Book Review: Makers and Takers

Makers and Takers: The Rise of Finance and the Fall of American Business by Rana Foroohar

Crown Business; 1st edition (May 17, 2016)

Ms. Foroohar does a fine job of journalistic reporting here. She identifies many of the failures of the current economic policy regime that has led to the dominance of the financial industry. She follows the logical progression of central bank credit policy to inflate the banking system, that in turn captures democratic politics and policymaking in a vicious cycle of anti-democratic cronyism.

However, her ability to follow the money and power is not matched by an ability to analyze the true cause and effect and thus misguides her proposed solutions. Typical of a journalistic narrative, she identifies certain “culprits” in this story: the bankers and policymakers who favor them. But the true cause of this failed paradigm of easy credit and debt is found in the central bank and monetary policy.

Since 1971 the Western democracies have operated under a global fiat currency regime, where the value of the currencies are based solely on the full faith and credit of the various governments. In the case of the US$, that represents the taxing power of our Federal government in D.C.

The unfortunate reality, based on polling the American people (and Europeans) on trust in government, is that trust in our governmental institutions has plunged from almost 80% in 1964 to less than 20% today. Our 2016 POTUS campaign reflects this deep mistrust in the status quo and the political direction of the country. For good reason. So, what is the value of a dollar if nobody trusts the government to defend it? How does one invest under that uncertainty? You don’t.

One would hope Ms. Foroohar would ask, how did we get here? The essential cause is cheap excess credit, as has been experienced in financial crises all through history. The collapse of Bretton Woods in 1971, when the US repudiated the dollar gold conversion, called the gold peg, has allowed central banks to fund excessive government spending on cheap credit – exploding our debt obligations to the tune of $19 trillion. There seems to be no end in sight as the Federal Reserve promises to write checks without end.

Why has this caused the complete financialization of the economy? Because real economic growth depends on technology and demographics and cannot keep up with 4-6% per year. So the excess credit goes into asset speculation, mostly currency, commodity, and securities trading. This explosion of trading has amped incentives to develop new financial technologies and instruments to trade. Thus, we have the explosion of derivatives trading, which essentially is trading on trading, ad infinitum. Thus, Wall Street finance has come to be dominated by trading and socialized risk-taking rather than investing and private risk management.

After 2001 the central bank decided housing as an asset class was ripe for a boom, and that’s what we got: a debt-fueled bubble that we’ve merely re-inflated since 2008. There is a fundamental value to a house, and in most regions we have far departed from it.

So much money floating through so few hands naturally ends up in the political arena to influence policy going forward. Thus, not only is democratic politics corrupted, but so are any legal regulatory restraints on banking and finance. The simplistic cure of “More regulation!” is belied by the ease with which the bureaucratic regulatory system is captured by powerful interests.

The true problem is the policy paradigm pushed by the consortium of central banks in Europe, Japan, China, and the US. (The Swiss have resisted, but not out of altruism for the poor savers of the world.) Until monetary/credit policy in the free world becomes tethered and disciplined by something more than the promises of politicians and central bankers, we will continue full-speed off the eventual cliff. But our financial masters see this eventuality as a great buying opportunity.

Politics, Economics, and the State of Our World

QE paradox

This is an interesting graphic that not only illustrates the futility of current monetary stimulus (the QE-ZIRP Paradox), but also the larger contradiction we’ve created in the relationship between politics and economics. I’ll explicate how this contradiction also explains Europe’s predicament with Greece and the other periphery countries in Eurozone, and also applies to emerging countries, especially China.

We can envision economics as a boundary of constraints or possibilities on the choices we can make in life. We might call these budgetary constraints, but it also pertains to constraints on growth and expansion. Relate this to personal finance:  economics constrains the choices we have on what kind of house we buy or rent, what cars we drive, what vacations we can take, what schools we attend, etc., etc. Within those constraints we often have many choices and possibilities for trade-offs. We can decide to buy a small house to afford a big car, or a tuition-free school in favor of more exotic vacations. We make these decisions everyday throughout our lifetimes.

The personal choices we make within the constraints of economics are analogous to the social choices we make through democratic politics. So, economics is like the box within which politics can allocate resources by democratic consensus. We can decide on more social welfare, or more national defense, or more leisure time. The irrationality is believing that we can somehow make choices that lie far outside the constraints of economics. Fantasies like we can all fly to the moon, all have a heart transplant, or perhaps live high on the hog without working to produce the necessary prosperity.

Economic constraints and political choices interact, an important dynamic since both are malleable over time. We can make choices that expand the constraints of economics, which would mean an expansion of possibilities through growth. Or we can make choices that shrink the boundaries of the economically possible, reducing our choices in the future. The interesting point to make at this stage of our exposition is that, like the boundaries we set for our children, economic constraints are a disciplinary factor that helps to keep our political choices honest.  In other words, economics disciplines our political choices by penalizing bad choices and rewarding good choices.

This has profound implications for how society works.

One can imagine that one of the major economic constraints on our personal set of choices is the amount of money we have. In other words, the fungible value of our assets and savings. Rich people have fewer economic constraints than poor people. But this supply of money is not fixed and can be augmented by borrowing through the issuance of credit and assumption of debt obligations. So, one can buy a more expensive house by borrowing the necessary funds from a mortgage lender and then paying it back over time. We soon figured out that when the supply of money is too strict, economic constraints are unnecessarily tight, so money supply should adapt to the needs of the political economy.

Thus, we can expand the economic constraints facing society by expanding the supply of money through credit. One might think, “Wow, that was easy. Now we have lots more choices!” And the next thought should be, “Well, what’s the limit on how much money we can create?”

First, we should remember that money is not wealth, it merely represents wealth. When money was backed by gold reserves, the supply of gold limited the amount of money in the system. If  Country A adopted bad policies relative to its trading partner Country B, gold reserves would flow out, threatening the underlying value of Country A’s currency. This would force Country A to correct its policies or risk impoverishment. The exchange rates between currency A and B did not reflect these changes because both were fixed to gold; but the underlying values had obviously changed demanding a revaluation of both currencies relative to gold. While workable, this was a herky-jerky way of adapting to changing economic conditions and resulted in many financial,  economic, and political crises along the way. It took WWI and WWII to finally break away from a gold standard as an economic constraint.

In 1948, the western powers that had been victorious in WWII established an international currency regime (called Bretton Woods) backed by the US$ fixed to gold and a host of institutions to help manage international relations, such as the IMF, the World Bank and the United Nations. Unfortunately, this regime depended on US policy to defend the monetary regime, even when it contradicted US domestic economic interests. With Vietnam war spending and Great Society social spending (guns and butter), too many dollars were created, causing a run on US gold redemptions by countries like France. In 1971, the Bretton Woods system finally broke down as Nixon closed the gold window to redemptions and all currencies began to float in value relative to other currencies. There was now no fixed relationship of the currency to anything of tangible value – its value was established by government fiat. The initial effect was a stagnating economy plus inflation, a decade-long slog in the 1970s that gave birth to the term stagflation.

At the time, it was thought that exchange rate movements would signal necessary policy changes to keep each countries’ political priorities aligned with economic constraints. It turns out this assumption did not hold up to political realities because volatile exchange rates do not necessarily affect domestic economic interests to the point where politicians feel the need to respond. How many of us know or care how the US$ is performing relative to the other currencies of the world? The result was that politically favorable (more for everybody!), but economically detrimental, policies could be pursued, while exchange rate volatility could be largely ignored. Thus, the economic discipline to guide political choices was lost, permitting bad policies to persist. We have seen this in the explosion of credit and debt around the world and the volatility in exchange rates and asset markets.

Now we can see the problem illustrated in the graphic above. Instead of forcing necessary fiscal reform, we end up throwing more monetary stimulus at the problem. The results have been rising inequality, asset booms and busts, and massive resource misallocations that will cost society economically for a long time. On the global stage, China is the poster child of excess. It will all end when we finally hit the wall and throwing more money at the problem no longer works.

Europe, the EU, and Greece.

We can consider another case in Europe where volatile exchange rates after 1971 inhibited trade with unnecessary currency risks and conversion costs. The idea was that a currency union under the euro would greatly expand intra-European trade by eliminating these costs. But a currency union requires consistent monetary and fiscal policy and a re-balancing mechanism. In the US this is achieved through a Federal government that taxes and redistributes resources. In the European view, economic discipline would by imposed by a set of consistent policy rules established under the European Union and Parliament. Once, again, the result was that individual country governments found ways to skirt the rules or outright deceive the EU on its government budgets. Sometimes this was necessary given the varying needs of uneven development among countries. We see the result in Greece, when it was soon discovered that Greece had borrowed and spent public funds far in excess of the 3% boundary established by the EU.

So, a currency union also has failed to discipline politics, and the result has been a catastrophe for the Greek people and a severe blow to the concept and credibility of the European Union and the euro.


The bottom line is that democratic politics needs a firm disciplinary constraint, or else a financially manipulated economy will give society just enough rope to hang itself with. Unfortunately, this has happened quite frequently in history.

The Swiss Bail


This is a good, succinct explanation of the significance of the Swiss National Bank action to cease printing money and what’s in store for the central bank policies of the world.

Quote from asset manager Axel Merk:

Ultimately, central banks are just sipping from a straw in the ocean. I did not invent that term. Our senior economic advisor, Bill Poole, who is the former president of the St. Louis Federal Reserve taught us this: that central banks are effective as long as there is credibility.

What central banks have done is to try to make risky assets appear less risky, so that investors are encouraged or coerced into taking more risks. Because you get no interest or you are penalized for holding cash, you’ve got to go out and buy risky assets. You’ve got to go out and buy junk bonds. You have to go out and go out and buy equities.

The equity market volatility, until not long ago, has been very low. When volatility is low, investors are encouraged to buy something that is historically risky because it is no longer risky, right?

But as the Swiss National Bank has shown, risk can come back with a vengeance. The same thing can happen of course, in any other market. If the Federal Reserve wants to pursue an “exit” to its intervention, if it wants to go down this path, well, volatility is going to come back.

Everything else equal, it means asset prices have to be priced lower. That is the problem if you base an economic recovery exclusively on asset price inflation. We are going to have our hands full trying to kind of move on from here. In that context, what the Swiss National Bank has done is it is just a canary in the coal mine that there will be more trouble ahead.

Creative Capitalism: Gates & Buffett

CreativeCapBook Review:

A noble effort that fails to converge on ideas…

There are basically two teams in this match of ideas, with several participants trying to referee. On one side are the economists by trade, who are very skeptical about non-market criteria in economics. On the other side are the non-economists who believe the art and science of economics needs to be broadened, but are unclear on how this can be accomplished. Notably, I found the most refreshing approach of the many experts participating in the blog offered by perhaps its youngest contributor – the student Kyle Chauvin – who argued how we need to expand the reach of traditional, or profit, capitalism, not only around the world but to the overlooked corners of the developed world as well.

Unfortunately, the two sides never really converge in this debate and I suppose that may be why the conversation has disappeared from public discourse. Both sides accept some common premises that need to be challenged in order to break out of the box we find ourselves in on these issues.

These premises derive from the neoclassical school of economic theory that laid the foundation for general equilibrium theory in macroeconomics. Specifically, actors within the economy are classified according to a loose application of factor analysis, so we have workers, entrepreneurs and small business owners, corporate firms and managers, investors, savers, lenders, borrowers, consumers, and political actors. Then we lump these categories into producers, savers, and investors on one side versus consumers, workers, and borrowers on the other. The consensus seems to settle on the idea that some people produce and so policy should empower this production. Then successful producers can be taxed by political actors, and/or encouraged by philanthropy, to redistribute the wealth to non-producers for reasons that range from compassion to demand stimulus.

Capital accumulation and equity ownership in capitalist enterprise is an essential form of participation in the modern global market economy. Concomitant with ownership is the question of control in governance and risk management as the flip side of profit. But instead of focusing on how wealth is created and distributed through these market structures and institutions, we insist on dividing capital from labor and then try to redistribute the outcomes by political calculus, or by corporate largess. This is industrial age capitalism and such a mode of production will never accomplish what we hope to through creative capitalism. (I do agree with Clive Cook that we need a better term—maybe Inclusive Capitalism or the Singularity, to borrow from Ray Kurzweil.)

The problems that corporate social responsibility (CSR) seeks to address are rooted in the skewed distribution of productive resources across society, widening the gap between the haves and the have-nots. But taxing the haves to give to the have-nots is a self-defeating form of compassion. We should try to adhere to the Chinese proverb about teaching a hungry man to fish so that he eats for a lifetime. This can be put most plainly by asking the following question: If corporations work solely to enrich shareholders, then why aren’t we all shareholders? To widen the economic net even more, why aren’t all enterprise stakeholders shareholders?

Equity participation may also be the most viable way to promote “recognition” as a complement to profit maximization, as stakeholders have a broader range of interests, of which immediate profits is only one. This idea also focuses our attention on the real problem of free societies: agency failures and governance. Market economies depend on a multiplicity of agent-principal relationships in economic enterprises and political institutions. The abuse of these relationships is the mark of cronyism that dominates public attitudes toward “undemocratic” capitalism these days. This is not an easy problem to solve, but suffice to say equity ownership, control, and risk management must be as open, transparent, and competitive as possible. This is the only way to confirm that these relationships are accepted as just.

The only sustainable solution to world poverty and the skewed distribution of resources is the creation of a worldwide, self-sufficient, productive middle class. This is as necessary for democratic politics as it is for economics. For the middle class to grow, it needs access to resources, mostly financial capital and technology these days.

We can point to the history of land homesteading that built the American Midwest, and just recently, the idea floated by Michigan’s governor to promote homesteading in Detroit for foreigners. Society’s resources need to be spread far and wide in order to reap the benefits of innovation and adaptation, while maximizing the utilization of these resources. The financial imperative of capital is to maximize return, but the socioeconomic objective seeks to do so by combining capital with labor. This flies a bit in the face of the efficiency argument that some people are better at managing risk and creating wealth, so specialization of function should favor the risk managers on Wall Street. The problem is that we never know where to find the successful entrepreneurs and job creating small businesses of the future, only those of the past. And Wall St. only considers those who manage to squeeze through the narrow access door.

Without angel capital provided by family relations who merely saved and accumulated their personal wealth, many enterprises would never see the light of day. At the early stages, venture capital money is too costly or unavailable. This story is repeated across the economy, yet today’s concentration of capital in venture firms, hedge funds, private equity, buyout firms, major bank holding companies, etc. narrows capital access to those who already have it. The proliferation of ideas must be forced through this bottleneck, to what end? Better that individuals, families, small group networks, etc. are empowered by policy to accumulate their own capital to put at risk in entrepreneurial ventures. After all, sometimes the idea is not so sexy and may be nothing more than a new restaurant idea or a better mousetrap. In a world where the future is unknown, we can’t lock ourselves into narrow investment models built on the past. Likewise, we should not underestimate the ancillary growth Microsoft seeded by enriching its own shareholders.

The key point, which cannot be overemphasized, is that broad capital accumulation achieves double the impact of other policy options. First, it helps finance ideas, innovation and entrepreneurial risk-taking that will increase labor utilization, spreading the risks and benefits of economic growth. Second, accumulated financial assets, or savings, help mitigate economic risks of unemployment, health, and retirement through self-insurance. This reduces political demands on the state’s safety-nets and the tax and redistributive policies on productive effort that hampers economic growth. Essentially, policies that promote broad-based capital accumulation are a win-win for all citizens of a democratic capitalist society.

A New World?

helicopter-ben-bernankeMonetary policy is in a serious quagmire and central banker policy discretion hasn’t yielded great results. By hook or by crook, we’re headed for a new world. The question is whether it will be a better or worse one than we have now. Remarks from Paul Volcker below:

Paul Volcker: Back to the Woods?

The world since the rule-based monetary system collapsed in the 1970s is not a pretty picture.

Former Federal Reserve Chairman Paul Volcker called last month in Washington for a new Bretton Woods, the 1944 conference of World War II Allies that set up an international gold-exchange regime. His remarks received little media attention.

This strikes me as an underplayed story, especially as Congress considers taking a serious look at the Federal Reserve. Some legislators in particular are concerned that the value of the dollar, while stronger than last year, is still worth less than a 1200th of an ounce of gold.

Mr. Volcker made his remarks at the annual meeting of the Bretton Woods Committee, a nonpartisan organization that has been getting together since 1983. He did not call for a return to the Bretton Woods gold-exchange regime per se and only mentioned “gold” twice. But the title of the speech was “A New Bretton Woods???” Let’s take those three question marks to mean that Mr. Volcker wants to put this question out there emphatically.

Mr. Volcker reprised the history of the Bretton Woods system, which allowed foreign governments to redeem dollars in gold and established the dollar as the world’s leading currency. The system collapsed under the weight of the Lyndon Johnson-Richard Nixon “guns and butter” strategy—paying for both the Vietnam War and expanded welfare benefits and doing so by deficit spending.

“Inevitable” was the word Mr. Volcker used to describe what has been called the “Nixon shock,” a series of policies implemented in 1971 that included suspending the gold convertibility of the dollar. Mr. Volcker didn’t say so directly, but he in effect vindicated Henry Hazlitt, the most prophetic critic of Bretton Woods when the system was first discussed in the 1940s. Hazlitt, then an editorial writer for the New York Times, believed Bretton Woods and the International Monetary Fund, which the agreements set up, were an inflation trap.

In his speech, Mr. Volcker also reprised the efforts to muddle through after Bretton Woods. The Plaza accord of 1985 devalued the dollar against the yen and the mark. The Louvre accord of 1987 sought to stem the dollar’s slide. Or, as Mr. Volcker put it, “a lot of floating, some fixing, some ‘do as you please.’ ”

“By now,” Mr. Volcker said, “I think we can agree that the absence of an official, rules-based, cooperatively managed monetary system has not been a great success. In fact, international financial crises seem at least as frequent and more destructive in impeding economic stability and growth.”

He spoke of the 1970s as “an unhappy decade of inflation ending in stagflation.” He touched on the Latin American, Mexican and Asian crises that followed and the crisis of 2008 and the Great Recession in 2009. “Not a pretty picture,” Mr. Volcker said, adding that he wanted to raise “a neglected question”: “Has the absence of a well-functioning international monetary system been an enabling (or instigating) condition?”

Mr. Volcker made “a plea for attention to the need for developing an international monetary and financial system worthy of our time.” He acknowledged what he styled the “forceful fiscal and monetary policies” of recent years, but clearly reckons them inadequate.

“The provision of ample liquidity by the key national central bankers is still taking place as we meet,” he said. “But those measures don’t really count as structural reforms.” He said he could not answer the question of what approach to take, but tinkering with the International Monetary Fund was “not enough” and would mean “little without substantive agreement on the need for monetary reform and practical approaches toward that end.”

Mr. Volcker added that he wanted to find “ways of encouraging—even insisting upon—needed balance of payments equilibrium” so that countries don’t either suddenly run out of foreign exchange reserves or accumulate too many. “Nor,” he said, “would I reject some reassessment of the use of a single national currency as the dominant international reserve and trading vehicle.”

The ex-chairman noted that we are a long way from a new Bretton Woods conference, but said that “surely events have raised, whether we want to admit it or not, some fundamental questions that have been ignored for decades.”

“It’s easy to say what’s wrong,” Mr. Volcker told me over the weekend, “but sensible reforms are a pretty tough thing.”

His remarks will still be music to the ears of many nursing the idea of monetary reform, even if he hasn’t endorsed gold. A rules-based approach is certainly getting new attention, including at an important conference organized by economist John Taylor last month at the Hoover Institution.

Congress is starting to look at monetary reform. In July 2012 a bipartisan majority in the House voted 327 to 98 for a serious audit of the Federal Reserve. If the Republicans gain the Senate, the audit could end up as law. As could a bipartisan measure to mark the first century of the Federal Reserve by establishing a Centennial Monetary Commission to look to the Fed’s second century.

That effort is coming from Congress’s Joint Economic Committee, led by Rep. Kevin Brady (R., Texas). Sens. John Cornyn (R., Texas) and Rand Paul (R., Ky.) are nursing the measure in the upper chamber. It strikes me as a good moment to get Mr. Volcker in and see if he will back a centennial review of the Fed.

The idea, after all, is to see how the Fed could be improved for the next century. The measure has had tough sledding. But if a paragon like Mr. Volcker got behind the idea and supported a new, rules-based system, the effort might be able to get off the base-metal dime.


What, Me Worry?

M policyUnfortunately, this is not an April Fool’s joke.

Central bank strategy, and what we refer to now as “forward guidance” is a never-ending puzzle. In divining future Fed policy we may also need to consider the international ramifications. The three major currency blocs in the free world today are the Japanese yen, the Euro and the US dollar.

For reasons of historical experience, both the Bank of Japanese (BoJ) and European Central Bank (ECB) have been far more reticent to lower interest rates and provide excess liquidity relative to the Fed in the wake of the world-wide financial crisis. But the US has pushed hard for coordination among the central banks to prevent wide exchange rate fluctuations through competitive depreciation of currencies. In the last year, the Fed’s argument has persuaded both the BoJ and now the ECB to provide more credit to their banking systems to stimulate their economies.

One can perceive a general strategic vision here: coordinated devaluation of currencies to reduce debt liabilities and forestall rising unemployment. This makes debt less burdensome while devaluing the real value of assets priced in those currencies. In other words, the bad debts of the financial crisis get absorbed by all the citizens of the world’s most productive economies, hopefully without them noticing. It’s the hidden inflation tax through gradual currency devaluation.

But one wonders who is going to blink first when it comes to tightening up monetary policy in the face of rising prices? The virtue of a stealth devaluation is that the inflation rates are obscured. How many people notice when their dollar  buys fewer European or Asian goods? Of course, financial markets will notice as liquidity flies to the protection of real assets, something that has been occurring  for the past several years (that’s where rising prices in select real estate, farm land, and luxury goods are coming from).

Will the Fed risk rising unemployment to stop perceived inflation? I doubt that will be politically feasible. The BoJ has engineered a swift depreciation of the yen, but one wonders what yen holders have to show for it. And will the ECB tolerate higher inflation or will dollar holders begin to abandon their large dollar reserves in the face of persistent depreciation? Trying to stimulate the real economy by manipulating currency values is a very tricky balancing act.

From the WSJ:

The Fed’s Missing Guidance

Janet Yellen should make clear what the central bank will do if inflation exceeds the 2% target rate.

Janet Yellen, like Ben Bernanke before her, believes that the Federal Reserve should communicate the reasons for its current policies and the strategy of its future policy actions. And so we have been told the basic plans are for gradually reducing the volume of large-scale asset purchases, and for keeping short-term interest rates low—”for some time,” as she said in her speech on Monday—in order to stimulate employment and raise the inflation rate toward 2%.

But the Fed’s leaders should also be telling the public and financial markets what they think about the risk that future inflation could rise substantially above the Fed’s 2% target—and what the Fed would do to prevent such inflation or reverse it if that occurs.

Experience shows that inflation can rise very rapidly. The current consumer-price-index inflation rate of 1.1% is similar to the 1.2% average inflation rate in the first half of the 1960s. Inflation then rose quickly to 5.5% at the end of that decade and to 9% five years later. That surge was not due to oil prices, which remained under $3 per barrel until 1973.

Although history teaches that a rapid expansion of the money supply leads eventually to rising inflation, the current inflation risk is not, as many people assume, that the Fed’s policy of quantitative easing has greatly expanded the money supply. Although the commercial banks received trillions of dollars of reserves in exchange for the assets that they sold to the Fed, these reserves were not converted into money balances but were deposited at the Federal Reserve, which now pays interest on such excess reserves. The broad money supply (M2) increased only about 6% in the past year.

The real source of the inflation risk is that the commercial banks can use their enormous deposits at the Fed to start lending when corporate borrowers with good credit ratings are prepared to borrow. That increase in lending to businesses will be welcomed until the economy is back at full employment.

The big question is how the Fed will respond when the lending is excessive and leads to inflationary increases in demand? The Federal Open Market Committee (the central bank’s policy-making body) and Chairwoman Yellen should reassure the public that the Fed will not tolerate high inflation and will take steps to prevent such a recurrence of rising inflation even if that requires allowing the unemployment rate to rise. To be credible they also should tell the public and the financial markets what policies they will use to limit that inflationary lending.

The Fed’s traditional anti-inflation strategy—raising the federal funds rate at which banks lend to each other—won’t work. Commercial banks have so much in excess reserves that they don’t need to borrow from each other.

As an alternative, the Fed could increase the interest rate paid on excess reserves. This would give commercial banks an incentive to keep their excess reserves on deposit at the Fed.

But this policy would create two problems. It would be politically awkward for the Fed to pay large amounts of interest to commercial banks as a way of discouraging them from lending to businesses and households. It would also be a political problem to pay more interest on the $2.5 trillion of excess reserves than the Fed itself earns on its current portfolio of bonds and mortgage-backed securities.

So paying higher interest rates on excess reserves is not a viable strategy for limiting commercial bank lending, especially if the interest rate has to be raised substantially to limit inflationary pressures.

The Fed has been experimenting with repurchase agreements (known as repos) to manage short-term market interest rates. Repos are essentially short-term sales of securities by the Fed—which suck money out of the financial system—with a promise to buy them back at a price that implies the Fed’s desired interest rate. This allows the Fed to deal with a wide range of financial institutions, not just banks but also primary dealers, money-market mutual funds, etc., and to do so in a way that obscures the interest rate that it is paying.

Repos may obscure the implied interest rate, but the repo strategy will not stop the Fed from losing money when it pays more than it earns on its bond portfolio. To be effective in preventing inflation, the Fed will have to push short-term market rates to a high enough level to deter excessive commercial borrowing. And with higher market rates, the banks still will want to lend to commercial borrowers unless the interest rate on excess reserves also rises substantially.

The alternative to interest-rate strategies is quantitative restrictions on bank lending. One way would be to increase required reserves, making it impossible for the commercial banks to use all of their current excess reserves to make loans. The Fed could pay a moderate rate of interest on such newly required reserves, reducing the pain felt by banks on their lost earnings. A different form of quantitative restriction would be to increase substantially the capital requirements imposed on the banks, particularly an increase in the leverage ratio that relates bank capital to all of the bank’s assets rather than a risk-weighted measure of assets.

I am not advocating either of these quantitative restrictions. But I think it is important for the Fed to explain now how it will prevent the banks from using their current short-term reserve assets to finance inflationary commercial lending in the future. If the public is convinced that the Fed is really committed to price stability, it will be less costly in unemployment to prevent or reverse future increases in inflation.


The March of Folly

Good quote to remember:


Mankind, it seems, makes a poorer performance of government than of almost any other human activity…three outstanding attitudes–obliviousness to the growing disaffection of constituents, primacy of self-aggrandizement, illusion of invulnerable status–are persistent aspects of folly…all are independent of time and recurrent in governorship.

– Barbara Tuchman, The March of Folly

China and the dangers of unbalanced growth


The article below reiterates one of the basic economic truths explained in Political Economy Simplified, which is that growth requires a cyclical balance between consumption and savings; borrowing and investment. China is producing more exports than the world can consume, especially by the de-leveraging developed economies. China’s growth path is essentially too steep to keep up and so will correct to a more sustainable path. This is what happened with the credit bubble in the US as well. China is attempting to turbo-charge both consumption and investment at the same time by excessive borrowing, just like the US did in the 2000s.

Fundamentally, the economy runs on four wheels: consumption, saving, investment and production. If either of these gets out of sync with the others, the vehicle will sputter and crash. Interest rates are normally what keeps it all together, but we’ve been distorting those worldwide for the past two decades. Such mismanagement will demand a reckoning, and more of the same merely delays the inevitable.

From the WSJ:

China Has Its Own Debt Bomb

Not unlike the U.S. in 2008, China is at the end of a credit binge that won’t end well.


Six years ago, Chinese Premier Wen Jiabao cautioned that China’s economy is “unstable, unbalanced, uncoordinated and unsustainable.” China has since doubled down on the economic model that prompted his concern.

Mr. Wen spoke out in an attempt to change the course of an economy dangerously dependent on one lever to generate growth: heavy investment in the roads, factories and other infrastructure that have helped make China a manufacturing superpower. Then along came the 2008 global financial crisis. To keep China’s economy growing, panicked officials launched a half-trillion-dollar stimulus and ordered banks to fund a new wave of investment. Investment has risen as a share of gross domestic product to 48%—a record for any large country—from 43%.

Even more staggering is the amount of credit that China unleashed to finance this investment boom. Since 2007, the amount of new credit generated annually has more than quadrupled to $2.75 trillion in the 12 months through January this year. Last year, roughly half of the new loans came from the “shadow banking system,” private lenders and credit suppliers outside formal lending channels. These outfits lend to borrowers—often local governments pushing increasingly low-quality infrastructure projects—who have run into trouble paying their bank loans.

Since 2008, China’s total public and private debt has exploded to more than 200% of GDP—an unprecedented level for any developing country. Yet the overwhelming consensus still sees little risk to the financial system or to economic growth in China.

That view ignores the strong evidence of studies launched since 2008 in a belated attempt by the major global financial institutions to understand the origin of financial crises. The key, more than the level of debt, is the rate of increase in debt—particularly private debt. (Private debt in China includes all kinds of quasi-state borrowers, such as local governments and state-owned corporations.)

On the most important measures of this rate, China is now in the flashing-red zone. The first measure comes from the Bank of International Settlements, which found that if private debt as a share of GDP accelerates to a level 6% higher than its trend over the previous decade, the acceleration is an early warning of serious financial distress. In China, private debt as a share of GDP is now 12% above its previous trend, and above the peak levels seen before credit crises hit Japan in 1989, Korea in 1997, the U.S. in 2007 and Spain in 2008.

The second measure comes from the International Monetary Fund, which found that if private credit grows faster than the economy for three to five years, the increasing ratio of private credit to GDP usually signals financial distress. In China, private credit has been growing much faster than the economy since 2008, and the ratio of private credit to GDP has risen by 50 percentage points to 180%, an increase similar to what the U.S. and Japan witnessed before their most recent financial woes.

The bullish consensus seems to think these laws of financial gravity don’t apply to China. The bulls say that bank crises typically begin when foreign creditors start to demand their money, and China owes very little to foreigners. Yet in an August 2012 National Bureau of Economic Research paper titled “The Great Leveraging,” University of Virginia economist Alan Taylor examined the 79 major financial crises in advanced economies over the past 140 years and found that they are just as likely in countries that rely on domestic savings and owe little to foreign creditors.

The bulls also argue that China can afford to write off bad debts because it sits on more than $3 trillion in foreign-exchange reserves as well as huge domestic savings. However, while some other Asian nations with high savings and few foreign liabilities did avoid bank crises following credit booms, they nonetheless saw economic growth slow sharply.

Following credit booms in the early 1970s and the late 1980s, Japan used its vast financial resources to put troubled lenders on life support. Debt clogged the system and productivity declined. Once the increase in credit peaked, growth fell sharply over the next five years: to 3% from 8% in the 1970s and to 1% from 4% in the 1980s. In Taiwan, following a similar cycle in the early 1990s, the average annual growth rate fell to 6%.

Even if China dodges a financial crisis, then, it is not likely to dodge a slowdown in its increasingly debt-clogged economy. Through 2007, creating a dollar of economic growth in China required just over a dollar of debt. Since then it has taken three dollars of debt to generate a dollar of growth. This is what you normally see in the late stages of a credit binge, as more debt goes to increasingly less productive investments. In China, exports and manufacturing are slowing as more money flows into real-estate speculation. About a third of the bank loans in China are now for real estate, or are backed by real estate, roughly similar to U.S. levels in 2007.

For China to find a more stable growth model, most experts agree that the country needs to balance its investments by promoting greater consumption. The catch is that consumption has been growing at 8% a year for the past decade—faster than in previous miracle economies like Japan’s and as fast as it can grow without triggering inflation. Yet consumption is still falling as a share of GDP because investment has been growing even faster.

So rebalancing requires China to cut back on investment and on the rate of increase in debt, which would mean accepting a rate of growth as low as 5% to 6%, well below the current official rate of 8%. In other investment-led, high-growth nations, from Brazil in the 1970s to Malaysia in the 1990s, economic growth typically fell by half in the decade after investment peaked. The alternative is that China tries to sustain an unrealistic growth target, by piling more debt on an already powerful debt bomb.

Honey, I Shrunk the Money


Here we go, or should we say it’s time to open our eyes to where we have been going for some time. The unelected heads of the world’s central banks now explicitly control our economic fates. But as I mentioned in a previous post, they have little experience or power to influence politics and so central bankers risk serious political fallout from their currency machinations. In the meantime, anyone holding dollars, or yen, or euros, or renminbi, or promises to be paid in any such paper, can watch the real value of their wealth slowly dissipate. This should have wonderful consequences.

From the WSJ:

‘Loose Talk’ and Loose Money

The G-20 concedes that central banks rule the world economy.

The main message out of the Group of 20 nations meeting in Moscow on the weekend boils down to this: Countries can continue to devalue their currencies so long as they don’t explicitly say they want to devalue their currencies. Markets got the message and promptly sold off the yen on Monday in anticipation of further monetary easing by the Bank of Japan.

This contradiction between economic word and deed shows the degree to which policy makers have defaulted to easy money as the engine of growth. The rest is commentary.

The days before the Moscow meeting were dominated by blustery fears about the “currency war” consequences of money printing in the service of devaluation. Lael Brainard, the U.S. Treasury under secretary for international affairs, gave a speech in Moscow warning against “loose talk about currencies.” She seemed to have in mind Japan, whose new prime minister Shinzo Abe has made a weaker yen the explicit centerpiece of his economic policy.

In the diplomatic event, all of that angst went by the wayside. The G-20 communique bowed toward a vow to “refrain from competitive devaluation.” But the text also repeated its familiar promise “to move more rapidly toward more market-determined exchange rate systems”—words that essentially mean a hands-off policy on currency values. So Japan can do what it wants on the yen as long as it doesn’t cop to it publicly.

That message was also underscored by Federal Reserve Chairman Ben Bernanke, who implicitly endorsed Japan’s monetary easing and declared that the U.S. would continue to use “domestic policy tools to advance domestic objectives.” When the chief central banker of the world’s reserve currency nation announces that he is practicing monetary nationalism, it’s hard to blame anyone else for doing the same.

The upshot is that this period of extraordinary monetary easing will continue. Economist Ed Hyman of the ISI Group counts dozens of actions in recent months in what he calls a “huge global easing cycle.” The political pressure will now build on the European Central Bank to ease in turn to weaken the euro. South Korea and other countries that are on the receiving end of “hot money” inflows may feel obliged to ease as well to prevent their currencies from rising or to experiment with exchange controls.

This default to monetary policy reflects the overall failure of most of the world’s leading economies to pass fiscal and other pro-growth reforms. Japan refuses to join the trans-Pacific trade talks that might make its domestic economy more competitive. The U.S. has imposed a huge tax increase and won’t address its fiscal excesses or uncompetitive corporate tax regime. Europe—well, suffice it to say that Silvio Berlusconi is again playing a role in Italian politics and the Socialists are trying to resurrect the ghost of early Mitterrand in France.

So the central bankers are running the world economy, with the encouragement of politicians who are happy to see stock markets and other asset prices continue to rise. Here and there someone will point out the danger of asset bubbles if this continues—ECB President Mario Draghi did it on Monday—but no one wants to be the first to take away the punchbowl. It’s still every central bank, and every currency, for itself.


Prof. John H. Cochrane, writing in the Jan. 25 issue of the Hoover Digest:

Momentous changes are under way in what central banks are and what they do. We’re accustomed to thinking that central banks’ main task is to guide the economy by setting interest rates. Their main tools used to be “open market” operations, that is, purchasing short-term Treasury debt, and short-term lending to banks.

Since the 2008 financial crisis, however, the Federal Reserve . . . has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed’s independence, allowing it to do one thing—conduct monetary policy—without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.

In addition, the Fed is now a gargantuan financial regulator. Its inspectors examine too-big-to-fail banks, come up with creative “stress tests” for them to pass, and haggle over thousands of pages of regulation. When we imagine the Fed of ten years from now, we’re likely to think first of a financial czar, with monetary policy the agency’s boring backwater.

The Currency Manipulators


This is another source of worry for the free world. Central bankers will never be able to withstand the winds of political and economic conflict from gross trade imbalances made worse by currency manipulation. And just imagine trying to get one nation’s taxpayers to pay for the mistakes of another nation’s politicians. Never happen. The historical result is a complete collapse of international cooperation. And sometimes world war. These guys are throwing gas on the flames.

Rumors of (Currency) War

G-7 finance ministers lament the rise of the monetary nationalism they all practice.

These days there’s not a market in the world that some regulator somewhere doesn’t want to meddle in. The big exception, curiously enough, is the currency market.

The finance ministers for the Group of Seven economic powers released a statement Tuesday washing their hands of responsibility for the value of their currencies: “We, the G7 Ministers and Governors, reaffirm our longstanding commitment to market determined exchange rates.” The intention was to calm global currency markets, but the result was even more turmoil.

And no wonder. Start with the basic fact that there is no such thing as a free market in paper currencies. Money is a commodity whose monopoly supplier is the state. Markets trade currencies—trillions of dollars every day—but governments and central banks have the biggest influence on their value by controlling their supply.

The G-7’s look-Ma-no-hands pose is fooling nobody who actually trades currencies, which is why exchange rates jump or fall these days based on the merest eyebrow twitch by Ben Bernanke, Mario Draghi or the other maestros of global money.

The G-7 statement goes on to say, “We are agreed that excessive volatility and disorderly movements in exchange rates can have adverse implications for economic and financial stability.” That’s another beauty. If the G-7 really wanted to return to stable exchange rates, they could do something about it. Their statement is a feeble attempt at open-mouth monetary operations that is a poor substitute for real policy.

The immediate cause of this G-7 eruption is Japan’s recent decision to join the rest of the world in monetary devaluation. New Prime Minister Shinzo Abe has been brow-beating the Bank of Japan to reduce the value of the yen, which had appreciated by more than 25% against the dollar from 2009 to late 2012. The yen has since fallen sharply, alarming Japan’s trading partners in South Korea and Europe.

Mr. Abe’s political intervention into central-bank independence is regrettable, but he’s merely joining the queue. Since the financial crisis, every major central bank has let itself become an agent of domestic economic policy. Mr. Bernanke’s Fed has led the trend, embracing near-zero interest rates for more than four years plus repeated “quantitative easing.”

The Fed is supposed to be the steward of the dollar, which is still the world’s reserve currency. But since the crisis Mr. Bernanke has all but declared that the rest of the world can take care of itself. So as the Fed has flooded the world with dollars, the rest of the world has had to ease as well to keep their currencies from rising too fast. Mr. Bernanke is the band leader in this round of monetary nationalism.

In the 42 years since the collapse of Bretton Woods—the postwar international monetary system anchored to the U.S. dollar—world leaders have played more or less the same game. The more respectable countries have insisted they believe in the virtues of a strong currency, while often secretly hoping for a weaker one to boost exports. The rest have simply resorted to devaluation when convenient, without the pretense of virtue.

Control of the money supply has only grown in importance as the size of government has increased: You have only to look at Greece to see what happens when you combine fiscal incontinence with a currency (the euro) that Greek politicians can’t manipulate. In the U.S. and U.K., a major side benefit for politicians of near-zero interest rates and bond purchases is that they help to finance huge government deficits at rock-bottom rates.

Fixed or more-stable exchange rates would impose a discipline on government spending that few politicians of any stripe really want. Thus the G-7’s putative defense of market-determined exchange rates is in part a veil for state manipulation of money in the hope of “managing” the economy. That hasn’t done all that much for growth in the past five years, so it’s no surprise that beggar-thy-neighbor devaluations look increasingly appealing to politicians.

It’s nice that the G-7 appreciates the dangers of currency war, but its Tuesday statement that “we will not target exchange rates” is a policy abdication. If the ministers really want to prevent “excessive volatility and disorderly movements” in currency markets, they would work together to coordinate their monetary policies to produce more stable exchange rates.

But that would require financial leadership, especially from the U.S. Treasury. If his Senate confirmation hearing is any indication (see nearby), Obama nominee Jack Lew is a babe in the monetary woods. He’s likely to continue the real G-7 policy, which is every currency for itself, the weaker the better.