on the fiscal and political policy actions, with the aim of correcting or repairing whatever had caused the problem in the first place.  

Monetary stimulus alone, without the will to effect political reform for example, results in very uncommon economic conditions, one of which Keynes described as a 'liquidity trap.'

In this case now in the US, we see a lack of political will to reform the outsized and corrupt banking system, and the nation's flows of funds.  The stagnant median wage is a major impediment to sustainable recovery.  Most of the economic benefit for the last twenty years has flowed to the top one percent of the population. 

How that is remedied is another matter, and will be subject to a great deal of political debate as the various interests fight for their portion of the pie as they say.

But in the case of monetary stimulus coupled with a lack of organic recovery, and the sort of slack aggregate demand that comes from economic imbalances, too much money in too few hands, what we will see is money being hoarded in safe havens of wealth, especially short term Treasuries, gold and silver, and bank reserves.   It really makes perfect sense.

Can this go on indefinitely?  No way.  Unless the system is reformed, it will resolve in one of three ways, or a combination of them: a hyperinflation, an authoritarian oligarchy with grinding stagflation, or a civil insurrection with a fascist response. 

I don't think a true deflation is in the cards unless the US becomes isolationist, or mercantilist, and it is forced upon the  population through a policy of austerity.   Then we might see that authoritarian oligarchy with a grinding deflation instead of stagflation.

It should be noted that all three are variations on a theme of the breakdown of the market system and individual economic liberty.

Finally, and this is directed primarily at the Modern Monetary Theorists, while one can create money without using a debt based system, the money creation must act as though it is governed by some restraint.  Traditionally this had been gold and silver, and in the case of a national bank, the debt markets.  Government may indeed print on their own volition, in those areas wherein they lack legal tender controls, most notably international trade, they are beholden to those parties in the manner of debtors to creditors, since the dollars are really promissory notes based on the full faith and credit of the government.

Hyperinflation is no certain outcome by any means at all.  Furthermore, it is not even likely yet except for a further string of remarkable policy errors.  It is therefore somewhat of a policy decision of incompetence.  But as things progress, the latitude of the policy makers becomes increasingly constrained by the sustainability of the real economy in particular and the social fabric as a whole. 

It should also be noted that there is a growing and largely unreported overhang of eurodollars around the world.  If at some time the world begins to repudiate US dollars and debt in a de facto devaluation, the resolution may not be in the hands of policy makers, and the progress of change could accelerate, dramatically.

Endnote:  People like to send me things that are basically chicken and egg examples with regard to money creation, wrapped in lots of accounting language.

These so called proofs are largely word plays, and mostly misunderstandings of the system because of lag times and complex relationships crushed into meaningless by overly simplistic models.

So, in other words, I have looked at most of them, and please don't bother. They are just rationalizations for reasons why certain things that have happened could not happen, and are thus a bit outdated.

I am not interested in resurveying the same real estate that I have already been over many times since 1996, when this current cycle of economic history began in earnest. Some of those dead horse theories have already been beaten thoroughly into glue, so it is time to move on.

And I am becoming somewhat indifferent to those who will not, since they obviously wish to live the destructive experience to the fullest. It must be some perversity in human nature, or the will of God, or some combination thereof that is beyond my power to affect or obtain value from any more.

But it is necessary to understand how things work, and what went wrong, to reform and recover from a crisis such as the Western world is undergoing, and so I leave you with this summary of where I am to date.

The economy will not enjoy a sustainable recovery without a significant improvement in the media wage, if you wish to look at some simplistic indicator. Those reforms that people propose, if any, since continuing to steal from the weak seems to be in vogue in some vocal circles, will be effective to the extent that they increase it.

Of the outcomes outlined above, America seems to be flirting with the path of an authoritarian oligarchy with a grinding stagflation, which has also been called financial repression in other quarters.  It is a monetary inflation in the face of slack aggregate demand, with an unreformed financial and political sector.

 This could look a bit like the mercantilist command economy of Japan, dominated as it is by a deeply entrenched oligarchy that honors its social contract with the mass of its people however.  I expect China to go down this route when their time comes.  I am not suggesting outright fascism except as a response to civil insurrection.

But in the case of the much larger and more open US economy, that is going to produce some interesting anomalies, and a mix of disinflation and soaring price inflation. I am not sure how long the aggregate demand slump will be able to hold its ground against the tide of paper.

And quite a few people seem to favor that, if they think it benefits them. So the things we see happen might well perk along as they are, at least for the time being, until the anger of the broader public reaches critical mass, and action with reaction intensifies.