Stocks and Precious Metals Charts - Chug-a-Lug - Hi-de-ho, Wall Street Does a Double Back Flip

Uncle Jay and his Monetary Moonshine

"The Federal Reserve, as one writer put it after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

William McChesney Martin, Speech to Investment Bankers Association of New York, October 1955


"We're not even thinking about thinking about the consequences of our actions."

Jerome Powell, Chairman, Federal Reserve


"Jukebox and sawdust floor
Sumpin' like I ain't never seen
And I'm just going on fifteen
But with the help of my finaglin' uncle I get snuck in
For my first taste of sin
I said "Lemme have a big old sip"
Brrrrr-bbbb, done a double back flip

Chug-a-lug, chug-a-lug
Make you want to holler hi-de-ho
Burns your tummy, don'tcha know
Chug-a-lug, chug-a-lug."

Roger Miller, Chug-a-lug

The spokesmodels were gushing with excitement as the SP500 snugged its beer goggles and managed to reach its pre-crash high.

The NDX is already in some alternate universe.

Thanks for the hot money for the recovery, Uncle Jay.

Great success.

Gold and silver responded to the call, as the Dollar continued to slide lower.

The commentary about the precious metals on financial TV is so shallow and badly informed that I think the metals may have quite a bit further to go.

The time to sell will be when even the most purblind Wall Street lounge lizards 'get it.'

Stock market will have its August stock option expiration on Friday.

Chug-a-lug, chug-a-lug.

Have a pleasant evening.

What Is the Effective Limitation on the Fed's Ability to 'Print Money?'

"There is felt today very widely the inconsistency in this condition of political democracy and industrial absolutism. The people are beginning to doubt whether in the long run democracy and absolutism can coexist in the same community; beginning to doubt whether there is a justification for the great inequalities in the distribution of wealth, for the rapid creation of fortunes, more mysterious than the deeds of Aladdin’s lamp."

Louis D. Brandeis, Speech to Harvard Ethical Society, May 4, 1905

In a purely fiat monetary system the effective limitation on the Fed is the acceptance of the dollar and the bond at value in objective, non-coercive market transactions.

Since the value of a currency can be viewed as 'relative' to other currencies, if one ignores the values of other goods, there is some thought that a group devaluation of money can be accomplished if all the issuing entities devalue at the same time, so that the average person will not notice it.  As if.

When such frauds fail, then there is the result to force.  There are numerous examples of non-objective market transactions being used by failing monetary regimes, where they are guided by a central bank or directly by politicians.

Most recently in the case of satellites of the former Soviet Union,  there was an increasing divergence between an 'official exchange rate' versus a 'black market' exchange rate, even in Russia itself as the old rouble failed.  The bad money crowded out the good,  the good which became the new benchmark of value. 

The notion that a sovereign government issuing their own currency and debt cannot fail flies in the face of history, if not common sense.   The ability of the government to enforce an increasingly arbitrary valuation ultimately comes down to a measure of the oppressive power and reach of the regime.   Therefore the failures tend to begin at the edges, where arbitrary force does not reach as effectively.

This is not to say that the US is at that point. But to say we are not yet at that point is like the drunk who says he has not crashed his car into a brick wall yet.  It is to say that the idea that money can be created endlessly without engaging powerful forces of political and financial hazard is nonsense. It requires increasing amounts of official fraud, fear, and force to maintain, until the system ultimately collapses. I have seen this first hand, and have listed numerous examples of it on this site in prior posts.

One of the reasons that this current scheme of the Fed seems to be succeeding is that instead of increasing the overall money supply by distributing it freely 'out of helicopters' and stimulating aggregate demand to the objective of stimulating a recovery,  they are printing loads of money and then carefully handing it to their cronies in the Banks and other private multinational corporations.

And since they are dealing with the world's reserve currency, the base of their Ponzi scheme is very broad in its number of potential contributors.

The notion is that they will be forced to do productive and constructive things with it, and prosperity will 'trickle down.'  Rather, they prefer to use that money to further enrich themselves, to acquire productive assets, rentals, establish new frauds and rig more markets, and buy other companies to establish monopolies, and to put themselves increasingly above the law.

The resulting distortion does not yet result in a general inflation, but certainly facilitates and promotes a bubble in certain financial paper, and a massive wealth transfer from the public to the privileged in a corrupt and systematized plunder.

This system will not cohere.  But it has become very profitable for the status quo, if one ignores the consequences.  It results in a society turned upside down, a bizarro world where nothing makes sense.

Wars have been fought to sustain such looting, and to distract the people from their misery.  It always ends badly, in social disruption and worse.

Russell 2000 Small Caps and the Wilshire 5000: In a Stall, Or the Pause That Refreshes the Bull

Bespoke has a recent article pointing out some weakness in the small caps.

It is interesting to see that the broad lower end of the equity market is stalling here, with a negative return year to date. This is what we see in the Russell 2000 small caps index. It has been flirting with this support level for some time, and is testing its 200 DMA once again.

This *could* be distribution, or profit-taking if you will, but absent determined selling on volume, the markets can continue to drift with an upward bias for some time, given the Fed's bubble of liquidity going right to the banks, and thereby to Wall Street.

And we get a broader perspective from the Wilshire 5000, which is effectively flat for the year, and is oscillating round its 50 DMA.

The SP 500 is the locus of market support, some might say propping, and if there is weakness it may first appear in sector specific areas and the broader markets.

But not so yet, even though we are seeing weakness, and the volumes are thin, especially if one discounts HFT antics. 

The market is vulnerable to an exogenous shock, lacking firm underpinnings from the real economy, but absent a shock the vicious cycle of wealth extraction through the printing of money and paper asset inflation seems to be operating quite efficiently for the gangster class.

"We must make our choice. We may have democracy, or we may have wealth concentrated in the hands of a few, but we can't have both."

Louis D. Brandeis

And this aggregation of power and wealth will likely continue until the next financial crisis.  Wealth and power are being steadily transferred, as a matter of de facto policy, from the many to a select few in the rise of a new, transnational oligarchy.

This is the Anglo-American way, which has been widely adopted both at home and abroad, through manipulation, intrusion, intimidation, and intervention.

Ben Bernanke On Money and the Sophistry of Modern Monetary Theory

soph·is·try (s f -str ). n. pl. soph·is·tries. 1. Plausible but fallacious argumentation. 2. A plausible but misleading or fallacious argument.

I see the Cullen Roche is back at it again, telling us all about the wonders of modern money. The Biggest Myths in Economics

I will take these myths, and comment on them one by one.  Some things make sense, and others, not so much.  But perhaps the discussion will help to shed some light.

I am going to try to do it simply and in straightforward language, because that is often the best antidote to sophistry.

1) The government “prints money”.

The government really doesn’t 'print money' in any meaningful sense. Most of the money in our monetary system exists because banks created it through the loan creation process. The only money the government really creates is due to the process of notes and coin creation. These forms of money, however, exist to facilitate the use of bank accounts.

This is the 'I didn't do it, because the guys who are working for me did it' argument.

As you might recall, the banks in the US, and most other places, operated under a license and regulation of the government. The banks are part of the Federal Reserve System. They create money under the supervision and regulation of the Federal Reserve Bank, which in turn is answerable to the government.

Most of the time the money is created, organically if you will, through economic activity. The Fed exercises quite a bit of direct and indirect control over this process as both actor in the markets and a regulator. This is the very basis of the Federal Reserve.

At other times, the Fed is able to create money on its own volition, by expanding its Balance Sheet. It can create money at will, and uses it to enact its policy objectives. Whether you say 'print' or 'create' money is a matter of usage, as they are both essentially the same in this context unless you are given to splitting hairs.

You want to know the difference here?  If some bank or person started 'printing' its own money apart from the Federal Reserve system or the rules of the government over commercial paper they would shut them down in a Manhattan minute.  Just ask the Liberty coins guy.  The almighty dollar is a jealous god.

There were times in the past when the 'currency of the US' was created by private parties and circulated.   That is not the case now, except in the fevered minds of creative imaginations.

2)  Banks “lend reserves”
  
This myth derives from the concept of the money multiplier, which we all learn in any basic econ course.  It implies that banks who have $100 in reserves will then “multiply” this money 10X or whatever.  This was a big cause of the many hyperinflation predictions back in 2009 after QE started and reserve balances at banks exploded due to the Fed’s balance sheet expansion.  But banks don’t make lending decisions based on the quantity of reserves they hold.

Banks lend to creditworthy customers who have demand for loans. If there’s no demand for loans it really doesn’t matter whether the bank wants to make loans.

This one gets definitionally tricky, because it involves the terminology of bank accounting and its own particular jargon. But let us cut to the heart of it by saying that banks make loans with some regards to their assets. A person cannot just stand up with no money in their pockets and say, I am a bank and am going to start making loans. They need to be licensed by the government, and must adhere to certain requirements from their books.   Those nasty things like leverage, risk, etc.

As for Banks being in the business of making loans, that is nonsense. Banks are in the business of making money, and we should never forget that.  Sitting idly on what in another business would be called working capital does not do them much good. And people tend to mistake 'working capital' for 'reserves' and that's where we go off into the jargon wilderness.

What is a creditworthy loan? This is not some black and white threshold, good or bad, but more like better or worse, an analog measurement of risk and reward. Anyone who has ever funded competing projects in corporations understand this. It is intimately tied to risk return and competing opportunities.

I would certainly think that most people understand that making commercial loans for some meager basis points in return over the long haul is boring stuff compared to the opportunities to be had in gaming hot money markets for outsized gains and large bonuses tied to short term results.

And that is the heart of much of the problems in the financial system today. Speculation is crowding out investment from the commercial banking system due to the repeal of Glass-Steagall, and the laxity of regulating the abusive practices of large and powerful players in the markets.

3) The US government is running out of money and must pay back the national debt.

There seems to be this strange belief that a nation with a printing press whose debt is denominated in the currency it can print, can become insolvent. There are many people who complain about the government 'printing money' while also worrying about government solvency. It’s a very strange contradiction...

As I’ve described before, the US government is a contingent currency issuer and could always create the money needed to fund its own operations. Now, that doesn’t mean that this won’t contribute to high inflation or currency debasement, but solvency (not having access to money) is not the same thing as inflation (issuing too much money).

This is a nice piece of sophistry because while it knocks down a thesis, it does not prove its antithesis.

Because the US government is NOT running out of money, and it does NOT have to pay back the national debt, that does not mean that the national debt has no limit. It just means that we have not yet reached it, whatever that may be.

At some point you have to get off the theoretical merry-go-round and try to exchange some of that money which you declare that you have for real goods. And the perspective of the counterparty weighs in heavily on that transaction I daresay. One only has to look at the many, many failed currencies throughout history, from 'contingent currency issuers,' in order to understand the fallacy of this argument.

Certainly you can force your own citizens to adhere to your commands, as the MMT crowd are often wont to imply.  But it is still a larger world out there, and absent one world government, there are some degrees of freedom in determining currency valuations.

4) The national debt is a burden that will ruin our children’s futures.

The national debt is often portrayed as something that must be “paid back”. As if we are all born with a bill attached to our feet that we have to pay back to the government over the course of our lives. Of course, that’s not true at all. In fact, the national debt has been expanding since the dawn of the USA and has grown as the needs of US citizens have expanded over time. There’s really no such thing as “paying back” the national debt unless you think the government should be entirely eliminated (which I think most of us would agree is a pretty unrealistic view of the world).

This one is almost the same as myth number 3. The national debt is something that will always exist in a debt based system. The pricing of debt in a marketplace is how the Federal Reserve system and Treasury are theoretically restrained from the excessive creation of money.

The very money in your pocket is itself is a 'note' of obligation on the Balance Sheet of the Fed, and overall a debt obligation of the Treasury.  The 'full faith and credit' of the United States if you will.

But that does not mean that the debt cannot become a burden on our children. If the debt is misspent and squandered and allowed to outgrow the capacity to manage it, it can become a very real burden.

But I find that those who make this argument are typically those who have already grabbed a good portion of the money from some financial bubble, and now seek to hold their gains.   Debt must be managed.

To this point Cullen says "All government spending isn’t necessarily bad just like all private sector spending isn’t necessarily good." And I agree with this completely.

5) QE is inflationary 'money printing' and/or 'debt monetization'

Quantitative Easing (QE) is a form of monetary policy that involves the Fed expanding its balance sheet in order to alter the composition of the private sector’s balance sheet. This means the Fed is creating new money and buying private sector assets like MBS or T-bonds.

When the Fed buys these assets it is technically 'printing' new money, but it is also effectively 'unprinting' the T-bond or MBS from the private sector. When people call QE 'money printing' they imply that there is magically more money in the private sector which will chase more goods which will lead to higher inflation. But since QE doesn’t change the private sector’s net worth (because it’s a simple swap) the operation is actually a lot more like changing a savings account into a checking account. This isn’t 'money printing' in the sense that some imply.

Well yeah, it is money printing, although I agree it is not magical. The Fed simply expands its Balance Sheet and creates, or prints if you will, Federal Reserve notes of zero duration, also known as dollars, and exchanges them for assets of various durations and quality at non-market based prices. It is not limited to Treasury debt, but can include almost anything really according to the Fed, whether it be toxic debt mortgages, or common stocks, etc.  

And the Fed is not 'unprinting' anything, until it either writes off the debt, or return it to its issuer.  The Fed is a private corporation.  You can say that the Fed withdraws the liquidity from the market place by keeping it relativelhy inactive because the Fed does not purchase many things, but even that is no longer the case.  The Fed has grown into quite the organization, with its own police force.  It merely surrenders any 'profits' remaining after all its discretionary expenses back to the Treasury.

If this was such a simple and benign swap why else would they do it? It is one of the primary levers the Fed uses to influence monetary policy.

They are increasing and changing the character of the money supply in the course of managing it. It is what they do for God's sake, besides riding herd on their banks who normally create the money for them, but occasionally get derailed by some financial bubble of their own creation.

7) Government spending drives up interest rates and bond vigilantes control interest rates.

Many economists believe that government spending 'crowds out' private investment by forcing the private sector to compete for bonds in the mythical 'loanable funds market.' The last 5 years blew huge holes in this concept. As the US government’s spending and deficits rose interest rates continue to drop like a rock. Clearly, government spending doesn’t necessarily drive up interest rates.

And in fact, the Fed could theoretically control the entire yield curve of US government debt if it merely targeted a rate. All it would have to do is declare a rate and challenge any bond trader to compete at higher rates with the Fed’s bottomless barrel of reserves. Obviously, the Fed would win in setting the price because it is the reserve monopolist. So, the government could actually spend gazillions of dollars and set its rates at 0% permanently (which might cause high inflation, but you get the message).

It is not government spending that drives up interest rates, but that does not mean government spending cannot drive up interest rates. It sure as hell can. 

And I would hope to think that bond vigilantes can help to control interest rates, otherwise the entire Federal Reserve system and the US dollar is based on a fallacy. See what Mr. Bernanke has to say below. This is the confidence on which the dollar rests.

In fact the Fed COULD exercise reserve monopolist powers and print all the money it wishes at zero rates. And the 'vigilantes' could respond by shifting their wealth into other non-dollar instruments, en masse.

What is somewhat confusing is that the relationship is not straightforward, but is a somewhat non-linear dynamic with a lag. You can get away with quite a bit of economic behavior in the short term. But eventually you can reach a tipping point, if there remain enough agents who are free to dissent from the dictates of a central authority that has fallen into error, aka 'vigilantes.'

8) The Fed was created by a secret cabal of bankers to wreck the US economy.

The Fed is a very confusing and sophisticated entity. The Fed catches a lot of flak because it doesn’t always execute monetary policy effectively. But monetary policy is not the reason why the Fed was created. The Fed was created to help stabilize the US payments system and provide a clearinghouse where banks could meet to help settle interbank payments.
...So yes, the Fed exists to support banks. And yes, the Fed often makes mistakes executing policies. But its design and structure is actually quite logical and its creation is not nearly as conspiratorial or malicious as many make it out to be.

This is reductio ad absurdam. The Fed is not a monster or inherently evil. But that does not make it good.

The Fed was created in somewhat extraordinary circumstances, wrapped in political secrecy in the aftermath of a banking crisis.  And it was driven by a small group of powerful men who united to promote a common purpose.  I will not speak to their motives.

There is a long controversy about the proper role of a central bank in the US, going back to its very founding, and this treatment makes light of that.

It is a great power to create and distribute money, that can be used for good or ill. And therefore it must be constrained, and subject to oversight. And history shows that this power is frequently abused.

9) Fallacy of composition.

The biggest mistake in modern macroeconomics is probably the fallacy of composition. This is taking a concept that applies to an individual and applying it to everyone.

Could not agree more, especially if you extend it to anecdotal information. But I would tend to refer to it as the fallacy of reasoning from the particular to the general.  But I would not call it 'the biggest.'

One of the most perennial myths is that a skill in making money, especially through financial speculation, is the sign of wisdom in other things.  Some of the best traders I have known are borderline savants and white collar criminals, whom I would hardly trust to handle my family's future. 

Alas, wealth and beauty are not always companions of virtue in this world.  They become accustomed to obsequiousness, and lose site of their common humanity.  And there is nothing sadder or more tedious than a man who has become wealthy, who decides to grace the public with his wisdom, bad haircut and all. 

I think a more pernicious and prevalent economic myth is the notion that economics can dictate public policy through some appeal to economic laws as if they were physical laws like gravity. Public policy is best decided by determining goals and priorities and then allowing many things, including economics, to shape the implementation of that policy.

But economics has been elevated to a position in our societies which is wholly inappropriate and a source of great mischief, especially when the truly dangerous myths like 'naturally efficient markets' become the basis for policy decisions without proper regard for their effects. The 'austerity for the sake of the public while sustaining corrupt practices' myth is perhaps the most cruel and appalling.

10) Economics is a science.

Economics is often thought of as a science when the reality is that most of economics is just politics masquerading as operational facts.

Economics is a social science, and not a physical science. There are plenty of facts, and somewhat ironically Mr. Cullen has just leaned heavily on quite of few of the ones he tends to favor, whether they are right or not.  

The worst of it is when economics is used by those who claim an 'authority' from it to promote policies that are quackery, as we have seen all too much in the past twenty years in particular with regard to the natural goodness of the power of 'the Market.'

What concerns me though is the follow on to this declaration of  the myth of economics as science. It is that extreme resort of relativism which holds that since economics is all bullshit, why not use it, and shamelessly, to promote a particular point of view, wrapping it in as much jargon and intimidating hoo hah as you can manage?  Since there is no science, there are no necessary consequences, and we may do as we please.  And that is a sophistry of the first order.

And this view is being promoted by the economists themselves, those few members of a 'disgraced profession' like accountants and regulators, who were willing to say and do almost anything for the promise of money, favors, and political connections.

And this deterioration in professional standards has long been my objection to much that has been said and is being said about money by these most modern of thinkers, caught up in the will to power, who believe that since there is no god of consequences, then everything is lawful.  

They lose their grounding in the reality of commerce and risk, and start throwing around harebrained notions like 'platinum coins.'  They bring the childish politics of their academic departments to weigh in on serious policy decisions with serious real world consequences.

Even a few faux Nobel laureates have been seen to join in this Dionysian dance, a filigree of modern monetary contrivance.  Skip the coin, default, and be damned if you will, but a old fish wrapped in silk is still a dead and stinking fish.

Speaking about money, It is worth reading what Mr. Bernanke has written about money in this essay below.  It speaks volumes. 

"What has this got to do with monetary policy? Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Of course, the U.S. government is not going to print money and distribute it willy-nilly (although as we will see later, there are practical policies that approximate this behavior). Normally, money is injected into the economy through asset purchases by the Federal Reserve.

To stimulate aggregate spending when short-term interest rates have reached zero, the Fed must expand the scale of its asset purchases or, possibly, expand the menu of assets that it buys.

Alternatively, the Fed could find other ways of injecting money into the system--for example, by making low-interest-rate loans to banks or cooperating with the fiscal authorities. Each method of adding money to the economy has advantages and drawbacks, both technical and economic.

One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies. Thus, as I have stressed already, prevention of deflation remains preferable to having to cure it.

If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."

Ben S. Bernanke, Deflation: Making Sure 'It' Doesn't Happen Here

Trickle Down Recovery: PBS Drops Bombshell Analysis on Fed's 100th Birthday

"It is to be regretted that the rich and powerful too often bend the acts of government to their selfish purposes. Distinctions in society will always exist under every just government. Equality of talents, of education, or of wealth can not be produced by human institutions.

In the full enjoyment of the gifts of Heaven and the fruits of superior industry, economy, and virtue, every man is equally entitled to protection by law; but when the laws undertake to add to these natural and just advantages artificial distinctions, to grant titles, gratuities, and exclusive privileges, to make the rich richer and the potent more powerful, the humble members of society — the farmers, mechanics, and laborers — who have neither the time nor the means of securing like favors to themselves, have a right to complain of the injustice of their government.

There are no necessary evils in government. Its evils exist only in its abuses."

Andrew Jackson, Veto of the Second Bank of the United States


"Unfortunately, however, trust is becoming yet another casualty of our country’s staggering inequality: As the gap between Americans widens, the bonds that hold society together weaken. So, too, as more and more people lose faith in a system that seems inexorably stacked against them, and the 1 percent ascend to ever more distant heights, this vital element of our institutions and our way of life is eroding."

Joseph Stiglitz, In No One We Trust

As you may recall I remarked on this apparent financial asset bubble policy by the Fed earlier this week here.

What many do not realize is that by printing money and directing it to the inflation of financial assets in a manner favorable to the Banks and the one percent, the Fed and the government are taking from almost everyone, including all holders of US dollars abroad, and redistributing it for the benefits of a few.

This is trickle down economics, and crony capitalism at its worst. And it will be covered up and denied by the usual suspects until the eve of the next financial crisis. And then, like bank bailouts, they will attempt to make the people another offer that they cannot refuse.

PBS Drops a Bombshell on the Federal Reserve’s 100th Birthday Party
By Pam Martens
December 22, 2013

PBS promised a “debate” this past Friday night on the “benefits and dangers” of the Federal Reserve as the Fed marks its 100 years of existence tomorrow. Instead of a debate, two famous stock market historians made the same stunning announcement – that the Fed has decided its job is to push up the stock market.

Consuela Mack’s Wealthtrack program on PBS had invited James Grant, Editor and Founder of Grant’s Interest Rate Observer, and Richard Sylla, the Henry Kaufman Professor of the History of Financial Institutions and Markets at NYU’s Stern School of Business. The opening scene for the program shows Sylla in a party hat lighting the candles on the Fed’s birthday cake while Grant snuffs them out – suggesting that Sylla would be making pro-Fed statements while Grant would take the opposing view.

What happened during the program, however, was that both men made the candid and bold accusation that the Federal Reserve, for the first time in its history, has assigned itself the job of propping up the stock market.

Grant had this to say: “New thing – it is in the business of talking up the stock market…The Fed is manipulating prices, especially on Wall Street.” To another question from Mack, Grant says: “The Fed has presided over the decay of finance.”

Professor Sylla adds more fuel to the fire, stating: “The Fed seems to have, I think almost deliberately, is trying to push the stock market up. I’ve watched this stuff for 40, 50 years now and this is the first time in my memory when it seemed to be official U.S. government policy that the stock market goes up. And the Fed likes this because it thinks that when the stock market goes up, people who own stocks feel richer, they’ll go out and spend more money, and the unemployment rate will come down.”...

Read the entire article with a link to the original video here.

Greenspan: Role Of Central Bankers Is to Try to Replicate the Stability of the Gold Standard

Greenspan said on any number of occasions that his model was that a 'fiat currency' works when it emulates the rigor of the gold standard.

I am using this post as a placemarker to gather a few citations along these lines. Sometimes people doubt these things, and it is not always easy to go back and find the actual idea in print.

I will place other example here as I find them but it is not a high priority because Alan Greenspan has never deviated from this point of view. One of the most poignant examples I have was when Ron Paul asked him if he still believed in what he wrote in his famous essay on Gold and Economic Freedom.

And Greenspan answered that he would not change a word.

I think the squaring up of what Greenspan believed, and what he did as Fed Chairman, is one of the more interesting conundrums that I hope that time will explicate. 

The other of course is why the flaming liberal and 'socialist' Obama is really closer to Richard Nixon in his performance and outlook than most would care to admit, on either the right or the left. 

This is from a 2007 Interview by National Public Radio with Alan Greenspan on Turbulence and Exuberance

Greenspan: Well actually, we were not fundamentally regulators [at the Fed]. The vast portion of our efforts were not involved in bank regulation.

NPR: No, but you were regulating interest rates, which have a profound effect on world economies.

Greenspan: You're raising really a very interesting question. I have always argued that the gold standard of the 19th century was a very effective stabilizer. It kept inflation essentially at zero, and I felt it was critical for the tremendous growth that occurred for the American economy in the latter part of the 19th century. When we went off the gold standard essentially in 1933, we then had to have what we call "fiat money" which is essentially money that is - it's printed paper money. Which unless we restrict the volume of, can be highly inflationary.

The type of interest rate regulation that I and indeed most central banks in the last 20 years have been involved in...has been to try to replicate the laws and rules that were governing the gold standard.

And so it is an odd situation where all the central bankers -- while none of them are advocating a return to the gold standard -- nonetheless try to replicate the various types of interest rate policies that the gold standard would have created. And it is an interesting question whether you call that regulation, or basically functioning of a central bank in stabilizing the economy."

I remember all such statements of Greenspan's vividly because they were one of the few times in which I felt that he was telling the truth, at least as he sees it.

I think that a fiat currency can 'work' if it emulates the rigor of an external standard. And exceptions that can be made to this rigor during times of exogenous shocks could be a quite useful tool for monetary policy.

The problem is that it NEVER seems to work out that way in the real world. It does not take long for financiers and politicians to discover the heady power and easy money to be had in manipulating the markets and the fiat currencies to their own advantage, the public and the real economy be damned. And then a pigfest ensues, and a nation's savings and civic virtue are consumed.

"And, indeed, since the late '70s, central bankers generally have behaved as though we were on the gold standard. And, indeed, the extent of liquidity contraction that has occurred as a consequence of the various different efforts on the part of monetary authorities is a clear indication that we recognize that excessive creation of liquidity creates inflation, which, in turn, undermines economic growth.

So that the question is: Would there be any advantage, at this particular stage, in going back to the gold standard? And the answer is: I don't think so, because we're acting as though we were there. So I think central banking, I believe, has learned the dangers of fiat money, and I think, as a consequence of that, we've behaved as though there are, indeed, real reserves underneath the system."

Greenspan, A., Hearing on Monetary Policy Report, US House Committee on Financial Services, 20 July 2005, Washington D.C.

From: Jude Wanniski < jwanniski@polyconomics.com
To: Ben.S.Bernanke@ * * * * *.GOV
Subject: Fwd: Re: Savings glut
5:44 pm, 7/21/2005

I thought you should see this. Greenspan was plain awful in his testimony this week. But members of Congress don't know any better, so they slobber all over him. He again said we don't need a gold standard, because he has demonstrated since he came to the Fed in 1987 that the central bank could "replicate" the gold standard.

Take a look at the dollar/gold price from 1987 until today and you will see how terrific he has been in replicating the gold standard. I can't wait for him to leave, Ben, because he now has so much invested in his Fed legacy as a Maestro that he could never admit he screwed up almost all along the way.

Famous 2005 Exchange Between Ron Paul and Alan Greenspan about the Gold Standard


Related: Why There Is Fear and Resentment of Gold's Ability to Reveal the True Value of Financial Assets

Fiat Monetary Theory: The Gamblers

'The Gamblers'

"The historical behavior of interest rates and growth rates in U.S. data suggests that the government can, with a high probability, run temporary budget deficits and then roll over the resulting government debt forever.

The purpose of this paper is to document this finding and to examine its implications. Using a standard overlapping-generations model of capital accumulation, we show that whenever a perpetual rollover of debt succeeds, policy can make every generation better off.

This conclusion does not imply that deficits are good policy, for an attempt to roll over debt forever might fail. But the adverse effects of deficits, rather than being inevitable, occur with only a small probability."

Ball, Elmendorf, Mankiw, The Deficit Gamble

As with most Ponzi schemes, modern fiat currencies are a matter of degree, belief, and tipping points.

There are always limitations in any system, and in paper money systems the debt must be balanced by real growth and investment, an organic growth that makes the rolling debt burden, which is really the basis of the money itself, sustainable and productive.    That growth must be broadly based in order to support consumption from within the system itself, and this implies income commensurate with increasing productivity.

The failure of every fiat currency has been tied to the abuse of power, in the non-organic use of created money not to increase the productive growth of the economy, but to establish monopolies, cartels, speculation, and of course, aggressive war, all in pursuit of the outsized enrichment of a relative few who define themselves as an elite.

And human nature being what it is, all paper money systems have failed within a few hundred years.

There is a variation of  Fiat Monetary Theory, also known as fiat money, which seeks to distinguish itself by its name in addition to its penchant for sophistry, called Modern Monetary Theory.

This variant eliminates the debt problem by switching from a debt based currency to a pure fiat currency issued directly by the government. The longer term problem of currency revulsion, or the rejection by the people of the stated value of the currency, is resolved by greater use of government force.

The resort to force is a tell tale marker of all ideological cults which are unable to achieve a natural stability and an informed, willing acceptance.  That force may include psychological persuasion including propaganda and ridicule.

We are seeing something like this today in Europe, with the compulsion to enforce austerity as the technocrats and careerists refuse to admit that, that by its very design, the Eurozone is inherently unstable. 

And the reforms required to avert disaster are unthinkable, because they will diminish their wealth and power.   And so they become increasingly desperate and self-destructive.

Since the leaders are naturally superior, it is the people that have failed them, because they did not believe enough, work hard enough, sacrifice enough. And so they must be punished.

The Moral Hazard of the Fed's Current Policy: The Resurgence of Fraudulent Paper

"As a dog returns to its vomit, so a fool returns to his folly."

Proverbs 26:11

A reader who works in commercial real estate finance shared a warning, informed by his own private industry perspective today. This was in response to my post this morning on the Fed's policy error of indiscriminately pumping money into an unreformed banking system, without adding safeguards and provisions for its employment in productive investment rather than wealth transfer control frauds.

It is almost tragically funny to see the economic principles learned from the Great Depression applied so blindly and haphazardly as advocated by some economists and policy makers. 

It is hard to explain the realities of things to people who see the rough world of the markets through the abstractions of their theory and models.

Yes, the approach used by the government in the Great Depression favoured the stimulus of government work and investment programs for a depression and liquidity trap, and a certain amount of financial security to ease the pain.  But it would have never been so wilfully complacent about the underlying fraud that caused it in the first place as the government is today.

And austerity without reform is a form of economic suicide.  FDR came right at Wall Street and the Banks with serious reform that saved capitalism from itself, and worked for a generation to hold back its darker impulses.  This is a lesson that we have apparently forgotten.

If the Fed attempts their old fix once again, they may do what I thought was almost inconceivable, and go a step beyond mere stagflation which is bad enough, and cause an actual break in confidence, and the bond of their word, the currency. The people of the world will not be fooled forever.

As Hyman Minsky once said, and the moderns seem to have forgotten, "Anyone can create money; the problem is in getting it accepted." He should have added, except by force.

Reform goes hand in hand with recovery.

From a reader:

CDO Resurgence Could Meet Resistance From RE Investors
Law360

A recent bump in demand for collateralized debt obligations has some experts predicting an onslaught of new deals in the coming months, but real estate attorneys caution that even with a more conservative structure, CDOs could be a hard sell with those still reeling from their role in the 2008 crash.

Also, Commercial Mortgage Alerts reflected commercial mortgage backed securities issuance of $48 billion last year (2012) - up from about $33 billion (2011). Remember the Fed is buying up to $45 billion in mortgage backed bonds per month!

"I believe the Fed has succeeded in provide the banks the incentive to begin issuing fraudulent paper again, the infamous CDO's. That's the only way the banks can meet the demand for higher yielding paper given their reluctance to engage in productive investments.

They know the game now, despite the real estate lawyers who are either wrong or just propagandizing. Open-ended QE.

The banks will issue large amounts of the CMBS paper and CDO paper and probably come up with other bond schemes and even LBO's that are fraudulent and probably worthless.

They'll sell them to whomever, because if the fraud is ever revealed, it will get charged to the Fed who will buy the paper from the investors or off the banks' books for near 100 cents on the dollar.

The great fraud machine is stirring. The debt bubble is reflating.

There is no underlying strength in the economy, so the loans being securitized will not be repaid in real terms and the banks and the investors will ultimately offer them to the Fed, who will buy them at non-market prices.

What's to stop this? There's nothing stopping it.

There is no threat of prosecution for fraud. There is no shame or sense of morality.

There is only a ton of money to be earned by the banks/hedge funds/private equity with no threat of punishment for engaging in massive fraud."

This later from another reader.  To be fair, CDO's are not in and of themselves bad assets, but they do tend to operate nicely in lending themselves as a vehicle for misstating risks because of their complexity and sometimes convoluted terms.  Therefore in that spirit, Deutschebank Selling CDO's to Meet Its Capital Goals.  And Private Equity Getting Deeper into Debt as Multiples Rise as well as Hampton's Average Home Price Hits Record.  

If this is productive debt with risks well-priced then no worries.  But I wonder if we will see a return to the LBO's, bond abuses, and dodgy IPO's of the past given the current climate of loose regulation and increased pressure to make easy money.

Bernanke's Hammer: When You Have a Printing Press, Everything Looks Like a Monetary Transaction

"I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail."

Abraham Maslow, The Psychology of Science, 1966

Apparently while Maslow made this saying famous with a more elegant formulation, the original source of the image is from a Mr. Kaplan who wrote his 'law of the instrument' in 1964.

"I call it the law of the instrument, and it may be formulated as follows: 'Give a small boy a hammer, and he will find that everything he encounters needs pounding.'"

Speaking of boys and their toys, the word that has made its way across the trading desks is that the Fed's put is back on, or more colloquially phrased, while Bernanke keeps printing, certain favored classes of assets can keep going higher, without regard to fundamentals, except for significant event-driven incidents, that will be quickly papered over.

Otherwise, the dips will be shallow and the trend will be maintained.  For how long I do not know, but as the VIX shows, perceived risk is back down to low levels that we have not seen since the growing credit bubble of 2004-2007.

As an aside, before snarky propeller heads with little better arguments to make point out that the Fed does not literally 'print money,' we all know that. It is a degenerate profession that mixes a pretension to lofty equations and high science with the taunts and arguments of the schoolyard, when they act as the politicians' bullyboys.

The pity is that 'the printing press' is not the only instrument at the Fed's disposal.  After all, they are a significant regulator of the banks, and have gained even more power and influence since the financial crisis.  But as might be obvious to most, they are a terribly conflicted regulator, and given to remarkable lapses in judgement.

Monetary inflation without reform is the 'solution' that most favors the monied interests and the financial class given the extractive nature of the system as it is.

The second most favorable policy is 'austerity,' again without serious reform.  One can increase the value of their own pile of ill gotten gains relative to others through either policy.  It is no choice when you can pick the choices you give to the people, all of which are favorable to you.

Unfettered capitalism is remarkably inventive in its ability to transfer wealth and destroy value.  It commoditizes everything, and subordinates all to a place on its hellish balance sheet.

The meme on the financial markets is that there may be shallow pullbacks, or even a greater correction in response to a specific event, such as the 'fiscal cliff,' but the Fed's policy is to target asset inflation once again, through the Too Big To Fail Banks and hedge funds, and their buying of paper at non-market prices.

There is also a belief, whether it is right or wrong, that the regulators will turn a blind eye to the capping of certain commodities like gold and silver, in the name of managing them as rival currencies.  Even a folk hero like Paul Volcker has previously endorsed this as a policy.

This turning of things upside down is what has been called Rubinomics, the principle that by supporting the buying of certain select instruments such as SP futures ahead of a crisis, one can more efficiently avert a financial problem than by allowing the markets to reflect the fundamentals, and then to clean up the mess afterwards.   It's cheaper and easier he observed.

It is the belief that rather than an instrument of price discovery within the real economy, the financial markets ARE the economy, and will lead rather than follow.  And it has become a form of financial totalitarianism through the manipulation of policy and money.

Robert Rubin articulated this policy perspective while he was the Secretary of the Treasury, and he somehow persuaded Greenspan, then the Chairman of the Fed, to go along with it, shortly after the Maestro had made his famous 'irrational exuberance' speech.  Although it should be noted that Greenspan had already found that tool, and used it.  He merely took it to another level, not as a response to be used to a crisis as in the case of the Crash of 1987, but as a proactive tool of financial engineering.

And this was the genesis of the principles of new Modern Monetary Theory, which in fact is a concept as old as the hills, appearing over again with different names, and the source of much recent misfortune through several Presidencies.

"Notwithstanding anything said or done by the Congress this year, operating through trained surrogates such as Geithner, Summers and others, Robert Rubin is still pulling the economic and financial strings in Washington. The fact that there is a Democrat in the White House almost does not seem to matter. President Obama arguably has a subordinate position to Rubin because of considerations of money."

Chris Whalen, The World According to Robert Rubin

And this is the problem I have with this Modern Monetary Theory that would save the system by placing the ability to simply create money in the hands of the Treasury, to be wielded such titans of sound judgement as Robert Rubin, Hank Paulson, and Tim Geithner, with oversight perhaps by those incorruptibles and paragons in the Congress.

I do not like the banking system as it is, as you know if you frequent this Cafe.  The corruption of insider dealings, opaque deals, and unequal justice has displaced the discipline of well run markets.

The system as it is has all the problems, inefficiences, and injustice of a corrupt and self-serving oligarchy. This is not to say that is a grand conspiracy, but rather a series of unfortunate events and human tendencies, aiding the actions of a relative few.

The solution seems obvious, which is to reform the system, to provide for transparency and the rule of law, and a return to regulations and reforms that worked for decades.  And it is not to replace it with some gimmicky solution that has the same faults or worse, that will be used by same rotten, self-serving gang of idiots and careerists.

And this is why I do not even favor something more rigorous like a return to a gold or mixed metal standard now, because with the system as it is, it would surely be used as an instrument of control and repression.  A corrupt system can corrupt all.  Ask the Greeks how an external standard like the euro is working for them.  It has become an instrument of official plunder. 

The thought of the central government having the power to set official gold prices and control inventory, which they most surely would do, makes one shudder. At least in a nominally free market they can provide some refuge against financial engineering, given a wide enough timeframe.

So what about the markets, and such similar financial engineering notions as 'Nominal GDP Targeting."  Well, we can wonder how the Fed might want to actually achieve such a thing, short of going out and buying iPhones and foodstuffs.  Would it be to continually stuff money into the banks and their associated companies and camp followers, and wait for the trickle down effect?

We have seen the result of such an approach in the past.  The 'hot money' seeks beta, and that means financial paper, and frauds like collateralized debt obligations, tied to whatever hapless aspect of the real economy that is convenient, such as housing for example.

And the self same snarky economists will say, 'Where is the inflation?' and point to the very instruments of measurement of inflation that have been distorted and disabled so as not to show it, 'Chained CPI' being the most recent aberration.  And they know full well that in a situation in which the money supply is being expanded selectively and distributed through a relatively narrow source like the biggest banks, the inflation will show up selectively for quite some time, in inflated assets, bonuses and even industries like the tech sector if one can remember back to the 1990's.

I know how tempting it is for 'a little boy with a hammer' to go about pounding everything in sight.  But at some point, the adults have to come and take away that hammer, and restore the instrument to its proper usage in the service of real work and creative, productive activity.

Be careful in this market.  In markets where stocks trade like commodities, the technicals tend to be dominant because the market is a cynical game of supply and demand, squeezes in both directions, divorced from the underlying economic fundamentals. And it has been made worse by the light volumes, as few bystanders want to put their money down on the three card monte table, such as it is.

The pity is that it is strangling the flow of money to the real economy.

Max Keiser interviews Jesse Eisinger of ProPublica about his recent piece in Atlantic magazine, "What's Inside America's Banks?"

I would like to see Mr. Eisinger interviewed on the Bill Moyers show on PBS.

I doubt he could obtain a fair hearing on any mainstream media channel which prefers to stage manage their discussions in the manner of red versus blue.

Money Supply Figures: Monetary Inflation But Real Economy Is Dysfunctional

"He that gives good advice, builds with one hand; he that gives good counsel and example, builds with both; but he that gives good admonition and bad example, builds with one hand and pulls down with the other."

Francis Bacon

The growth in the MZM and M2 money supplies are very strong, almost remarkably so given the very slack growth in employment and GDP.

So why do we not see any serious inflation in prices?  Or real gains in employment for that matter.

As an aside, I think some of the more 'modern'  and aggressively modified measures of price inflation, like chained CPI, do not measure price inflation at all, but the consumer behaviour of product substitution under increasingly trying circumstances as people cope by reducing their standard of living. That is a measure of gradual deprivation, not inflation.

I would like to see a system where no social policy is passed that the leadership of a country does not accept first.  If there is to be austerity, pension cuts, reductions in medical services and food, let them accept it first for the good of the country and an example to their citizens.  I do not say this out of meanness, but charity.  For the double standard with selective justice is the slow and silent killer of oligarchies.

The velocity of money tells part of the story. Please note that those charts below are based on much longer timeframes to show that they are a trend, and not a short term affect of the collapse.

The 'velocity of money' is a calculation that shows the relationship between money supply and real economic activity as a ratio. It is falling to new lows. Some might even use the word 'plummet.' There is lots of new money, but not so much real activity.

The standard economic answer would be that the US is in a liquidity trap, and the recovery will have lags in employment gains.   The money is added, and then recovery follows, with employment showing the longest delay.  The standard remedy would be to create more jobs, artificially if necessary.  But that is not much different than unemployment insurance and programs like food stamps.  It is kind, and sensible, but not sustainable. 

A liquidity trap is described by Keynesian economics as a condition in which injections of money can support zero interest rates, but fail to generate real economic activity.

I think the current situation in the US and UK in particular involves a serious policy error in the failure to address the problems and imbalances that caused the financialization of the real economy, and its subsequent collapse under the weight of malinvestment and corruption.

Aggregate demand is not stimulated because sufficient money does not reach consumers, as it passes through a corrupt and broken financial and political system, being diverted largely to insiders at 'the top.'  Nothing could be more clear than looking at the statistics regarding income inequality.

Any gains by the large middle and lower classes will tend to be short term and illusory, involving more household balance sheet problems and debt until the system is reformed.  Some of this has to do with a policy bias that considers the vast mass of the people as consumers, but not as workers.

Merely adding more financialized money into an unreformed system will further compound the problems, and ultimately force a more significant crisis and change.  This is true whether done does it via more debt issuance or flashier gimmicks like modern monetary totems.

The underlying social tensions can only be ignored by the comfortable for so long.  As a corollary, applying austerity without reform is insanely self-destructive.  The proof of this is forthcoming.

Japan has been able to hold their system together for a protracted period of slack recovery due to their demographics, their industrial policy position in the world economy, and a largely homogeneous and communal society that cares for its own.  The US and the UK will have a shorter half life I am afraid.

The situation is Europe is a bit different, and likely to result in serious dislocations in their organizational fabric fairly soon if some of the problems there are not addressed.  The monetary union without fiscal cohesion is inherently unstable.  Only fraud allowed it to last as long as it did.

There is a possibility that the current policies in the US may succeed if austerity if not applied, and something happens in the currency war to affect the balance of trade.  I am not optimistic  So let's see what happens.

The UK may provide a good counter example to the US  Some new school of economic thought may find some useful data from that, if they can free themselves from the 'say for pay' mentality that currently impairs the public policy discussion in a disgraced profession.

The Legacy of the Fed and the US Experiment with Fiat Currency In One Chart

Please notice that the CPI really 'gets some legs' when Nixon closed the gold window and released the modern monetary theory from its next to last restraint, the bond vigilantes being the last thin blue line.

And below that a quote on the modern monetary system, in which I detect the root of Paul Krugman's confusion about money.

To his credit, Krugman does recognize the liquidity trap, which sets him head and shoulders apart from the Austerians. He just does not understand the markets and how they work in practice rather than theory, and the absolutely compelling need for reform. But that puts him in with most regulators, central bankers, and the herd of academic economists.

Shifting Mandates: The Federal Reserve’s First Centennial
Carmen M. Reinhart and Kenneth S. Rogoff

For presentation at the American Economic Association Meetings, San Diego,
January 5, 2013

Session: Reflections on the 100th Anniversary of the Federal Reserve

Read the entire paper in PDF form here.


h/t Bill P and Business Insider

"The current world monetary system assigns no special role to gold; indeed, the Federal Reserve is not obliged to tie the dollar to anything. It can print as much or as little money as it deems appropriate [History suggests that while they technically can print as much as they wish, there is an effective upper bound along with a law of diminishing returns in there somewhere. Weimar and John Law, amongst others, tended to show that. - Jesse]

There are powerful advantages to such an unconstrained system. Above all, the Fed is free to respond to actual or threatened recessions by pumping in money. To take only one example, that flexibility is the reason the stock market crash of 1987—which started out every bit as frightening as that of 1929—did not cause a slump in the real economy.

While a freely floating national money has advantages, however, it also has risks. For one thing, it can create uncertainties for international traders and investors. Over the past five years, the dollar has been worth as much as 120 yen and as little as 80.

The costs of this volatility are hard to measure (partly because sophisticated financial markets allow businesses to hedge much of that risk) [O brave New World, that has such derivative sophisticates in it. - Jesse] but they must be significant. Furthermore, a system that leaves monetary managers free to do good also leaves them free to be irresponsible—and, in some countries, they have been quick to take the opportunity." [Yes, THOSE countries may experience a financial collapse because of a monetary credit bubble, no doubt because of a lack of economic sophisticates. - Jesse]

Paul Krugman, The Goldbug Variations, 22 November 1996

John C. Williams: The Federal Reserve's Brand of Modern Monetary Theory

I will comment more on this later but I thought it was interesting and probably quite important for future reference.

One point of contention for me has been this whole issue of the Fed paying interest on excess reserves, essentially incenting banks, if the rate is high enough, to cause banks to hoard reserves at the Fed rather than lend the money out to the real economy.

This point was argued quite vociferously some years ago during the first quantitative easing.  We were told by the New York Fed, as I recall, that this was not the case, and that the payment of interest on excess reserves was only a means for the Fed to manage rates at the zero bound, and did not affect the levels of reserves which are only an accounting identity, after all.

Williams seems to contradict this now.  But I have to give it an extra careful reading in this case.

However, some might look at his data and his reasoning and conclude that while the Fed's policies have been doing quite a bit to provide solvency to the banking system, it has not done well by the real economy.  The GDP and employment numbers seem to bear this out.

One might conclude that reducing the interest paid on reserves would cause the banks to make more loans to the real economy.  And yet not so long ago the NY Fed and several of their economists also argued against what seems like common sense that this was not the case, not at all.

So it might be important to pin the Fed down a bit on this now.  Their thinking could be evolving, or it might just be dissembling to suit the changing situation.   One might gather from what Mr. Williams is saying about rewriting established theory that they don't quite know what it is that they are doing, but instead are feeling their way along in uncharted waters.

This of course widens the risk of a policy error enormously.  Greenspan's Fed was replete with policy errors, but of course he was the gure, the infallible one.  And we should trust these same economists who lionized him now for what reason?

From my own perspective the Fed has spun what they are doing in so many different ways at different times that it is difficult to take what they are saying here at face value.

And that is another feature of the credibility trap.

I believe this speech by John C. Williams is significant, in the manner of Bernanke's famous printing press speech.  Deflation: Making Sure It Doesn't Happen Here. 

Let's give it a careful read and see if it provides any additional clues to what they are thinking, and what they might do next.

San Francisco Federal Reserve Bank
Monetary Policy, Money, and Inflation
John C. Williams, President and CEO
2 July 2012

Good morning. I’m very pleased to be in such eminent company, especially that of my former advisor at Stanford, John Taylor. And I’ll begin my presentation with a reference to another pathbreaking monetary theorist. Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” 1

We are currently engaged in a test of this proposition. Over the past four years, the Federal Reserve has more than tripled the monetary base, a key determinant of money supply.   Some commentators have sounded an alarm that this massive expansion of the monetary base will inexorably lead to high inflation, à la Friedman.

Despite these dire predictions, inflation in the United States has been the dog that didn’t bark. As Figure 1 shows, it has averaged less than 2 percent over the past four years. (Past performance is not an indicator of future success - Jesse)  What’s more, as the figure also shows, surveys of inflation expectations indicate that low inflation is anticipated for at least the next ten years.  (Did they anticipate the financial collapse? - Jesse)

In my remarks today, I will try to reconcile monetary theory with the recent performance of inflation. In my view, recent developments make a compelling case that traditional textbook views of the connections between monetary policy, money, and inflation are outdated and need to be revised. As always, my remarks represent my own views and not necessarily those of others in the Federal Reserve System.

I’ll start with two definitions. The monetary base is the sum of U.S. currency in circulation and bank reserves held at the Federal Reserve. Figure 2 shows the key components of the monetary base since 2007. Up until late 2008, it consisted mostly of currency, with a small amount of bank reserves held mostly to meet regulatory requirements. Since then, the monetary base has risen dramatically, primarily because of a $1.5 trillion increase in bank reserves. The money stock is a related concept. It is the total quantity of account balances at banks and other financial institutions that can easily be accessed to make payments. A standard measure of the money stock is M2, which includes currency, and certain deposit and money market accounts.

Here I should make an important point about something that often confuses the public. The worry is not that the Fed is literally printing too much currency. 2 The quantity of currency in circulation is entirely determined by demand from people and businesses. It’s not an independent decision of monetary policy and, on its own, it has no implications for inflation. (It is the money stock that concerns people, not the adjusted monetary base per se - Jesse)

The Federal Reserve meets demand for currency elastically. If people want to hold more of it, we freely exchange reserves for currency. If people want less, then we exchange it back. Of course, currency doesn’t pay interest. People hold it as a low-cost medium of exchange and a safe store of value. In fact, over the past four years, U.S. currency holdings have risen about 35 percent. This reflects low interest rates, which reduce the opportunity cost of holding currency. It’s also due to worries about the economy and the health of the banking system, both here and abroad. In fact, nearly two-thirds of U.S. currency is held outside our borders. 3  U.S. currency is widely seen as a safe haven. When a country is going through economic or political turmoil, people tend to convert some of their financial assets to U.S. currency. Such increased demand for U.S. currency is taking place in Europe today.

For monetary policy, the relevant metric is bank reserves. The Federal Reserve controls the quantity of bank reserves as it implements monetary policy. To keep things simple, I’ll start with what happens when the Fed doesn’t pay interest on reserves, which was the case until late 2008. I’ll return to the issue of interest on reserves toward the end of my talk.

Before interest on reserves, the opportunity cost for holding noninterest-bearing bank reserves was the nominal short-term interest rate, such as the federal funds rate. Demand for reserves is downward sloping. That is, when the federal funds rate is low, the reserves banks want to hold increases. Conventional monetary policy works by adjusting the amount of reserves so that the federal funds rate equals a target level at which supply and demand for reserves are in equilibrium. It is implemented by trading noninterest-bearing reserves for interest-bearing securities, typically short-term Treasury bills.

Normally, banks have a strong incentive to put reserves to work by lending them out. If a bank were suddenly to find itself with a million dollars in excess reserves in its account, it would quickly try to find a creditworthy borrower and earn a return. If the banking system as a whole found itself with excess reserves, then the system would increase the availability of credit in the economy, drive private-sector borrowing rates lower, and spur economic activity. Precisely this reasoning lies behind the classical monetary theories of multiple deposit creation and the money multiplier, which hold that an increase in the monetary base should lead to a proportional rise in the money stock.

Moreover, if the economy were operating at its potential, then if the banking system held excess reserves, too much “money” would chase too few goods, leading to higher inflation. Friedman’s maxim would be confirmed. Here’s the conundrum then: How could the Fed have tripled the monetary base since 2008 without the money stock ballooning, triggering big jumps in spending and inflation? What’s wrong with our tried-and-true theory?

A critical explanation is that banks would rather hold reserves safely at the Fed instead of lending them out in a struggling economy loaded with risk. The opportunity cost of holding reserves is low, while the risks in lending or investing in other assets seem high. Thus, at near-zero rates, demand for reserves can be extremely elastic. The same logic holds for households and businesses. Given the weak economy and heightened uncertainty, they are hoarding cash instead of spending it. In a nutshell, the money multiplier has broken down. 4

The numbers tell the story. Despite a 200 percent increase in the monetary base, measures of the money supply have grown only moderately. For example, M2 has increased only 28 percent over the past four years. 5  Figure 3 shows that the money multiplier—as measured by the ratio of M2 to the monetary base—plummeted in late 2008 and has not recovered since. Nominal spending has been even less responsive, increasing a mere 8 percent over the past four years. As a result, the ratio of nominal gross domestic product, which measures the total amount spent in the economy, to the monetary base fell even more precipitously, as the figure shows. This ratio also has not recovered, illustrating how profoundly the linkage between the monetary base and the economy has broken.

A natural question is, if those reserves aren’t circulating, why did the Fed boost them so dramatically in the first place? The most important reason has been a deliberate move to support financial markets and stimulate the economy.  By mid-December 2008, the Fed had lowered the federal funds rate essentially to zero. Yet the economy was still contracting very rapidly. Standard rules of thumb and a range of model simulations recommended setting the federal funds rate below zero starting in late 2008 or early 2009, something that was impossible to do. 6  

Instead, the Fed provided additional stimulus by purchasing longer-term securities, paid for by creating bank reserves. These purchases increased the demand for longer-term Treasuries and similar securities, which pushed up the prices of these assets, and thereby reduced longer-term interest rates. In turn, lower interest rates have improved financial conditions and helped stimulate real economic activity. 7 

The important point is that the additional stimulus to the economy from our asset purchases is primarily a result of lower interest rates, rather than a textbook process of reserve creation, leading to an increased money supply. It is through its effects on interest rates and other financial conditions that monetary policy affects the economy.

But, once the economy improves sufficiently, won’t banks start lending more actively, causing the historical money multiplier to reassert itself? And can’t the resulting huge increase in the money supply overheat the economy, leading to higher inflation? The answer to these questions is no, and the reason is a profound, but largely unappreciated change in the inner workings of monetary policy. 

The change is that the Fed now pays interest on reserves. The opportunity cost of holding reserves is now the difference between the federal funds rate and the interest rate on reserves. The Fed will likely raise the interest rate on reserves as it raises the target federal funds rate. 8 Therefore, for banks, reserves at the Fed are close substitutes for Treasury bills in terms of return and safety. A Fed exchange of bank reserves that pay interest for a T-bill that carries a very similar interest rate has virtually no effect on the economy. Instead, what matters for the economy is the level of interest rates, which are affected by monetary policy.

This means that the historical relationships between the amount of reserves, the money supply, and the economy are unlikely to hold in the future. If banks are happy to hold excess reserves as an interest-bearing asset, then the marginal money multiplier on those reserves can be close to zero. As a result, in a world where the Fed pays interest on bank reserves, traditional theories that tell of a mechanical link between reserves, money supply, and, ultimately, inflation are no longer valid. In particular, the world changes if the Fed is willing to pay a high enough interest rate on reserves. In that case, the quantity of reserves held by U.S. banks could be extremely large and have only small effects on, say, the money stock, bank lending, or inflation.

As I noted earlier, inflation and inflation expectations have been low for the past four years, despite the huge increase in the monetary base. Of course, if the economy improved markedly, inflationary pressures could build. Under such circumstances, the Federal Reserve would need to remove monetary accommodation to keep the economy from overheating and excessive inflation from emerging. It can do this in two ways: first, by raising the interest rate paid on reserves along with the target federal funds rate; and, second, by reducing its holdings of longer-term securities, which would reverse the effects of the asset purchase programs on interest rates.

In thinking of exit strategy, the nature of the monetary policy problem the Fed will face is no different than in past recoveries when the Fed needed to “take away the punch bowl.” Of course, getting the timing just right to engineer a soft landing with low inflation is always difficult. This time, it will be especially challenging, given the extraordinary depth and duration of the recession and recovery. The Federal Reserve is prepared to meet this challenge when that time comes. Thank you.

End Notes

1. Friedman (1970), p. 24.

2. Technically, the Bureau of Engraving and Printing prints paper currency. The Federal Reserve is responsible for processing and distributing currency to the banking system. The Federal Reserve also distributes coins, which are distinct from paper currency, to the banking system, but the amount of coins in circulation is comparatively small.

3. See Goldberg (2010).

4. For a discussion of this, see Williams (2011a).

5. Similarly, an alternative measure of the money stock, MZM, increased 26 percent over the past four years.

6. See Chung et al. (2011) and Rudebusch (2010).

7. See Williams (2011b) for details.

8. For details on the Fed’s planned exit strategy, see the minutes for the June 2011 FOMC meeting (Board of Governors 2011).