Interesting Money Graphics

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One cannot take these graphs at face value, for example, the long $ decline from 1933 to the present has also been the Pax Americana where the US has dominated geopolitics. Also, the Roman denarius was a commodity based currency, while the US$ is a fiat currency backed by US government taxing power over US assets.

But the larger issue of the costs of empire over time are instructive. One should dig deeper in analysis, but not be too complacent. Especially in light of the currency manipulations of the current age.

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At Long Last, the Fed Faces Reality

The Fed faces reality? After 8 years, I’m not holding my breath…

Unconventional monetary policy—including years of ultralow interest rates—simply hasn’t delivered.

By GERALD P. O’DRISCOLL JR.

WSJ, Dec. 15, 2016 

As was widely anticipated, Federal Reserve officials voted Wednesday to raise short-term interest rates by a quarter percentage point—only the second increase since the 2008 financial crash. The central bank appears to have finally confronted reality: that its unconventional monetary policy, particularly ultralow rates, simply has not delivered the goods.

In a speech last week, the president of the New York Fed, William Dudley, brought up “the limitations of monetary policy.” He suggested a greater reliance on “automatic fiscal stabilizers” that would “take some pressure off of the Federal Reserve.” His proposals—such as extending unemployment benefits and cutting the payroll tax—were conventionally Keynesian.

Speaking two weeks earlier at the Council on Foreign Relations, Fed Vice Chairman Stanley Fischer touted the power of fiscal policy to enhance productivity and speed economic growth. He called for “improved public infrastructure, better education, more encouragement for private investment, and more effective regulation.” The speech, delivered shortly after the election, almost channeled Donald Trump.

Indeed, the markets seem to be expecting a bigger, bolder version of Mr. Fischer’s suggestions from the Trump administration.

• Infrastructure: Mr. Trump campaigned on $1 trillion in new infrastructure, though the details are not fully worked out. The left thinks green-energy projects—such as windmill farms—qualify as infrastructure. Living in the West, I’d prefer to build the proposed Interstate 11, a direct line from Phoenix, to Las Vegas and then to Reno and beyond.

• Education: Nominating Betsy DeVos to lead the Education Department shows Mr. Trump’s commitment to real education reform, including expanded school choice. Much of America’s economic malaise, including income inequality and slow growth, can be laid at the feet of deficient schools. Although some students receive a world-class education, many get mediocrity or worse.

• Private investment and deregulation: Mr. Trump promises progress on both fronts. He is filling his cabinet with people—including Andy Puzder for labor secretary and Scott Pruitt to lead the Environmental Protection Agency—who understand the burden that Washington places on job creators.

Businesses need greater regulatory certainty, and reasonable statutory time limits should be placed on environmental reviews and permit applications. That, along with tax cuts, would do the trick for boosting investment.

All that said, central bankers have a role to play as well. The Fed’s ultralow interest rates were intended to be stimulative, but they also squeezed lending margins, which further dampened banks’ willingness to loan money.

There’s a strong case for a return to normal monetary policy. The prospects for economic growth are brighter than they have been in some time, and that is good. The inflation rate may tick upward, which is not good. Both factors argue for lifting short-term interest rates to at least equal the expected rate of inflation. Depending on one’s inflation forecast, that suggests moving toward a fed-funds rate in the range of 2% to 3%.

The Fed need not act abruptly, but it also does not want to get further behind the curve. Next year there will be eight meetings of the Federal Open Market Committee. A quarter-point increase at every other meeting, at least, would be in order.

This could produce some blowback from Congress and the White House. Paying higher interest on bank reserves will reduce the surplus that the Fed returns to the Treasury—thus increasing the deficit. But the Fed could ease the political pressure if it stopped resisting Republican lawmakers’ effort to introduce a monetary rule, which would curb the central bank’s discretion and make its policy more predictable. This isn’t an attack on the central bank’s independence, as Fed Chair Janet Yellen has wildly argued, but an exercise of Congress’s powers under the Constitution.

The one big cloud that darkens this optimistic forecast is Mr. Trump’s antitrade stance. Sparking a trade war could undo all the potential benefits that his policies bring. David Malpass, a Trump adviser and regular contributor to these pages, argues that trade deals like the North American Free Trade Agreement are rife with special benefits for big companies, but that they do not work for America’s small businesses. The argument is that Mr. Trump wants to renegotiate these deals to make them work better. I hope Mr. Malpass is correct, and that President-elect Trump can pull it off.

But for now, a strengthening economy offers a chance to return to normal monetary policy. Fed officials seem to have come around to that view. With any luck, Wednesday’s rate increase will be only the first step in that direction.

America’s Bank – A Review

Interesting book review with highlights of the history of the Federal Reserve. We should keep in mind that all financial crashes are rooted in excess credit creation. Unconstrained credit creation has now become the primary strategy of our central banks.

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

By James Grant

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.”

America’s Bank

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.

Piqued by Piketty?

“Money makes money. And the money that money makes makes more money.”

– Benjamin Franklin

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Over the past 18 months there’s been a gushing and gnashing over the book by French economist Thomas Piketty, Capital in the Twenty-first Century. I have to admit I’m a bit late to the party and am just getting around to reading (perusing?) it. (I have a good excuse – an 18 mo. old baby.)

Seems most of the feedback has been delineated by political ideology – the left embraces Piketty’s work and the right dismisses it. Perhaps we can pursue a non-ideological tack to dissect Piketty’s take on capitalism.

Piketty has been rightly praised for the work he has led on the collection of historical wealth and income data, and he generously offers this data to the world for future study. Most of the controversy involves his particular interpretation of these historical statistics, claiming that inequalities have reached the same levels as the roaring ’20s a century earlier. Depending on one’s measures and comparisons, that might be argued as true. The devil is in the details.

Piketty makes broad claims that inequality is inherent to the internal dynamics of capitalist markets and that the interim period – 1930s-1970s – was a reversal due to the wealth destruction of the Great Depression and WWII. Then he explicates his “law” of capital that the rate of return on capital (r) will always exceed the rate of economic growth (g), leading to ever narrower concentrations of wealth among the owners of capital. But this is too broad a brush.

We need to unbundle the capitalist wealth creating process and the dynamics of distribution in order to understand why the data looks the way it does. How, when and why does r exceed g and what are the distributional consequences? Piketty so far has not provided satisfying answers.

First, he defines capital as the stock of all assets held by private individuals, corporations and governments that can be traded in the market no matter whether these assets are being productive or not. This includes land, real estate and intellectual property rights as well as collectibles such as art and jewelry. Thus, there is no distinction made between financial or physical capital or non-productive real assets and thus no explanation for why different asset classes might experience varying growth rates and what that means for wealth and incomes. The return on capital does not always exceed the growth rate and will often drop precipitously over the business or trade cycle, as well as due to the falling marginal rate of return on existing investment. (Certainly r was negative for a considerable period of time during the Great Depression, the 70s stagnation and our recent Great Recession.) With his broad brush, Piketty ignores these insightful details.

Financial assets, as claims on real assets (a form of derivative really), often fluctuate more widely than real assets. Real asset classes that are illiquid, such as art and real estate, often don’t trade, thus making true value difficult to ascertain. Let us explain why this matters (see Figure I.1 below from Piketty’s dataset): The two periods that Piketty claims represent his conclusion on inequality (red circles) were both marked by financial asset bubbles fomented by easy credit bubbles (green squares). In both cases, when the credit crunch inevitably came, these asset prices adjusted quite drastically and quickly, erasing much of the wealth accumulated during the bubble (look at the wealth shares of the 1% over time – it’s quite a roller coaster ride). The difference today is that we have harnessed public credit to maintain these inflated asset prices. Let me make the difference plain: in the panic of 1929 and the early ’30s stock brokers jumped out of windows to their untimely deaths; after the panic of Lehman’s collapse, they jumped out with Federal Reserve-issued parachutes and landed safely on their yachts and vineyards.

Income-USA-1910-2010Piketty’s graph does highlight a concern here. The massive crash in asset prices and capital incomes after 1940 was surely due to the destruction of WWII when high property values in Europe became worthless. The central banks of the world have done their utmost to prevent such a crash after 2008, but one can still manage a price correction to reassert pre-bubble values. Admittedly, this is difficult to do with debt and requires a lot of bankruptcy that needs to be managed. But instead we’ve reflated the bubble asset prices at the high end, and with them the high incomes derived from capital. Life is good when you’re the king (or the Fed chairperson).

Second, we should understand that housing is playing an outsized role in our recent widening of wealth inequality. Housing policy rewarded real estate investments over other investments during the long credit bubble that accompanied the maturation of the baby boom generation (green square on right). This gave the housing sector a double stimulus: rising demand plus a generous tax preference. When housing wealth is stripped from the current distribution of capital, wealth inequality appears much flatter (see Rognlie).

So, rather than some immutable law of capitalism, perhaps Piketty has identified an artifact of short-sighted policy, especially by central banks and government housing policy. In our recent financial market “correction,” these asset prices have not really corrected, as de-leveraging of private credit (mostly in the FIRE sector) has merely been assumed by public credits. The Fed has expanded its balance sheet by about $4.5 trillion and the Treasury has increased the total debt by almost $8 trillion. With all that liquidity sloshing around, the rich have gotten richer because of their ownership of capital assets, both real and financial, while economic growth and employment have stagnated because of de-leveraging and the uncertainty of price distortions keyed off a deliberately depressed interest rate. These monetary and fiscal policies have greatly aggravated inequality and created the more serious problem of allowing those with inflated financial assets to trade them for more permanent real assets, thus narrowing the control over these real asset classes. In the distant past this was called feudalism and we risk recreating such class distinctions.

Nevertheless, Piketty hits on some key truths about the workings of capitalism, none of which are really new but are worth reiterating. First, we call it CAPITAL-ism for a reason – it depends on the accumulation and productive deployment of capital in order to create wealth. To quote Ben Franklin: “Money makes money. And the money that money makes makes more money.”

For the same reason we don’t call it LABOR-ism, because capitalism is about successful risk-taking and our property rights legal system assigns risks and returns to a priori ownership claims. For too long we’ve understood the distributional mechanism of capitalism to be wage incomes, when an increasing share of that distribution is remitted through capital ownership claims on profits. Technology and globalization has only amplified this trend. In addition, a mature capitalist society with an aging demographic depends on an increasing share of rents earned by accumulated capital.

The growing disparity of wage incomes can be largely traced to incomes associated with financial capital, such as in the FIRE sector, and by winner-take-all, or superstar, markets in many professions such as entertainment and sports, but also among corporate managerial elites. In a free and just society this inequality needs to be addressed, but turning back to a laborist model of economic development would mean turning back the tides of trade and freedom.

Rather, we need to promote capital accumulation across the broadest stretch of the population. This simple graph of the relationship between physical capital per worker and income shows the symbiosis between these two factors of production – we merely need to cease dividing them into their antagonistic corners through misguided tax policy.

capital-income – from David Weil, Economic Growth.

In addition, we need policies that promote long-term risk-taking and risk management and de-emphasize short-term asset trading. A return to saving and prudent investment will require disciplinary constraints on credit policy, something we’ve lost with too much central bank discretion over monetary policy. The question is how will we attain that discipline with a fiat monetary regime that allows credit creation according to the policy whims of the central bank and the Treasury?

The answers to inequality are not simple and certainly more complex than Piketty’s retrograde and admittedly unworkable proposal of taxing capital for redistribution by the state. The leftist appeal of this argument readily embraces the idea that wealth in private hands is somehow more easily abused than wealth in the hands of politicians and bureaucrats. Tell that to the victims of statism across former Soviet societies. Instead, wealth should be enjoyed by the widest possible swath of the citizenry to be earned by the sweat of their brows and the liberated ingenuity of their imaginations. As I presented in an earlier post, Billie Holiday makes the most insightful observation when it comes to our capitalist society: “God Bless the Child that’s got his own.”