Bubblenomics

Some people will read this and say, “No inflation, no problem.” But that completely misses the point of asset price volatility and distortions of resource allocations. People complain about inequality, but then ignore these policies that aggravate inequality while making unequal outcomes rather arbitrary. In the meantime we live in a far more volatile and precarious world.

The Federal Reserve’s everything bubble

Desmond Lachman, May 19, 2020

Good economic policymaking resembles good medical practice. In much the same way as a skilled doctor’s effective prescription for a disease rests on an accurate diagnosis of the illness, so too a wise economic policymaker’s effective crisis policy response depends on a comprehensive understanding of the crisis’s underlying causes.

One has to regret Federal Reserve Chairman Jerome Powell’s seemingly partial diagnosis of our present daunting economic challenge, especially considering his key role in defusing the crisis. In Powell’s view, our economic predicament has nothing to do with the possibility that years of ultra-easy U.S. monetary policy might have contributed to the creation of worldwide asset and credit market bubbles. Rather, he seems to believe that our economic challenge is solely the result of the supply side shock delivered to the economy by the coronavirus pandemic. 

Following the bursting of the U.S. housing and credit market bubble in 2008, it took the U.S. economy some six years to regain its pre-crisis employment level. Dismissing any notion that the coronavirus pandemic might now be bursting asset and credit market bubbles of the Fed’s creation, Powell believes that this time around we could have a quicker economic recovery than we did following the 2008-2009 Great Recession. 

Indeed, Powell believes that the U.S. economy could fully recover by the end of 2021, notwithstanding the very much deeper economic recession that we are now experiencing than in 2008-2009. 

Despite Mr. Powell’s assertions to the contrary, over the past decade the Fed, along with the world’s other major central banks, created a global asset and credit market bubble. They did so by buying a staggering cumulative $10 trillion in low-risk government and private sector bonds with the aim of forcing investors to take on more risk and to stretch for yield. The net result of that policy was the creation of a global equity and housing market boom as well as the major distortion of world credit markets.

One indication of the world equity price bubble was the very high valuation to which the U.S. equity market reached before its large coronavirus-induced correction earlier this year. Measured by the cyclically adjusted price-earnings ratio, before the pandemic’s onset U.S. equity valuations reached lofty levels experienced only three times in the past hundred years. Meanwhile, numerous housing markets around the world, including those in several large U.S. cities, had price-to-income ratios that exceeded those reached at the 2006 peak of the earlier housing market bubble.

More troubling yet, the world’s major central banks have distorted global credit markets in a major way, as investors were encouraged to take on excessive risk. One indication of such credit market excess was the more than doubling in the risky U.S. leveraged-loan market to its present level of around $1.3 trillion. Other indications were the approximate doubling over the past decade of lending to the emerging market economies and the very low interest rates at which highly indebted countries like Italy were able to finance themselves. 

A key point to which Powell is choosing to turn a blind eye is the great likelihood that the very depth of the current economic recession, which is almost certain to be the worst experienced in the past 90 years, will burst asset price bubbles around the globe and make it all the more difficult for debtors to service their loans. This will be particularly the case for the travel, hospitality and entertainment sectors of the world economy that are bound to be particularly hard hit, at least until a COVID-19 vaccine is made widely available. If a wave of debt defaults and bankruptcies were to occur, we could see real stress in the world financial system. [The only option the Fed has at this point is to ramp up ZIRP and QE4ever as well as underwrite US Treasury borrowing.]

Another key point that Powell seems to overlook is the likelihood that the global economic recession could trigger both another round of the European sovereign debt crisis and yet one more major emerging market economic crisis. In this respect, it is hardly encouraging that the European economic recession shows every sign of being deeper than that in the United States and that Europe is still struggling to fashion a united fiscal response to the recession. Nor is it encouraging that capital is being withdrawn from the emerging market economies at a record pace and that a number of emerging market currencies already appear to be in free fall.     

To his credit, Powell responded both boldly and promptly to the initial phases of the current economic crisis. Hopefully, he stands ready to do more of the same at the first signs of real stress in the global financial system. If not, we can be sure that our full economic recovery will be delayed until well after the end of 2021. 

[Not sure how writing more trillion$ blank checks really is a solution.]

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.


The problem we see here is that the world’s economies, made up of the world’s citizens, have been dangerously pushed out on the risk curve. Meltdowns of inflated asset values are sure to occur and each one means we are less able to respond to excess risk and loss. The USA is in an envious position because its control of the world currency means all those dollars come back to the US economy to buy real assets, so those who own those assets (Americans) are far more fortunate than those who want to buy them. But this only means more economic and political volatility across the globe.

Why…

…Aren’t Presidential Candidates Talking About the Federal Reserve?

Yes, why? Much of our economic and financial lives are being guided by an unelected board of Federal Reserve governors who have been flying blind for about 8 years now…manipulating interest rates and asset markets to what end? Nobody seems to know, except to try to prevent a financial reckoning for previous misguided policies. A less charitable interpretation is the financial industry’s desire to keep the casino open as the only game in town.

By Jordan Haedtler

In an election fueled by populist anger and dominated by talk of economic insecurity, why aren’t any of the presidential candidates talking about the Federal Reserve?

After nearly a decade of high unemployment, severe racial and gender disparities and wage stagnation, voters are heading to the ballot box in pursuit of a fairer economy with less rampant inequality. In California and New York, low-wage workers are celebrating historic agreements to raise the minimum wage to $15 per hour. And the economy and jobs consistently rank among the top concerns expressed by voters of all political stripes.

One government institution reigns supreme in its ability to influence wages, jobs and overall economic growth, yet leading candidates for president have barely discussed it at all. The Federal Reserve is the most important economic policymaking institution in the country, and it is critical that voters hear how candidates plan to reform and interact with the Fed.

Related: The Federal Reserve Bank, Explained [Well, kind of.]

The Fed too often epitomizes the problems with our economy and democracy over which voters are voicing frustration: Commercial banks literally own much of the Fed and are using it to enrich themselves at the expense of the American working and middle class. When Wall Street recklessness crashed the economy in 2008, American families paid the price.

At the time, JP Morgan Chase CEO Jamie Dimon sat on the board of the New York Federal Reserve Bank, which stepped in during the crisis to save Dimon’s firm and so many other banks on the verge of collapse. Although the Fed’s actions helped Wall Street recover, that recovery never translated to Main Street, where jobs and wage growth stagnated.

Commercial banks should not govern the very institution that oversees them. It’s a scandal that continues to threaten the Fed’s credibility. An analysis conducted earlier this year by my parent organization, The Center for Popular Democracy, showed that employees of financial firms continue to hold key posts at regional Federal Reserve banks and that leadership throughout the Federal Reserve System remains overwhelmingly white and male and draws disproportionately from the corporate and financial world.

Yellen-and-Rate-Hike-cartoon

When the Fed voted in December to raise interest rates for the first time in nearly a decade, the decision was largely driven by regional Bank presidents — the very policymakers who are chosen by corporate and financial interests. In 2015, the Fed filled three vacant regional president position, and all three were filled with individuals with strong ties to Goldman Sachs; next year, 4 of the 5 regional presidents voting on monetary policy will be former Goldman Sachs insiders. Can we trust these blue-chip bankers to address working Americans’ concerns?

Yet despite the enormous power it wields and the glaring problems it continues to exemplify, the Fed has received little attention this election cycle. As noted by Reuters last week, two of the remaining candidates for president, Hillary Clinton and John Kasich, have been mute on what they would do about the central bank. Donald Trump’s sporadic statements about the Fed have been characteristically short on details, prompting former Minneapolis Federal Reserve Bank President Narayana Kocherlakota to call for Clinton, Trump and all presidential candidates to clarify exactly how they plan to oversee the Fed’s management of the economy. Ted Cruz has piped up about the Fed on a few occasions, although his vocal endorsement of “sound money” and other policies that contributed to the Great Depression warrant clarification. [One expects that none of the candidates really understand the arcana of central banking and prefer to leave well enough alone.]

The most detailed Fed reform proposal from a presidential candidate to date was a December New York Times op-ed in which Bernie Sanders wrote that “an institution that was created to serve all Americans has been hijacked by the very bankers it regulates,” and urged vital reforms to the Fed’s governance structure.

On Monday, Dartmouth economist Andy Levin, a 20-year Fed staffer and former senior adviser to Fed Chair Janet Yellen and her predecessor Ben Bernanke, unveiled a bold proposal to reform the Federal Reserve and make it a truly transparent, publicly accountable institution that responds to the needs of working families. [That’s pretty vague, as the interests of all are best served by a monetary policy that insures the stability of the price level and value of the currency as a unit of exchange and store of value. Employment growth is best addressed through fiscal policy.]

The New York primary provides a perfect opportunity for the remaining presidential candidates to tell us what they think about the Federal Reserve. Candidates in both parties should specify whether they support Levin’s proposals, and if not, articulate their preferred approach for our federal government’s most opaque but essential institution.

As Trump, Cruz and Kasich gear up for a potentially decisive primary, they would do well to respond to the many calls for clarity on the Fed. And on Thursday night, Sanders and Clinton will have the chance to clarify their stances on the Fed when they debate in Brooklyn, just a few miles away from Wall Street and the global financial epicenter that is the New York Federal Reserve Bank.

As New York voters get ready to decide which of the remaining candidates would make the best president, they will be asking themselves which candidate will better handle the economy. The candidates’ positions on the Fed must be part of the equation.

Over Fed

(The Illusion of) The Perpetual Money Machine

money_machine2

This is an excerpt from an excellent paper by Didier Sornette and Peter Cauwels on the state of our world financial economy. Your can download a pdf of the entire paper here. It’s worth a read. The layman’s version can be found here.

There is no use trying,” said Alice. “One can’t believe impossible things.”

“I daresay you haven’t had much practice,” said the Queen. “When I was your age, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”
 – Lewis Carroll

Chasing fantasies is not the exclusive pastime of little girls in fairy tales. History is speckled with colorful stories of distinguished scientists and highly motivated inventors pursuing the holy grail of technology: the construction of a perpetual motion machine. These are stories of eccentric boys with flashy toys, dreaming of the fame and wealth that would reward the invention of the ultimate gizmo, a machine that can operate without depleting any power source, thereby solving forever our energy problems. In the mid-1800s, thermodynamics provided the formal basis on what common sense informs us: it is not possible to create energy out of nothing. It can be extracted from wood, gas, oil or even human work as was done for most of human history, but there are no inexhaustible sources.

What about wealth? Can it be created out of thin air? Surely, a central bank can print crispy banknotes and, by means of the modern electronic equivalent, easily add another zero to its balance sheet. But what is the deeper meaning of this money creation? Does it create real value? Common sense and Austrian economists in particular would argue that money creation outpacing real demand is a recipe for inflation. In this piece, we show that the question is much more subtle and interesting, especially for understanding the extraordinary developments since 2007. While it is true that, like energy, wealth cannot be created out of thin air, there is a fundamental difference: whereas the belief of some marginal scientists in a perpetual motion machine had essentially no impact, its financial equivalent has been the hidden cause behind the current economic impasse.

The Czech economist Tomáš Sedlácek argues that, while we can understand old economic thinking from ancient myths, we can also learn a lot about contemporary myths from modern economic thinking. A case in point is the myth, developed in the last thirty years, of an eternal economic growth, based in financial innovations, rather than on real productivity gains strongly rooted in better management, improved design, and fueled by innovation and creativity. This has created an illusion that value can be extracted out of nothing; the mythical story of the perpetual money machine, dreamed up before breakfast.

To put things in perspective, we have to go back to the post-WWII era. It was characterized by 25 years of reconstruction and a third industrial revolution, which introduced computers, robots and the Internet. New infrastructure, innovation and technology led to a continuous increase in productivity. In that period, the financial sphere grew in balance with the real economy. In the 1970s, when the Bretton Woods system was terminated and the oil and inflation shocks hit the markets, business productivity stalled and economic growth became essentially dependent on consumption. Since the 1980s, consumption became increasingly funded by smaller savings, booming financial profits, wealth extracted from house prices appreciation and explosive debt. This was further supported by a climate of deregulation and a massive growth in financial derivatives designed to spread and diversify the risks globally.

The result was a succession of bubbles and crashes: the worldwide stock market bubble and great crash of 19 October 1987, the savings and loans crisis of the 1980s, the burst in 1991 of the enormous Japanese real estate and stock market bubbles and its ensuing “lost decades”, the emerging markets bubbles and crashes in 1994 and 1997, the LTCM crisis of 1998, the dotcom bubble bursting in 2000, the recent house price bubble, the financialization bubble via special investment vehicles, speckled with acronyms like CDO, RMBS,  CDS, … the stock market bubble, the commodity and oil bubbles and the debt bubbles, all developing jointly and feeding on each other, until the climax of 2008, which brought our financial system close to collapse.

Each excess was felt to be “solved” by measures that in fact fueled following excesses; each crash was fought by an accommodative monetary policy, sowing the seeds for new bubbles and future crashes. Not only are crashes not any more mysterious, but the present crisis and stalling economy, also called the Great Recession, have clear origins, namely in the delusionary belief in the merits of policies based on a “perpetual money machine” type of thinking.

“The problems that we have created cannot be solved at the level of thinking we were at when we created them.” This quote attributed to Albert Einstein resonates with the universally accepted solution of paradoxes encountered in the field of mathematical logic, when the framework has to be enlarged to get out of undecidable statements or fallacies. But, the policies implemented since 2008, with ultra-low interest rates, quantitative easing and other financial alchemical gesticulations, are essentially following the pattern of the last thirty years, namely the financialization of real problems plaguing the real economy. Rather than still hoping that real wealth will come out of money creation, an illusion also found in the current management of the on-going European sovereign and banking crises, we need fundamentally new ways of thinking.

A graph of the Perpetual Money Machine can be viewed here. Some of those new ways of thinking can be found here.