Where We Are Today: Interest Rates 'Too High,' Double Dip on Deck, the Failure of Economics

David Rosenberg of Gluskin Sheff is a daily read of mine. His most recent breakfast message does a remarkably concise job of summarizing the US financial markets.

The reason for the gold market rally is obvious; declining production in the face of record monetization and increasing demand. The same financial engineers in the central banks that ruined the economy had been suppressing the price of gold through managed sales for almost thirty years in a desperate reaction to the Nixon assault on Bretton Woods in 1971. And now we see the fruits of their long contrivance, and its inevitable failure. The world will have to develop a replacement to this incredible farce we call globalization and world trade based on arbitrary and easily manipulated values.

At the same time, Dave points out that according to the Taylor Rule the Fed is overly tight, even with ZIRP! We have spoken about this in the past, in making a distinction between quantitative and qualitative easing. This also speaks to the massive deformity which the US economy had become under first Greenspan and then Bernanke, and a financial sector turned outsized predator, with little connection to real market discipline of supply and demand thanks in large part to the proliferation of derivatives.

Ben could mitigate this with the interest payments on reserves which the Fed is now allowing. I suspect at some point he will, even taking them negative if necessary. But the Fed's first priority is the insolvent Wall Street firms, and the continued charade that allows them to still pay outrageous bonuses while the nations suffers between the hammer of unemployment and the anvil of a toxic disaster in the Gulf and the collapse of its local economies. The first policy failure was in not nationalizing the insolvent US banks like Goldman and liquidating them. The second policy error is the failure to engage in serious financial reform, severely curtailing the derivatives market to something more resembling a well regulated insurance industry, and separating it completely from the commercial banking system.

It takes a certain kind of mindset and attitude to understand this dynamic, and few economists have yet taken up that challenge; economic contraction in the face of very low interest rates, with gold soaring in a bull market while long term inflation vectors are near record lows. It should be acknowledged that the Fed is active in the markets, 'tinkering' with the longer end of the yield curve among other things. And of course, derivatives, easily printed and without position limits, are pressed on various targets in the real economy almost at will by the banks and hedge funds, distorting prices and markets, destroying real wealth.

And yet this is what we have, facts in collision with theories. The austerity reaction in Europe is the resurrection of Hoover, of the liquidationism which drove the US into the agony of the trough of the Great Depression of 1933. This was of course the moment of failure for the Austrian School. It is one thing to be able to spot a problem and to stop it ahead of time, which their theories do well. But the Austrians seemed unable then, and now, to recommend practical and implementable programs to remedy the current situation in which the US now finds itself.

This is not to say the theory has failed, but rather that it has intellectual arteriosclerosis and atrophy. It is one thing to read and write about riding a bicycle or having sex; it is another thing to get out of your rooms and do it, and actually learn something. To their credit they were certainly not fooled by the neo-liberals. But their response is little better than the neo-Keynesians, which is to reflexively stimulate or liquidate without practical reforms and actually fixing the distortions which policy errors over a long period of time have caused.

I have to admit that I like to tweak the nose of 'the Austrian school' now and then. But since I tend to hit the neo-liberals with brass knuckles, and the neo-Keynesians with the kind of premeditated distance one gives to a crotchety old maiden aunt dwindling into senility, I would hope they understand that it is not personal; all of the modern schools of economic thought have failed. All of them, for varying reasons. That is all well and good and human, but it is the lack of recognition of that failure, and the resolution to adapt and do better, and to roll up one's sleeves and actually shame the politicians into doing better for the people, that is so cloying.

The failure of economists in general to speak out, except in the usual sniping reminiscent of departmental politics, is leaving the field open to quackery, and the draconian measures of oligarchy. Just as their failure to speak out permitted China to distort the world economy, and Greenspan to destroy the economic infrastructure of the US.

The current economic landscape seems littered with self serving cronyism, broken theories disconnected from reality, quackery, and obtuse boasting from dismal failures. Economics seems more like astrology, or Elliot Wave theory, or the writings of Nostradamus, with so little rigor that it can be used to 'prove' or justify just about any outcome, after it has happened. In short, economics seems these days to be little more than propaganda, social commentary rather than harder science or something as simply practical as mechanical engineering.

What I am saying is that all the economic schools of thought have come up short, failing badly, the free market neo-liberals most spectacularly of all. Their failure is not in having got it wrong, but in continuing to beat the dead horses of their theories until the stench is unbearable.

The lack of significant financial reform, and restraint of unbridled speculation through the use of derivatives, is going to strangle the western world until they can bring themselves to restrain their banking system gone mad.

The U.S. turned 234 years old yesterday, and yet over half of the nation’s money supply was created since Helicopter Ben took over the flight controls four years ago.

No wonder gold is in a full fledged bull market. The annual output of gold has declined 12% in the past decade while the marginal cost has more than doubled, to $500, according to David Hale. Moreover, David points out in his recent report that since 1900, more than 80% of the world’s proven reserves have ready been mined.

The marginal cost of pressing on Dr. Bernanke’s printing machine is basically zero, and, the prospects of a re-expansion of QE by the Fed as double-dip risks rise with each and every passing data-point are rather high.

Gold has corrected to the 50-day moving average in recent weeks, which in the past has been a terrific entry point — for the past six months, each low has been higher and each high has been higher too. Nice upward channel that is to be respected and to be bought.

As for double dip risks, the ECRI leading index is predicting over 50-50 odds of such, and is exactly where it was in December 2007 when unbeknownst to the vast majority at the time that the downturn was just getting started.

As an aside, even after cutting his growth forecast on Friday, Bank of America’s chief economist went on CNBC after the market closed and declared that the economy would manage to “muddle through” — this has now become the widespread consensus that all this is nothing more than a temporary soft patch. [akin to quicksand, an economic netherworld such as that which the kereitsu inflicted on the people of Japan - Jesse]

Jeffrey Frankel, a member of the NBER’s business cycle committee, had this to say over the weekend:

“You cannot rule out a double dip, in light of Europe’s problems … I think the next couple of months of indicators will be more telling than the last couple of months.”

Economists have spent so much time trying to assess when the last recession ended that they have taken the eye off the ball as to when the next one would begin. Yet this is what the NBER is grappling with — maybe the same day the NBER announces that the last recession ended in June 2009, they will tell us that another one began in June 2010.

Can a sub 3% yield on the 10-year note and the “flattest” Treasury curve (still near 230bps, mind you, for the 2s/10s spread) in nine months really be sending out the wrong message of heightened hard-landing risks? Or, for that matter, the lowest close in the S&P 500 since September 4th of last year. Did anyone back then think we would go from Labour Day to Independence Day with nothing to show for it?"

...What does not get enough play is that Fed policy is tighter than it should be right now, based on the Taylor Rule, believe it or not — zero policy rate and the size of the Fed’s balance sheet is equivalent to a -2% rate, when at this stage the two tools should be equivalent to a -5% rate. [We might have an effective negative rate if the government had not fouled the measures of inflation - Jesse] And, fiscal policy is actually far less stimulative than meets the eye when the impact of State/local government restraint is factored into the equation. In the past two months, whether one looks at the Kansas City or St. Louis Fed’s stress indices, there have been 60 basis points of tightening in overall financial conditions, just as the economy is hitting a possible inflection point.

David Rosenberg, Gluskin Sheff, Breakfast with Dave

A double dip recession will be a strong indication, if not a proof, of policy error, both on the part of the Federal Reserve and of the Obama Economic Team. When the recession can no longer be hidden from the public the reaction could be swift. The oligarchs are acting pre-emptively to cushion the blow on their ill gotten gains by preaching austerity measures, at a time when the lower and middle classes are taking it on the chin. Empathy and common sense have little place with obsessive sociopaths

Part of the problem is the China peg to the US dollar. This obviously thwarts the international market's system of checks and balances, its ability to adjust naturally to changes in economic fortunes. That peg and devaluation ought never have been allowed.

But this is merely one instance in a series of economic manipulations and sometimes aggressive deceptions by the world powers that have been occurring since 1971, when Nixon unilaterally broke the Bretton Woods regime and took down the international gold standard, and not incidentally brought Greenspan into the service of the federal government.

Reform is the only solution that is sustainable. Austerity or stimulus without reform are worse than useless. One does not fix a car with a blown engine by flooding it with gasoline, since it did not run out of gas, but in fact blew up from prolonged abuses and disrepair. And on the other hand, one cannot restart the economy by watching it burn, waiting for the flames to extinguish themselves, hoping for a chance to start over anew and do it 'the right way' according to theory. By the time you would wish to get started, there will have been a revolution conducted by the impatient and long suffering people. So what does one do?

You fix it. You restore it to a state when it was last actually working, and resist the temptation to 'optimize' and redesign it on the fly, cramming in pet projects that surpass performance tweaks. That can come later, after the system is running again in some reasonable way. You take the harder hits when they can be absorbed with toppling the recovery.

That is how it is. Everything else is noise, excuses, partisanship, and waffling.

The Monetary Base During the Great Depression and Today

Economic commentator Marty Weiss has put out this chart with the somewhat florid headline, Bernanke Running Amuck

"Fed Chairman Bernanke is running amok, and for the first time since the birth of the U.S. dollar, our government is egregiously abusing its power to print money.

Specifically, from September 10, 2008 to March 10 of this year, he has increased the nation’s monetary base from $850 billion to $2.1 trillion — an irresponsible, irrational and insane increase of 2.5 times in just 18 months.

It is, by far, the greatest monetary expansion in U.S. history. And you must not underestimate its sweeping historical significance."

This chart with its editorial commentary are from Marty Weiss.



Here is a closer look at this monetary expansion, without the editorial comment



Is it without historical precedent? I wondered.

Let's take a look again at a prior period of dollar devaluation and monetary expansion in a period of deep recession, the period in the 1930's in which the US departed from specie currency to facilitate the radical expansion of the monetary base.



As you can see, the Federal Reserve increased the monetary base in several steps, resulting in an aggregate increase of about 155% in four years. In this chart above one can also nicely see the contraction in the monetary base, the tightening, that caused a dip again into recession in 1937.

It is also good to note that the recession ended and the economy was in recovery prior to the start of WW II, which I would tend to mark from Hitler's invasion of Poland in August, 1939. There was a military buildup in Britain before then, but I believe that the common assumption that only the World War could have ended the Great Depression was mistaken.

If real GDP is any indication, the recovery of the economy was underway, but somewhat anemic compared to its prior levels, reflected in a slow decline in unemployment. It is absolutely essential to remember that the US had become a major exporting power in the aftermath of the first World War. The decline therefore of world trade with the onset of the Depression hit the US particularly hard. But the recovery was underway, until the Fed dampened it with a premature monetary contraction that brought the country back into recession, a full eight years after the great crash. Such is the power of economic bubbles to distort the productive economy and foster pernicious malinvestment.



What prolonged the Depression in the US was the Federal Reserve's preoccupation with inflation that caused it to prematurely contract the money supply. In addition, the Supreme Court overturned most of the New Deal employment programs before the economy had fully recovered from the shock of the Crash of 1929, and the severe damage inflicted by liquidationism on the financial system and the real economy. One can hardly appreciate today the impact of repeated banking failures, with no recourse or insurance, on the public confidence.

It is instructive to look at the Consumer Price Index for that period of time to see what was motivating the Fed.



It is fair to say that the Fed made several policy errors out of a fear of inflation. Keep in mind that it was only 1933 that the Fed had been freed of the gold standard, and there was tremendous pressure from the monied interests to maintain a strong currency, as we can see, to a fault. The public interest was sacrificed to protect the pre-Crash gains of the wealthy.

The US economy had a more difficult time adjusting to the collapse and the Depression because it had been a net exporting nation in the 1920's. The decline in markets for its exports, and the constrictions in international trade symbolized in the US by the Smoot-Hawley tariffs, affected it much more than other nations that had been net importers, and which exited the Depression earlier.

With the collapse of its export business, the US would have been well-advised to stimulate its domestic markets, to help take up the slack and help to rebalance its productive capacity. In this case, domestic liquidationism was exactly the wrong thing to do. This, by the way, is why the Wall Street money men starting looking at foreign direct investments in the domestic production of recovering economies such as Germany and Italy in the late 1930's. Indeed, the search for profit was so compelling that several of the money houses, and famous men, did not stop investing with the Nazis until they were prosecuted under the Trading with the Enemy laws.

This provides an instructive example to the exporters German and China in this modern crisis perhaps. Now is the time for them to stimulate domestic markets. China must create internal markets, and Germany best try and hold the EU together and keep it healthy.

Japan is in a much more difficult circumstance because of its particular demographics and cultural homogeneity. I see no way out for them in the short term.

Here is what the monetary base did during World War II. As one can easily see, war is bad for people but good for industrial output and monetary expansion.



Expansion of the monetary base during the war was nothing short of astonishing, if one forgets that there was a significant monetization of war debts occurring, and there was less opportunity for inflation because of rationing and wage and price controls. But inflation there was, and it gained a significant leg up after the War.



Here is our real GDP chart extended through the War so one can more easily see the build up and then the flattening of growth post War.



Where Do We Go From Here?

The status quo has failed in its own imbalances and artificial distortions. But while avoiding bubbles in the first place through fiscal responsibility and restraint is certainly the right thing to do, plunging a country which is in the aftermath of a bubble collapse into a hard regime, such as the liquidationists might prescribe, is somewhat like taking a patient which has just had a heart attack and throwing them on a rigorous treadmill regimen. After all, running is good for them and if they had run in the first place they might not have had a heart attack, so let's have them run off that heart disease right now. Seems like common sense, but common sense does not apply to dogmatically inclined schools of thought.

What the US needs to do now is reform its financial system and balance its economy, which means shrinking the financial sector significantly as compared to its real productive economy. This is going to be difficult to do because it will require rebuilding the industrial base and repairing infrastructure, and increasing the median wage.

The US needs to relinquish the greater part of its 720 military bases overseas, which are a tremendous cash drain. It needs to turn its vision inward, to its own people, who have been sorely neglected. This is not a call to isolationism, but rather the need to rethink and reorder ones priorities after a serious setback. Continuing on as before, which is what the US has been trying to so since the tech bubble crash, obviously is not working.

The oligarchies and corporate trusts must be broken down to restore competition in a number of areas from production to finance to the media, and some more even measure of wealth distribution to provide a sustainable equilibrium. A nation cannot endure, half slave and half free. And it surely cannot endure with two percent of the people monopolizing fifty percent of the capital. I am not saying it is good or bad. What I am saying is that historically it leads to abuse, repression, stagnation, reaction, revolution, renewal or collapse. All very painful and disruptive to progress. Societies are complex and interdependent, seeking their own balance in an ebb and flow of centralization and decentralization of power, the rise and fall of the individual. Some societies rise to great heights, and suffer great falls, never to return. Where is the glory that was Greece, the grandeur that was Rome?

The lesser concern for the US now is globalization, new trade agreements, and its debt, which is largely held by foreigners who have provided vendor financing while using exports to build their own economies. The mercantilists are addicted to exports because it provides them the means to bring in national wealth for the benefit of a narrow elite, without empowering the masses and allowing them a greater measure of say in their government, with only a modestly improved standard of living.

This Will Not Be Your Father's Inflation

Why is this important? Because as I think is apparent in the stunning chart contained in Debt Saturation in the US Dollar Economy, the US dollar is already entering an inflationary spiral that will lead to its destruction and reissuance.



Although as you know I always allow that deflation and inflation are policy decisions, at some point a threshold can be passed, and the likelihood of one event or the other becomes more compelling. The US is at that crossroads wherein it must change, or go down the painful path of selective monetary default, of a degree different than a hyperinflation, more similar to that which was seen in the former Soviet Union, than the monetary implosion of a Weimar.

One can watch the growth of the traditional or even innovative money supply figures, and be reassured at their nominal levels, only to misunderstand that money has a character and quantity of backing, that can erode as surely as the supply of money can increase, to produce a type of inflation that comes upon a nation quickly, like a thief in the night. It will bear the appearance of stagflation, because it is caused by a degeneration of the productive economy coupled with a disproportionately increasing money supply.

A transactional economy can have all the appearance of vital growth and activity, when in fact it may be an increasingly hollow shell, a Ponzi scheme, and prone to unexpected collapse. Such a systemic collapse was almost witnessed when the US financial system was threatened by the fall of Lehman Brothers. That event was averted. But the system still remains in a precarious, unreformed state of imbalance.

What does a country have to providing a backing to its money, except its natural resources, its productive labor, and the ability to create products of value? Some countries, or more properly empires, may provide the backing for their currency through force and fraud, and a sort of indirect or de facto taxation on the many. These types of arrangements can last many years, but can disappear quickly, based as they are on conditional situations, subject to relatively sudden change.

Cutting expenses to reduce deficits is a weak attempt to reform. One does not starve themselves back to health. What is needed is growth, savings and investment, the reallocation of capital and true valuation of goods and services. The productive economy must come back into balance with the administrative sectors, those being finance and government.

At the end of the day, some of the greatest impediments to economic recovery reside in the selfish and fearful desire for control and power in rather narrow oligarchies, both in the East and the West. They were the primary beneficiaries of the status quo, and they will seek to maintain and even recreate it, even though it has proven to be unsustainable.