Central banking and inflation.


Quoted in WSJ:

From an interview with former Federal Reserve chairman Paul Volcker (Class of 1949) in the Daily Princetonian, May 30:

DP: [D]oes high inflation matter as long as it’s expected?

PV: It sure does, if the market’s stable. . . . The responsibility of the government is to have a stable currency. This kind of stuff that you’re being taught at Princeton disturbs me. Your teachers must be telling you that if you’ve got expected inflation, then everybody adjusts and then it’s OK. Is that what they’re telling you? Where did the question come from?

DP: Okay. Could you talk a little bit about the justification behind the Volcker Rule and the effect you think it’s had on the market?

PV: The rule is that institutions that are protected by the government, implicitly or explicitly, should not be engaged in speculative activities that bear no real relationship to the purposes for which banks are protected. Banks are protected to make loans, they’re protected to keep the payments system stable. They’re protected so you have a stable place to put your money. That’s why banks are protected. They’re not protected to engage in speculative activities which led to risk and jeopardized the banking system. That’s the basic philosophy. I think it’s pretty well-accepted. . . .

DP: Okay. And to get back to the central banking a little bit, given the trade-off between inflation and unemployment—

PV: I don’t believe that. That’s my answer to that question. That is a scenario and a delusion, which economists have gotten Nobel Prizes twenty years ago to disprove.

Free People, Free Markets

freedomQuote from the WSJ celebrating its 125th anniversary:

The answer to our current slow growth and self-doubt isn’t a set of magical “new ideas” or some unknown orator from the provinces. The answer is to rediscover the eternal truths that have helped America escape malaise and turmoil in the past.

These lessons include that markets—the mind of free millions—allocate scarce resources more efficiently and fairly than do committees in Congress; that the collusion of government with either big business or big labor stifles competition and leads to political cynicism; that government will be respected more when it does a few things well rather than too many poorly; and that innovation and human progress spring not from bureaucratic elites but from the genius of individuals.

Above all, the lesson of 125 years is that whatever our periodic blunders Americans have always used the blessings of liberty to restore prosperity and national confidence. A free people have their fate in their own hands.

The Fed Needs Discipline


I couldn’t agree more. From the WSJ:

The Fed Needs to Return to Monetary Rules

The economic outcomes when the central bank plays it by ear have not been good, especially in the last decade.

WSJ, June 26, 2014

As the Federal Reserve’s large-scale bond purchases wind down, financial markets and policy makers now are focused on when the Fed will move to increase interest rates. There is a more fundamental question that needs to be answered: Will the central bank continue its highly interventionist and discretionary monetary policies, or will it move to a more rules-based approach?

A conference last month at Stanford’s Hoover Institution brought top Fed policy makers and staff together with monetary experts and financial journalists to discuss this crucial question.

David Papell of the University of Houston used a statistical analysis to determine objectively when the central bank followed rules-based policies. The periods when it did—such as in much of the 1980s and ’90s—coincided with good economic performance: price stability, steady employment and output growth. Using a different approach based on his research of the Fed’s 100-year history, Carnegie Mellon University’s Allan Meltzer concluded as well that “following a rule or quasi rule in 1923-28 and 1986-2002 produced two of the best periods in Federal Reserve history.”

From 2003 to 2005, however, the Fed kept interest rates lower than such a rules-based approach would imply. This contributed mightily to the housing bubble and the risk-taking search for yield. The Fed’s discretionary policies since the financial crisis—particularly the large-scale purchases of mortgage-based securities—have continued and have also set a dangerous precedent, according to John Cochrane of the University of Chicago. “Once the central bank is in the business of supporting particular sectors, housing—and homeowners at the expense of home buyers—why not others? Cars? Farmers? Exporters?”

Digging deeper into history, Lee Ohanian of UCLA found that the Fed’s deviations from rules that would produce low and stable inflation during periods of large changes in regulatory policies—such as the National Industrial Recovery Act of the 1930s—often harmed the economy. He concluded that “economic growth would have been higher had the Fed stuck to policy rules.”

Michael Bordo of Rutgers noted another central-banking responsibility that the Fed has discharged in an ad hoc and discretionary manner: to act as a lender-of-last-resort. This, he wrote, has led to instability throughout the Fed’s history, most recently in 2008 when it bailed out Bear Stearns and AIG but let Lehman Brothers go under. Mr. Bordo recommends that the central bank adopt a rule to govern when it will make loans of last resort, and make it publicly known. This could mitigate or even prevent future crises of the sort precipitated by the ad-hoc policies of 2008.

Marvin Goodfriend of Carnegie Mellon University also noted that uncertainty about which creditors would be bailed out by the Fed created confusion among policy makers and led to a botched rollout of the Troubled Asset Relief Program in 2008. He recommends a new “Fed-Treasury Credit Accord” which would require “Treasurys only” asset-acquisition policy with exceptions in specific emergency situations.

There were dissenting views. Andrew Levin, a former special adviser to the Federal Reserve now on leave at the International Monetary Fund, emphasized that the parameters of policy rules shift over time making them less reliable. Indeed, the long-run average level of the federal-funds rate—central to any Fed interest-rate policy rule—could change. Mr. Levin did not recommend throwing out rules-based policy altogether, however. Rather, if a key interest-rate rule must change the Fed should communicate the reasons clearly.

The clear implication of the monetary ideas presented at the conference is that the Fed should transition to a more rules-based policy. Richard Clarida of Columbia University showed that these same ideas apply globally and would have beneficial effects for the entire international monetary system. A start, suggested by Charles Plosser, president of the Federal Reserve Bank of Philadelphia, would be for the Fed to report publicly the estimated impacts of the reference policy rules that it uses internally. An open discussion, in press conferences and congressional testimony, would lead to questions and answers about why the Fed deviates from such rules and thereby create more accountability.

In my view more is needed. The big swings between discretion and rules that have characterized Fed history—and the damage this has led to—leads me to favor legislation requiring the Fed to adopt rules for setting policy on the interest rate or the money supply. The Fed, not Congress, would choose the rule. But the rule would be public. If the Fed deviated from it, the Fed chair would be obligated to explain why, in writing and congressional testimony.

Although it is likely to resist such legislation, the Fed could make it work to a good end. The Fed has already adopted a 2% inflation target, which is the value embedded in the rule-like policy advocated by many at the conference at Stanford. In addition, the forecasts for the terminal or equilibrium federal-funds rate by the members of the Federal Open Market Committee now average about 4%, which was also built into the rule-like policies discussed by many at the conference.

Fed Chair Janet Yellen has expressed agreement that the Fed should eventually “adopt such a rule as a guidepost to policy,” though she adds that the time is not yet ripe because the economy is not yet back to normal. So the main debate now is about when, not whether, a rules-based policy should be adopted. Based on recent research, the sooner the better.


One might also question if the economy will ever get back to normal under zero interest rate policies that have distorted nominal prices and real values across the world economy? How does one allocate resources efficiently blindfolded?

Stressed Out: Geithner’s Stress Test

Stress-Test-BookThis is a review of former US Treasury Secretary and Chair of the New York Federal Reserve Bank Timothy Geithner’s explanation of the financial crisis and its subsequent management (also posted at Amazon).

Though full of interesting perspectives, Geithner’s exposition seems more of a desire to preempt the writing of history with a rationalization of his policy choices than provide any insight into the reality of the crisis or how it has reconfigured the financial landscape for the worse. Not surprisingly, fellow liberal Paul Krugman’s critical review is not cited by the publishers.

Geithner’s view of the economy and the role of finance is colored by the myopic banker’s view of the credit system, but I guess we should have expected this from a Treasury Secretary whose only preparation for the job was as head of the NY Federal Reserve Bank.

Geithner believes the financial crisis was a liquidity crisis akin to a bank run. Geithner’s solution was calibrated to the Federal Reserve stepping in as the lender of last resort, a role which it performed admirably. But the payments breakdown was merely the symptom of the problem, not the cause. The cause was (and still is) insolvent balance sheets across the financial sector. And this insolvency can be traced back to bad policies: easy credit by Greenspan, Bernanke and Co. and the lack of banking oversight, by, well, guess who? Timothy Geithner at the head of the NY Fed.

A housing bubble fueled by easy credit and securitized mortgages led to balance sheets with mispriced assets for financial intermediaries the world over. In other words, the AAA-rated MBSs they were holding as capital reserves were only as good as the value of the underlying collateral: all those ridiculously priced houses leveraged on cheap credit. When people began to realize this, the run was on and the repo market froze, cascading across all the credit markets. This was an insolvency crisis reflected in a payments freeze. The Fed needed to stand in as lender of last resort and did so, with Geithner’s full support.

But then Geithner’s solution to the post-liquidity financial de-leveraging has been to make bankers whole and push the mispricing costs onto taxpayers, savers, homeowners, and lenders. AIG went into receivership, but all the counter parties from Goldman Sachs to European banks were paid back at par on their credit default swaps. This not only enriched, but sheltered bad actors like Goldman from accountability. This served Geithner’s Wall Street constituency rather well (not exactly the constituency of the US Treasury Secretary, which is a bit broader). This was “heads we win, tails you lose,” on a grand scale. Now the banking system is more concentrated than ever with systemic risk of another shock even more threatening. Meanwhile, Main Street business struggles to obtain credit to grow the real economy. Hence anemic job creation. I doubt the Stress Test assures an all-clear, except for certain favored banking actors who now have a virtual government guarantee as TooBigToFail.

Instead, the Fed and Treasury should have managed the deleveraging of the historical credit bubble until asset prices again reflected fundamental values rather than false confidence in monetary engineering. Like AIG, failed banks should have been restructured by the government and then sold off to profitable buyers.


Despite the self-congratulatory tone of the author, we are nowhere near writing the end of this story. The Fed has expanded its balance sheet by $3.5 trillion and is holding much of that in overvalued MBSs that it has purchased through Quantitative Easing. The policies have tried to inflate housing values in order to return these mortgages back to nominal face value, but the prices of houses are artificially being pumped up by Fed credits while housing fundamentals (median incomes) remain in the doldrums. The bubbles in financial markets are also a direct manifestation of Fed policy. The Fed knows that it can cover its bad assets by merely creating more credit liabilities. The final reckoning will likely be the depreciation of the US$ and the loss of real value to savers, lenders, and working people.

Krugman is right, Geithner and the Fed saved the world from a Great Depression (of their own making – thank you very much), but have invited even greater economic disaster in lost opportunity for the middle class.

The Dummies Guide to Piketty’s “Capital”


From The Economist:

Thomas Piketty’s “Capital”, summarized in four paragraphs

IT IS the economics book taking the world by storm. “Capital in the Twenty-First Century”, written by the French economist Thomas Piketty, was published in French last year and in English in March of this year. The English version quickly became an unlikely bestseller, and it has prompted a broad and energetic debate on the book’s subject: the outlook for global inequality. Some reckon it heralds or may itself cause a pronounced shift in the focus of economic policy, toward distributional questions. This newspaper has hailed Mr Piketty as “the modern Marx” (Karl, that is). But what’s it all about?

“Capital” is built on more than a decade of research by Mr Piketty and a handful of other economists, detailing historical changes in the concentration of income and wealth. This pile of data allows Mr Piketty to sketch out the evolution of inequality since the beginning of the industrial revolution. In the 18th and 19th centuries western European society was highly unequal. Private wealth dwarfed national income and was concentrated in the hands of the rich families who sat atop a relatively rigid class structure. This system persisted even as industrialization slowly contributed to rising wages for workers. Only the chaos of the first and second world wars and the Depression disrupted this pattern. High taxes, inflation, bankruptcies, and the growth of sprawling welfare states caused wealth to shrink dramatically, and ushered in a period in which both income and wealth were distributed in relatively egalitarian fashion. But the shocks of the early 20th century have faded and wealth is now reasserting itself. On many measures, Mr Piketty reckons, the importance of wealth in modern economies is approaching levels last seen before the first world war.

From this history, Mr Piketty derives a grand theory of capital and inequality. As a general rule wealth grows faster than economic output, he explains, a concept he captures in the expression r > g (where r is the rate of return to wealth and g is the economic growth rate). Other things being equal, faster economic growth will diminish the importance of wealth in a society, whereas slower growth will increase it (and demographic change that slows global growth will make capital more dominant). But there are no natural forces pushing against the steady concentration of wealth [Blogger’s note: So, economic corrections and depressions are not natural market processes?]. Only a burst of rapid growth (from technological progress or rising population) or government intervention can be counted on to keep economies from returning to the “patrimonial capitalism” that worried Karl Marx. Mr Piketty closes the book by recommending that governments step in now, by adopting a global tax on wealth, to prevent soaring inequality contributing to economic or political instability down the road. [Ah, and who would get to disburse that global tax revenue?]

The book has unsurprisingly attracted plenty of criticism. Some wonder whether Mr Piketty is right to think the future will look like the past. Theory argues that it should become ever harder to earn a good return on wealth the more there is of it. And today’s super-rich mostly come by their wealth through work, rather than via inheritance. Others argue that Mr Piketty’s policy recommendations are more ideologically than economically driven and could do more harm than good. But many of the skeptics nonetheless have kind words for the book’s contributions, in terms of data and analysis. Whether or not Mr Piketty succeeds in changing policy, he will have influenced the way thousands of readers and plenty of economists think about these issues.

Dig deeper:
“Capital” is a great piece of scholarship, but a poor guide to policy (May 2014)
Why did the French version of “Capital” not make the same splash? (April 2014)
Revisiting an old argument about the impact of capitalism (January 2014)

I can’t actually recommend this summary of the argument as I think it fails to address some of the weaknesses of Piketty’s logic (for example, r is embodied in g but Piketty’s all-encompassing definition of capital inhibits our understanding of how r is composed and what are the disparate distributional effects of r and g.). His data do provide valuable insights, but how to interpret these is fraught with potential error and ideological bias. I’d have to say that Mr. Piketty possesses the same ability to predict the future as Mr. Marx. (And that’s not Groucho.)

Added comment by The Economist:
[Piketty] prescribes a progressive global tax on capital (an annual levy that could start at 0.1% and hits a maximum of perhaps 10% on the greatest fortunes). He also suggests a punitive 80% tax rate on incomes above $500,000 or so.

Here “Capital” drifts to the left and loses credibility. Mr Piketty asserts rather than explains why tempering wealth concentration should be the priority (as opposed to, say, boosting growth). He barely acknowledges any trade-offs or costs to his redistributionist agenda. Most economists, common sense and a lot of French businesspeople would argue that higher taxes on income and wealth put off entrepreneurs and risk taking; he blithely dismisses that. And his to-do list is oddly blinkered in its focus on taxing the rich. He ignores ways to broaden the ownership of capital, from “baby bonds” to government top-ups of private saving accounts. Some capital taxes could sit nicely in a sensible 21st-century policy toolkit (inheritance taxes, in particular), but they are not the only, or even the main, way to ensure broad-based prosperity.

ZIRP’s Perps and Those They Fleece


This is reposted from money manager John Mauldin’s mauldineconomics.com


The Unintended Consequences of ZIRP
By John Mauldin | Nov 17, 2013

McKinsey estimates that households in the US have lost a cumulative $360 billion. Meanwhile, banks and businesses have done very well… Wall Street makes a bundle, and Main Street gets stuck with higher risks and lower returns.

Yellen’s coronation was this week. Art Cashin mused that it was a wonder some senator did not bring her a corsage: it was that type of confirmation hearing. There were a few interesting questions and answers, but by and large we heard what we already knew. And what we know is that monetary policy is going to be aggressively biased to the easy side for years, or at least that is the current plan. Far more revealing than the testimony we heard on Thursday were the two very important papers that were released last week by the two most senior and respected Federal Reserve staff economists. As Jan Hatzius at Goldman Sachs reasoned, it is not credible to believe that these papers and the thinking that went into them were not broadly approved by both Ben Bernanke and Janet Yellen.

Essentially the papers make an intellectual and theoretical case for an extended period of very low interest rates and, in combination with other papers from both inside and outside the Fed from heavyweight economists, make a strong case for beginning to taper sooner rather than later, but for accompanying that tapering with a commitment to an even more protracted period of ZIRP (zero interest rate policy). In this week’s letter we are going analyze these papers, as they are critical to understanding the future direction of Federal Reserve policy. Secondly, we’ll look at what I think may be some of the unintended consequences of long-term ZIRP.

We are going to start with an analysis by Gavyn Davies of the Financial Times. He writes on macroeconomics and is one of the more of the astute observers I read. I commend his work to you. Today, rather than summarize his analysis, I feel it is more appropriate to simply quote parts of it. (I will intersperse comments, unindented.) The entire piece can be found here.

While the markets have become obsessively focused on the date at which the Fed will start to taper its asset purchases, the Fed itself, in the shape of its senior economics staff, has been thinking deeply about what the stance of monetary policy should be after tapering has ended. This is reflected in two papers to be presented to the annual IMF research conference this week by William English and David Wilcox, who have been described as two of the most important macro-economists working for the FOMC at present. At the very least, these papers warn us what the FOMC will be hearing from their staff economists in forthcoming meetings.

The English paper extends the conclusions of Janet Yellen’s “optimal control speeches” in 2012, which argued for pre-committing to keep short rates “lower-for-longer” than standard monetary rules would imply. The Wilcox paper dives into the murky waters of “endogenous supply”, whereby the Fed needs to act aggressively to prevent temporary damage to US supply potential from becoming permanent. The overall message implicitly seems to accept that tapering will happen broadly on schedule, but this is offset by super-dovishness on the forward path for short rates.

The papers are long and complex, and deserve to be read in full by anyone seriously interested in the Fed’s thought processes. They are, of course, full of caveats and they acknowledge that huge uncertainties are involved. But they seem to point to three main conclusions that are very important for investors.

1. They have moved on from the tapering decision.

Both papers give a few nods in the direction of the tapering debate, but they are written with the unspoken assumption that the expansion of the balance sheet is no longer the main issue. I think we can conclude from this that they believe with a fairly high degree of certainty that the start and end dates for tapering will not be altered by more than a few months either way, and that the end point for the total size of the balance sheet is therefore also known fairly accurately. From now on, the key decision from their point of view is how long to delay the initial hike in short rates, and exactly how the central bank should pre-commit on this question. By omission, the details of tapering are revealed to be secondary.

Yellen said as much in her testimony. In response to a question about QE, she said, “I would agree that this program [QE] cannot continue forever, that there are costs and risks associated with the program.”

The Fed have painted themselves into a corner of their own creation. They are clearly very concerned about the stock market reaction even to the mere announcement of the onset of tapering. But they also know they cannot continue buying $85 billion of assets every month. Their balance sheet is already at $4 trillion and at the current pace will expand by $1 trillion a year. Although I can find no research that establishes a theoretical limit, I do believe the Fed does not want to find that limit by running into a wall. Further, it now appears that they recognize that QE is of limited effectiveness with market valuations where they are, and so for practical purposes they need to begin to withdraw QE.

But rather than let the market deal with the prospect of an end to an easy monetary policy (which everyone recognizes has to draw to an end at some point), they are now looking at ways to maintain the illusion of the power of the Federal Reserve. And they are right to be concerned about the market reaction, as was pointed out in a recent note from Ray Dalio and Bridgewater, as analyzed by Zero Hedge:

“The Fed’s real dilemma is that its policy is creating a financial market bubble that is large relative to the pickup in the economy that it is producing,” Bridgewater notes, as the relationship between US equity markets and the Fed’s balance sheet (here and here for example) and “disconcerting disconnects” (here and here) indicate how the Fed is “trapped.” However, as the incoming Yellen faces up to her “tough” decisions to taper or not, Ray Dalio’s team is concerned about something else – “We’re not worried about whether the Fed is going to hit or release the gas pedal, we’re worried about whether there’s much gas left in the tank and what will happen if there isn’t.”

Dalio then outlines their dilemma neatly. “…The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up, in that interest rates are at zero and US asset prices have been driven up to levels that imply very low levels of returns relative to the risk, so there is very little ability to stimulate from here if needed. So the Fed will either need to accept that outcome, or come up with new ideas to stimulate conditions.”

The new ideas that Bridgewater and everyone else are looking for are in the papers we are examining. Returning to Davies work (emphasis below is mine!):

2. They think that “optimal” monetary policy is very dovish indeed on the path for rates.

Both papers conduct optimal control exercises of the Yellen-type. These involve using macro-economic models to derive the path for forward short rates that optimize the behavior of inflation and unemployment in coming years. The message is familiar: the Fed should pre-commit today to keep short rates at zero for a much longer period than would be implied by normal Taylor Rules, even though inflation would temporarily exceed 2 per cent, and unemployment would drop below the structural rate. This induces the economy to recover more quickly now, since real expected short rates are reduced.

Compared to previously published simulations, the new ones in the English paper are even more dovish. They imply that the first hike in short rates should be in 2017, a year later than before. More interestingly, they experiment with various thresholds that could be used to persuade the markets that the Fed really, really will keep short rates at zero, even if the economy recovers and inflation exceeds target. They conclude that the best way of doing this may be to set an unemployment threshold at 5.5 per cent, which is 1 per cent lower than the threshold currently in place, since this would produce the best mix of inflation and unemployment in the next few years. Such a low unemployment threshold has not been contemplated in the market up to now.

3. They think aggressively easy monetary policy is needed to prevent permanent supply side deterioration.

This theme has been mentioned briefly in previous Bernanke speeches, but the Wilcox paper elevates it to center stage. The paper concludes that the level of potential output has been reduced by about 7 per cent in recent years, largely because the rate of productivity growth has fallen sharply. In normal circumstances, this would carry a hawkish message for monetary policy, because it significantly reduces the amount of spare capacity available in the economy in the near term.

However, the key is that Wilcox thinks that much of the loss in productive potential has been caused by (or is “endogenous to”) the weakness in demand. For example, the paper says that the low levels of capital investment would be reversed if demand were to recover more rapidly, as would part of the decline in the labor participation rate. In a reversal of Say’s Law, and also a reversal of most US macro-economic thinking since Friedman, demand creates its own supply.

This concept is key to understanding current economic thinking. The belief is that it is demand that is the issue and that lower rates will stimulate increased demand (consumption), presumably by making loans cheaper for businesses and consumers. More leverage is needed! But current policy apparently fails to grasp that the problem is not the lack of consumption: it is the lack of income. Income is produced by productivity. When leverage increases productivity, that is good; but when it is used simply to purchase goods for current consumption, it merely brings future consumption forward. Debt incurred and spent today is future consumption denied. Back to Davies:

This new belief in endogenous supply clearly reinforces the “lower for longer” case on short rates, since aggressively easy monetary policy would be more likely to lead to permanent gains in real output, with only temporary costs in higher inflation. Whether or not any of this analysis turns out to be justified in the long run, it is surely important that it is now being argued so strongly in an important piece of Fed research.

Read that last sentence again. It makes no difference whether you and I might disagree with their analysis. They are at the helm, and unless something truly unexpected happens, we are going to get Fed assurances of low interest rates for a very long time. Davies concludes:

The implication of these papers is that these Fed economists have largely accepted in their own minds that tapering will take place sometime fairly soon, but that they simultaneously believe that rates should be held at zero until (say) 2017. They will clearly have a problem in convincing markets of this. After the events of the summer, bond traders have drawn the conclusion that tapering is a robust signal that higher interest rates are on the way. The FOMC will need to work very hard indeed to convince the markets, through its new thresholds and public pronouncements, that tapering and forward short rates really do need to be divorced this time. It could be a long struggle.

On a side note, we are beginning to see calls from certain circles to think about also reducing the rate the Fed pays on the reserves held at the Fed from the current 25 basis points as a way to encourage banks to put that money to work, although where exactly they put it to work is not part of the concern. Just do something with it. That is a development we will need to watch.

The Unintended Consequences of ZIRP

Off the top of my head I can come up with four ways that the proposed extension of ZIRP can have consequences other than those outlined in the papers. We will look briefly at each of them, although they each deserve their own letter.

  • The large losses from the continued financial repression of interest rates on savers and pension funds

Simply put, ultra-low interest rates mean that those who have saved money in whatever form will be getting less return on that money from safe, fixed-income investments. We’re talking about rather large sums of money, as we will see. Ironically, this translates into a loss of consumption power when the Federal Reserve is supposedly concerned about consumption and requires increased savings at a time when the Fed is trying to boost demand. This is robbing Peter to favor an already well-off Paul.

A new report from the McKinsey Global Institute examines the distributional effects of these ultra-low rates. It finds that there have been significant effects on different sectors in the economy in terms of income interest and expense. From 2007 to 2012, governments in the Eurozone, the United Kingdom, and the United States collectively benefited by $1.6 trillion, both through reduced debt-service costs and increased profits remitted by central banks (see the chart below). Nonfinancial corporations – large borrowers such as governments – benefited by $710 billion as the interest rates on debt fell. Although ultra-low interest rates boosted corporate profits in the United Kingdom and the United States by 5% in 2012, this has not translated into higher investment, possibly as a result of uncertainty about the strength of the economic recovery, as well as tighter lending standards. Meanwhile, households in these countries together lost $630 billion  in net interest income, although the impact varies across groups. Younger households that are net borrowers have benefited, while older households with significant interest-bearing assets have lost income.

McKinsey estimates that households in the US have lost a cumulative $360 billion. Meanwhile, banks and businesses have done very well.

This loss of household income requires tightened spending by retirees and means that those facing retirement have to spend less and save more in order to make sure they will have enough to live on. It also requires the older generation to work longer, which is demonstrably keeping jobs away from the younger generation, as I’ve documented clearly in past letters.

ZIRP means that the pension funds and insurance companies responsible for your annuities are making significantly less on their portfolios than they had hoped. There are lots of ways to express this loss, but I will offer three charts that will give us some indication of the magnitude of the loss over a period of 30 years.

Most public pension funds work with some variation of the traditional 60-40 portfolio, that is to say, 60% in equities and 40% in fixed income. They also target anywhere from 7 to 8.5% returns from their portfolios over the next 30 years in order to be able to generate the money they will need to pay retirees. The amount of assets they have today in their accounts is quite small in comparison to future requirements, and thus they are depending upon the magic of compound interest in order to be able to deliver the needed pension funds to their clients.

The next three graphs show what happens if interest rates are held near zero for 3 more years, 6 more years, and 10 more years. I assume that in the low-interest-rate environment returns from investment portfolios will be less than 3.5% after expenses and then rise back to the more typical (but optimistic) 7% level. What we see is that there are significant cumulative return shortfalls after 30 years because of the initial period of low interest rates, with the shortfalls ranging from 9% to 28% of the final needed assets, depending on how long ZIRP persists. Those losses can be made up only by additional contributions from retirees and/or governments or by some magical increase in expected returns.

Please note that there is nothing critical about the assumptions of 3.5% or 7% – you can make whatever assumptions you like, but the simple fact is that there will be a cumulative shortfall in later years as a result of a ZIRP environment in the initial years. Thus pensions will require more funding by the pensioners at some point, which means that their future consumption will be reduced. Once again we are borrowing from our future in order to finance ephemeral consumption today.

  • The creation of a carry trade and misallocation of capital

There is no question in my mind that many of my friends in the hedge fund and investment world will see an extended zero interest rate policy as a gift horse. If you tell a rational investor that he or she will be able to borrow money at very low rates for four or five years, then you are inviting all manner of financial transactions to take advantage of low borrowing rates. If, as an investor, you can borrow at 3% and get a 6% return, then a modest four times leverage gets you a 12% return on your capital. The financial engineering made possible by guaranteed low rates is really rather staggering. Whole books could be (and probably are being) written about all the ways to take advantage of such an environment. But also, the overall return from risk assets will be reduced as investors look to create carry trades and leverage up. So the very policy of encouraging investors to move out the risk curve in fact reduces the returns on the risks taken, especially for the average investor who can’t take advantage of the financial engineering available to sophisticated investors. Wall Street makes a bundle, and Main Street gets stuck with higher risks and lower returns.

This is simply a trickle-down monetary policy by another name. The Federal Reserve hopes to inflate wealth assets and thereby encourage the wealthy to spend more, which will somehow trickle down to the average investor and worker on Main Street. This approach exacerbates the rich/poor divide even further. This is not a design flaw or an unintended consequence; it is the very essence of the policy. The fact that significant research shows that the wealth effect is minimal seems to be lost in the policy debates. This is infuriating beyond my ability to adequately express my frustration, but it is a clear result of the capture of the Federal Reserve by academic economists and the implementation of the interesting theory that 12 people can make better decisions than the market can about the value of money and the proper environment for investments. This is the philosopher king writ large.

As Dylan Grice wrote so eloquently this week in the Outside the Box I sent you, “From these observations can be derived a straightforward corollary on economic policy makers: trying to control a variable you can’t measure (inflation) with a tool you don’t fully understand (money) in a complex system with hidden, unobservable and non-linear interrelationships (the economy) is a guaranteed way to ensure that most things which happen weren’t supposed to happen.”

  • What happens when the velocity of money turns around?

We have no credible idea what drives movement in the velocity of money. As the chart shows below, it topped out in the ’90s and has been dropping rather precipitously ever since. Charts that estimate the velocity of money back to the beginning of the 20th century show that we are close to all-time lows. One of the things we do know is that the velocity of money is mean-reverting. It will begin to go back up. The fact that it is been dropping has allowed the Federal Reserve to print money in a rather aggressive fashion without stimulating inflation. When the velocity of money starts back up, inflation could become a problem rather quickly. I have no idea when that might happen or why it would start to happen anytime soon. But one day it will happen. That’s just the way of things. Central banks that might be comfortable with 2-3% or even 4% inflation will find themselves dealing with much higher inflation than they had anticipated. Janet Yellen told us she would be capable of raising rates to fight inflation if need be, just as Volcker did. Let’s hope she doesn’t have to prove it.

  • The misallocation coming from rates being held below the natural rate of interests

I have written on this in the past. When interest rates are held lower than the “natural rate of interest,” it becomes more efficient for companies and investors to use money for financial transactions such as buying other companies rather than for productive purposes such as increasing capacity and competing for customers and sales. Why take the risk of competition, which is fraught with problems, when it is so much cheaper to simply borrow money and buy your competition? There is a reason that so many industries have effectively ended up as duopolies since the advent of low rates 12 years ago. While ZIRP makes money for those who have access to capital and for those who can sell their assets, it does not create new productive capacity and thus jobs, let alone help to create more efficient markets and pricing.

Psst, Buddy, Would You Like to Buy a Model?

As Jonathan Tepper and I write in Code Red, the Fed has elaborate models of the economy, which they use to make projections about its performance. Sadly, the Fed’s forecasting track record is very poor. Now, they are giving us models in the papers we reviewed that suggest the proper direction of monetary policy is toward an extended regime of ZIRP.

Think about that for a minute. We are about to base our monetary policy once again on models built by a Fed that has repeatedly struck out in the forecasting game and whose models do not inspire great confidence. Like previous policy approaches, this new one is almost sure to produce unintended consequences and market disturbances.

The best and the brightest assure us they have the situation under control. How’s that working out with regard to Obamacare?

True Confessions

pigs2Now we get the truth from the horse’s mouth. This is what’s been happening all along and the costs increase with each passing month of this failed policy. From the WSJ:

Confessions of a Quantitative Easer

We went on a bond-buying spree that was supposed to help Main Street. Instead, it was a feast for Wall Street.

By Andrew Huszar
I can only say: I’m sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed’s first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I’ve come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.Five years ago this month, on Black Friday, the Fed launched an unprecedented shopping spree. By that point in the financial crisis, Congress had already passed legislation, the Troubled Asset Relief Program, to halt the U.S. banking system’s free fall. Beyond Wall Street, though, the economic pain was still soaring. In the last three months of 2008 alone, almost two million Americans would lose their jobs.

The Fed said it wanted to help—through a new program of massive bond purchases. There were secondary goals, but Chairman Ben Bernanke made clear that the Fed’s central motivation was to “affect credit conditions for households and businesses”: to drive down the cost of credit so that more Americans hurting from the tanking economy could use it to weather the downturn. For this reason, he originally called the initiative “credit easing.”

My part of the story began a few months later. Having been at the Fed for seven years, until early 2008, I was working on Wall Street in spring 2009 when I got an unexpected phone call. Would I come back to work on the Fed’s trading floor? The job: managing what was at the heart of QE’s bond-buying spree—a wild attempt to buy $1.25 trillion in mortgage bonds in 12 months. Incredibly, the Fed was calling to ask if I wanted to quarterback the largest economic stimulus in U.S. history.

This was a dream job, but I hesitated. And it wasn’t just nervousness about taking on such responsibility. I had left the Fed out of frustration, having witnessed the institution deferring more and more to Wall Street. Independence is at the heart of any central bank’s credibility, and I had come to believe that the Fed’s independence was eroding. Senior Fed officials, though, were publicly acknowledging mistakes and several of those officials emphasized to me how committed they were to a major Wall Street revamp. I could also see that they desperately needed reinforcements. I took a leap of faith.

In its almost 100-year history, the Fed had never bought one mortgage bond. Now my program was buying so many each day through active, unscripted trading that we constantly risked driving bond prices too high and crashing global confidence in key financial markets. We were working feverishly to preserve the impression that the Fed knew what it was doing.

It wasn’t long before my old doubts resurfaced. Despite the Fed’s rhetoric, my program wasn’t helping to make credit any more accessible for the average American. The banks were only issuing fewer and fewer loans. More insidiously, whatever credit they were extending wasn’t getting much cheaper. QE may have been driving down the wholesale cost for banks to make loans, but Wall Street was pocketing most of the extra cash.

From the trenches, several other Fed managers also began voicing the concern that QE wasn’t working as planned. Our warnings fell on deaf ears. In the past, Fed leaders—even if they ultimately erred—would have worried obsessively about the costs versus the benefits of any major initiative. Now the only obsession seemed to be with the newest survey of financial-market expectations or the latest in-person feedback from Wall Street’s leading bankers and hedge-fund managers. Sorry, U.S. taxpayer.

Trading for the first round of QE ended on March 31, 2010. The final results confirmed that, while there had been only trivial relief for Main Street, the U.S. central bank’s bond purchases had been an absolute coup for Wall Street. The banks hadn’t just benefited from the lower cost of making loans. They’d also enjoyed huge capital gains on the rising values of their securities holdings and fat commissions from brokering most of the Fed’s QE transactions. Wall Street had experienced its most profitable year ever in 2009, and 2010 was starting off in much the same way.

You’d think the Fed would have finally stopped to question the wisdom of QE. Think again. Only a few months later—after a 14% drop in the U.S. stock market and renewed weakening in the banking sector—the Fed announced a new round of bond buying: QE2. Germany’s finance minister, Wolfgang Schäuble, immediately called the decision “clueless.”

That was when I realized the Fed had lost any remaining ability to think independently from Wall Street. Demoralized, I returned to the private sector.

Where are we today? The Fed keeps buying roughly $85 billion in bonds a month, chronically delaying so much as a minor QE taper. Over five years, its bond purchases have come to more than $4 trillion. Amazingly, in a supposedly free-market nation, QE has become the largest financial-markets intervention by any government in world history.

And the impact? Even by the Fed’s sunniest calculations, aggressive QE over five years has generated only a few percentage points of U.S. growth. By contrast, experts outside the Fed, such as Mohammed El Erian at the Pimco investment firm, suggest that the Fed may have created and spent over $4 trillion for a total return of as little as 0.25% of GDP (i.e., a mere $40 billion bump in U.S. economic output). Both of those estimates indicate that QE isn’t really working.

Unless you’re Wall Street. Having racked up hundreds of billions of dollars in opaque Fed subsidies, U.S. banks have seen their collective stock price triple since March 2009. The biggest ones have only become more of a cartel: 0.2% of them now control more than 70% of the U.S. bank assets.

As for the rest of America, good luck. Because QE was relentlessly pumping money into the financial markets during the past five years, it killed the urgency for Washington to confront a real crisis: that of a structurally unsound U.S. economy. Yes, those financial markets have rallied spectacularly, breathing much-needed life back into 401(k)s, but for how long? Experts like Larry Fink at the BlackRock investment firm are suggesting that conditions are again “bubble-like.” Meanwhile, the country remains overly dependent on Wall Street to drive economic growth.

Even when acknowledging QE’s shortcomings, Chairman Bernanke argues that some action by the Fed is better than none (a position that his likely successor, Fed Vice Chairwoman Janet Yellen, also embraces). The implication is that the Fed is dutifully compensating for the rest of Washington’s dysfunction. But the Fed is at the center of that dysfunction. Case in point: It has allowed QE to become Wall Street’s new “too big to fail” policy.

Money Delusions


The following is from this week’s Barrons:

Why the Fed Wants Higher Prices

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


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

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


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

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

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

It’s 1984.

Breaking News (from the Financial Times):

G7 reaffirms commitment not to devalue currencies for domestic gain.

Finance ministers and central bank governors of the Group of Seven rich economies have reaffirmed a commitment not to seek to devalue their currencies for domestic gain.

After an informal two-day gathering in a country house hotel outside London with no communiqué, participants said on Saturday they were reassured by Japan that its revolutionary new economic strategy was not intended to weaken the yen.

And the results:


What planet do these central bankers think we live on?

Traveling The Road to Serfdom


This, too, is an illusion.

This post borrows from the famously titled book by Friedrich Hayek, The Road to Serfdom. In his landmark critique, Hayek laid out the reasons why government-directed socialism would lead to the impoverishment of society. Maybe more of us should be reading such books these days instead of watching American Idol.

A couple of weeks ago I also posted an article here on the “feudalization” of capitalism. In that article I explained how feudalism was based on the narrow ownership and control of land, while feudal capitalism would be based on the concentrated ownership and control of financial capital. But, of course, financial capital is only good for the economic power it provides over real resources, and now we are seeing that applied rather transparently. From a recent news report:

After quite a bit of bingeing — and more than a little purging — the private equity real estate market appears to be finding a bit of equilibrium, even after poor performance and regulatory changes have thinned the ranks of dealmakers in the sector.

This month’s issue of Private Equity Analyst takes a look at how a number of buyout firms, some with dedicated real estate funds and some without, are positioning themselves to profit from a nascent real estate recovery, even as fundraising for real estate funds remained well off its 2008 high of $139.9 billion.

Private equity real estate funds raised an aggregate $54.9 billion last year, and a further 451 funds are currently on the road chasing $148 billion According to data provider Preqin.

Leading the charge of successful fund raises in 2012 was the Blackstone Group, which held a final close on $13.3 billion for Blackstone Real Estate Partners VII LP in the fourth quarter of 2012. The fund’s predecessors, including the $11 billion Blackstone Real Estate Fund VI LP raised in 2007, were top performers in the portfolio of the New Jersey Division of Investment.

The changing investment landscape has led Blackstone to shift Fund VII into some previously-untapped territory, namely, the single-family housing market. The firm created a company called Invitation Homes to buy foreclosed homes, fix them up and rent them to families.  So far it has put about $2.6 billion to work in that space, amassing a portfolio of 16,000 homes.

The housing/financial bubble, bust, and nascent recovery is transferring the ownership of housing and land to an ever-narrower group of financial plutocrats – those the popular press refer to as the 1%. If you think Democrats (Obama or anyone else) or Republicans in Washington are doing anything to prevent this, you’re fooling yourself. They are all, through the Federal Reserve, promoting it.

Can’t afford your house because of the massive credit bubble we engineered? Okay, we’ll let Blackstone partners buy it out from under you with the cheap credit we’ve provided them and then they’ll rent it back to you! Problem solved. When the day comes when the real value of these assets results in much higher prices, Blackstone will sell it back to you or somebody else for a tidy profit. In the meantime, the steady devaluation of the dollar will make us one-percenters much richer and you serfs much poorer. Neat trick, eh?

This tragic state of affairs all resulted from an historic scam to turn homes into speculative trading assets. It would be wrong to blame just the 1%. Everyone who thought flipping houses was a great way to get rich (and they’re coming back in force) is complicit in this scam. As are the politicians and housing industry lobbyists who promote housing tax subsidies. If house prices were stable and based on fundamental economic relationships to incomes and rents, there would be no profit to be had by trading them and we might all live easier with a lot more financial security.

Instead, we are surely truly traveling down Hayek’s Road to Serfdom.

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