Some analysts noted that the Fed has lost credibility. But perhaps traders have just had too much faith in the omniscience of central bankers all along. They don’t have a crystal ball and are apparently as vulnerable as anyone else to misreading economic tea leaves. There is no corner on certainty in an uncertain world.
In the last 30 years, the FED has been good at only one thing and that is creating bubbles. Greenspan started them, handed off to Bernanke who then handed off to Yellen. One double talking FED chair after another seeking to destroy the middle class under the guise of ‘this is good for you.’ Financial engineering is reaching epidemic proportions while destroying everything in its path.
U.S. economic growth between January and March was 0.8% compared to the same time frame a year ago. That’s better than the initial estimate of 0.5%, which came in April, but still pretty sluggish.
Job creation tumbled in May, with the economy adding just 38,000 positions, casting doubt on hopes for a stronger economic recovery as well as a Fed rate hike this summer.
The Labor Department also reported Friday that the headline unemployment fell to 4.7 percent. That rate does not include those who did not actively look for employment during the month or the underemployed who were working part time for economic reasons. A more encompassing rate that includes those groups held steady at 9.7 percent.
The drop in the unemployment rate was primarily due to a decline in the labor force participation rate, which fell to a 2016 low of 62.6 percent, a level near a four-decade low. The number of Americans not in the labor force surged to a record 94.7 million, an increase of 664,000.
We’ve been predicting such disappointing results of ineffectual monetary and fiscal policies since this blog began back in August of 2011. And providing corroborating evidence along the way. Yet our policy experts continue to double-down on failed policies.
The problem is that when a nation inflates asset bubbles like we did with commodities, houses, stocks, and bonds over the past 20 years, there is no silver-lining policy correction that does not involve some economic pain for the body politic. We had that awakening in 2008, but since then we have merely jumped on the same train by pumping out cheap credit for 8+ years.
Perhaps a medical metaphor works here. When prescribing antibiotics to combat an infection one can use small doses to avoid side-effects or one large overkill dose to knock-out the offending bacteria. The first treatment is the conservative, prudent approach that seeks a gradual recovery. The second risks a sudden shock to the system that kills off the infection so the patient can begin healing.
In medicine we’ve discovered that the gradual treatment can enable the bacteria to evolve and resist the antibiotics, making them ineffectual. In a nutshell, this is what we have done with economic policy, especially monetary policy that has distorted interest rates for more than 15 years.
The conservative approach marked by bailouts and government bail-ins has kept the patient flat on his back for 8 years. The more disciplined approach would have shocked the economy severely but gotten the patient out of the recovery room much quicker. We’ve seen that with other countries, like Iceland, that were forced to swallow their medicine in one quick dose.
But, of course, that would have meant a lot of politicians would have lost their cozy jobs. That may happen anyway after the next election.
In fact, the combination of pumping-up inflation toward 2% and hammering-down interest rates to the so-called zero bound is economically lethal. The former destroys the purchasing power of main street wages while the latter strip mines capital from business and channels it into Wall Street financial engineering and the inflation of stock prices.
In the case of the 2% inflation target, even if it was good for the general economy, which it most assuredly is not, it’s a horrible curse on flyover America. That’s because its nominal pay levels are set on the margin by labor costs in the export factories of China and the EM and the service sector outsourcing shops in India and its imitators.
Accordingly, wage earners actually need zero or even negative CPI’s to maximize the value of pay envelopes constrained by global competition. Indeed, in a world where the global labor market is deflating wage levels, the last thing main street needs is a central bank fanatically seeking to pump up the cost of living.
So why do the geniuses domiciled in the Eccles Building not see something that obvious?
The short answer is they are trapped in a 50-year old intellectual time warp that presumes that the US economy is more or less a closed system. Call it the Keynesian bathtub theory of macroeconomics and you have succinctly described the primitive architecture of the thing.
According to this fossilized worldview, monetary policy must drive interest rates ever lower in order to elicit more borrowing and aggregate spending. And then authorities must rinse and repeat this monetary “stimulus” until the bathtub of “potential GDP” is filled up to the brim.
Moreover, as the economy moves close to the economic bathtub’s brim or full employment GDP, labor allegedly becomes scarcer, thereby causing employers to bid up wage rates. Indeed, at full employment and 2% inflation wages will purportedly rise much faster than consumer prices, permitting real wage rates to rise and living standards to increase.
Except it doesn’t remotely work that way because the US economy is blessed with a decent measure of free trade in goods and services and virtually no restrictions on the flow of capital and short-term financial assets. That is, the Fed can’t fill up the economic bathtub with aggregate demand because it functions in a radically open system where incremental demand is as likely to be satisfied by off-shore goods and services as by domestic production.
This leakage through the bathtub’s side portals into the global economy, in turn, means that the Fed’s 2% inflation and full employment quest can’t cause domestic wage rates to rev-up, either. Incremental demands for labor hours, on the margin, are as likely to be met from the rice paddies of China as the purportedly diminishing cue of idle domestic workers.
Indeed, there has never been a theory so wrong-headed. And yet the financial commentariat, which embraces the Fed’s misbegotten bathtub economics model hook, line and sinker, disdains Donald Trump because his economic ideas are allegedly so primitive!
The irony of the matter is especially ripe. Even as the Fed leans harder into its misbegotten inflation campaign it is drastically mis-measuring its target, meaning that flyover American is getting an extra dose of punishment.
On the one hand, real inflation where main street households live has been clocking in at over 3% for most of this century. At the same time, the Fed’s faulty measuring stick has led it to keep interest pinned to the zero bound for 89 straight months, thereby fueling the gambling spree in the Wall Street casino. The baleful consequence is that more and more capital has been diverted to financial engineering rather than equipping main street workers with productive capital equipment.
As we indicated in Part 1, even the Fed’s preferred inflation measuring stick——the PCE deflator less food and energy—has risen at a 1.7% rate for the last 16 years and 1.5% during the 6 years. Yet while it obsesses about a trivial miss that can not be meaningful in the context of an open economy, it fails to note that actual main street inflation—led by the four horseman of food, energy, medical and housing—–has been running at 3.1% per annum since the turn of the century.
After 16 years the annual gap, of course, has ballooned into a chasm. As shown in the graph, the consumer price level faced by flyover America is now actually 35% higher than what the Fed’s yardstick shows to the case.
Stated differently, main street households are not whooping up the spending storm that our monetary central planners have ordained because they don’t have the loot. Their real purchasing power has been tapped out.
To be sure, real growth and prosperity stems from the supply-side ingredients of labor, enterprise, capital and production, not the hoary myth that consumer spending is the fount of wealth. Still, the Fed has been consistently and almost comically wrong in its GDP growth projections because the expected surge in wages and consumer spending hasn’t happened.
Martin Feldstein is nowhere near as excitable as David Stockman on Fed manipulations (link to D.S.’s commentary), but they both end up at the same place: the enormous risks we are sowing with abnormal monetary policies. The economy is not nearly as healthy as the Fed would like, but pockets of the economy are bubbling up while other pockets are still deflating. There is a correlation relationship, probably causal.
The problem with “inflation targeting” is that bubble economics warps relative prices and so the correction must drive some prices down and others up. In other words, massive relative price corrections are called for. But inflation targeting targets the general price level as measured by biased sample statistics – so if the Fed is trying to prop up prices that previously bubbled up and need to decline, such as housing and stocks, they are pushing against a correction. The obvious problem has been these debt-driven asset prices, like stocks, government bonds, and real estate. In the meantime, we get no new investment that would increase labor demand.
The global economy needs to absorb the negative in order to spread the positive consequences of these easy central bank policies. The time is now because who knows what happens after the turmoil of the US POTUS election?
Ending the Fed’s Inflation Fixation
The focus is misplaced—and because it delays an overdue interest-rate rise, it is also dangerous.
By MARTIN FELDSTEIN
The Wall Street Journal, May 17, 2016 7:02 p.m. ET
The primary role of the Federal Reserve and other central banks should be to prevent high rates of inflation. The double-digit inflation rates of the late 1970s and early ’80s were a destructive and frightening experience that could have been avoided by better monetary policy in the previous decade. Fortunately, the Fed’s tighter monetary policy under Paul Volcker brought the inflation rate down and set the stage for a strong economic recovery during the Reagan years.
The Federal Reserve has two congressionally mandated policy goals: “full employment” and “price stability.” The current unemployment rate of 5% means that the economy is essentially at full employment, very close to the 4.8% unemployment rate that the members of the Fed’s Open Market Committee say is the lowest sustainable rate of unemployment.
For price stability, the Fed since 2012 has interpreted its mandate as a long-term inflation rate of 2%. Although it has achieved full employment, the Fed continues to maintain excessively low interest rates in order to move toward its inflation target. This has created substantial risks that could lead to another financial crisis and economic downturn.
The Fed did raise the federal-funds rate by 0.25 percentage points in December, but interest rates remain excessively low and are still driving investors and lenders to take unsound risks to reach for yield, leading to a serious mispricing of assets. The S&P 500 price-earnings ratio is more than 50% above its historic average. Commercial real estate is priced as if low bond yields will last forever. Banks and other lenders are lending to lower quality borrowers and making loans with fewer conditions.
When interest rates return to normal there will be substantial losses to investors, lenders and borrowers. The adverse impact on the overall economy could be very serious.
A fundamental problem with an explicit inflation target is the difficulty of knowing if it has been hit. The index of consumer prices that the Fed targets should in principle measure how much more it costs to buy goods and services that create the same value for consumers as the goods and services that they bought the year before. Estimating that cost would be an easy task for the national income statisticians if consumers bought the same things year after year. But the things that we buy are continually evolving, with improvements in quality and with the introduction of new goods and services. These changes imply that our dollars buy goods and services with greater value year after year.
Adjusting the price index for these changes is an impossibly difficult task. The methods used by the Bureau of Labor Statistics fail to capture the extent of quality improvements and don’t even try to capture the value created by new goods and services.
The true value of the national income is therefore rising faster than the official estimates of real gross domestic product and real incomes imply. For the same reason, the official measure of inflation overstates the increase in the true cost of the goods and services that consumers buy. If the official measure of inflation were 1%, the true cost of buying goods and services that create the same value to consumers may have actually declined. The true rate of inflation could be minus 1% or minus 3% or minus 5%. There is simply no way to know.
With a margin of error that large, it makes no sense to focus monetary policy on trying to hit a precise inflation target. The problem that consumers care about and that should be the subject of Fed policy is avoiding a return to the rapidly rising inflation that took measured inflation from less than 2% in 1965 to 5% in 1970 and to more than 12% in 1980.
Although we cannot know the true rate of inflation at any time, we can see if the measured inflation rate starts rising rapidly. If that happens, it would be a sign that true inflation is also rising because of excess demand in product and labor markets. That would be an indication that the Fed should be tightening monetary policy.
The situation today in which the official inflation rate is close to zero implies that the true inflation rate is now less than zero. Fortunately this doesn’t create the kind of deflation problem that would occur if households’ money incomes were falling. If that occurred, households would cut back on spending, leading to declines in overall demand and a possible downward spiral in prices and economic activity.
Not only are nominal wages and incomes not falling in the U.S. now, they are rising at about 2% a year. The negative true inflation rate means that true real incomes are rising more rapidly than the official statistics imply. [Sounds good, huh? Not quite. Read Stockman’s analysis.]
The Federal Reserve should now eliminate the explicit inflation target policy that it adopted less than five years ago. The Fed should instead emphasize its commitment to avoiding both high inflation and declining nominal wages. That would permit it to raise interest rates more rapidly today and to pursue a sounder monetary policy in the years ahead.
Somehow we cling to the hope that debt on our side of the world works differently than debt on the other side of the world. And then we wonder why GDP constantly falters and consumer spending is so reticent.
Beijing can rely only on stimulus. Extraordinary spending in March produced only a one-month bump—and that blip came at a high price. The government in March piled up debt at least four times faster than it created nominal GDP…eventually rapid credit creation must produce a disaster. Already, the country’s debt-to-GDP ratio is well north of 300 percent…
by Gordon G. Chang
After a near-disastrous start to the year and a one-month recovery in March, the Chinese economy looks like it’s now headed in the wrong direction again. The first indications from April show the country was unable to sustain upward momentum.
Even before the first dreadful numbers for last month were released, Anne Stevenson-Yang of J Capital Research termed the uptick the “Dead Panda Bounce.”
The economy is essentially moribund as there is not much that can stop the ongoing slide. A contraction is certain, and a severe adjustment downward—in common parlance, a crash—looks likely.
At the moment, China appears healthy. The official National Bureau of Statistics reported that growth in the first calendar quarter of this year was 6.7 percent. That is just a smidgen off 6.9 percent, the figure for all of last year. Moreover, the quarterly result cleared the bottom of the range of Premier Li Keqiang’s growth target for this year, 6.5 percent.
The first-quarter 6.7 percent was too good to be true, however. And there are two reasons why we should be particularly alarmed.
First, China’s statisticians appear to be just making the numbers up. For the first time since 2010, when it began providing quarter-on-quarter data, NBS did not release a quarter-on-quarter figure alongside the year-on-year one. And when NBS got around to releasing the quarter-on-quarter number, it did not match the year-on-year figure it had previously reported.
NBS’s 1.1 percent quarter-on-quarter figure for Q1, when annualized, produces only 4.5 percent growth for the year. That’s a long distance from the 6.7 percent year-on-year growth that NBS reported for the quarter.
Even China’s own technocrats do not believe their own numbers. Fraser Howie, the coauthor of the acclaimed Red Capitalism, notes that the chief of a large European insurance company, who had just been in meetings with the People’s Bank of China, said that even the Chinese officials were joking and laughing in derision when they talked about official reports showing 6 percent growth.
Second, the central government simply turned on the money taps, flooding the economy with “gobs of new debt,” as the Wall Street Journal labeled the deluge.
The surge in lending was one for the record books. Credit growth in Q1 was more than twice that in the previous quarter. China created almost $1 trillion in new credit during the quarter, the largest quarterly increase in history. [The Fed has created $3.5+ trillion and counting during our non-recovery.]
Of course, Chinese banks tend to splurge in Q1 when they get new annual quotas, but this year’s lending exceeded all expectations.
The Ministry of Finance also did its part to refloat the economy. Its figures show that in March, the central government’s revenue increased 7.1 percent while spending soared 20.1 percent.
All that money produced good results—for one month. In April, the downturn continued. Exports, in dollar terms, fell 1.8 percent from the same month last year, and imports tumbled 10.9 percent. Both underperformed consensus estimates. A Reuters poll, for instance, predicted that exports would decline only 0.1 percent, while imports would fall 5 percent.
Exports have now dropped in nine of the last ten months, and imports, considered a vital sign of domestic demand, have fallen for eighteen straight months.
Both figures show a marked deterioration from March, when exports jumped 11.5 percent and imports fell 7.6 percent.
The trade figures followed extremely disappointing surveys of the manufacturing sector. The official Purchasing Managers’ Index came in at 50.1, down from March’s 50.2, barely above the 50.0 that divides expansion from contraction.
The widely followed Caixin survey registered at 49.4, down from March’s 49.7. April was the fourteenth straight month of contraction in this more representative—and far more reliable—survey.
Beijing will release additional numbers in the next two weeks, but its reported figures—especially those showing consumer prices, retail sales and industrial output—have obviously become less accurate in recent months. By now, with the first indications for April, it’s clear the economy did not turn the March spike into a recovery.
That has grave implications for Beijing, as Chinese technocrats have evidently lost control of the economy. For one thing, they are no longer helped by strong external demand, and there is little prospect of relief in coming months. As Zhou Hao of Commerzbank told the Wall Street Journal, “China is on its own.”
And alone, Beijing can rely only on stimulus. Extraordinary spending in March produced only a one-month bump—and that blip came at a high price. The government in March piled up debt at least four times faster than it created nominal GDP.
Although debt does not work the same way in China’s state-directed economy as it does in freer ones, eventually rapid credit creation must produce a disaster. Already, the country’s debt-to-GDP ratio is well north of 300 percent, as Barron’s, referring to Victor Shih’s calculations, notes. Soros in January said the ratio could be as high as 350 percent, and Orient Capital Research in Hong Kong suggests 400 percent.
Whatever it is, China is just about at the limits of the debt it can bear, as growing defaults—and a stark warning from the Communist Party itself on Monday—indicate.
There are many problems, but state firms, backed by Beijing’s spend-like-there’s-no-tomorrow approach, are investing capital, and private ones are not. Leland Miller and Derek Scissors note that their China Beige Book survey of 2,200 Chinese businesses shows that in the first quarter, capital expenditure by lumbering state firms was “stable from a year ago” while private companies “cut back substantially.”
That is an issue because virtually no one thinks an even bigger state sector is a good idea. Yet Chinese leaders have opted for one because, as a practical matter, they have no choice. Structural economic reform, which everyone knows is necessary, would lower growth rates too far, well below zero. That’s politically unacceptable, so they continue with a strategy that must result in a crash, simply because it buys time.
It is no coincidence that Chinese leaders are now pressuring analysts and others to brighten their forecasts and not report dour news, to show zhengnengliang—“positive energy”—a sure indication Beijing has run out of real options.
China, therefore, has passed not only an inflection point but also the point of no return. There are no longer off ramps on the road leading over the cliff.
And that thud you just heard when the first April numbers were issued? That was the big black-and-white bear hitting the floor.
[IllustratIon: Martin Kozlowski]
The rabbi and philosopher Shimon Green, founder of the Bircas Hatorah center in Jerusalem for the study of ancient wisdom, has observed that the fear of zombies is cross-cultural: “The fear stems from our own fear of living hopeless lives…a fear that our lives are nonproductive, and that we are the walking dead.”
Many fear that the U.S. economy is “the walking dead”—that the economy is a charade produced by an elixir of low interest rates administered by the Federal Reserve. In an effort partly intended to dispel that fear, the Fed raised the federal-funds rate in December.
With inflation languishing below its 2% target, the Fed began a process of interest-rate normalization, thereby demonstrating confidence in the economy. Raising the fed-funds rate was supposed to encourage expectations of higher growth, which resulted, in part, from the Fed’s recognition of considerable improvements in labor markets.
When the Fed raised rates, it said it was reasonably confident that inflation would rise to meet its objective, describing the impact of energy prices as transitory and predicting that they would pick up in 2016.
While 2016 got off to a rocky start with oil and stock prices declining, both have rebounded and are now trading at levels comparable to December. The Fed continues to project confidence, and the Federal Open Market Committee recently announced that it is on course to continue to raise rates.
The official dot plot of members’ expectations shows that they expect two rate hikes in 2016 and a fed-funds rate of 3% by mid-2018. This contradicts market expectations for a more muted path forward.
While the Fed sends a message of confidence, pointing to decreases in unemployment, a pickup in average hourly earnings, and core consumer-price-index inflation exceeding 2%, it is aware that inflation continues to run below its longer-run objective.
The Fed is also mindful of the potential for adverse shocks that could derail the economy. The International Monetary Fund last week lowered its global growth forecast, saying that the sluggish pace of growth leaves the world economy more exposed to risks.
The Fed needs to remain accommodative while continuing to raise the fed-funds rate. While that rate is a short-term one charged between banks for overnight money, longer rates have the greatest impact on asset purchases (like buying a home).
Thus, the Fed pursued quantitative easing, purchasing longer-term securities to directly lower long-term yields. It intended to encourage growth more directly.
The QE program effectively ended in 2014, but longer-term rates have continued to decline. Since the Fed raised fed-funds rates in December, 30-year yields have gone down from 3% to 2.5%.
THUS THE END OF QE and a rising fed-funds rate do not necessarily spell the end of easy money. The Fed continues to buy long bonds by reinvesting principal and interest from its maturing securities. Its balance sheet is about $4.5 trillion, of which approximately $1.5 trillion matures in fewer than seven years.
An oft-overlooked paragraph in FOMC statements promises to continue the reinvesting until the normalization of federal funds is “well under way.”
It is no surprise that the Fed’s balance sheet grew for over a year after QE ended. Reinvestment can keep pressure on longer-term rates as the Fed deploys its reinvestment across the curve. Its role in monetary policy will grow as short-dated bonds mature.
The Fed’s reinvestment policy is vital, considering the impact of rising rates and a shrinking balance sheet on fiscal policy. In 2007, the government paid $430 billion in interest on $9 trillion of debt. In 2015, the total interest paid on $19 trillion was about $402 billion. Like many Americans, Treasury has more debt and pays less interest.
If that is not enough to encourage the Fed to keep interest rates low, consider that Treasury effectively pays zero interest on T-bonds that the Fed keeps on its balance sheet (most of the interest Treasury pays to the Fed is given back to Treasury as profit). Higher rates and a shrinking balance would certainly create new burdens that might not be offset by economic growth.
Fiscal realities and the fear of adverse economic shocks drive the Fed to keep long rates lower. Vice Chairman Stanley Fischer recently said a larger balance sheet is accommodative and reduces risks to the economy. This would explain why the yield curve has flattened since December, as the market digested the distinction between higher fed-funds rates and an easy long-rate policy.
Raising the fed-funds rate demonstrates confidence in the economy; lowering long-term rates may be what is necessary to make that perception a reality. Former Fed Chairman Ben Bernanke recently described longer-term “rate targeting” as a possible tool that the Fed could use to stimulate growth. With rate targeting, the Fed would peg long-term interest rates while creating a ceiling for long-term Treasury debt. Though he declared that such an “exotic” approach is not likely in the foreseeable future, he pointed out that “public beliefs about these tools may influence expectations.”
If the Fed continues to emphasize that it will be reinvesting in long bonds for some time, it can change public perception of rising short rates to navigate long rates lower without using exotic tools. On the path to normalization, the Fed then would maintain the flexibility to raise the fed-funds rate while keeping long rates low. [So we move into an inverted yield curve? That is supposed to signal tightening credit.]
Such an accommodative stance would help our economy grow while relieving some of the fiscal pressure. This is how the Fed’s balance sheet can buy time until we arrive at a point where the inflation data confirm that we are not zombies after all. [So, inflation is going to save us? Why, instead, does a little deflation scare the Fed so much? Because we are over-leveraged with cheap credit?]
From an interview of Bill Gross in Barron’s:
You have taken central bankers to task for impotence and ignorance, among other sins. In particular, you have written that Fed Chair Janet Yellen and others are ignorant of the harm done by their policies “to a classical economic model that has driven prosperity.” Just what did you mean, and what sorts of dangers do we face?
The Federal Reserve was created in 1913. President Nixon took the U.S. off the gold standard in 1971. For the past 40-plus years, central banks have been able to print as much money as they wanted, and they have. When I started at Pimco in 1971, the amount of credit outstanding in the U.S., including mortgages, business debt, and government debt, was $1 trillion. Now it’s $58 trillion. Credit growth, at least in its earlier stages, can be very productive. For all the faults of Fannie Mae and Freddie Mac, the securitization of mortgages lowered interest rates and enabled people to buy homes. But when credit reaches the point of satiation, it doesn’t do what it did before.
Think of the old Monty Python movie, The Meaning of Life. A grotesque, rotund guy keeps eating to demonstrate the negatives of gluttony, and finally is offered one last thing, a “wafer-thin mint.” He swallows it and explodes. It’s pretty funny. Is our financial system, with $58 trillion of credit, to the point of a wafer-thin mint? Probably not. But we’re to the point where every bite is less and less fulfilling. Even though credit isn’t being created as rapidly as in the past, it doesn’t do what it did before.
Central banks believe that the historical model of raising interest rates to dampen inflation and lowering rates to invigorate the economy is still a functional model. The experience of the past five years, and maybe the past 15 or 20 in Japan, has shown this isn’t the case.
So where does that leave our economy?
In the developed financial economies, as a bloc, lowering interest rates to near zero has produced negative consequences. The best examples of this include the business models of insurance companies and pension funds. Insurers have long-term liabilities and base their death benefits, and even health benefits, on earning a certain rate of interest on their premium dollars. When that rate is zero or close to it, their model is destroyed.
To use another example, California bases its current and future pension payments to civil workers on an estimated future return of 8% or so from bonds and stocks. But when bonds return 1% or 2%, or nothing in Germany’s case, what happens? We’ve seen the difficulties that Puerto Rico, Detroit, and Illinois have faced paying their debts.
Now consider mom and pop and other people who read Barron’s. They are saving for retirement and to put their kids through college. They might have depended on a historic 8%-like return from stocks and bonds. Well, sorry. When interest rates get to zero—and that isn’t the endpoint; they could go negative—savers are destroyed. And savers are the bedrock of capitalism. Savers allow investment, and investment produces growth.
Are you suggesting a recession looms?
No. I see very slow growth. In the U.S., instead of 3% economic growth, we have 2%. In euroland, instead of 2%, growth is 1%-plus. In Japan, they hope for anything above zero.
What governments want, and what central banks are trying to do, is produce, in addition to minimal growth, a semblance of inflation. Inflating is one way to get out from under all the debt that has been accumulated. It isn’t working, because with interest rates at zero, companies and individual savers sense the futility of taking on risk. In this case, the mint eater doesn’t explode, but the system sort of grinds to a halt.
It doesn’t look like anything is grinding to a halt around here. You can see gorgeous golf courses from one window and a yacht basin from the other.
This isn’t the real economy. It is Disneyland and Hollywood. It is finance-based prosperity, based on money that doesn’t produce anything anymore because yields are so low.
Even in a negative-rate environment, as in Germany or Switzerland, banks and big insurance companies have little choice but to park their money electronically with the central bank and pay 50 basis points. But an individual can say “give me back my money” and keep it in cash. That’s what would make the system implode. I’m not talking about millionaires or Newport Beach–aires, but people with $25,000 or $50,000. Without deposits, banks can’t make loans anymore, so the system starts to collapse.
Let’s say Yellen steps down and President Obama appoints you the new head of the Fed. What would you do differently?
What you’re really asking is: What is the way out? The way out is a little bit of pain over a relatively long period of time. That is a problem for politicians and central bankers who are concerned with their legacy. It means raising interest rates and returning the savings function to normal. The Fed speaks of normalizing the yield curve but knows it can’t go too fast. A 25-basis-point increase [in the federal-funds rate] in December had consequences in terms of strengthening the dollar and hurting emerging markets.
Will the Fed raise rates this year?
Yes, as long as the stock market permits it. They have to normalize interest rates over a period of two, three, four years, or the domestic and global economy won’t function. In today’s world, normalization would mean a 2% fed-funds rate, a 3.5% yield on the 10-year bond, and a 4.5% mortgage rate. Would this create some pain? Of course. Housing prices probably would stop rising, and might fall a bit. The Fed has to move gradually.
What will be the 10-year Treasury yield at the end of 2016?
Close to what it yields now. I expect the Fed to raise rates once or twice this year. That would put the fed-funds rate at 1%. Does the 10-year deserve to yield 1.90% with fed funds at 1%? Yes, so long as inflation is 2% or less. If the Fed raises rates, the euro and yen could weaken. That would mean rates in Europe and Japan don’t have to go negative, or to extreme lows. In a sense, the Fed is driving everything. But it can’t raise rates too much without threatening a country like Brazil, whose corporations have tons of dollar-dominated debt.
What will the global economy look like in five or 10 years?
Structurally, demographics are a problem for global growth. The developed world is aging, with Japan the best example. Italy is another good example, and Germany is a good, old society, too. As baby boomers get older, they spend less and less. But capitalism has been based on an ever-expanding number of people. It needs consumers.
Another thing happening is deglobalization, whether it’s Donald Trump building a wall to keep out Mexicans, or European nations putting up fences to keep out migrants. Larry Summers [former secretary of the Treasury] has talked about secular stagnation, or a condition of little or no economic growth. At Pimco, I used the term “the new normal” to refer to this condition. It all adds up, again, to very slow growth. The days of 3% and 4% annual growth are gone.
An All Too Visible Hand
When Wilson signed the Federal Reserve Act into law in 1913, the very idea of a macroeconomy—something to be measured and managed—was yet to be invented
The Federal Reserve is America’s problem and the world’s obsession. When will Janet Yellen choose to lift the federal-funds rate from its longtime resting place of zero, thereby upending or not upending (it depends on whom you ask) individuals and markets in all four corners of the earth? Her subjects await a sign. While tapping their feet, they may ponder how things ever came to this pass. How, indeed, did such all-powerful body come into existence in the first place—and why?
Roger Lowenstein’s “America’s Bank,” which chronicles the passage of the 1913 Federal Reserve Act, is victor’s history. Its worldview is that of today’s central bankers, the bailers-out of markets, suppressors of interest rates and practitioners of money conjuring. In Mr. Lowenstein’s telling, what preceded the coming of the Federal Reserve was a financial and monetary dark age. What followed was the truth and the light.
It sticks in the craw of good Democrats that, in 1832, their own Andrew Jackson vetoed the rechartering of the Second Bank of the United States, the predecessor of the Federal Reserve. Just as galling is the fact that Old Hickory’s veto message is today counted as one of America’s great state papers. In it, Jackson denies to Congress the power to delegate its constitutionally given duty to “coin money and regulate the value thereof.” To do so, Jackson affirmed, would render the Constitution a “dead letter.”
By Roger Lowenstein
Mr. Lowenstein contends that, in the creation of the Federal Reserve 80 years later, Congress and the people commendably put that hard-money Jacksonian claptrap behind them. Mandarin rule is the way forward in monetary policy, he suggests—the Ph.D. standard, as one might call it, under which former tenured economics faculty exercise vast discretionary power over the value of money and the course of interest rates, financial markets and business activity. Give Mr. Lowenstein this much: As the world awaits the raising of the Fed’s minuscule interest rate, the questions he provokes have never been timelier. Not for the first time the thoughtful citizen must wonder: What’s money and who says so?
When Woodrow Wilson signed the Federal Reserve Act into law in 1913, the dollar was defined as a weight of gold. You could exchange the paper for the metal, and vice versa, at a fixed and statutory rate. The stockholders of nationally chartered banks were responsible for the solvency of the institutions in which they owned a fractional interest. The average level of prices could fall, as it had done in the final decades of the 19th century, or rise, as it had begun to do in the early 20th, without inciting countermeasures to arrest the change and return the price level to some supposed desirable average. The very idea of a macroeconomy—something to be measured and managed—was uninvented. Who or what was in charge of American finance? Principally, Adam Smith’s invisible hand.
How well could such a primitive system have possibly functioned? In “The New York Money Market and the Finance of Trade, 1900-1913,” a scholarly study published in 1969, the British economist C.A.E. Goodhart concluded thus: “On the basis of its record, the financial system as constituted in the years 1900-1913 must be considered to have been successful to an extent rarely equalled in the United States.”
The belle epoque was not to be confused with paradise, of course. The Panic of 1907 was a national embarrassment. There were too many small banks for which no real diversification, of either assets or liabilities, was possible. The Treasury Department was wont to throw its considerable resources into the money market to effect an artificial reduction in interest rates—in this manner substituting a very visible hand for the other kind.
Mr. Lowenstein has written long and well on contemporary financial topics in such books as “When Genius Failed” (2000) and “While America Aged” (2008). Here he seems to forget that the past is a foreign country. “Throughout the latter half of the nineteenth century and into the early twentieth,” he contends, “the United States—alone among the industrial powers—suffered a continual spate of financial panics, bank runs, money shortages and, indeed, full-blown depressions.”
If this were even half correct, American history would have taken a hard left turn. For instance, William Jennings Bryan, arch-inflationist of the Populist Era, would not have lost the presidency on three occasions. Had he beaten William McKinley in 1896, he would very likely have signed a silver-standard act into law, sparking inflation by cheapening the currency. As it was, President McKinley signed the Gold Standard Act of 1900, which wrote the gold dollar into the statute books.
The doctrine that interest rates are the Federal Reserve’s to manage has come to be regarded, at least by the mandarins, as settled science. It was not so when the heroes of Mr. Lowenstein’s story were conspiring to create a new central bank. Abram Piatt Andrew Jr. took to the scholarly journals to denounce the government’s attempts to pin down money-market interest rates.
Indiana-born, Andrew came East to study, taught economics at Harvard and lent his talents to the National Monetary Commission in 1909 and 1910—the group that conducted the field work to prepare for the grand banking reform. Somewhere along the line, he conceived the idea that the money market should be free of federal manipulation. As prices had been rising—a gentle inflation had begun just before the turn of the 20th century—interest rates should have followed prices higher. That they did not was the complaint that Andrew laid at the doorstep of the government.
Andrew contended that the Treasury Department—under Lyman J. Gage, who served from 1897 to 1902, and his successor, Leslie M. Shaw, who resigned in 1907—“succeeded in keeping the money rate of interest below the rate which would have been ‘normal’ or ‘natural.’ . . . They had kept alive a continuously excessive demand for credit by making it available at less than the normal cost. They had sown the wind and their successor was to reap the whirlwind.”
It is an indictment that comes ready-written against the Federal Reserve’s policy today. Interest rates are prices. Far better that they be discovered in the marketplace than administered from on high. One has to wonder what Andrew would say if he were spirited back to earth to read a random edition of this newspaper in the seventh year of the Fed’s attempt to create prosperity through the technique of zero-percent interest rates. He might want a quiet word with Ms. Yellen.
Andrew is not the only vivid personality in this tale of unintended consequences. Mr. Lowenstein entertainingly limns a gallery of them: Paul Warburg, a German-banker immigrant eager to import European ideas into his adopted country; Carter Glass, an irritable Virginia newspaperman turned congressman (later senator) and currency reformer; Nelson Aldrich, a suspiciously affluent Rhode Island senator and central-bank exponent; Robert Owen, a former Indian agent from the Oklahoma Territory who pushed the Federal Reserve Act through the Senate; William Gibbs McAdoo Jr., the Treasury secretary who married the boss’s daughter; that boss himself, Woodrow Wilson; and Frank Vanderlip, president of what today is Citigroup.
Vanderlip, not alone among his fellow agitators for a central bank, was keen on the gold standard and “fervent,” as Mr. Lowenstein puts it, in his “denunciations of government control.” Here is a fine piece of irony. Government control is exactly what the authors of the Federal Reserve Act unintentionally achieved, though Andrew, at least, might have anticipated this public-policy reversal. He noticed that, under Leslie Shaw’s meddling stewardship in the early years of the 20th century, the Treasury had shifted government deposits to private institutions in times of crisis. “Outside relief in business, like outdoor charity,” as Mr. Lowenstein quotes him saying, “is apt to diminish the incentives to providence, and to slacken the forces of self-help.”
Centralized government control arrived in force with the Banking Act of 1935. It established the centralization of monetary power within the Federal Reserve Board in Washington, and it repealed the so-called double-liability law on bank stocks: No more would the holders of common stocks in failed banks be assessed to help defray the debts of the institutions in which they had invested. Anyway, there would be precious few failures to deal with, proponents of the new thinking contended. Knowing that the Federal Deposit Insurance Corp. stood behind their money, depositors would give up running; they would rather walk to the bank.
The new doctrines repulsed H. Parker Willis, a key player during the organization of the Fed and later a professor of banking at Columbia University. “It is far better, both for the depositor and the banker,” said Willis of the FDIC, “that the actual net irreducible losses growing out of bank failure should fall where they belong. The universal experience with this kind of insurance—if it may be called—has pointed to the danger of increasing losses as the result of bad banking management induced by belief in deposit guarantee.”
Willis didn’t imagine the half of it. On top of deposit insurance evolved the notion that some banks—Citi, for instance—were too big to fail. They must be nurtured through subsidy and bank-friendly monetary policy: low money-market interest rates, for example. It happened that the Citigroup that evolved from Vanderlip’s National City Bank became a ward of the state in 2008. The massive federal bailout of Citi exacted many costs, including a level of regulatory micromanagement that Vanderlip could not have begun to conceive.
J.P. Morgan Chase, which did not fail in 2008, recently went public to describe the intensity of the federal oversight it labors under. More than 950 employees, it revealed, are dedicated to complying with 750 requirements laid down by 21 government entities to achieve and maintain capital adequacy. The Fed itself is high among those demanding overseers. The workers shuffle 20,000 pages of documentation and manipulate 225 econometric models.
The rage to micromanage spans the world. “It can’t be,” the head of Sweden’s Nordea Bank was quoted forlornly saying last year in the Financial Times, “that the only purpose of banking is to stop banks from going bankrupt.” Oh, yes it can.
One thinks back to the supposed financial dark ages when, in 1842, New Orleans bankers, setting down a kind of operational manifesto, succeeded in committing the essentials of safe and sound banking practice to one side of one page. They prospered by simple maxims—e.g., do what you will with your own capital but do not abuse the depositor’s funds—well after the Civil War. Some may protest that banking has become more complex since those days. The boggling, 23,000-page length of the Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 (complete with supporting rules) would suggest that it has become 23,000 times more complex. I doubt that.
The legislation to which President Wilson affixed his signature in 1913—Mr. Lowenstein observantly notes that he signed with gold pens—included no intimation of the revolutionary techniques of monetary control that would come into being after 2008: zero-percent interest rates, “quantitative easing,” and central-bank-sponsored bull markets in stocks and real estate, among others.
The great value of “America’s Bank” is the comparison it invites between what lawmakers intend and what they achieve. The act’s preamble described a modest effort “to provide for the establishment of the Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper and to establish a more effective supervision of banking in the United States and for other purposes.” “And for other purposes”—our ancestors should have known.
We can distill “inclusive capitalism” down to a single word that captures the concept in its fullest dimensions. That word is EQUITY.
There is a movement afoot called The Coalition for Inclusive Capitalism that counts Prince Charles, Pope Francis, Bill Clinton, and the world’s richest industrialist Carlos Slim among its supporters. Our first reaction to this news might be to ask, “What exactly is meant by the term Inclusive Capitalism?”
The Coalition provides this definition:
“Inclusive Capitalism provides that firms should account for themselves, not just on the bottom line, but on environmental, social, and governance (ESG) metrics… Every firm has a license to operate from the society in which it trades. This is both a legally and socially defined license… Firms must contribute proportionately to the societies in which they operate. Without fairly contributing, firms free-ride on services that other people have paid for. Firms that practice unsustainable activities, disrespect their stakeholders and the communities in which they operate will find their licenses threatened, first by the engaged consumer, then by government. Firms practicing Inclusive Capitalism will see their license strengthened.”
While laudable in its aspirations, operationalizing this value-laden definition poses a few questions and challenges.
First, this definition focuses on firm responsibility according to ESG sustainability metrics and firm performance. In fact, citing studies of corporate performance measures, the IC literature asserts that such practices deliver superior firm performance in terms of profit and market valuations. If true, then market competition should insure the widespread adoption of best practices with the gradual attrition of less profitable, less sustainable firm behavior. In other words, markets should provide sufficient correctives. If they do not, we probably need to question such assumptions that the market is functioning as expected, that it is complete, or that best practices across firms and industries are readily transparent.
Second, one can inadvertently blur the operational differences between public corporations and non-corporate, small business where ESG metrics are more difficult to discern or measure. Since much of capitalism’s innovation, job creation, and business expansion occurs at the small business level, we need to expand the idea of inclusion beyond corporate management practices and stakeholder governance.
Third, the search for an acceptable definition can also put different class segments of society at odds. The British Guardian has already described the Coalition’s efforts as a “Trojan Horse” cynically deployed to placate the public so that crony capitalism can thrive unscathed. Our definition then must not only articulate a vision and a direction, but also gain acceptance and buy-in from all segments of society. In other words, our definition must be “inclusive” in order to mediate conflicts among groups that appear to harbor diverging interests.
Finally, when we probe practitioners we find that different people have different ideas of what Inclusive Capitalism means, so we still lack a consistent and concise definition. Perhaps we can start by eliminating what it is not. It’s more than just corporate social responsibility (CSR) or ESG sustainability. It’s not defined by charity, philanthropy, or noblesse oblige. It’s more than “people-centered” and not really Robin Hood-style tax and redistribution, or even social welfare.
This is not to declaim or disparage these policies and activities, which in many cases yield positive social and economic results. The problem is that these policies are not really designed to be inclusive; rather they target compensation for past exclusion. In contrast, we should understand that inclusive capitalism seeks to reduce the need for such compensation. Thus, the motivating criterion is bottom-up empowerment, not top-down redirection. For example, inclusive capitalism is less about artificially raising wages, and more about creating the demand for and utilization of labor where a minimum or living wage becomes a moot issue.
With this objective, I believe we can distill “inclusive capitalism” down to a single word that captures the concept in its fullest dimensions. That word is EQUITY. Why equity? Because the multiple meanings and usage of the word “equity” expand the idea into every realm of a free society: political equity in terms of democratic participation, legal equity in terms of rights and accountability, moral equity in terms of justice, and economic equity in terms of capital ownership structures, control, risk, and reward. A free society that lacks any one of these dimensions of equity is in need of repair.
Naturally, the focus of the term “inclusive capitalism” applies primarily to economic equity, begging the next question of how we define and understand economic equity. This can be problematic because a moral precept of equity as “fairness” is not definitive. In other words, What is economically fair? is a question that cannot really be answered objectively. In economic relations, equity implies a linkage between action and consequence; in finance we might refer to the direct link between risk and reward. In fact, the financial framework may offer the clearest insight into the logic of economic equity in capitalism.
Economic growth is a result of successful risk-taking and productive work. The rewards of success are, or should be, distributed accordingly. The simplest formulation asserts that capital takes the risks and labor does the work. The distributional outcomes of success or failure are then perceived as a protracted conflict between capital and labor over issues of equity. I would argue this conflict is misconstrued.
The linkage between risk and reward is inter-temporal. In other words, financial risks are assigned and taken before the enterprise is engaged: capital is borrowed and invested, suppliers are paid, and labor is contracted. The payment contracts reflect a complex web of legal relations and covenants that stipulate the assignment of liabilities and the seniority of claims over the product after it has been produced and, hopefully, sold. The liability risks of all participants are encoded in these contracts. After standard accounting practices measure the results, the returns to success or the losses of failure are distributed accordingly.
In starkest terms: In capitalism, she who takes the risk, gets the reward (or the loss). We can see the importance of residual claimancy over the profits of the enterprise. Under most corporate legal covenants, these profits accrue to “equity holders,” also referred to as shareholders or owners of firm assets. We should note the usage of that word “equity.”
Inclusive capitalism warrants “inclusion” in the profit-making enterprise of capitalism, which by legal necessity requires contractual claims on residual profits as well as the assumption of liabilities for loss. To control the financial risks associated with these liabilities, the corporate charter was deliberately designed to limit liability to the liquidation value of the firm’s assets.
Some correctly make the argument that wider stakeholders in capitalism (those without ownership claims) have rights that should be reflected in the governance of capitalist enterprise. An example might be a community downriver that suffers water contamination from a producer upstream. Economic externalities, such as environmental degradation, are important considerations for inclusion. Politically imposed regulation can be one means of asserting stakeholders’ interests, but the preferred strategy would be to assign stakeholder claims through the accepted legal structures of ownership and control. In other words, stakeholders should be represented as the voice of shareholders participating as owners in capitalist enterprise. In this way, stakeholders assert their interests and can also claim the material benefits of success, i.e., profits.
Thus, inclusive capitalism explicitly requires inclusion in the economic system as “capitalists,” as well as workers. This all can be as simple as being a passive shareholder. This begs the penultimate question of why, in a capitalist economy, we are not all striving to be capitalists? Alternatively, we might ask: Why is economic inclusion so elusive?
I believe this is where the discussion of inclusive capitalism gets interesting. The answers hinge on the risk-taking nature of capitalist enterprise juxtaposed against the risk-averse, loss-averse behavior dictated by our natural survival instinct. There is a selective bias among successful capitalists to perceive a natural order of things whereby some people are natural risk-taking innovators, while others are not. For them, this “natural order” explains the distribution of success in a capitalist society. The elitist bias can reveal itself in attitudes of paternalism and noblesse oblige.
This perspective is largely the product of a theoretical approach to the market economy where participants are grouped by function: producers vs. consumers; employers vs. workers; investors and borrowers vs. savers and lenders; innovators and wealth-creators vs. welfare dependents. When it comes to distributional outcomes, this is a limited analytical paradigm. Let us just consider the risk-takers. Innovators like Bill Gates, Steve Jobs, Jeff Bezos, or Google’s Page and Brin are perhaps one in a million. But each of these immensely successful individuals has been eager to share the risks and returns of their enterprise through the sale of equity in financial markets. The important lesson is not the fact that Gates may have a net worth of more than $30 billion, but that Microsoft (and Apple and Amazon) has enriched thousands of other stakeholders along the way. This is the key to inclusion and we should pay mind to how it is narrowing.
Though risk preferences and animal spirits do vary across the population, economic risk is ubiquitous and borne in some manner by all. As the capitalist risks loss of principal, the worker risks loss of income. The real question is whether the risk-bearers are receiving just compensation commensurate with those risks and whether the risk-takers are also accountable for losses. This is equity in the moral and economic sense of the word. A free society demands that the innocent not pay for the mistakes of the guilty and this applies in capitalist enterprise as well. (Our recent financial bail-outs appear to have violated this moral imperative.)
For inclusion to work, participants in capitalist enterprise must also be empowered to control and manage their risks. Inclusion and participation then becomes a question of enforceable property rights and gets us back to the legal conventions of assigning ownership rights and risks to tangible assets of the firm. In many situations, different stakeholders eschew the risks because they cannot control or manage them, so they pay to have someone else assume them (i.e., sign a labor contract for a lower risk-return profile). Overcoming these impediments to equity participation inherent to the governance issue is the main challenge of inclusion.
Unfortunately, we have many tax and regulatory policies, as well as financial practices and conventions, that contradict the goal of inclusion through equity. Access to credit, debt leverage, collateral requirements, capital and income taxes, conflicts of interest in governance, etc. work to the disadvantage of those who are thereby excluded from the financialization of the economy. A long laundry list of reforms can be offered in this respect, but that is beyond the purview of this effort, which is to first define what we mean by inclusive capitalism.
A more serious challenge is posed by an industrial global economy being transformed by the digital information age, globalization, and AI robotics. Production in the digital age is revealing itself as labor-saving, capital and skill intensive, with winner-take-all product and service markets. Some of the effects we observe are the rise of celebrity branding; the marginalization of wage labor as a distributional mechanism and mode of inclusion; and the explosive growth of wealth concentration enjoyed by those who feed off digital processes—companies like Amazon, Apple, Google, and Facebook. These trends present a dire challenge to the concept of equity and inclusion. It is a challenge that will require far deeper thinking and rethinking of the 21st century economy and how we conceive of a free society. Despite what politicians may promise, I would advise there is no going back.