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.

Welcome to the Fed’s Casino


“What Happens in the Fed’s Vegas …Spreads Everywhere.”

The article below focuses on the role of traders as the middle men between buyers and sellers of financial securities and the inefficiencies they generate from excessive churning. But trading volatility occurs in the context of a much larger issue of winners and losers in capital markets and society at large. Not only is trading excessive, but the swings in asset prices are creating massive winners and losers with arbitrary outcomes while enriching a winner-take-all circle of financial wealth that can buy up and shape our politics and regulatory policy.

These are the kinds of things that raise hackles among average Americans, but if we wish to fix the problem the more important question is how and why this has happened. It is a direct result of the Fed’s monetary policy and our governments’ fiscal policies in the face of a changing global economy. As I have explained in a previous post, Banking Vegas-Style, the focus of all macroeconomic policy on stabilizing headline statistics such as GDP growth, unemployment, and inflation has led to much greater price volatility in asset markets.

Economists refer to the past 35 years as The Great Moderation, denoting the reduction in the volatility of business cycle fluctuations starting in the mid-1980s. But to stabilize GDP growth with monetary liquidity means that excess liquidity must lead to productive investment. This is predominantly what happened with technology investment during the 1990s. But eventually excess credit leads to malinvestment and the misallocation of resources ( This is reflected in the volatility of asset prices, as we saw reflected in currency crises, the dotcom crash,  commodity and housing bubbles during this same period we refer to as The Great Moderation. Others mark this time as the transition to the Bubble Economy.

The  data that most reveals what has happened has been the explosion in trading and the transformation of capital markets into asset price casinos dominated by hedge funds, private equity, and big banking conglomerates. In other words, our policies created the hedge fund industry with currency volatility, credit bubbles and crunches, housing bubbles and crashes, commodity bubbles and crashes, and Too Big to Fail banks.

Think about it. If prices don’t move in wild gyrations, there is almost no money to be made from constant trading. Instead we’ve turned such markets into casino gambling dens.

So, should this all be a surprise to our policymakers?

Legendary Fund Manager John Bogle Calls Wall Street’s Number—–99% Of Trading ($32 Trillion/Year) Is A Waste

by MITCH TUCHMAN @  • July 30, 2015

An astonishing $32 trillion in securities changes hands every year with no net positive impact for investors, charges Vanguard Group Founder John Bogle.

Meanwhile, corporate finance — the reason Wall Street exists — is just a tiny slice of the total business. The nation’s big investment banks probably could work for less than a week and take the rest of the year off with no real effect on the economy.

The job of finance is to provide capital to companies. We do it to the tune of $250 billion a year in IPOs and secondary offerings,” Bogle told Time in an interview. “What else do we do? We encourage investors to trade about $32 trillion a year. So the way I calculate it, 99% of what we do in this industry is people trading with one another, with a gain only to the middleman. It’s a waste of resources.”

Rent seekers

It’s a lot of money, $32 trillion. Nearly double the entire U.S. economy moving from one pocket to another, with a toll-taker in the middle. Most people refer to them as “stock brokers,” but let’s call them what they are — toll-takers and rent-seekers.

Rent-seeking as an occupation is as old as the hills. In exchange for working to build up credentials and relative fluency in the arcane rules of an industry, one gets to stand back from actual work and just collect money.

Ostensibly, the job of a financial adviser is to provide advice. Do you actually get that from your broker? It is worth anything?

Research shows, over and over, that stock brokers can’t do much of anything demonstrably valuable. They don’t know which stocks will go up or down and when. They don’t know which asset classes will outperform this year or next.

Nobody knows. That’s the point. If you’re among that small cadre of extremely high-level traders who can throw loads of cash at a short-term fluke, fantastic. If you have a mind for numbers like Warren Buffett that allows you to buy companies on the cheap and hold them forever, excellent.

If you’re a normal retirement investor trying to get from A to B and retire on time, well, you have a really big problem to face: The toll-taker wants your money.

Dead weight

So he needs you to trade — a lot. Because that’s how stock brokers make money. Not by doling out retirement advice, but by ensuring that your account is active and churning commissions on behalf of them and their employers.

What’s a highway with no traffic on it? If you’re a toll-taker, it’s a money loser. So Wall Street’s rent-seekers need traffic in the form of regular trading. An account that sits invested for months at a time with no trades is dead weight to them.

Nevertheless, as Bogle maintains, doing nothing is the key. “Don’t do something, just stand there!” he has often said.

A portfolio indexing approach to investing codifies Bogle’s time-tested and effective way of investing for retirement — without lining the pockets of toll-taking stock brokers along the way.

Beyond Piketty’s Capital


What Ben Franklin and Billie Holiday Could Tell Us About Capitalism’s Inequalities

It has now been two years since French economist Thomas Piketty published his tome, Capital in the Twenty-First Century, and one year since it was published in English, raising a fanfare of praise and criticism. It has deserved both, most notably for “putting the distributional question back at the heart of economic analysis.”[1] I would imagine Professor Piketty is also pleased by the attention his work has garnered: What economist doesn’t secretly desire to be labeled a “rock-star” without having to sing or pick up a guitar to demonstrate otherwise?

Piketty’s study (a collaborative effort, to be sure) is an important and timely contribution to economic research. His datasets across time and space on wealth, income, and inheritances provide a wealth of empirical evidence for future testing and analysis. The presentation is long, as it is all-encompassing, tackling an ambitious, if not impossible, task. But for empirics alone, the work is commendable.

Many critics have focused on methodology and the occasional data error, but I will dispense with that by accepting the general contour of history Piketty presents as accurate of real trends in economic inequality over time. And that it matters. Inequality is not only a social and political problem, it is an economic challenge because extreme disparities break down the basis of free exchange, leading to excess investment lacking productive opportunities.[2] (Piketty ignores the natural equilibrium correctives of business/trade cycles, presumably because he perceives them as interim reversals on an inevitable long term trend.) I have followed Edward Wolff’s research long enough to know there is an intimate causal relationship between capitalist markets and material outcomes. I believe the meatier controversy is found in Piketty’s interpretations of the data and his inductive theorizing because that tells us what we can and should do, if anything, about it. Sufficient time has passed for us to digest the criticisms and perhaps offer new insights.

Read the full essay, formatted and downloadable as a pdf…


[1] Distributional issues are really at the heart of our most intractable policy challenges. Not only are wealth and income inequalities distributional puzzles, so are hunger, poverty, pollution, the effects of climate change, etc. Unfortunately, the profession tends to ignore distributional puzzles because the necessary assumptions of high-order mathematical models that drive theory rule out dynamic network interactions that characterize markets. Due to these limitations, economics is left with the default explanations of initial conditions, hence the focus on natural inequality, access to education, inheritance, etc. General equilibrium theory (GE) also assumes distributional effects away: over time prices and quantities will adjust to correct any maldistributions caused by misallocated resources. For someone mired in poverty or hunger, it’s not a very inspiring assumption.

[2] As opposed to distributional problems, modern economics is very comfortable studying and prescribing economic growth. Its mathematical models provide powerful tools to study and explain the determinants of growth. This is why growth is often touted as the solution to every economic problem. (When you’re a hammer, everything looks like a nail.) But sustainable growth relies on the feedback cycle within a dynamic market network model, so stable growth is highly dependent on sustainable distributional networks.

The Ironies of ZIRP


This is an excellent explanation of the behavioral illogic of Zero Interest Rate Policies being imposed by the major central banks of the world. If only they paid more attention to how they were increasing perceived risks and uncertainty in markets.

From Barrons:

Low Interest Rates: A Self-Defeating Strategy

Instead of encouraging spending and boosting the economy, low rates can lead people to squirrel more money away to meet their retirement or other goals.

April 17, 2015
When I think back on all the crap I learned in grad school, it’s a wonder I can think at all, to paraphrase Paul Simon. And that also goes for what was drummed into me as an undergraduate, way back when we used Kodachrome film to take photographs with Nikon cameras, instead of iPhones (and Eastman Kodak was among the elite 30 Dow industrials).Among those shibboleths was that low interest rates always stimulate the economy. Reduced borrowing costs make it easier for folks to buy houses and companies to invest and expand. Lower yields on savings cut the incentives for consumers to stash their cash in the banks like Scrooge and instead make them more inclined to go out and spend and have a good time. And all that spending should tend to push up prices and, in due time, set up the next cycle of rising rates.

And if interest rates ever hit zero, money would be free, which should mean the economy should be like an open bar—a real party. Then think about what would happen if rates went where they never had gone before—below zero percent and into negative territory. Lenders would be paying borrowers, rather than the other way around.

This isn’t some alternate universe, but rather what’s actually happening in Europe. As The Wall Street Journal reported last week, some borrowers in Spain had the rates on their mortgages fall below zero, which meant the bank owed them money. That comes as approximately one-third of all European government bonds carry negative yields.

Those are mainly short-to-intermediate maturities whose yields have followed the European Central Bank’s minus 0.20% deposit rate into negative territory. But, by week’s end, the benchmark 10-year German bund yield seemed inexorably headed below zero, as it set another record closing low of 0.073%, according to Tradeweb. At that return, investors would double their money in a mere 1,000 years.

But the boom that the textbooks predict is nowhere in evidence. That’s not a surprise to Jason Hsu, vice chairman and co-founder of Research Affiliates and also a card-carrying Ph.D. and adjunct professor at UCLA. As a frequent visitor to Japan over more than a decade, he’s had a chance to observe firsthand the effect of near-zero interest rates.

In the complete opposite of what classical economics teaches, low returns actually have induced Japanese consumers to spend less, he says. As the aging population saves more to get to a threshold of assets needed for retirement, firms seeing no spending are loath to spend, invest, or hire. “This is a bad spiral that never was predicted,” Jason explains (appropriately enough, over a sushi lunch).

This had always been assumed to reflect both the demographics and cultural traits of Japan. But that world view will have to be revised, as there’s evidence of the same thing happening in Europe, he adds, with Germans reacting to zero interest rates by saving more. This behavioral dimension helps explain the tepid payoff from the unprecedented “financial repression” that has taken interest rates to zero and below.

The restraints on spending from forcing savers to save more in a low-rate environment has been a theme sounded by a number of critics, including David Einhorn, the head of Greenlight Capital, a hedge fund. At a recent Grant’s Interest Rate Observer conference, he quoted Raghuram Rajan, the head of India’s central bank, who, in a lecture at the Bank for International Settlements in 2013, spoke of the plight of someone nearing retirement and facing losses on savings (from two bear markets this century) and low prospective returns. That “can imply low real interest rates are contractionary—savers put more aside as interest rates fall in order to meet the savings they think they will need when they retire.” Indeed, according to a widely cited estimate by Swiss Re, U.S. savers have foregone some $470 billion in interest earnings since 2008.

That conundrum was quantified in a report by David P. Goldman, head of Americas research at Reorient Capital in Hong Kong. A saver who accumulates assets for retirement through stocks would want to “annuitize” or convert that wealth into a stream of income for retirement. “But the amount of income investors can expect to receive from an equity portfolio converted into bonds actually has fallen over the past 18 years,” he writes.

At the peak of the stock market in 2000, Goldman calculates that one unit of the Standard & Poor’s 500 annually earned the real equivalent of $1,900 (adjusted for inflation, in 1982 dollars) when invested in Baa (medium-grade) corporate bonds. At the market’s recovery in 2007, one unit of the S&P would earn $1,300; now, it’s only $1,100.

The same goes for home prices. A house bought for $500,000 in 2000 and sold today and reinvested in Baa bonds would yield $16,000 annually in 1982 dollars, versus $22,000 when it was bought 15 years ago. Bottom line: “Assets have soared, but the prospective interest on these assets has shrunk.”

Which means that even the affluent top 20% of Americans (who accounted for 61% of domestic consumption in 2012, up from 53%, according to data cited by Goldman) who actually have assets are more cautious about spending than a naïve view of the wealth effect might suggest, he concludes.

To be fair, what we learned about interest rates and the economy were predicated on “normal” levels. A decline in mortgage rates from, say, 7% to 5% could reliably be counted on to set off a rebound. That would lower the monthly payment on a $300,000, 30-year loan by nearly 25%, to around $1,600 from $2,000. First-time home buyers then might qualify to get into a house; the sellers could trade up to nicer digs; those who stayed put could refinance and cut their payment or take down more money to pay off other debt or spend on a car, boat, or college tuition.

It may be that, as interest rates—which represent the time value of money [plus the risk premium for uncertain outcomes]—approach zero, their impact is distorted, just as time is distorted as the speed of light is approached, according to Einstein.

Financial repression that has depressed rates to levels that are unprecedented in history is having unpredictable effects, which shouldn’t be entirely unexpected. Even if we didn’t learn about them in school.

The Bull Market Bull


From David Stockman’s blog:

Never has there been a more artificial—-indeed, phony—–gain in the stock market than the 215% eruption orchestrated by the Fed since the post-crisis bottom six years ago today. And the operative word is “orchestrated” because there is nothing fundamental, sustainable, logical or warranted about today’s S&P 500 index at 2080.

In fact, the fundamental financial and economic rot which gave rise to the 672 index bottom on March 9, 2009 has not been ameliorated at all. The US economy remains mired in even more debt, less real productive investment, fewer breadwinner jobs and vastly more destructive financialization and asset price speculation than had been prevalent at the time of the Lehman event in September 2008.

Indeed, embedded in Friday’s allegedly “strong” jobs report is striking proof that the main street economy is the very opposite of bullish. In January 2015 there were still 2 million fewer full-time, full-pay “breadwinner” jobs in the US economy than there were before the crisis in December 2007.


Read more




We have enough data and David Stockman nails it on the head here…

Q4 Obliterates The Case For QE And ZIRP

by  • February 27, 2015

The most important number in today’s Q4 GDP update was 2.3%. That’s the year/year change in real final sales from Q4 2013. As an analytical matter it means that the Great Slog continues with no sign of acceleration whatsoever.

Indeed, the statistical truth of the matter is that this year’s result amounted to a slight deceleration—–since the Y/Y gain in real final sales for Q4 2013 was 2.6%.  But beyond the decimal point variation the larger point is this: Take out the somewhat jerky quarterly impacts of inventory stocking and destocking, and view things on a year/year basis to eliminate seasonal maladjustments and data collection and timing quirks, such as the double digit gain in defense spending during Q3 and the negative rate for Q4, and what you get is a straight line slog since the recession ended in 2009.

read more

Why You Should be INTERESTed


My policy primer, Common Cents, explains why the interest rate(s) is the most important price in a free market economy. Distorting it has far-reaching consequences, as David Stockman explains in this post from his blog, Contra Corner, from which I quote below:

The single most important price in all of capitalism is the money market interest rate. That is the price of poker in the Wall Street casino; it is the cost of production for the carry traders and gamblers who provide the marginal “bid” for risk assets.

By supplanting free market price discovery with an artificially pegged price of zero, the Fed is unleashing the furies of greed and reckless speculation in the financial system once again. So it has truly become a serial bubble machine headed by a babbler who apparently believes in make pretend.

Read full article here.


Currency Wars (and more…)

QE Forever

This article explains in greater detail a subject I addressed in a recent comment in the Wall St. Journal:

“…our macroeconomic models are wholly incapable of incorporating operational measures of uncertainty and risk as variables that affect human decision-making under loss aversion. We’ve created this unmeasurable sense of uncertainty by allowing exchange rates to float, leading to price volatility in asset markets because credit policy is unrestrained.

The idea of floating exchange rates was that currency markets would discipline fiscal policy across trading partners. But exchange rates don’t directly signal domestic voters in favor of policy reform and instead permit fiscal irresponsibility to flourish. Lax credit policy merely accommodates this fiscal fecklessness. The euro and ECB were tasked with reining in fiscal policy in the EU, but that has also failed with the fudging of budget deficits and the lack of a fiscal federalism mechanism.

The bottom line is that we do NOT have a rebalancing mechanism for the global economy beyond the historic business cycles of frequent corrections that are politically painful. The danger is we now may be amplifying those cycles.”

From Barron’s:

Currency Wars: Central Banks Play a Dangerous Game

As nations race to reduce the value of their money, the global economy takes a hit.”

Feb. 13, 2015
It’s the central banks’ world, and we’re just living in it. Never in history have their monetary machinations so dominated financial markets and economies. And as in Star Trek, they have gone boldly where no central banks have gone before—pushing interest rates below zero, once thought to be a practical impossibility.At the same time, central bankers have resumed their use of a tactic from an earlier, more primitive time that was supposed to be eschewed in this more enlightened age—currency wars.
The signal accomplishment of these policies can be encapsulated in this one result: The U.S. stock market reached a record high last week. That would be unremarkable if central bankers had created true prosperity.
But, according to the estimate of one major bank, the world’s economy will shrink in 2015, in the biggest contraction since 2009, during the aftermath of the financial crisis. That is, if it’s measured in current dollars, not after adjusting for inflation, which the central bankers have been trying desperately to create, and have failed to accomplish thus far.
Not since the 1930s have central banks of countries around the globe so actively, and desperately, tried to stimulate their domestic economies. Confronted by a lack of domestic demand, which has been constrained by a massive debt load taken on during the boom times, they instead have sought to grab a bigger slice of the global economic pie.Unfortunately, not everybody can gain a larger share of a whole that isn’t growing—or may even be shrinking. That was the lesson of the “beggar thy neighbor” policies of the Great Depression, which mainly served to export deflation and contraction across borders. For that reason, such policies were forsworn in the post–World War II order, which aimed for stable exchange rates to prevent competitive devaluations.

Almost three generations after the Great Depression, that lesson has been unlearned. In the years leading up to the Depression, and even after the contraction began, the Victorian and Edwardian propriety of the gold standard was maintained until the painful steps needed to deflate wages and prices to maintain exchange rates became politically untenable, as the eminent economic historian Barry Eichengreen of the University of California, Berkeley, has written. The countries that were the earliest to throw off what he dubbed “golden fetters” recovered the fastest, starting with Britain, which terminated sterling’s link to gold in 1931.

This, however, is the lesson being relearned. The last vestiges of fixed exchange rates died when the Nixon administration ended the dollar’s convertibility into gold at $35 an ounce in August 1971. Since then, the world has essentially had floating exchange rates. That means they have risen and fallen like a floating dock with the tides. But unlike tides that are determined by nature, the rise and fall of currencies has been driven largely by human policy makers.

Central banks have used flexible exchange rates, rather than more politically problematic structural, supply-side reforms, as the expedient means to stimulate their debt-burdened economies. In an insightful report last week, Morgan Stanley global strategists Manoj Pradhan, Chetan Ahya, and Patryk Drozdzik counted 12 central banks around the globe that recently eased policy, including the European Central Bank and its counterparts in Switzerland, Denmark, Canada, Australia, Russia, India, and Singapore. These were joined by Sweden after the note went to press.

In total, there have been some 514 monetary easing moves by central banks over the past three years, by Evercore ISI’s count. And that easy money has been supporting global stock markets (more of which later).

As for the real economy, the Morgan Stanley analysts write that while currency devaluation is a zero-sum game in a world that isn’t growing, the early movers are the biggest beneficiaries at the expense of the late movers.

The U.S. was the first mover with the Federal Reserve’s quantitative-easing program. Indeed, it was the initiation of QE2 in 2010 that provoked Brazil’s finance minister to make the first accusation that the U.S. was starting a currency war by driving down the value of the dollar—and by necessary extension, driving up exchange rates of other currencies, such as the real, thus hurting the competitiveness of export-dependent economies, such as Brazil.

Since then, the Morgan Stanley team continues, there has been a torrent of easings (as tallied by Evercore ISI) to pass the proverbial hot potato by exporting deflation. That has left just two importers of deflation—the U.S. and China.

The Fed ended QE last year and, according to conventional wisdom, is set to raise its federal-funds target from nearly nil (0% to 0.25%) some time this year. That has sent the dollar sharply higher, resulting in imported deflation. U.S. import prices plunged 2.8% in January, albeit largely because of petroleum. But over the past 12 months, overall import prices slid 8%, with nonpetroleum imports down 1.2%.

China is the other importer of deflation, they continue, owing to the renminbi’s relatively tight peg to the dollar. The RMB’s appreciation has been among the highest since 2005 and since the second quarter of last year. As a result, China has lagged the Bank of Japan, the ECB, and much of the developed and emerging-market economies in using currency depreciation to ease domestic deflation.

The bad news, according to the Morgan Stanley trio, is that not everyone can depreciate their currency at once. “Of particular concern is China, which has done less than others and hence stands to import deflation exactly when it doesn’t need to add to domestic deflationary pressures,” they write.

But they see central bankers around the globe being “fully engaged” in the battle against “lowflation,” generating monetary expansion at home and ultralow or even negative interest rates to generate growth.

The question is: When? Bank of America Merrill Lynch global economists Ethan Harris and Gustavo Reis estimate that global gross domestic product will shrink this year by some $2.3 trillion, which is a result of the dollar’s rise. To put that into perspective, they write, that’s equivalent to an economy somewhere between the size of Brazil’s and the United Kingdom’s having disappeared.

Real growth will actually increase to 3.5% in 2015 from 3.3% in 2014, the BofA ML economists project; but the nominal total will decline in terms of higher-valued dollars. The rub is that we live in a nominal world, with debts and expenses fixed in nominal terms. So, the world needs nominal dollars to meet these nominal obligations.

A drop in global nominal GDP is quite unusual by historical standards, they continue. Only the U.S. and emerging Asia are forecast to see growth in nominal-dollar terms.

The BofA ML economists also don’t expect China to devalue meaningfully, although that poses a major “tail” risk (that is, at the thin ends of the normal, bell-shaped distribution of possible outcomes). But, with China importing deflation, as the Morgan Stanley team notes, the chance remains that the country could join in the currency wars that it has thus far avoided.

WHILE ALL OF THE central bank efforts at lowering currencies and exchange rates won’t likely increase the world economy in dollar terms this year, they have been successful in boosting asset prices. The Standard & Poor’s 500 headed into the three-day Presidents’ Day holiday weekend at a record 2096.99, finally topping the high set just before the turn of the year.

The Wilshire 5000, the broadest measure of the U.S. stock market, surpassed its previous mark on Thursday and also ended at a record on Friday. By Wilshire Associates’ reckoning, the Wilshire 5000 has added some $8 trillion in value since the Fed announced plans for QE3 on Sept. 12, 2012. And since Aug. 26, 2010, when plans for QE2 were revealed, the index has doubled, an increase of $12.8 trillion in the value of U.S. stocks.

The Swiss Bail


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

Quote from asset manager Axel Merk:

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

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

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

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

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

Concentrating Equity and Wealth


This author rightly criticizes the concentration of corporate wealth away from new public equity toward existing ownership shares, but fails to identify the key role that low-priced subsidized debt has played in this story. 0-1% real interest rates encourage any smart financial officer to issue new debt to buy back equity and improve corporate performance by reducing the weighted cost of capital. The Fed did this, not the regulatory reforms.

That said, there are regulatory reforms that could enhance the broader accumulation of capital through public corporations by rebalancing the tax treatment between debt and equity. Equity “shares” wealth (and risk), debt leverages and concentrates wealth while shifting the risk to the lenders.

From The Atlantic:

Stock Buybacks Are Killing the American Economy

        By Nick Hanauer

President Obama should be lauded for using his State of the Union address to champion policies that would benefit the struggling middle class, ranging from higher wages to child care to paid sick leave. “It’s the right thing to do,” affirmed the president. And it is. But in appealing to Americans’ innate sense of justice and fairness, the president unfortunately missed an opportunity to draw an important connection between rising income inequality and stagnant economic growth.

As economic power has shifted from workers to owners over the past 40 years, corporate profit’s take of the U.S. economy has doubled—from an average of 6 percent of GDP during America’s post-war economic heyday to more than 12 percent today. Yet despite this extra $1 trillion a year in corporate profits, job growth remains anemic, wages are flat, and our nation can no longer seem to afford even its most basic needs. A $3.6 trillion budget shortfall has left many roads, bridges, dams, and other public infrastructure in disrepair. Federal spending on economically crucial research and development has plummeted 40 percent, from 1.25 percent of GDP in 1977 to only 0.75 percent today. Adjusted for inflation, public university tuition—once mostly covered by the states—has more than doubled over the past 30 years, burying recent graduates under $1.2 trillion in student debt. Many public schools and our police and fire departments are dangerously underfunded

The answer is as simple as it is surprising: Much of it went to stock buybacks—more than $6.9 trillion of them since 2004, according to data compiled by Mustafa Erdem Sakinç of The Academic-Industry Research Network. Over the past decade, the companies that make up the S&P 500 have spent an astounding 54 percent of profits on stock buybacks. Last year alone, U.S. corporations spent about $700 billion, or roughly 4 percent of GDP, to prop up their share prices by repurchasing their own stock.

In the past, this money flowed through the broader economy in the form of higher wages or increased investments in plants and equipment. But today, these buybacks drain trillions of dollars of windfall profits out of the real economy and into a paper-asset bubble, inflating share prices while producing nothing of tangible value. Corporate managers have always felt pressure to grow earnings per share, or EPS, but where once their only option was the hard work of actually growing earnings by selling better products and services, they can now simply manipulate their EPS by reducing the number of shares outstanding.

So what’s changed? Before 1982, when John Shad, a former Wall Street CEO in charge of the Securities and Exchange Commission loosened regulations that define stock manipulation, corporate managers avoided stock buybacks out of fear of prosecution. That rule change, combined with a shift toward stock-based compensation for top executives, has essentially created a gigantic game of financial “keep away,” with CEOs and shareholders tossing a $700-billion ball back and forth over the heads of American workers, whose wages as a share of GDP have fallen in almost exact proportion to profit’s rise.

To be clear: I’ve done stock buybacks too. We all do it. In this era of short-term-focused activist investors, it is nearly impossible to avoid. So at least part of the solution to our current epidemic of business disinvestment must be to discourage this sort of stock manipulation by going back to the pre-1982 rules.

This practice is not only unfair to the American middle class, but is also demonstrably harmful to both individual companies and the American economy as a whole. In a recent white paper titled “The World’s Dumbest Idea,” GMO asset allocation manager James Montier strongly challenges the 40-year obsession with “shareholder value maximization,” or SVM, documenting the many ways that stock buybacks and excessive dividends have reduced business investment and boosted inequality. Almost all investment carried out by firms is financed by retained earnings, Montier points out, so the diversion of cash flow to stock buybacks has inevitably resulted in lower rates of business investment. Defenders of SVM argue that investors efficiently reallocate the profits they reap from repurchased shares by investing the proceeds into more promising enterprises. But Montier shows that since the 1980s, public corporations have actually bought back more equity than they’ve issued, representing a net negative equity flow. Shareholders aren’t providing capital to the corporate sector, they’re extracting it.

Meanwhile, the shift toward stock-based compensation helped drive the rise of the 1 percent by inflating the ratio of CEO-to-worker compensation from twenty-to-one in 1965 to about 300-to-one today. Labor’s steadily falling share of GDP has inevitably depressed consumer demand, resulting in slower economic growth. A new study from the Organization for Economic Co-operation and Development finds that rising inequality knocked six points off U.S. GDP growth between 1990 and 2010 alone.

It is mathematically impossible to make the public- and private-sector investments necessary to sustain America’s global economic competitiveness while flushing away 4 percent of GDP year after year. That is why the federal government must reorient its policies from promoting personal enrichment to promoting national growth. These policies should limit stock buybacks and raise the marginal rate on dividends while providing real incentives to boost investment in R&D, worker training, and business expansion.

If business leaders hope to maintain broad public support for business, they must acknowledge that the purpose of the corporation is not to enrich the few, but to benefit the many. Once America’s CEOs refocus on growing their companies rather than growing their share prices, shareholder value will take care of itself and all Americans will share in the benefits of a renewed era of economic growth.

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