Higher Inflation Displays Bad Economics

Friday provided an interesting litmus test for Bernanke’s views on further monetary stimulus and the market’s perceptions of his comments. Leading up to the statement, I warned that expectations were very high with markets awaiting a repeat of Jackson Hole 2010. When the first headlines hit, claiming no new stimulus, markets dropped 2 percent in a matter of minutes. As individuals parsed through the speech, a report from the Wall Street Journal’s Jon Hilsenrath, who often “speaks” for the Fed, suggested that Bernanke had all but guaranteed QE3 in September. An enormous surge of buying reversed the losses and by the end of the day equity markets were up 1.5-2%.

Using history as a guide, the next few weeks could very well see further gains in equity markets and commodities (especially oil and gold), while the dollar weakens further. If expectations were high for Jackson Hole, it appears they will be even higher for the next FOMC meeting. At the last meeting, Bernanke faced a rarity in three dissenting members. Considering inflation is already within the Fed’s target range, a surge in oil and food prices similar to 2010 is unlikely to encourage further support inside or outside the FOMC. Despite the failure of QE2 to positively impact the real economy, markets are now expecting QE3 and we must prepare for the potential consequences of such a policy.

Although I remain skeptical of the power of monetary policy in this current environment, several economists on the left are calling for further monetary stimulus through higher inflation targets. The idea behind this theory is that higher inflation will reduce the real value of debt, encouraging consumers to stop saving and increase consumption. Witnessing a pickup in demand will then spur businesses to build up inventories and hire more employees. These actions result in a self-fulfilling cycle that sparks higher GDP growth and speeds up the timetable for reclaiming trend line growth.

While this notion of higher inflation targets as a panacea for growth sounds promising in theory, the policy makes a critical error common to economics, highlighted by Frédéric Bastiat many years ago. (emphasis mine)

“In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause--it is seen. The others unfold in succession--they are not seen: it is well for us if they are foreseen. Between a good and a bad economist this constitutes the whole difference--the one takes account of the visible effect; the other takes account both of the effects which are seen and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, at the risk of a small present evil.”

Bastiat, Frédéric (2005-05-31). Essays on Political Economy (Kindle Locations 485-491).

Earlier, I mentioned that inflation is already within the Fed’s targeted range but several economists are suggesting initiating higher targets. Before delving further into this discussion, ask yourself, why do we have inflation targets at all? Why is inflation desirable? These questions are rarely discussed in today’s society but were frequently debated by renowned economists in previous decades and centuries. Many of the economists, including Bastiat, concluded that inflation was a prime example of a policy whose “immediate consequence is favourable, [but] the ultimate consequences are fatal.”

Understanding this view of inflation requires initially dispelling a frequent misconception. Most discussion of inflation these days tends to remark at the increasing price of goods. In reality, inflation is the devaluation of money. Although this may seem like unnecessary semantics, the difference is actually substantial. The critical difference stems from recognizing that the change in comparative values stems not from any difference in the supply or demand for goods, but rather from an increase in the supply of money. As Milton Friedman stated, “Inflation is always and everywhere a monetary phenomenon.”

Regarding inflation as a monetary phenomenon allows us to recognize some misconceived ideals relating to value. Although value may be thought of in terms of money, the truth is that money is only valuable based on the amount and kind of goods a given quantity can purchase. An individual earning $10,000 per year in the 1920’s would certainly have been much better off than someone earning the same amount today.

Returning to the concept of inflation, it should now be clear that a higher rate of inflation means increasing the supply of money, not the demand for goods. The most obvious effect of inflation is therefore to make people feel richer, despite the truth that a collective peoples’ wants can not be satisfied any more than previously. If individuals all started with an equal amount of money and goods, the consequences of inflation would not be so severe. However, this is obviously not the case and the unseen effects of inflation have very serious distributional consequences.



Second, let us consider the effects of inflation on possession of goods versus money. Inflation is caused by an increase in the supply of money. An individual holding savings in cash or money therefore loses real purchasing power over time as those holdings are devalued. On the contrary, an individual possessing non-perishable goods will experience an increase in the real value of their holdings, which could be exchanged for a greater sum of money. Further, those individuals owning the necessary supplies and means for production of goods will benefit as well.

From these examples it should be apparent that inflation encourages the accumulation of debt and benefits those possessing and producing goods. The reverse also holds true as inflation discourages saving by either delaying consumption or not accepting debt. Provided these insights, it becomes obvious that inflation also promotes poor investment of capital.

So why are many economists arguing for higher inflation targets? When initially implemented, an inflationary policy should create a debt financed and consumption led burst in economic growth. This economic stimulus marks the immediate and seen portion of the policy. Over time, however, poor investment and a lack of savings prove insufficient to maintain aggregate demand. The resulting excess supply of goods causes falling prices and corresponding losses on investment. If this outcome only resulted in prices falling back to normal levels, one might concede the merits in creating inflation. Unfortunately, over the entire cycle, a lack of accumulated savings and misguided investment results in less goods being produced by society and therefore lower economic growth. It is these consequences that are ultimately fatal and too often not foreseen.
 
The other reason economists may argue for higher inflation is due to excess household debt that currently restrains demand. On the notion that household debt is excessive and provides a headwind to economic growth, I certainly agree. What I cannot condone is the use of inflation to remedy this problem. It is important to remember that for every debt there must be a corresponding credit. An inflationary policy hurts those individuals who have wisely saved or been careful in their investments, while helping those who lived beyond their means or invested poorly. Not only does inflation unfairly impair certain groups of individuals, but it encourages a continuation of the past actions that resulted in the current economic malaise. If debt reduction is desired, a better plan would involve enacting policies that allow debt to be written off. Principal reduction on home mortgages offers a reasonable example. In this case, the losses would fall on banks or mortgage lenders that made the poor investment (provided the loan). This policy largely constricts the consequences to those parties directly involved and should discourage similar practices going forward.

One other consideration that seems often overlooked is the distribution of individuals within an economy and how inflation affects the varying classes. As mentioned earlier, the groups benefiting the most from inflation either have excessive debt, significant non-cash assets, or the means for production of goods. Although excessive debt may often be thought of in relation to lower income groups, I think this idea may be incorrect for our consideration here. Wealthy individuals often appear to pose the least credit risk and are therefore able to obtain loans at low interest rates. Due to the cheap cost of debt, wealthy individuals frequently accept significant sums of debt to expand investments. On the opposing end of the spectrum, many lower income households likely experience difficulty obtaining loans, constraining the amount of outstanding debt they can acquire. From this perspective, at best, it seems inconclusive that one income class benefits more than another. As for the latter two groups, it seems fair to say that households with significant non-cash assets or owning the means for production, largely fall in upper income classes. Based on this assessment, one could reasonably suggest that inflation benefits the wealthy class at the expense of less wealthy households.

A final consideration of inflation must consider the effect of such policies on the government’s finances. During much of U.S. history, the federal government has run budget deficits. Despite no longer being necessary to finance spending, since removal of the gold standard, the federal government still sells debt in the form of Treasury bills and notes. By instituting an inflationary policy, the federal government ensures that the real value of it’s future debt burden is reduced. Inflation therefore allows the government to hide the real value of its expenses and slowly capture a greater share of wealth over time.

For decades the Federal Reserve has maintained a mandate for generating inflation, which is now being questioned with regards to whether the target level is high enough. As Bastiat warned, it appears several economists are falling into the trap of only noticing those consequences which are seen and failing to acknowledge those which are not. Better policy making requires attempting to foresee those effects that are not immediately visible. While a higher inflation policy likely creates an initial debt-financed expansion, the ultimate consequences are almost certainly reduced long-term growth and greater inequality.

Limited Options for Monetary Policy

During my lunch break at work, I typically read books on my kindle while using the elliptical in our office’s gym. Following today’s unexpected earthquake, I embarked on my normal routine. Unfortunately, mid way through my work out the kindle ran out of power. At that point I resigned to watching CNBC for the remaining 25 minutes. Needless to say, I was quickly reminded of the reasons I gave up watching the channel in the first place. During this short period of time, the guest host for the hour proclaimed both that second half growth would be supported by lower oil prices and he expected oil prices to move higher. This fits with other recent bullish remarks noting how equity markets would respond positively to lower oil prices while ignoring that Exxon and Chevron account for more than 10% of the Dow (and were the market leaders during today’s steep gains).

Among other misplaced comments by the guest host was his claim that markets were not expecting any policy change from the Fed Chairman Bernanke during Friday’s speech at Jackson Hole. Apparently he’s missed almost every news story the past week and simply ignored the CNBC commentators, who were proclaiming today’s rally was due to expectations of QE3. Luckily for this host, a separate market commentator made (in my opinion) an even more ridiculous statement during the same short time frame. Speaking about the oil market, this commentator said that any mention by Bernanke about potential future policy options would imply QE3. Maybe this commentator isn’t aware of Bernanke’s past, but throughout much of his career as a professor, Dr. Bernanke outlined creative means for implementing monetary policy in order to avoid repeating the Great Depression or to end Japan’s deflationary trend. There is basically zero chance that Bernanke or any Fed Chairman in the near future publicly states that the Federal Reserve is out of potential policy options.

From my perspective, market bulls are probably holding their overweight long positions in hopes the Fed announces further stimulus. Market bears however may have started covering positions aggressively having witnessed an elongated period during which the Fed has tried one trick after another to prop up equity markets. Going into Friday’s speech, being short appears the scarier position. However, if Bernanke fails to announce or implicitly suggest a policy change, I have a feeling the tables will turn very quickly.

Previously I’ve outlined why QE2 failed and further quantitative easing in a similar fashion would be equally ineffective. I believe the Fed has begun to recognize this fact and Bernanke will present other options available to the Fed, primarily for use if inflation expectations begin falling back towards zero. One of my favorite bloggers, Cullen Roche at Pragmatic Capitalism, wrote a post today discussing the remaining policy options available to the Fed and their individual merits. For anyone curious about the possible options Bernanke will outline or the current potential of monetary policy, the following piece is a must read.

A LOOK INSIDE THE FED’S LIMITED TOOLKIT

Harrison: Why Permanent Zero is toxic and leads to depression

Recently I discussed the Fed’s decision to suggest interest rates will remain at zero percent for at least another 2 years. Edward Harrison of Credit Writedowns, who’s forecasts have been incredibly accurate the past couple years, offers his thoughts on the topic. Despite taking a different angle, he reaches a similar conclusion. One significant aspect he addresses is the reduction on bank profits due to a flattening yield curve. With fears just beginning to swirl regarding the solvency of a few large banks, loan loss reserves may prove inadequate going forward.

Another focus of the article is the increasing probability that the Fed will be forced to maintain zero percent rates indefinitely. As I noted yesterday, any further expansion of the Fed’s balance sheet will only serve to make permanent zero an even more likely outcome. From a historical perspective, Japan provides the best comparison for a nation maintaining minimal nominal interest rates. At the end, Harrison shows an important correction to previous comments about permanent zero hurting savers. Real interest rates have actually been positive in Japan for a majority of the last decade. Savers, or those invested in government bonds, therefore can actually purchase more goods than 10 years earlier. The notion that inflation is desirable or makes everyone better off appears supplanted in today’s thinking and a future post will take aim at clearing up misconceptions about the positive effect of inflation. For now, I strongly recommend reading the full article to understand potential economic problems that lie ahead.

Why Permanent Zero is toxic and leads to depression

QE3: Risks Outweigh Rewards

Earlier today I outlined Why QE2 Failed to positively impact economic growth or employment. The principle reasons for the ineffectiveness of monetary policy are based on the theory of a liquidity trap. In general one would only expect a liquidity trap to occur when private sector debt is extremely high and interest rates are already at the lower bound. Numerous economists have supported this theory based on current economic data and used it to push for greater fiscal stimulus. Despite the blatant contradiction, several of these economists have recently been calling for the Fed to employ further monetary stimulus through QE3. Given the relatively widespread agreement on the ineffectiveness of QE2, I’m sufficiently perplexed by these requests.

Economists aren’t the only group pushing for QE3. This morning I came across the following post from Zero Hedge, QE3 ON: Goldman Lowers Global Government Bond Forecasts Following 2012 US GDP Cut To 2.1%, Repeats "QE3 Is Part Of Baseline Estimates". Goldman not only claims QE3 is coming, but that several hundred billion is already priced in to markets. Supporting an opposing view, Dallas Fed President Richard Fisher spoke today about Connecting the Dots: Texas Employment Growth; a Dissenting Vote; and the Ugly Truth. Fisher helps explain his recent dissenting opinion by stating:

“I posit that nonmonetary factors, not monetary policy, are retarding the willingness and ability of job creators to put to work the liquidity that we have provided.”

Surprisingly, several economists from the group noted above have been quick to write off these comments as foolish. The contradiction is once again apparent since Fisher is basically agreeing with the principle of a liquidity trap and current ineffectiveness of monetary policy. In the midst of all this debate over the merits of QE3, a noteworthy topic lacking any mention is the risks involved. To objectively make a judgment in this debate, this topic should be breached.

From my perspective there are two significantly large risks the Fed accepts in further expansion of its balance sheet. Yes, the policy is likely to create temporary commodity inflation that depresses growth, but that’s been addressed previously . The primary risks in focus here are a reduced ability to manage short-term interest rates and potential insolvency. One might argue that loss of confidence in the Federal Reserve Bank represents a third major risk, however that outcome is probably not a cause, but result of the other risks.

The central means by which the Fed controls short-term interest rates is through adjusting the supply of reserves. This influences the federal funds rate, which dictates the rate banks pay to borrow reserves overnight in order to meet reserve requirements and maintain balances sufficient to cover payments. Normally the Fed has maintained a slight shortage of reserves and increased the amount as necessary to meet its target rate. Increases in reserves are supplied through purchase of Treasuries, otherwise known as open market operations. As previously stated, QE2 was effectively a large scale version of normal open market operations. Despite its appearance, QE has altered the normal policy mechanisms of the Fed by vastly increasing the supply of reserves well beyond bank requirements. The Fed initiated a policy of paying interest on reserves in order to generate demand for the surplus.

As long as loan demand remains low and the private sector continues reducing debt, the Fed’s sizable balance sheet is unlikely to create problems in maintaining low nominal interest rates. However, at some point in the future the private sector will almost certainly experience renewed desire for borrowing. A subsequent increase in base money will push up inflation rates. Hopefully having learned from past errors, the Fed will increase short-term rates to restrain loan growth from expanding too quickly. This moment is where the large balance sheet becomes a concern.

When the Fed chooses to raise rates in the future, its normal policy would involve restricting the supply of reserves. But given the current oversupply, the Fed will have to reverse nearly the entire expansion of its balance sheet to affect rates in this fashion. This process requires unloading an enormous amount of Treasuries back on to the open market. Assuming economic growth is rebounding at this time, the Fed may end up exchanging its Treasury holdings at prices well below (rates higher) those paid at purchase. Realizing these losses would quickly cut into the Fed’s minimal capital because the central bank, even more so than commercial banks, is highly leveraged. If the Fed’s solvency is called into question, a general lack of confidence could sweep through the entire banking system and cause a severe reduction in base money.

Hoping to avoid this scenario, instead of adjusting the supply of reserves, the Fed could raise the rate of interest paid on reserves. This policy allows the Fed to manage short-term interest rates and maintain its sizable balance sheet. Despite its seemingly simple resolution, this policy is not without consequences. Considering the current low interest rate environment, increasing the interest on reserves could create a scenario where the Fed is paying interest in excess of earnings on its holdings. In this situation, the Fed not only witnesses mark-to-market losses on its holdings but could also experience a slow drain on capital. If inflation picked up quickly, the Fed would face the daunting prospect of trying to stem growth through interest rate hikes that could impair its own solvency.

QE is being discussed, any further expansions of the Fed’s balance sheet will only exaggerate these risks for the central bank going forward.

Based upon an objective view of the merits for QE3, the potential long-term risks seem to drastically outweigh any marginal short-term benefits. Considering recent statements by Fed members, it appears many are coming to a similar conclusion. Although I understand the desire for action during troubling times, policy makers should step back and assess the entire situation. The recent economic malaise has been most accurately forecast by theories including the concept of a liquidity trap. A scary but natural extension of this view includes accepting that monetary policy has been rendered ineffective for the time being. At this moment, nonmonetary policies are the best and only remaining hope for avoiding prolonged economic stagnation.


(Note: For those interested in a more extensive explanation of Open Market Operations, the
New York Fed website is a wonderful resource: Open Market Operations)

Why QE2 Failed, Part 1

Following last week’s severe volatility and steep drops, equity markets have regained their footing this week. Renewed confidence in the economic outlook has come despite continued weakness in economic data as evidenced by a 30-year low in U.S. consumer confidence, deteriorating manufacturing reports and nearly stalled growth in Germany, as well as the rest of the Eurozone. Some of the confidence may stem from expectations that Eurobonds are becoming a more realistic option, providing support for the Euro. Other investors appear to be holding out hope that Fed Chairman Bernanke will hint at QE3 during the forthcoming economic conference at Jackson Hole. Having previously highlighted aspects of zero percent interest rates and monetary illusions, the operations of quantitative easing can be further explained. Understanding this process will help explain why QE2 failed to have a noticeable impact on the economy or create sustained inflation.

As I noted in Monetary Illusions, as long as individuals maintain confidence in a bank’s solvency, banks can grant credit through fiduciary media that is uncovered by current capital. A bank’s ability to provide loans is therefore never constrained by the amount of capital. Loan creation, however, is constrained by price and demand. To recognize the effects of QE it is important to consider the impact on price, demand and the quantity of “money” within the economy. Before looking into the Fed’s actions, further consideration of non-central banks is necessary.

An obvious function of banks is holding deposits and making loans. A less obvious observation is that most credit is granted without the backing of money. Although this credit is treated equivalent to money, for our purposes it will be considered money substitutes. During normal economic periods, the demand for credit vastly exceeds the money held by banks. Seeking to earn interest income, banks provide loans through fiduciary media to customers. The interest rate (price) on the loan corresponds to market interest rates and the perceived credit risk, or potential of the loan not being repaid.

When banks grant credit uncovered by money, customers simply promise to repay the loan plus interest in the future. Based on this action, the total base money (money and money substitutes) is actually increased. The extra funds are free to circulate through the economy. Since the supply of “money” has expanded, holding the number of goods in the economy constant, the price of goods initially rises. Also, because one person’s spending is another person’s income, total income temporarily rises. In theory this process could continue indefinitely, if production of goods doesn’t exceed growth in base money and confidence in the banking system is maintained. Unfortunately, maintaining this balance has proved elusive throughout history.

At this point it should be clear that banks have the ability to create “money” (money substitutes) out of thin air. Many people seem to believe that the Fed is undertaking this process through quantitative easing. Yet there is a very distinct difference between QE and granting credit through fiduciary media. As stated earlier, when banks provide credit through fiduciary media, consumers only promise repayment in the future. No current assets are exchanged for the loan. During QE it’s true that the Fed created new reserves separate from any capital. The crucial difference is that the reserves were exchanged for another current asset, Treasury notes. Although the Fed’s balance sheet expanded, this process in no different than normal open market operations used to control short-term interest rates and the supply of base money. As for banks involved in the process, their balance sheets were not expanded, but rather the composition of assets was changed.

Many economists and investors have focused on charts that display monetary growth including banks’ excess reserves. Using this definition of “money” has led many individuals to believe that QE will create high inflation as more money chases the same number of goods. This assumption misses the critical point that bank lending is not constrained by reserves. Net financial assets in the real economy (excluding the Fed) remain unchanged. Since no base money has been added to the real economy, the long-run exchange value also holds steady.

These concepts are certainly clear to the Federal Reserve Board, so an interesting question is, why would the Fed perform QE? As stated by the Fed, a primary goal was to reduce interest rates. Through QE2, the Fed swapped short-term reserves for longer-term Treasury notes. This process reduced the number of Treasury notes freely traded in the economy, lessening the amount of effectively risk-free securities. With the demand for risk-free securities expected to remain relatively constant, reducing the supply drives up prices and lowers interest rates.

The Fed also intended to generate a positive wealth effect through QE2. This expectation stemmed from the belief that the remaining supply of risk-free securities would not satisfy demand. Funds resulting from this excess demand would be invested in slightly riskier securities rather than simply held in cash. By increasing demand for riskier securities, asset prices would be pushed higher. Ultimately, increasing paper wealth should reduce the desire to save and increase spending.

Despite the Fed’s best efforts, unintended consequences of their policy resulted in failure on the first goal and only temporary success on the latter. Due to a common misconception that the Fed was “printing money, “ inflation expectations rose. Fear of losses in real purchasing power countered the reduction of Treasury note supply and potential decrease in interest rates. These fears, coupled with increasing asset prices, spurred demand for hard commodities rather than finished goods that might require subsequent increases in production. The resulting commodity inflation actually reduced aggregate demand for finished goods, creating a drag on the economy.



At the onset of QE2, the solvency of banks was not in question. Rather than removing illiquid securities from the economy, the Fed exchanged one liquid asset for another. Without altering net financial assets in the system, the main goal was to reduce real interest rates, convincing individuals to increase loan and aggregate demand. Misunderstanding of the monetary system, by much of the public, created outcomes far less stimulative than hoped. Future risks to the system have also been heightened by continued intervention. Had policy makers looked beyond neoclassical economics and considered the impact of private sector debt burdens, it’s hard to envision QE2 having been practiced. A future post will delve further into these unresolved issues. For now, I hope readers will recognize the non-inflationary impacts of QE and invest wisely on any further mention of the Fed continuing these policies.

Monetary Illusions

In Deflationary Monetary Policy, I argued that quantitative easing (QE) is not money printing and would therefore not lead to a sustainable increase in inflation. While that piece focused on the Federal Reserve’s expectation of maintaining zero percent interest rates, further explanation on the illusion of money printing is necessary. This concept will become far clearer once the distinction between money and money substitutes is proven.

Ludwig von Mises presented the foundations of monetary theory in his seminal work, The Theory of Money and Credit, nearly 100 years ago. Although his insights regarding inflation, deflation and exchange rates are equally enlightening, discussion of those topics will have to wait for another day. Understanding the actual effects of quantitative easing on the money supply first requires an understanding of Mises’ theory on the banking system.

Mises states that “the business of banking falls into two distinct branches: the negotiation of credit through the loan of other people's money and the granting of credit through the issue of fiduciary media, that is, notes and bank balances that are not covered by money. (p.146)” Further explanation of this latter branch of banking will help eliminate monetary illusions. To better display Mises’ concepts, some simple examples are necessary.

The first branch of banking is fairly straight forward. Person A deposits $100 in Standard Bank (fictional name). Standard Bank holds $5 as cash reserves and loans $95 to Person B to grow crops. In this situation, Standard Bank is merely acting as an intermediary between two parties and earning a small profit for bringing the two parties together. At the end of the loan period, Person B repays the principal amount plus interest to Standard Bank (hopefully having earned a small profit on selling crops). Standard Bank pays Person A interest on the deposit. The total cash (money) in the system started with $100 and ends with $100 plus interest (a return on capital).

Now consider the same situation above, but with a twist. After Standard Bank loans $95 to Person B, another loan of $100 is made to Person C. There is now a $100 deposit liability, $5 in reserves and $195 in loans. An obvious question that arises is, where did the extra $100 come from? Before answering this question, it’s imperative to consider the banking system in a larger economy.

Imagine an economy with one thousand people. On any given day, a number of people deposit funds, request loans or withdraw funds from various banks. Standard Bank currently holds $100,000 in deposits. On typical days, Standard Bank receives $1,000 in new deposits and withdrawal requests for $500. Since the bank can easily cover withdrawals on most days, Standard Bank is only required to maintain cash reserves of 5 percent. Out of $100,000 in deposits, the bank must only retain $5,000 in cash on hand. The other $95,000 can be lent out or invested at the bank’s choosing. Up until this point, the situation has not deviated from the initial example.

Once the bank has lent or invested the other $95,000, one might assume the bank can no longer make loans. This view happens to be incorrect, as a bank’s ability to make loans is not operationally constrained by its amount of capital. Standard Bank can still grant credit through issue of fiduciary media. Previously this form of loan might have included physical letters of credit or bank notes. In today’s electronic world, these credits may simply show up as numbers on a computer. Regardless, let us continue with the simulation.

Standard Bank, having already lent $95,000, provides new loans for another $100,000. These loans are not covered by money but still represent a current liability of the bank. A good question at this juncture is, why would anyone except this form of credit? The answer stems from confidence. As discussed earlier, most banks typically receive deposits in excess of withdrawal requests on any given day. Therefore, under common circumstances, customer repayment is practically guaranteed. As long as loans are invested productively, the bank also gets repaid in time. Confidence in the continuation of this pattern allows uncovered credit, or money substitutes, to be treated as money.

What happens if confidence in the bank is lost? Extending this concept to its natural limit will conclusively display the difference between money and money substitutes. Standard Bank starts the day with $100,000 in deposits, of which only $5,000 is being held in cash reserves. The other $95,000 has been loaned and another $100,000 of credit granted. This $195,000 in loans and credit has already been used in purchasing goods.

During the day rumors questioning the financial soundness of the bank begin to circulate. Customers holding deposits and merchants holding bank credit become nervous about the consequences of the bank’s potential bankruptcy. All claims holders rush to the bank and attempt to withdraw their money. At this point it becomes clear that the bank cannot repay all of the claims. Even if the bank sells its assets, the total equity of $100,000 will only cover half of the bank’s liabilities. Unfortunately for those remaining depositors and holders of credit, Standard Bank is bankrupt and the outstanding liabilities are worthless. The $100,000 of credit granted in fiduciary media has been entirely wiped out.

This example began with individuals depositing $100,000 in the bank and ended with an equal amount being returned, though not necessarily to the same individuals. In the interim, Standard Bank allowed the “granting of credit through the issue of fiduciary media” for another $100,000. Although $200,000 may have been circulating through the economy at various times, half remained “not covered by money.” This uncovered portion is best described as money substitutes.

Although this example ignores some details including the accrual of interest or potential losses on assets, the underlying concept is constant. All banks, including the Federal Reserve, have the ability to grant credit apart from any current capital. Confidence in the system allows individuals, corporations and governments to accept these money substitutes as forms of payment. However, as should be abundantly clear, if all parties were to request physical money in return, only a portion could actually be repaid.

In theory, banks could extend unlimited credit if confidence in the system was never questioned. History suggests this outcome is unlikely, as vast increases in fiduciary media will sow the seeds that create growing fear about the bank’s ability to repay. While extension of credit in this form can create temporary inflation, the extension of credit is actually a dilution of claims on real money. Without an increase in the real money supply (by the Treasury), the extension of credit and inflation will ultimately resolve itself through default and deflation.

Through quantitative easing the Federal Reserve Bank created fiduciary media, but not real money. Although the normal extension of credit through fiduciary media can create temporary inflation, the next post will further explain why quantitative easing is less effective in this task. Understanding the difference between money and money substitutes is critical to recognizing the effects of inflation versus deflation, appreciation versus depreciation of exchange values, and fiscal versus monetary policy. Monetary illusions have resulted in frequently poor allocation of resources and capital. Hopefully clearer recognition about the theory of money will lead to better policies, better investments and a better economy.

Europe Revives Failed Policies of 2008

"Those who cannot remember the past are condemned to fulfill it."

-George Santayana

Tuesday’s blog ended with the above quote, but Europe’s actions today require the quote come first. Over the past couple years, policy makers pointed to rapidly rising financial markets as proof that the financial crisis was behind us. In trying to convince the public to move beyond the past, leaders appear to have erased their own memories of countless policy mistakes with unintended negative consequences. Unfortunately, Europe is embarking on the same flawed regulatory path circa 2008 and one would be foolish to expect any differing outcome.

For a moment let us look back upon the events of September 2008. On September 7th, Fannie Mae and Freddie Mac were effectively nationalized. A week later, Merrill Lynch sold itself to Bank of America. Over the next four days, Lehman Brothers filed for bankruptcy, the Reserve Primary fund broke the buck, the Federal Reserve bailed out AIG  and Treasury Secretary Paulson laid out initial plans for TARP. With financial stocks under significant pressure, on September 19th, regulators responded:

“The Securities and Exchange Commission, acting in concert with the U.K. Financial Services Authority, took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence.”

Stock markets responded positively that day, with the S&P 500 rising over three percent to close at 1255. The next day, markets opened flat before giving back the previous day’s gains. The sell off continued from there and that closing level of 1255 was not reclaimed until January 1st, 2011.

Over the past two weeks, Europe’s peripheral crisis has been morphing into a Euro-core crisis as Spanish and Italian sovereign yields rose, while France witnessed a proverbial run on its largest banks. Having apparently forgotten the lessons of 2008, this evening, France, Spain, Italy and Belgium banned short sales on numerous financial institutions (Greece and Turkey have already instituted this policy). Apart from the obvious previous failure of this policy, it’s important to understand why the policy failed and why it almost certainly will again.

Many policy failures are due to a fundamental misdiagnosis of the problem at hand. Recent weakness in bank shares stems from fear of significant asset write downs and potentially inadequate capital levels that could ultimately render the firms insolvent. Banning short selling implies these concerns are based on widespread rumors willingly accepted by millions of investors. The policy also fails to acknowledge that short selling is largely employed by financial institutions and investment funds as a means of hedging risk. Ignoring these factors has resulted in establishing a policy that reduces liquidity and discourages buying.

During normal times, potential stock buyers include investors wishing to acquire or increase long positions and others trying to cover short positions. On the opposing end, possible sellers consist of investors wanting to reduce or eliminate long positions and others initiating or adding to short positions. Although banning short selling is aimed at reducing sellers, in actuality it removes both buyers and sellers from the market. An initial consequence of reduced liquidity will probably be heightened volatility going forward.

By reducing selling pressure, the policy aims to strengthen investor confidence in European banks. Although I believe the ban actually signals desperation by policy makers aware of deteriorating fundamentals, I’ll ignore this point for a moment. Determining the future direction of bank stocks requires comparing the vantage points of remaining potential buyers and sellers.

Apart from rising sovereign yields across Europe, weakening economies have put pressure on bank earnings. Stress tests that were clearly rigged supported claims that banks were severely under-capitalized. Bank stocks have been falling rapidly back toward levels from the previous crisis. For investors, the question is, why buy now? Certainly some investors will believe the recent sell off is over done and that considerable value can be found in owning bank stocks. Even for these individuals, the risks run incredibly high.

As currently enacted, the short sell bans only last 15 days. Since few individual investors actively use short selling, outright short positions were likely held by sophisticated fund managers. It seems reasonable to expect these managers will continue shorting bank stocks after the ban ends. In that case, buyers may be well served to wait for even lower prices. Potential buyers may also fear that some rumors are true, as witnessed frequently over the past several years. Investors therefore must risk being almost entirely wiped out. With thousands of other stocks to potentially invest in, a strong desire by investors to purchase bank shares at this time is hard to fathom.

While potential buyers include current holders and investors starting new positions, possible sellers are now limited to investors with current positions. Having already experienced significant losses, these owners are confronted with the same concerns as the buyers mentioned above. However, if buyers prove to be scarce, sellers face an added fear of acting too slow. Within illiquid markets, a shortage of buyers means that sellers may frequently be forced to hit bids (selling at the current best bid, often a sign of weakness). Selling in this manner typically lowers prices and could cause buyers to withdraw or lower bids further. Sellers who act first will therefore receive the best prices. The biggest risk is that recognition of this process becomes widespread and sparks a surge of selling interest. In that case, prices could free fall as selling begets more selling and buyers retreat.



Yesterday’s equity market gains were probably the result of investors rushing to exit short positions before the ban was made effective. With those buyers now removed from the market, who will replace them in the days ahead? Investment funds and financial institutions that used short selling for hedges must now seek alternative measures or reduce long exposure. Shifting to other hedging strategies will result in prices of those short instruments being bid up significantly and further discouraging equity buying. Reducing long exposure will generate an imbalance favoring sellers and push markets lower.

Aside from failing to prevent further declines in bank stocks, banning short selling could very well directly reduce bank profits and lending. Banks earn profits from trading, both on their own account and through transaction fees from customers. Less liquidity means less transactions and lower profits. As mentioned earlier, financial institutions account for a significant portion of short sales. These positions are often used to hedge counterparty risk. Without an ability to hedge this risk, banks may become less willing to lend to other banks and in turn, consumers.

In September 2008, the U.S. and U.K. instituted widespread bans on short selling of financial institutions. Despite fiscal and monetary stimulus, liquidity declined in equity markets and practically vanished in interbank lending. Desperately attempting to raise capital, banks were forced to sell assets and accept bailouts. Deposit withdrawals pushed banks to the brink of bankruptcy and caused a contraction of credit. The rest of the story is history.

To be clear, the ban on short selling did not cause the financial crisis. Banks had lent recklessly and rung up massive amounts of leverage. Financial systems are built on confidence and once that falters it becomes increasingly difficult to reacquire. In my view, banning short selling in 2008 was an ill conceived sign of panic among regulators. Attempting to focus blame upon a few select short sellers, the policy discouraged buying and removed liquidity at a time it was desperately needed.

For the global economy’s sake, I hope this time is different. Maybe buyers will show up in droves to purchase bank stocks upon the removal of short sellers. Maybe 2 weeks will allow policy makers to create a plan of action for shoring up bank capital. Maybe the short sellers were just making up rumors on the fly. Sadly I have a hard time envisioning any of these scenarios taking place. My worst fear, that nothing would be learned from the Great Recession, appears to be coming true. Here’s to hoping the days ahead are not filled with more 2008 déjà vu.

Deflationary Monetary Policy

“The first requirement is that the monetary authority should guide it-self by magnitudes that it can control, not by ones that it cannot control. If, as the authority has often done, it takes interest rates or the current unemployment percentage as the immediate criterion of policy, it will be like a space vehicle that has taken a fix on the wrong star. No matter how sensitive and sophisticated its guiding apparatus, the space vehicle will go astray. And so will the monetary authority.”

-The Role of Monetary Policy by Milton Friedman

On Sunday I outlined a game plan for the week with expectations of increasing volatility. Needless to say the first two days have far exceeded my imagination. While most investors watched in disbelief on Monday as markets sank over 6 percent, yesterday’s nearly 9 percent reversal from overnight lows was even more remarkable. For those unaware, after China reported higher than expected inflation, S&P futures tumbled from 1111 to 1077. By the market open, futures had roared back to 1138. After stumbling near flat, the market surged another 30-plus points. Following the Federal Reserve’s statement, trading ranges expanded dramatically with the market initially selling off nearly 50 points before rallying back 75 to ultimately close almost 5 percent higher. Volatility certainly appeared heightened by the Fed meeting and their semi-policy change is worth further consideration.

Over the past several days, an increasing number of investors and economists have been calling for the Fed to enact QE3. When the Fed initially decided to apply quantitative easing (QE), market liquidity had dried up and financial institutions were witnessing modern day bank runs. QE was an effective means for exchanging liquid assets (Federal Reserve notes) in return for illiquid (generally devalued) securities. Responding to a liquidity crisis, QE was well directed and ultimately successful.

Last summer the economic recovery showed deterioration and stock markets sold off substantially. Renewed Fed intervention involved another round of quantitative easing aimed at reducing interest rates and increasing asset values. If successful, these measures would generate increasing consumption and debt while lowering savings. This policy was ill-advised as the economy no longer suffered from a liquidity crisis, but rather a balance sheet recession in which excessive private debt decreases aggregate demand.

Beyond being misguided, QE2 was also poorly understood by much of the general public. Common conception is that quantitative easing is inflationary money printing. However, as noted earlier, quantitative easing (as practiced) is strictly an asset swap between the Federal Reserve and banks. Operationally, QE2 simply involved the Fed exchanging interest-bearing Federal Reserve notes for treasury notes. Net financial assets were not actually increased during this process. Quantitative easing therefore involves no money printing, simply swapping assets.

Misunderstanding the Fed’s policy as inflationary, markets sold dollars and bid up asset prices. Unfortunately for the Fed, markets viciously bid up prices of real assets including food and energy. With many households still over-burdened by debt and high unemployment restraining income growth, these increasing costs actually reduced demand for other goods. This recognition is likely why the Fed correctly believes higher inflation will be temporary. Reviewing recent GDP and unemployment data, it’s patently false that QE2 had a significant, if any, positive economic impact.

An obvious follow up question, why are people demanding QE3? One argument claims that dollar devaluation increases exports and as a byproduct, economic growth. Ludwig von Mises and Frédéric Bastiat (among others) clearly disproved this notion decades ago, but I’ll save that topic for another day. Others hold out hope that wealth effects create far larger multipliers than most economic research shows. Another group believes simply doing something is better than nothing. In spite of requests, the Fed thankfully did not proceed with QE3 (at least not yet).

So what did the Fed do? Well, in some ways nothing and in some ways everything. From their statement:

“The committee currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013”

Although not explicitly stating interest rates will remain “exceptionally” low through mid-2013, markets reacted as such. In Treasury Yields Low for Good Reason, I noted that “interest rates are a function of the expected rates over that time period.” Hence shifting expectations for 0 percent rates through 2013 sent treasury yields plunging, with 10-year notes briefly touching an all-time low of nearly 2 percent. Longer-term inflation expectations also moved higher, devaluing the dollar and creating a surge in equity markets. Impressively, without committing to actual policy change, the Fed effectively generated the impact of QE (at least for a day) with some wisely chosen words.

This post began with equally wise words from Milton Friedman, chosen specifically from his paper, The Role of Monetary Policy, which outlines my greatest fear of the new Fed policy. Friedman posits that monetary policy is unable to control real interest rates, apart from short periods, which remain relatively stable over longer time horizons. Since economic capital is only produced if expected returns are positive, real interest rates must be positive in the long-run. Monetary policy, as determined by the Fed, sets nominal interest rates. Friedman’s theory implies that long-term nominal interest rates are equivalent to long-run real interest rates plus inflation. Therefore a “monetary authority could assure low nominal rates of interest--but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy.”

In 1996 the Bank of Japan (BOJ) lowered benchmark interest rates to 0.5 percent, attempting to jump start economic growth stunted by debt deleveraging. Over 15 years later the benchmark interest rate sits at 0 percent, having never exceeded 0.5 percent during that span. Given Friedman’s framework, if long-run real interest rates are around 1 percent, then maintaining an effectively 0 percent nominal interest rate requires Japan to experience small, consistent deflation. Japan’s economic record the past decade displays confirming evidence of this assumption.

During the financial crises of 2008, the Fed lowered its benchmark interest rate practically to 0. Although initially expected to be temporary, yesterday’s projection portends retaining a lower bound rate policy for at least 5 years. If structural changes are not made, a weak economy could keep Fed rate hikes on hold far longer. As Friedman theorized and Japan bore witness, maintaining low nominal interest rates is ultimately deflationary.

What I find most discouraging is that the names of Keynes, Hayek and Friedman are highly revered today, yet much of their work and philosophy appears to have been lost in translation. Monetary policy today focuses on both fronts Friedman argued would lead the “space vehicle...astray.” Avoiding an outcome similar to Japan requires policy makers to recall the great economic minds of the 20th century. As the philosopher George Santayana said, "those who cannot remember the past are condemned to fulfill it."