Comment on Inequality


I’ve reposted below an excellent letter printed in the WSJ in response to an article on the president’s policies to address inequality. The political agenda here is a sham and the financial policies fueling the sham are the real culprit.

Your editorial “The Inequality President” (July 25) points out the unquestionably large and growing income divide in America. While the president shares in the responsibility, it is sadly far more the doing of the Federal Reserve than the administration. The subsidization of the largest commercial banks through Fed-repressed rates on savings has been characterized as the biggest wealth transfer in U.S. history. What provides cheap financing for banks, provides dismal returns for savers. In so doing, savers are subsidizing the banks. But this is just the beginning of the Fed’s half-witted contribution to growing income inequality.

Ben Bernanke is on record promoting Fed policies designed to encourage investment in “risk assets.” He argues that near-zero interest rates on safe assets (money-market funds, CDs and savings deposits) are designed to encourage greater investment in risk assets. But endless studies have shown that the holders of these risky assets (stocks, high-yield bonds) are disproportionately the wealthy. The problem is, as evidenced by your study of median income, the wealth effect isn’t trickling down as the Fed assumed it would.

This is also the enigma of the Fed’s program of quantitative easing. The Fed doesn’t buy U.S. Treasurys or mortgage securities from the “open market,” but rather directly from the largest commercial banks, or “primary dealers,” who are required to sell these obligations to the Fed. With abysmally weak loan demand, the banks choose to redeploy the proceeds of these sales into stocks and high-yield bonds. This Fed subsidy has been much of the fuel driving stock prices skyward, the swift recovery of bank profits and the growing levels of income inequality that you report.

Richard L. DeProspo

Westlake Village, Calif.

One Big Reason You Can’t Find a Job: Zero Interest Rate Policy


This isn’t rocket science, it’s fairly simple: zero interest rates are a sign of a very sick economy. The occurrences should be short and temporary. A healthy economy must price the time-value of money and risk at a range somewhere between 1-3% real interest rates, depending on the term structure and liquidity. Instead, the Fed has hampered the recovery of capital markets on which the real economy depends. So we have a casino where the bettors are subsidized and the asset markets become where all the action is. They once called this “irrational exuberance,” but under this Fed policy it’s perfectly rational.

The Fed’s (and our!) real problem is that it’s recovery policy depends on inflated asset values to collateralize unsustainable debt. The only result is to completely distort price signals and keep the economy on its back. Bernanke’s public pronouncements have essentially confirmed that he’s going to keep the economy sick as far into the future as he can see. Well done, Ben.

From the WSJ:

The Near-Zero Interest Rate Trap

If long-term rates rise to normal levels, banks holding government bonds would be de-capitalized—a disaster.


The conventional critique of the Federal Reserve’s policies of near-zero interest rates and massive monetary expansion is that they risk kindling excess aggregate demand and high inflation. Yet inflation world-wide remains low, and some major trading partners of the United States, such as Japan and now China, are worried about deflation. China’s Producer Price Index fell 2.7% in June, the 16th consecutive monthly decline.

Nevertheless, artificially low short- and long-term interest rates can still distort the financial system and hold the economy back. And modest increases in interest rates to more “normal” levels could lead to more investment without an inflation risk.

For an example of how near-zero short-term interest rates can inhibit private investment, consider a bank that accepts deposits and makes new loans of three-months’ duration. The traditional spread between deposit and loan rates is about three percentage points. With this spread, banks can lend to small- and medium-size enterprises, the so-called SMEs—making loans that carry moderate risks and higher administrative costs per dollar lent. To increase the safety of its overall loan portfolio, the bank can also lend greater amounts to larger, more established corporate enterprises.

However, as short-term interest rates are compressed toward zero, larger corporate borrowers find it more advantageous to raise money by selling short-term commercial paper directly to other corporations, pension funds and money-market mutual funds. This leaves smaller banks in particular with a riskier portfolio of loans to SMEs, and the need to raise more bank capital to support riskier liabilities—so they may instead shrink the size of their loan portfolios.

Also, smaller banks can’t easily borrow funds from other banks to lend out to companies when interest rates are near zero. These other banks aren’t inclined to lend their excess reserves for a tiny yield, especially in the presence of even a moderate counterparty risk. They will instead just hold excess reserves.

As interest rates fall, money-market mutual funds will buy highly rated commercial paper and other short-dated financial instruments. However, if short-term interest rates approach zero, these money funds fear “breaking the buck.” Even a small negative random shock to the mutual fund’s portfolio from a client failing to repay could jeopardize the fund’s ability to cover interest payments to depositors. This means that depositors might only get 99 cents back on each dollar invested. Sponsors of these money-market mutual funds, often banks, are paranoid about the reputational costs of breaking the buck—so they may either close them or limit new deposits to the funds.

Despite the difficulties in an ultralow interest environment in getting short-term financing, can’t larger, well-known corporations still get the investment funds they need by selling longer-term bonds?

The problem here is that as banks and other financial institutions get used to near-zero interest rates and accumulate low-interest bonds for some years, they end up in a trap from which escape is difficult. And this trap has negative implications even for corporations that seek direct, long-term financing.

The trap was revealed for all to see after Fed Chairman Ben Bernanke’s suggestion, in congressional testimony on May 22, that the central bank might slow down its huge purchases of long-term Treasury bonds and other long-term securities—purchases designed to keep long-term interest rates low.

Mr. Bernanke carefully hedged his statement. He said that certain preconditions of the economic recovery, notably a sharp fall in the unemployment rate to 6.5%, had to be met before tapering could begin. But markets ignored these caveats. Long-term interest rates rose from 1.5% to 2.5% in the U.S., and stock markets crashed around the world in the four days that followed.

A chastened—and trapped—Mr. Bernanke said in a June 19 press conference that money will remain easy for the foreseeable future. But the trap matters for the efficiency of the long-term bond market.

What have central banks wrought? As Andrew Haldane, a top official at the Bank of England, declared in June of his own institution, “the biggest government bond bubble in history.”

The Federal Reserve, the Bank of England, the Bank of Japan and European Central Bank all have used quantitative easing to force down their long-term interest rates. The result is that major industrial economies have all dramatically increased the market value of government and other long-term bonds held by their banks and other financial institutions. Now each central bank fears long-term rates rising to normal levels, because their nation’s commercial banks would suffer big capital losses—in short, they would “de-capitalize.”

But the potential turmoil in bond values also makes it more difficult for corporations seeking to raise long-term financing. Indeed, bond-market dealers in the U.S. are currently paring their inventories because of the risks associated with high volatility.

In 2009, when the Federal Reserve initiated quantitative easing, the prices of bonds and equities rose as long-term interest rates fell so as to buoy the economy. Now, after a low-interest-rate “equilibrium” for some years, the potential for exiting its quantitative-easing program means high volatility in bond markets—a volatility that inhibits new bond offerings for domestic investment. Mr. Bernanke’s tapering speech illustrates how that can happen: New bond and equity issues are put on hold.

By trying to stimulate aggregate demand and reduce unemployment, central banks have pushed interest rates down too much and inadvertently distorted the financial system in a way that constrains both short- and long-term business investment. The misnamed monetary stimuli are actually holding the economy back.

The way out is for major central banks—the Federal Reserve, the Bank of England, the Bank of Japan and the European Central Bank—to begin slowly increasing short-term interest rates in a coordinated way to some common modest target level, such as 2%. Coordination is crucial to minimize disruptions in exchange rates. They should also phase out bond buying so that long-term interest rates once again become determined by markets.

Paradoxically, such modest increases in interest rates could actually stimulate investment and growth in all four economies.

Doubling Down on Stupid.

dollar shock

For monetary policy under a new Fed Chairman (oops, Chairperson), it’s shaping up as a battle between two worst-case scenarios. From the WSJ:

The real problem is that neither Ms. Yellen nor Mr. Summers seems likely to do what should be the next chairman’s priority—restoring the Fed’s independence by ending its post-crisis political interventions and focusing above all on maintaining price stability.

Obama’s Fed Circus

Democrats put on a spectacle of Wall Street and gender politics.

The Federal Reserve chairman is the world’s most important economic official, especially with today’s weak U.S. Treasury. So how embarrassing for American economic leadership to see the choice of Ben Bernanke’s successor devolve into a brawl between the Democratic Party’s gender liberals and its Wall Street wing. If only the two sides disagreed on the conduct of monetary policy.

President Obama opened the circus in June when he signaled to PBS’s Charlie Rose that Mr. Bernanke had “already stayed a lot longer than he wanted or he was supposed to.” A more managerially competent President would have quietly advised Mr. Bernanke about his intentions and let the Fed chairman announce his departure on his own terms after eight years.

Mr. Bernanke would have been treated with more respect. And the President could have given himself more flexibility in vetting a replacement and avoiding what is now a very public scramble for the job.

Janet Yellen, the current Fed vice chairman, has emerged as the favorite of the Democratic left. As an economist with long experience at the Fed, she doesn’t lack for professional credentials. But her cause has been taken up by the liberal diversity police as a gender issue because she’d be the first female Fed chairman.

Nancy Pelosi has bellowed her support, and Christina Romer, who was chief White House economist for the first two years of Mr. Obama’s Presidency, has all but said it would be a defeat for women if Ms. Yellen doesn’t get the Fed job. That led our friends at the New York Sun to wonder if they had somehow missed the creation of “the female dollar” given that they thought the Fed’s main task is to preserve the value of the currency.

Ms. Yellen is also seen, in and outside the Fed, as a leading monetary dove. That isn’t limited to her backing for Mr. Bernanke’s monetary interventions since the 2008 panic. We’ve followed Ms. Yellen for 20 years and can’t recall a key juncture when her default policy wasn’t to keep spiking the punchbowl. Many Democrats think the Fed needs to keep interest rates at near zero through the 2016 election, and Ms. Yellen is their woman.

The gender bender is compounded because White House aides are leaking that Ms. Yellen’s main competitor is none other than economist Lawrence Summers. Aficionados of diversity politics will recall that Mr. Summers was run out of the Harvard presidency by the faculty after he observed that women may have “different availability of aptitude at the high end” in the hard sciences. He was merely musing aloud trying to explain the relative dearth of tenured women professors in the sciences, but at Harvard this is like insulting Muhammad in Mecca.

Mr. Summers also worked in the Obama White House in the first term and repeatedly clashed with Ms. Romer. Among Democratic feminists, for Ms. Yellen to lose out to a man would be bad enough. To have her trumped by Larry Summers would be like losing to Phyllis Schlafly.

Mr. Summers, who was Bill Clinton’s last Treasury secretary, is also being pushed by his patrons on Wall Street and the other Robert Rubin protégés who populate the Obama Administration. They include Treasury Secretary Jack Lew, chief White House economic aide Gene Sperling and U.S. Trade Representative Michael Froman. They want one of their own at the Fed, as well as someone who would have more immediate credibility in financial markets.

The political problem is that Wall Street ties aren’t as golden as they once were among Democrats. Mr. Summers has in particular been part of the Democratic revolving door at Citigroup, which has been saved by the feds no fewer than three times, most recently in 2008-2009. Citi runs a best-in-class program for Democrats in between big political jobs, such as Mr. Lew, Mr. Froman and currently Peter Orszag, the former Obama budget director and architect of ObamaCare.

Mr. Summers has been a consultant to Citigroup since 2012, the year after he left the White House. A Citi spokesman says that “In addition to speaking at internal meetings, we engage Mr. Summers for small Private Bank client and institutional client meetings, where he provides insight on a broad range of topics including the global and domestic economy.” Neither Mr. Summers nor the bank will disclose his compensation.

Whatever it is, Citibankers will consider it a bargain if their man ends up running the agency with primary responsibility for regulating Citigroup. In the Dodd-Frank world, too-big-to-fail banks are public utilities that resist regulatory advice at their peril. If he returns to the heights of financial political power, Mr. Summers wouldn’t forget who helped him build a comfortable nest egg.


This political Big Top has everything—except a debate over what the Fed actually does. Mr. Summers has recently been quoted as saying the benefits of the Bernanke-Yellen quantitative easing are exaggerated, but that hasn’t been a major theme of his public writing since he left the White House.

We wonder if this isn’t merely a come-lately attempt to sound more hawkish than Ms. Yellen. Mr. Summers is above all a Democratic Party loyalist and would do whatever he thought necessary to help elect Hillary Clinton in 2016.

The real problem is that neither Ms. Yellen nor Mr. Summers seems likely to do what should be the next chairman’s priority—restoring the Fed’s independence by ending its post-crisis political interventions and focusing above all on maintaining price stability.

Same Old, Same Old?

The president made his fourth or fifth, or maybe it’s the seventh or eighth, pivot to the economy on Wednesday, and a revealing speech it was. We counted four mentions of “growth” but “inequality” got five. This goes a long way to explaining why Mr. Obama is still bemoaning the state of the economy five years into his Presidency.

Some might say this is unfair, but a brief chronology of the president’s pronouncements on the economy makes it all but obvious.

  1. February 2009: The president tells Congress “now is the time to jumpstart job creation” and his agenda “begins with jobs.”
  2. November 2009: Meeting with his Economic Recovery Advisory Board, the president says his administration “will not rest until we are succeeding in generating the jobs that this economy needs.”
  3. April 2010: Obama goes on a “Main Street” tour, saying “it’s time to rebuild our economy on a new foundation so that we’ve got real and sustained growth.”
  4. June 2010: The president declares a “Recovery Summer” to highlight the jobs created by stimulus-funded infrastructure projects. “If we want to ensure that Americans can compete with any nation in the world, we’re going to have to get serious about our long-term vision for this country and we’re going to have to get serious about our infrastructure,” he said.
  5. December 2010: The president tells reporters “we are past the crisis point in the economy, but we now have to pivot and focus on jobs and growth.”
  6. August 2011: After lawmakers reach a compromise to avert default, the president vows “in the coming months, I’ll continue also to fight for what the American people care most about: new jobs, higher wages and faster economic growth.”
  7. February 2013: At the start of his second term, the president refocuses on job creation in his State of the Union address, saying “a growing economy that creates good, middle-class jobs–that must be the North Star that guides our efforts.”
  8. May 2013: Kicking off his “Jobs and Opportunity Tour,” the president says “all of us have to commit ourselves to doing better than we’re doing now. And all of us have to rally around the single-greatest challenge that we face as a country right now, and that’s reigniting the true engine of economic growth, a rising, thriving middle class.”

The problems we have with economic policy and inequality is that inequality is best addressed by distributing the benefits of growth as that growth occurs, not redistributing the wealth after the fact. As the WSJ puts it in today’s editorial:

The core problem has been Mr. Obama’s focus on spreading the wealth rather than creating it. ObamaCare will soon hook more Americans on government subsidies, but its mandates and taxes have hurt job creation, especially at small businesses. Mr. Obama’s record tax increases have grabbed a bigger chunk of affluent incomes, but they created uncertainty for business throughout 2012 and have dampened growth so far this year.

The food stamp and disability rolls have exploded, which reduces inequality but also reduces the incentive to work and rise on the economic ladder. This has contributed to a plunge in the share of Americans who are working—the labor participation rate—to 63.5% in June from 65.7% in June 2009. And don’t forget the Fed’s extraordinary monetary policy, which has done well by the rich who have assets but left the thrifty middle class and retirees earning pennies on their savings.

Mr. Obama would have done far better by the poor, the middle class and the wealthy if he had focused on growing the economy first. The difference between the Obama 2% recovery and the Reagan-Clinton 3%-4% growth rates is rising incomes for nearly everybody. …If only Mr. Obama understood that before a government can redistribute wealth, the private economy has to create it.

Facing Facts About Race


Last week President Obama weighed in again on the Trayvon Martin episode. Sadly, most of what he said was wrong, both literally and ethically.

I don’t usually post about cultural politics but I link to this truly excellent article by Victor Davis Hanson published by National Review Online, regarding an ongoing tragedy that has sucked a lot of oxygen out of our public discourse.

Tweet From Aristotle


I always love a good quote from Aristotle reminding us of long-standing truths we so easily forget.

Aristotle on the importance of the middle class.

From Benjamin Jowett’s 1885 translation of Aristotle’s “Politics”:

A city ought to be composed, as far as possible, of equals and similars; and these are generally the middle classes. Wherefore the city which is composed of middle-class citizens is necessarily best constituted in respect of the elements of which we say the fabric of the state naturally consists. And this is the class of citizens which is most secure in a state, for they do not, like the poor, covet their neighbors’ goods; nor do others covet theirs, as the poor covet the goods of the rich; and as they neither plot against others, nor are themselves plotted against, they pass through life safely. Wisely then did Phocylides pray—’Many things are best in the mean; I desire to be of a middle condition in my city.’

Demographics and Society


Quote from Alan Murray, President of the Pew Center:

When the Pew Research Center surveyed nearly 40,000 people in 39 countries this spring, we asked the quintessential question of middle-class aspiration: Will children in your country be better off than their parents? Large majorities in most advanced economies said “no.” Only 33% of Americans think children will be better off than their parents. The number was 17% in Britain, 15% in Japan and 9% in France.

But in China, 82% now expect their children to live better, and in Brazil, 79% think the same way. Majorities in Chile, Malaysia, Venezuela, Indonesia, the Philippines, Nigeria, Ghana and Kenya believe that the next generation will be better off than the current one.

A society with hope for the future tends to invest in that future by having more children. As these surveys below reveal, the future is unfolding with less hope in rich countries and more hope in poor countries. It is significant that the birth rates in Japan and much of Western Europe have fallen below the replacement rate.

This has clear implications for what makes people happy and productive: not so much the absolute level of wealth as their expectations for the future.

A Day Late and a Dollar Short?


Central Bankers Hone Tools to Pop Bubbles

From the WSJ (full article here).

An interesting article about how to address the most obvious cause of bubbles and busts: excessive financial leverage amped by easy credit. That only took a generation of asset bubbles and busts to figure out.

A Financial House of Cards

House of cards

Yup. From the WSJ:

Central Banking Needs Rethinking

The Fed’s monetary policy is hazardous, its bank supervision ineffectual.


The Federal Reserve did well to supply liquidity after Lehman Brothers failed in September 2008 and the world was plunged into financial crisis. But since then the Fed’s monetary policy has been increasingly hazardous and bank supervision by the Fed and other regulators dangerously ineffectual.

Monetary policy might focus on the manageable task of keeping expectations of inflation on an even keel—an idea of Mr. Phelps’s in 1967 that was long influential. That would leave businesses and other players to determine the pace of recovery from a recession or of pullback from a boom.

Nevertheless, in late 2008 the Fed began its policy of “quantitative easing”—repeated purchases of billions in Treasury debt—aimed at speeding recovery. “QE2” followed in late 2010 and “QE3” in autumn 2012. Fed Chairman Ben Bernanke said in November 2010 that this unprecedented program of sustained monetary easing would lead to “higher stock prices” that “will boost consumer wealth and help increase confidence, which can also spur spending.”

It is doubtful, though, that quantitative easing boosted either wealth or confidence. The late University of Chicago economist Lloyd Metzler argued persuasively years ago that a central-bank purchase, in putting the price level onto a higher path, soon lowers the real value of household wealth—by roughly the amount of the purchase, in his analysis. (People swap bonds for money, then inflation occurs, until the real value of money holdings is back to where it was.)

True, stock prices did rise in real terms in 2009-10. But surely that rebound in share prices from the panic of 2008 was mainly due to a stunning rise in after-tax corporate profits, much of it overseas. Stock markets did not begin their recent breakout until late 2012, by which time other factors were at work, such as Washington’s heightened concern over continuing fiscal deficits on top of already high public debt and entitlements. Had Fed purchases raised stock prices to levels that caught the eye of business owners, the purchases might have prompted accelerated business investment, a powerful creator of jobs. But the rise was evidently too little and too late to hasten markedly the recovery.

Moreover, the Fed’s quantitative easing appears not to have increased confidence and may have reduced it. No one—the Fed included—knows how much more it will buy or how much of its mountain of Treasurys will be sold back to the market. The Fed said it would end easing at serious signs of faster inflation. But as the housing bubble that preceded the financial crisis showed, imprudent speculation can be destructive without high inflation. Today we have banks, insurance companies and pension funds leveraging their assets and loading up on credit risks because prudence cannot provide acceptable returns.

The cost of this uncertainty can be considerable. An attendant foreboding may lie behind some of the depression in business investment—even if myopic traders in bonds and currencies are impervious to it and too-big-to-fail banks go on making one-way bets. Also, the time and money that businesses give to innovation and efficiency gains are squeezed if the businesses are distracted by the uncertainties surrounding monetary policy.

This ambiguity notwithstanding, President Obama commends Mr. Bernanke for “helping us recover much stronger than, for example, our European partners.” Sure, the European Central Bank did not adopt quantitative easing. But the delay in Europe’s recovery plausibly derives from the severity of its fiscal and banking problems and its structural disadvantages, such as inflexible labor markets and lack of institutions for early renegotiation of debts.

The Fed attributes persistent joblessness in the U.S. to a deficiency of aggregate demand, which the Fed blames on foreigners’ thrift. But if the West’s problem were simply that, it long ago would have increased its money supply to meet the increases demanded and would have invested in businesses at an increased pace to take advantage of the cheap credit.

Households have maintained their strong propensity to consume, persuaded that their retirement incomes will be topped up with entitlements. But consumer-goods production—giant machines needing only a guard and a dog, as some wag put it—is generally not labor-intensive enough to provide high employment at normal wages. A central bank’s monetary policy, no matter how ambitious, cannot solve this structural problem.

What we do need from the Fed is reform of the ways banks are regulated and supervised. Tough, on-the-ground examination of individual banks not only helps keep them solvent, such scrutiny can also prevent out-of-control money growth without suppressing productive lending. Similarly, rules that discourage banks from relying on yield-chasing hot money will limit the runs and panics the Fed has to fight.

Unfortunately, over the past couple of decades, bank regulation, like the Fed’s macro-interventions, has become more top-down and formulaic.

Until the 1980s, for instance, bank examiners would assess how large a capital buffer each bank should have, taking into account its specific risks instead of relying on internationally standardized ratios.

Dysfunctional rules have also sustained the growth of monolithic megabanks that have little interest in traditional productive lending.

Unsurprisingly, the Fed’s aggressive monetary easing has helped large companies already flush with cash issue bonds at low rates, while small businesses have struggled to secure working-capital loans.

In a modern economy some areas of top-down control are likely to be unavoidable. But that does not mean we should settle for institutions that are less participatory or accountable. It is not desirable that seven people on the Federal Open Market Committee have the power to intervene on a massive scale based on theories that may or may not be right and do not reflect a popular consensus.

America has a constitutional takings clause, as well as checks and balances on the state’s power of eminent domain. Such matters as tax laws and budgets are subject to votes rather than being left to “experts.” These arrangements are as much about legitimacy and consent of the governed as they are about economic efficiency.

Congress passed the Federal Reserve Act in 1913 mainly to forestall and contain panics, discourage speculation and improve the supervision of banks, not to steer the economy. Indeed, the Federal Reserve System was set up as 12 more-or-less independent reserve banks to assuage concerns about centralized control and capture by financial interests.

Restoring the modest foundational aims and diffused governance of the Fed would be good for our economy and good for our democracy.

Money Delusions


The following is from this week’s Barrons:

Why the Fed Wants Higher Prices

It’s trying to exploit the power of positive wealth effects.


An important issue that the Fed has not discussed in detail is the idea that rising asset values in housing and the stock market will translate into more economic activity, and a speedier economic recovery—the impact of wealth effects.

Wealth effects are determined by changes in asset prices. In the U.S., two asset classes determine the intensity of wealth effects. They are housing prices and the stock market. (Read the rest of the article here.)


Mr. Kotok is likely correct in explaining why the Fed wants higher housing and stock prices, but neglects to mention the negative externalities of its policies. Seeking positive wealth effects by recapitalizing asset prices is like putting the cart before the horse: rising incomes drive asset prices, not the reverse, so asset price increases that depart from fundamental income flows are unsustainable, as every financial analyst knows.

Through QE4ever and interest rates subsidies, the Fed is hoping for real gains from money illusion, much like it tried with an inflationary bias in the 1970s with the Philips Curve. The ultimate consequences are hidden at first, but all asset bubbles generated by leveraged credit are built on hot air, overconfidence, and moral hazard. When the tipping point is reached the subsequent busts explode like a pin-pricked party balloon.

Our anemic jobless recovery reflects the fact that prices have been distorted for more than a decade while the time value of money has been driven to zero and held there by a feckless monetary policy. Asset speculation has benefited to the detriment of work, saving, and investment. This cannot end well and Mr. Bernanke has proven again and again that he is no sage when it comes to predicting and managing the future.