The Deflationary Trap and the Central Bank Game of Chess

chessMy financial start in life came in the 1970s when rent houses seemed to be a good idea. That was because its rental stream was ratcheting upwards in an inflationary environment and could also be acquired with its original fixed-rate mortgage still intact.

What made the investment especially appealing was that the inflationary wind was to my back; rental streams grew while the mortgage’s interest carry remained low and locked at a fixed rate that reflected earlier and more modest inflation.

And as you might think, the combination of inflation-enhancing income streams and cheap fixed rate financing is an environment that promotes the building of more of the same — not only more houses but more importantly corporate plant and equipment that grows jobs and output. Hence, economic performance benefits from inflation, to some degree.

A return to these conditions is what central banks of the world, especially in Europe and Japan, lust for today. Instead, they find themselves on the edge of exactly the opposite — a deflation that neutralizes the benefit of the low fixed rates that central banks have manipulated since the onset of the Great Recession.

But one must appreciate the full extent of the deflationary threat facing many developed countries today that drives policy and markets.

Deflation more than neutralizes the low interest rates provided by central banks because investment in real physical assets is deterred by the prospect of deflating income streams. And that reduces spending on new physical assets which, in turn, reinforces the deflationary environment.

That is, while deflation may be the product of previous soft economic conditions, it inhibits further physical investment in real assets thus reinforcing the existing deflation.

This is known as the deflationary trap.

And that’s not the end of the self-reinforcing deflationary damage. Deflation also shrinks top-line income of the corporate, government, and consumer sectors which diminishes spending and in turn makes it more difficult to repay existing debt. In other words, the real value of debt increases leading to default and default takes down not just the borrower but also the lenders.


The iconic scenes of bank panics of yore in which depositors line up to withdraw their funds tell a story. The depositors believe deflation induced defaults in the banks’ loan portfolios will cause the banks to fail and they had best retrieve their deposits while they can.

The dynamic leaves the banks not only with loan losses but no lendable cash. It still plays out today though not as visibly as deposit withdrawals are on-line as in southern Europe.

That was the story of the l930s.

If both the desire to borrow and the ability to lend go away, the wheels of an economy no longer function in the way we are accustomed, no matter how much money supply the central bank spreads around.

Since the developed countries are on the edge of the deflationary trap, many of their central banks are resorting to quantitative easing (QE). These epic asset purchases do not produce the lending and spending or inflation that monetarism suggests, nor do the QEs reduce interest rates, as they are already at the near-zero floor. Rather, in a great Hail Mary, the QE at this stage is intended to devalue the home currency so that domestic produced goods become relatively cheaper for foreign buyers and they do buy more.

That is the motive for quantitative easing — to gain greater global market share through a cheaper currency and hence goods, which is all that monetary policy contributes these days.

While selling currency on the foreign exchange markets is the direct route to a cheaper currency as practiced by China, it goes against the rules of central bank monetary chess. So the currency selling needs to be more subtle.

The preferred way to accomplish the same is a QE of large-scale asset purchases of domestic financial assets. The central banks claim its domestic monetary policy and leave it up to private investors seeking higher yield to head for the financial markets of other countries where slightly more than microscopic yield still exists.

In the process, the investors heading abroad sell their currency and cause the currency devaluation and do the dirty work for the central bank. It’s not much of a cover-up, but it’s what central banking has come to be these days.

What other reason would cause, for example, Japan to roll out yet another QE in heroic proportions and then, less than a month later at the news of yet another Japanese recession, to increase its very recent QE by 33%?

If successful, a cheaper Yen attracts foreign buyers of Japanese goods and enough demand to turn deflation into inflation that generates inflation streams for home-grown investment in physical capital. It also gives domestic producers pricing power, when the prices of imported goods rise in terms of the Yen.

So the self-reinforcing deflationary depression leads to often contentious policies of currency devaluation via investors in an effort to capture greater global market share and some modicum of inflation. The Fed’s QE3 of the previous two years that ended last month paid dividends for the U.S. in this game at the expense of Europe, Japan, and others, which, in turn, triggered their re-entry into the currency wars just as the Fed ended theirs.

Other countries are now in retaliation mode in this game of central bank monetary chess, hoping to steal some demand back from the U.S. This leads to not just the depreciation of their currency but the ascendency of the U.S. dollar and the value of U.S. assets, which was nice at first until we find out it’s gained at the cost of a now-perceptible slowdown in the U.S. economy.   In this stage of the currency wars, the U. S. is about to lose some of what it previously gained when the Fed was in QE3 mode.

Hence, quantitative easing is no more than a cover-up for currency devaluation: it allows government officials to claim their hands are clean from a practice that is globally frowned upon.

In the process, central banks have revealed that money growth is not the inflationary threat once thought, at least not in this environment. We have come to the understanding that in the deflationary trap, neither fiscal nor monetary policies are what the textbooks say they are.

Public policy has come down to the sorry state of manipulating growth and inflation at the expense of someone else’s deflation. It’s a zero sum game of redistribution among countries that adds little overall lift to the global economy.

Few who lived through the “runaway” inflation of the 1970s would have dreamed that someday inflation would be a desirable public policy? We have come to find out that it surely beats deflation. But how to achieve inflation has proven to be elusive when lenders are fearful of deflationary induced default and business investment borrowers need more inflationary wind to their back.

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On Saving the Economy: Plan B

The antidote to a troubled macro environment since Keynes wrote the book in the 1930s has been the dual demand-side sledgehammers of government deficit spending and monetary expansion.

Both were thought to induce private spending with multipliers that would generate output and absorb the unemployed. Well, that’s how the theory went.

When it was first applied, it was not a theoretical experiment but rather the necessity of paying for and financing WWII.

At that time, the twin necessities of fiscal and monetary policy jolted the economy forward with such force that the unemployment rate was driven down to 1.2%. It appeared to provide validation of what fiscal and monetary policy could do, and economists and policymakers around the globe embraced it (and they still do).

After all, it simply required legislation for spending, raising the debt ceiling, and the Fed’s Open Market Committee’s agreement to go along with it. Basically, it was Bureau of Engraving and Printing policy that printed both the Treasury securities to pay for the deficit spending and the dollars to purchase them.

It was the easy way out, which became Plan Ain times of economic distress, whether they’re related to shortfalls of income or jobs. And now it’s also intended to rebuild wealth, save banks, and cheapen the dollar as well.

But for these macroeconomic sledgehammers to work, they are not cheap. US Government debt to GDP has increased from 62.7% to 101.6% in the last eight years. The relative size of the Fed’s wartime quantitative easing was a 50% expansion of its balance sheet — as opposed to a 300% expansion in the modern day reincarnation of QE. But alas, unemployment has been driven down to but a narrowly measured 6.7%.

So it’s obvious that something else is afoot, and it has to do with the question of why the twin sledgehammers are not working as well anymore. And furthermore, what is the “something else” that policy makers are now turning to? That is to say, what is Plan B?

The basic answer to why the sledgehammers are not working is that both monetary policy and fiscal policy are debt-financed spending, either by the government or the private economy. The problem is that it works as a cyclical remedy, as long as the debt doesn’t accumulate — which implies that in the prosperities that follow, debt reduction should take place. That is what George W. did not do, but Bill Clinton did.

The need to avoid accumulating debt was forgotten as the economic high just induced a greater desire for prosperity with mindless expansion of the debt-to-income ratio.

Basically, debt-driven spending — whether public or private — is a cyclical policy that is not meant to be a long-term secular fix. If a government and the Fed keep at it as a secular fix, it has offsetting effects when a greater share of income is required to service debt.

This is not lost on the private economy, as consumer debt relative to income has been worked down since it peak in 2007, which in turn continues to slow the economy today. Nor was it lost on Keynes himself. But governments didn’t get the memo, and they keep on piling up debt, which restricts the economy by creating a need for more revenues to service that debt.

The twin forces of stimulus from debt-financed spending and the subsequent need to service or retire debt is becoming evident today. As an example, in Japan since the last election, Abonomics has employed the macro sledgehammers with great force but has followed up with a national consumption tax that offsets Plan A. Much the same is happening in Europe and in the U.S. with QE tapering and fiscal sequester reining in the expansion of Plan A.

So what becomes Plan B when Plan A is being made to face the facts — specifically that secular debt accumulation is ultimately counterproductive?

Politicians are now doing what is pragmatic to attract business to their geographical location without the benefit of Ivy League economic theory. This is being done city against city, state against state, and now country against country. Plan B at the country level was the subject of the recent G-20 meetings as a response to the Fed’s tapering of QE, so it’s going global.

Plan B takes the form of reducing taxes as compared to your competitor, enacting less costly and burdensome regulations, and even underwriting business start-up expenses. It also takes the form of job training and infrastructure development. Those and other efforts are supply-side efforts to be relatively more competitive.

Some of them are outliers by historical example. That would include Michigan, which became a right-to-work state in 2012, and others in the Midwest are following.

There is a significant difference in the public perception of Plan B as compared to Plan A. In B there is little accompanying press and no photo opps for the politicians or the Fed Chairman, and hence fewer images to drive Wall Street expectations. But these low-profile policies are relentless, albeit slow. On the surface they appear to be policies that do more in totality than merely change the location of business. The benefits come in the form of greater efficiency (measured by output per worker) and less debt accumulation, either public or private.

Are they enough to offset the unintended debt consequences of previous demand stimulus? That we shall see, but at least this is a move in the right direction toward offsetting the ill effects of secular debt accumulation.

A major question is: Can these policies that are associated with the Right Wing be implemented by Left Wing majorities in many places? Well, if Liberals are in political control, they are also responsible for economic outcomes. So they will find ways to implement typical conservative platforms packaged as inspired liberal genius.


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Economic Direction as Seen Below the Radar

The financial press’s take on the economy and financial markets has lately been cloudy. The growth rate has indeed been drifting and the economy is being subjected to adverse shocks. But let me suggest there is good reason to believe there is a positive direction emerging below the radar of the cross-currents.

One way to reveal patterns of growth is to break down or decompose economic time series into long-term secular trends, cycles and shocks, which take on a pattern of random noise. Since the noise sells newspapers, it receives the lion’s share of daily attention, and it can also cloud the economy’s overall sense of direction. Certainly, the recent plethora of shocks — whether tapering and then more tapering, the emerging market sell-off, Obamacare’s attendant ripples, or adverse winter weather — can create a sense of economic drift or even contraction.

But it seems to me that more important cyclical forces are unfolding below the radar, moving the economy so slowly that its movement is barely detectable.

When I say cyclical forces are moving the economy, I mean that they have a life and momentum of their own apart from the shocks and the secular influences. That is, economies slipping downward don’t go to zero, and economies moving upwards don’t go to infinity. Growth sets in constraints — which typically are overinvestment in durables and plant and equipment — indeed leading to an absence of investment in the recession that follows.

Similarly, during times of recession, a backlog of deferred replacement for capital goods occurs and is ultimately fulfilled. This is true whether the capital goods or durables are those of the consumer, business or even the government.

The below graph depicts the duration and amplitude of U.S. employment cycles during the last 70 years or so. The graph reveals that when the economy goes down, so does peak employment from the previous cyclical high. The depiction of cycles is centered on the cyclical employment bottom, which is measured relative to the number of months since the beginning of the recession.

As you can see, most of the post-WWII cycles were relatively short and mild compared to our current episode (shown in red), which is still struggling to return to peak employment six years later. The current recession is a long-bottoming-out saucer that stands out from the much shorter and shallower post-WWII business cycles. The graph shows how the current “recovery” has been slow-moving but nonetheless persistent.

Easier and cheaper money has been the usual driving force that lifts the economy out from a cyclical bottom. In the first wave, it stimulates consumer durable spending, including housing after an absence of durable replacement. This revival has already occurred in the U.S., causing a bottoming out of our current great saucer.

The typical second wave of a cyclical recovery is business investment spending on plant and equipment, which kicks in after demand rises faster than the supply side is expanding. The usual pattern is that business meets higher demand levels first by adding labor, which becomes more expensive as it becomes scarce.

The availability of skilled cheap labor in the U.S. is becoming constrained due not just to rising employment levels but also to an unprecedented drop-out factor in labor participation. Furthermore, much of the globalism movement of the past 30 years (i.e., moving production to countries with large pools of cheap labor) has pretty much run its course.

In that situation, the recessionary lag in business investment spending tends to kick in, driving the next phase of a cyclical expansion.

The usual benchmark for this to occur is when industry capacity utilization reaches 80 percent — and U.S. total industry utilization is now knocking on that door at the 79.2 percent level.

capacityFurthermore, most of our emerging market competitors’ utilization rates are above those of the U.S., so the expansion of the capital goods industries is likely to be a global phenomenon.

Basically, there has not been a capital expenditure boom since the tech go-go years in the late 1990s, and the capital equipment we do have is aging, with an estimated life of 22 years (up from a more usual 19 years.

Much like my 1999 Pathfinder of the tech year vintage, it has physically worn out, and the usual capital goods replacement phenomenon has me reaching for my wallet. But in that regard the business sector is cash-rich like never before, so the usual obsessing over interest rate elasticity of investment spending is less relevant. If it were relevant, rates are low enough.

Indeed on the financing front, a great deal of financing occurred last year via the non-bank banking sector on top of retaining earnings for years during the recession. To the extent that the Ma and Pa shops did not get in on last year’s financing bonanza, the commercial banking system is showing signs of loosening up credit six years after the shockwaves of 2008, and banks should again become relevant for them.

So basically we are at the point where the baton to keep this race moving forward is in the hands of business cap spending, as consumers are showing signs of constraints in paying for more expensive health care.

The other missing sector that has not been heard from (or at least is not making a lot of noise) is the gradual removal of the net export drag. Available domestic energy is a very positive and long term “shock” to the system.

So cap goods spending, which disappears in recession, reappears at about this juncture of the business cycle, fortified by physical obsolesce, a shortage of skilled labor, and ample cash on hand.

Will this be a typical business cycle recovery? Well, there is nothing about this recovery that is totally classical, as it’s been a classic all to its own. But this fundamental impetus from deferred demand for capital goods stands a high probability of being realized to keep the ball rolling forward.

Moreover, despite governments at all levels attempting to get their fiscal houses in order, there is also a deferred infrastructure demand that will pressure the replacement if not the expansion of the existing roadways across America that are in critical neglect.

While there is good reason to believe that the current cyclical movement will continue into its next phase, one must realize that as employment grows and labor markets become tighter — especially for the skills needed for today’s plant and equipment — labor costs tend to rise as a percentage of the corporate top-line revenue leaves a thinner margin of corporate profits.

So we get into the anomalous territory where growth continues but profit margins and total profit growth decline. So the growth of the economy and the growth of profit diverge at this juncture as an aggregate number, but the focus on the growth industries in this environment makes this a stock-pickers market — unlike last year, when the broad indices outperformed the economy.

As a last note: Cost-push inflation often creeps into this second stage of a cyclical recovery,  which causes fixed-income prices to decline in the later portions of cyclical patterns. We should anticipate much the same to happen again, which makes inflation-sensitive income streams more valuable at this juncture.


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The Now Generation Government Has Failed the Marshmallow Test: Making Sense of the Fiscal Cliff Outcome

Over the past five years, the government has applied the usual demand-side remedies in the epic battle against The Great Recession. The graph shows the time profile of past recessions and recoveries as compared to the Great one that we are still in. Though stimulus fiscalcliff1has been applied in heroic proportions, the employment high ground of five years ago has not been revisited.  This graph clearly reveals this recovery lags all others in the post WWII era in which stimulus spending was considerably lower.

At this moment in history, the realization that continuing to run deficits to win the recessionary battle is compromising the ability to win the war of fiscal sustainability — and without that goes future entitlements, at least in real terms. Thus a trade-off of now vs. the future needed to be confronted.

As former Wells Fargo CEO Richard Kovacevich puts it, at the end of the day, the fiscal cliff deliberations continued to put the stimulus on the overstretched Federal Credit Card.  In his words our federal budget is equivalent to a family earning $22,000 per year, but spending $38,000 per year with an existing credit card debt of $143,000.  The next leg of the saga is to raise the debt ceiling so we can continue to max out a higher credit card limit.

What all this did was to reveal in plain sight that our leaders, who are likely a reflection of our population at large, are members of the Now Generation.

Overcoming our current inability to deal with the bigger problem of fiscal sustainability is key to economic growth as well as maximizing future fiscal proceeds and government benefits. To do so requires an inter-temporal trade-off.

This is a classic test of immediate vs. deferred gratification.

This trade-off was memorably tested in the “Marshmallow Experiment”fiscalcliff2 of children aged  4 to 6 by Stanford psychologist Walter Mischel  who found in a follow-up study that children who were capable of deferring gratification eventually went on to earn higher scores on their SATs and achieved other life accomplishments that require some front-end investment.

Now it is important to note that the Stanford Marshmallow Experiment offered higher returns as compared to present returns. That is, the promise of two marshmallows later vs. one today was made by Professor Mischel, not the U.S. fiscal system.

In our case with projected growing entitlements, we just can’t vote them in and expect them to happen.  We need an environment that would be conducive to fiscal discipline so as not to allow unaffordable debt overhead, lest Reinhart and Rogoff effects of slower growth and government default set in. While this might seem Utopian it has happened, even in the U.S.

The Gramm-Rudman-Hollings Balanced Budget Act nearly 30 years ago addressed the issue of defining a framework to self-control government deficits. Basically, the Act created the requirement that adding a dollar of spending would require identifying a specific spending reduction. This caused each dollar of additional spending to be traded against some existing obligation as a yardstick of value.

Well you can image how popular that was, even then, when leaders could pass the marshmallow test!  Regrettably, the automatic self-constraint mechanism was found to be unconstitutional and was replaced by a succession of legislation that watered down the spending and deficit constraints and brought us to our current state of allowing debt to compromise the economic growth engine along with fiscal sustainability.

In today’s societal trade-off, Congress likely has already put us in an environment in which one marshmallow today will only perhaps generate a fraction of a marshmallow tomorrow. That is, growing marshmallows for the future requires deferred gratification today so that today’s debt is not a deterrent to economic growth and future government revenues and marshmallows.

One factor that reinforces the lack of will to bring about deficit and debt control that could lead to additional future marshmallows is the unwritten American ethic to not willingly fork over to the federal government more than 20 percent of annual GDP in all forms of collected taxes.  If individual income tax rates would generate Treasury Revenue that exceed that proportion of total GDP, deductions and exemptions have been added to the tax code to keep the checks written within society’s actual shadow ceiling.

Even during the height of WWII, with an economic boom and confiscatory individual and corporate income tax rates, the government was only able to raise an income share of 20.9 percent of GDP from all tax sources —  even though the federal spending shares of GDP was 43.6 percent in that wartime period.

Since then, only capital gains of the tech era generated a Treasury revenue share of GDP barely in excess of 20 percent of total income. The state of the economy is the primary determinant of the Treasury taxes paid, so a slow-growth economy spells big trouble for the deficit almost irrespective of tax rates being agonized over in Washington.

The rates that Congress does apply are more for political showmanship and a statement of the collective values, wants and needs of its members rather than a reflection of actual revenues received — though I doubt most of them realize it.

In 2011, the Treasury collected only 15.4 percent of total GDP against spending of 24.1 percent, accumulating debt equal to 8.7 percent of the current GDP pie. This will continue for as long as the eye can see or until the deficit can no longer be financed or pawned off on the central bank.

On top of those implicit American inhibitions, the issue of shared sacrifice in the face of imminent danger is also a passé American ethic, as discussed here by Lacy Hunt.  In 2011, the bottom half of the income spectrum contributed but 2.4 percent of individual income taxes receipts, and the recent taxing the “wealthy” adjustment only reduces that proportion.

We can only guess what tomorrow’s marshmallow allotment will be. But with no deferred gratification constraining debt blow-up, no shared sacrifice, and no willingness to give up more than 20 percent of GDP, future gratification will fall on the back of the central bank until inflation inescapably reduces tomorrow’s marshmallows in real terms.

If there is any rationality to it, what Congress and the President seem to be saying is that they realize there is no Professor Mischel to supply two future marshmallows and that the government’s ability to do so is already lost, except via money illusion of the printing press. So, their logic has become, deferred gratification on our watch is senseless.

Investors thus far have been concerned that would be the unintended consequence, but it now appears to be the unspoken plan.  Investors would be wise to protect themselves.


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What does Thomas Edison have to do with bonds and gold?

In these times of economic upheaval, divergent opinions regarding future inflation exist side by side:  Either Grand-scale inflation or deflation, take your pick.  The differences are actually not side by side but at either tail of a subjective probably distribution of inflation expectations.  This is economic jargon for the simple idea that there two opposing stories being told as to how future inflation will play out.

This cleavage in expectations exists not just among economists, but opinions also divide Fed policymakers and financial market participants alike who simultaneously assign, for example, very high prices to both fixed income debt that benefits from deflation and inflation-adjusting debt (a la the Treasury TIPs) that benefits from inflation.

There was a time in my life when I was involved in the development of inflation adjusting financial products that ultimately earned a U. S. patent.  In what was an education in investor behavior, I was surprised to find both buyers and sellers projecting 30 years of future inflation solely based on the last monthly CPI report extrapolated forward for 30 year.  So today’s bimodal inflation expectations are a notable exception to the usual normal distribution of expectations squarely centered on the most recent past.

So what is at the heart of the cleavage in inflation expectation?  Obviously, there are two visions of the eventual outcome of the financial crisis and the Great Recession whose repercussions continues to morph and plague the economy.  It has resulted in extremism in government financial needs and monetary policies never before seen in the developed world to contain the recession and aid and abet the refinancing of consumer debt and the financing of government deficits.

But also on the minds of inflation watchers is the implication of the baby boomer entitlement boom which is now booming.  For example, the Social Security Trust Fund, the only entitlement with a trust fund of any significance, is expected to be depleted in only 3 years. Thereafter the financing of the boomer entitlement packages will create leaps in government financing stains and further central bank co-opting to make an inflation outlier possible.

Whatever the historical model or the free floating paranoia cited by the Grand-scale inflationist, it all follows from the pressure on governments to raise funds by selling bonds either to support the economy or support the entitlements and for their central banks in turn to purchase a large portion of that debt as central banks do with printing money.  That is made necessary because private saving both domestic and/or foreign are insufficient to finance the government’s debt lust. To most Grand-scalars the process comes down to the single catchword: “printing.”

Since much ink has been devoted to Grand-scale inflationist arguments, likely as much ink as needed to print their feared currency explosion and I won’t add to it here but rather review the deflationist’s positions which are less well known and are subject to recent qualifications.

The deflationist views are almost as radical a departure from our historical norms at least among the living. Deflation is associated with depression which to the deflationists arises from the idea that servicing both the consumer debt load and the government debt load, both present and future, will deplete income streams leaving very soft goods markets demand and hence soft pricing.

Other deflationists point to the possibility of a sovereign default which is not likely with the printing press within reach of our government.  If it were to be a sovereign default generated deflation it would likely be delivered as the result of contagion from a depressed European default.

But deflationists still find falling prices a likely outcome even without a default as a result of the fiscal restraint to prevent one.  That is, the upcoming fiscal cliff is not seen as a one-off exception but as the forerunner of generalized austerity for a long time to come that will be sufficient to soften demand in goods markets so as not to put upward pressure on goods prices, despite the “printing” they observe.

So to today’s highly influential deflationists and bond devotees, the soft demand creates excess supply in goods markets is seen as an insulation from inflation if not the driver of absolute deflation. In this case, the asset of choice is fixed income, the longer the maturity the better, general stated as a strategy of safety and income at a reasonable price (SIRP) championed by David Rosenberg and other very notable financial economists.

The supply insulation from inflation is measured by the excess productive capability relative to aggregate demand and is shown in the accompanying graph as the difference between Potential GDP (the supply side) and Actual GDP (the demand side) for the past dozen years.  When the Great Recession arrived, the demand side (Actual GDP) plummeted well below Potential creating what is known as a deflationary gap.  Deflationary gaps have been seen before but never of this magnitude in the post WWII period.

What could eliminate the inflation safety margin would be successful government attempts to spur Actual GDP upward and onward to approach the path of Potential GDP.  However, the massive fiscal and monetary stimulus during the Great Recession years has only put an end to the GDP free fall and thereafter GDP demand has only been able to track below and in parallel with Potential GDP target leaving what appears to be a substantial margin of inflation insurance.

But alas, the deflationary gap comfort margin for fixed income also depends on the growth path of Potential GDP.   The estimates of Potential supply are made by the Congressional Budget Office from projections of increases in capital (plant and equipment), the labor force and the productivity of the combined labor and capital inputs.  For much of the post WWII era we lived in the heady bubble of steady state growth with relatively minor and short recessions which made steady state, trend extrapolation easy and more reliable.

But, we are now finding that without the pressure of demand growth, a lot of things change including the incentives to add new plant capacity when excess capacity exists and labor is cheap.  An additional slowdown of Potential occurs as new plant and equipment generally embodies the latest technology and makes a productivity contribution to Potential as well. That is, the engine of Potential Supply runs through the Thomas Edisons in the laboratory, to venture start-ups and through the IPO process but it has downshifted and reduced not just the level of Potential GDP but its growth rate as well.

As a result, at year end 2011 the deflationary gap would have been a very large 11.3% of GDP had the estimated Potential Supply growth made at the onset of the Great Recession been realized.  However about half of the inflation insurance provided by the deflationary gap has disappeared based on the 2011 Potential GDP revision, leaving a deflationary Gap of 5.6%.   If one were to examine the graph and extrapolate both Actual and Potential GDP it would not be many years before they cross.

Further concerns for the supply side exists when we find that when Plant and Equipment spending slows down, its average age is getting older hence both labor and capital should be comforting each other as they grow old together.

Moreover the general negative view of the outlook for productivity growth has been expressed by Robert Gordon the well-known productivity expert and is well summarized by Martin Wolf in “Is Unlimited Growth a Thing of the Past?”

While the Deflationary Gap is still substantial, we can see where things appear to be headed. The logic is clear: Necessity is the mother of invention, and without pressure to produce more, there is little sense in building a capital stock that imbeds productivity gains. This idea is consistent with recent data revisions.

With an economy that is trapped into long term sluggishness and consolidation on the demand side from fiscal austerity pressures, it will also slow the Potential Supply side. This means it takes a lot less growth on the demand side to generate inflation.  And add to that the commodity supply shortfalls which keep upward pressure on food, energy and raw materials prices.

Indeed, even with a Great Recession when, other than in the cascading shrinkage of 2009, deflation has not been forthcoming as suggested by theory.

While the Tomas Edisons of the world are still out there tinkering, fewer of the fruits of their research are benefitting productivity.  The implication is more inflationary sensitivity than one would expect from a relatively slow growth economy which provides comfort to the value of the investment categories favored by the Grand-scalers such as gold and real assets.


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Ben Bernanke and the Implications of The Great Monetary Hail Mary

These are epic times in the developed world’s attempt to deal with the implications of government and consumer over-indebtedness. A general unshakable malaise has set in due to sluggish spending and a deleveraging banking sector, and as a result, employment growth is suffering. Governments in turn are faced with diminished tax yields and deficits remain bloated. As shown in Europe, ultimately they run out of willing buyers of government debt.

Inevitably central banks are called in to treat all these related symptoms of the underlying debt disease. That momentous time has arrived for Europe as the debt symptoms have progressed to adversity in the selling of government bonds. Meanwhile, the more stressful symptom for the U.S. at this time is unemployment.

In the past weeks, the central banks of the developed world have taken the next big step, a monetary Hail Mary, to combat these symptoms. A Hail Mary is an act of desperation associated with putting all the chips on the line when your team is behind and time is running out. The ECB offered to support the bonds of those Euro countries that have lost willing private buyers and Germany — the last holdout — has accepted the offer. This will be a four-decade bond support program given the demographic-related deficits that will occur. For the baby boomer generation, their related entitlement spending has only just begun.

The Fed then made an open-ended Hail Mary of mega asset purchases that will ostensibly continue until the labor market is healed through self-sustaining growth.

This could be a long period of time given Bernanke’s claim that 2 million jobs have been created as a result of $2 trillion of QEs to date. If this estimate is correct — and there is ample evidence that it is an overestimate of monetary effectiveness — it implies that each added job comes at a cost of very close to a million dollars of monetary expansion.  These are very expensive jobs.

The Fed’s estimate is imbedded in its macro model of the economy, which is based on the good old times when the Fed could be effective when not faced with the retardant effects of an over-indebted consumer wishing to deleverage and a banking system that does respond to more base money (See Eisenbeis Critique).

But for the sake of argument, let’s accept the Fed’s estimate of the employment response to base money increases to allow us to ballpark the needed size of the current QE. There are more than 12 million unemployed and 9 million labor force dropouts since the onset of the Great Recession, some of whom would return to the labor force if jobs were forthcoming. Furthermore, in the years ahead there will be new labor force entrants which number over a million per year.

To make this both easy and highly conservative, let’s assume that jobs will be created for only half of the jobless and half of the recent labor force dropouts, setting aside the future labor force entrants. That works out to about 10 million new jobs — a policy victory that the Fed would happily claim.

At the Fed’s implied rate of dollars per job created, this implies an asset purchase/monetary injection of perhaps $10 trillion on top of their original (pre-QE) balance sheet of $1 trillion and a current balance sheet of nearly $3 trillion.  This would take the Fed’s balance sheet to $13 trillion — which, interestingly, is the size of the moribund commercial banking system that contributes no balance sheet expansion in response to the Fed’s base liquidity. Basically a beefed-up Fed would fill the gap of the petrified banking system, at least in term of the quantity of assets held by financial institutions.  Too bad the Fed doesn’t have loan officers to make small business loans to make the effects really comparable.

This lack of commercial banking response to central bank liquidity growth is demonstrated (thanks to Gary Shilling) in the accompanying graph. M2 is approximately the sum of the balance sheets of the commercial banks and the central bank is shown relative to the central bank monetary base. It has shrunk by two-thirds as a result of the tripling of the central bank monetary base without much follow through by the commercial banking system.

Hence, to get the same monetary punch by itself, the central bank would need to expand to be an equally sized banking system as a replacement for the petrified banking system that hopes to survive by not lending.

But this is not the end of the epic monetary growth story. It didn’t take long for these QE announcements to have expectation changes that will lead to further second-round monetary expansion coming from abroad.

In response to the Fed’s actions, investors imbued with the Milton Friedman Reflex of money causing inflation are known to move wealth to countries with less exposure to what they believe is an inflationary future in the countries receiving the high doses of money.  These dollars run to some alternative port that would cause the recipient country’s currency to appreciate, as occurred with QE2.

In anticipation of this, central banks around the world are stepping in with plans to preempt a loss of export competitiveness that occurs when inflows of foreign capital cause currency to appreciate. As a defensive measure, the central bank sells its currency on foreign exchange markets to offset a currency appreciation. But the same money, when deposited in its still-intact banking system, is parleyed with banking system expansion. All in all, this makes inflation more likely with money flowing from central banks worldwide.

Japan will be the first big domino to fall in this monetary knock-down process, and Brazil, Turkey, and Korea are likely to follow. The Swiss are prone to offset currency appreciation, and so is China if capital washes up on its shores. So, the ripples of mega money expansion from the U.S. and Europe in turn creates mega monetary expansion in countries that were simply minding their own business and wishing to buy some protection their currency appreciation as a byproduct of the developed world’s debt problems.

This phenomenon, last seen in the depression years of the l930s, has a few names associated with it in the history books, but the clearest tag is competitive (currency) devaluations.

So now the monetary Hail Mary is “QE Squared” or “QE to the Third Power” (or more, depending on how many follow suit. So where does that take us?

This scaling up of monetary expansion with so little in the way of positive economic impacts calls into serious question the efficacy of Keynesian economics as it is currently understood, but this will not stop academia from teaching it. Keynesianism will likely remain the gospel for some time, but hopefully it will at least be amended to include the important idea that aggregate demand generation only works if there is not a debt load to scuttle spending and a well-capitalized flexible banking system to ramp up the monetary base. These pre-conditions cannot be taken on faith.

Furthermore, this blatant policy failure scuttles the 60-year era of faith in the efficacy of not just monetary policy but also fiscal policy to smooth out the business cycle. Emphasis is shifting to supply-side issues as opposed to more demand-side fixes that, in the words of David Rosenberg, have gone to infinity without positive effects.

While the Fed intended for QE3 to aid the unemployed, little or no mention was made that it has been financing approximately 60 percent of net new government debt issuance in recent years. So, there are both stated and unstated purposes of this monetary Hail Mary. On the sly, the Fed is doing the same thing the ECB is doing, which is treating both the employment symptom as well as the government finance symptom of the debt overload disease.

While the need to treat the government finance symptom in the U.S. will be more evident in coming years, as it is in Europe today, the more immediate goal is to maintain as near to zero nominal interest rates all along the yield curve with a constrained but positive inflation rate. The net result of that magic is that the real cost of borrowing is negative — hence benefitting debtors both private and public. But this is confined only to those able to refinance into today’s negative real interest rates.

This leaves out perhaps the most important stressed consumers: those with upside-down mortgage debt relative to home values.

While this monetary Hail Mary is good news for some debtors, the flip side to investors is known as financial repression. This does significant damage not just to the “moneyed” class (in today’s class warfare terms) but to everyone with hopes for either a private defined-benefit or defined-contribution retirement plan with income generation based on microscopic yields in the fixed income market. This also includes state and muni pensions (which are seriously underfunded to boot,) as well as the Social Security Fund that to the extent it is funded is 100 percent invested in U.S. Treasuries.

So saving the unemployed and creating the ability to honor entitlements today comes at a high cost to future cash flows for retirees and institutions hoping to survive on a steady income flow. The classic Keynesian marginal investment function is not responding to the lowest interest rates ever available. Few benefits and lots of costs have been the result of this over the top monetary Hail Mary.

But given that the inhibition to run the printing press is now passé, the race to the bottom (the cheapest currency) is a race to produce more money that enters the economic system not as money in our pocket but as money chasing assets that have a chance to appreciate. That has included stocks to some extent, though that movement seems overstretched relative to floundering profit growth tied to a floundering economy.

Taking all this policy action and associated responses, the markets will put premiums on real assets, especially those producing income that have some inflation sensitivity. There are not many assets in this category. As an example, the yield on Treasury TIPs has appreciated to the point where the yields are now negative based on the fixed return component, requiring a 2.7 percent future inflation to have an equivalent positive yield compared to the fixed income equivalent.

The most desirable asset class is the long duration and real income producing variety, especially if financed with fixed rates — which augurs well for income producing real estate or infrastructure. This includes the new respect given dividend paying stocks. Gold and precious metals are also up there despite not producing income.  These are the premium assets in today’s markets, especially if found in the few countries that might not move to offset currency appreciation until seriously burned in the export markets. That might be Canada, for example, given its bent for market-determined exchange rates and financial prices.

There are endless issues raised by these historic and monumental QEs. For now I will note a few of them: The Fed will most certainly lose some of its cherished independence as a result of this overreach, especially in that it has created income redistribution. That is, it has stepped on a Congressional prerogative. The only question is how much Congress will dictate future monetary policy. It depends on how inflationary it actually becomes. As a reminder, in the inflationary 1970s, Congress stepped in to restrain the Fed with the Humphrey-Hawkins Act, even under a Democratic majority and president. For better or worse, Ron Paul’s status as cult hero is growing.

Secondly and perhaps most sadly, given the Fed’s inability to stimulate the economy under the circumstances of a consumer and government debt burden and a petrified banking system that fears future losses and an over-dictatorial FDIC driven by self-defense rules. This means the Fed’s Hail Mary is destined to fail under today’s circumstances. The market will consider the Fed de-fanged even if it is not de-fanged by Congress. It will be considered the toothless tiger of Constitution Avenue.

With such a fall from grace, the intangible but important confidence factor in the Fed as a reliable rudder to the system will be lost for a long time to come. The Fed will cease to be held with reverence but rather will be considered irrelevant.

All this invites major Congressional recapture of the monetary compass, which is its Constitutional prerogative and would be the largest setback of all.  For if that were to happen, Congress, not an independent Fed, would at the time of  U. S. government bond market stress be in the driver’s seat to do just as the ECB is doing in Europe. The Fed’s has sadly extended its reach beyond its grasp with ill consequences ahead.

Some will say that academic lessons are sometimes learned well, but not wisely. This could well be the final ultimate test of Keynesianism or more broadly demand generating economic policy. Not only can they not be afforded, but they are also not effective in today’s circumstances, but they will still try.


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Milton Friedman and the Monetarist Reflex: Can the Fed create inflation?

These are complicated times, especially when it comes to inflation.

An excess of debt, both private and public, has retarded the spending stream, resulting in sluggish economic growth. Given the Fed’s legislated commitment to prevent financial implosion and unemployment, rounds of central bank monetary responses have followed. The intuition of more money in our pockets chasing a limited supply of goods, as well as our long intellectual history of monetarism, sets off the reflex that printing results in inflation. That hasn’t appreciably happened yet, but multiple rounds of QE keep markets on edge given the teaching of Milton Friedman,

To add to the inflation paradox, last January, for the first time, the Fed committed to producing moderate inflation (2 percent) “over the long run“. However, as recently reported by David Rosenberg, inflation at the producer level was flat over the last quarter, and given the Euro recession and continued U.S. sluggishness, it appears likely that the inflation goal might not be reached. Indeed, many credible sources are forecasting long-run deflation, a la the trend in Japan.

On top of that there is the conjecture, mentioned in a recent post that in the (likely) event of an uncontrolled government deficit, the role of the central bank would be to generate actual inflation that exceeds the expected inflation premium that had been priced into interest rates. The purpose would be to reduce the real cost of government debt. This seems to suggest that the long-term Fed inflation target is to keep expectations anchored at a number the Fed hopes to exceed.

But in the longer run, while accumulating four decades of baby boomer entitlement debt, it would take one surprise after another to exceed expected and priced inflation. And each would have to be larger than the last to continuously have actual inflation exceed that which is priced by the market. This is the implied path to what is journalistically called “runaway inflation.”

The Fed inflation targeting in the long run is one thing, but the real question is whether the Fed can deliver when it so far has not.

The paradox of strong growth in the monetary base without the inflation implied by monetarism first surfaced when the first Federal Reserve balance sheet leap occurred in 2008. At the time, many people believed that a doubling of central bank money chasing a short term fixed supply of goods would bring about a doubling of the price level.

Obviously, that didnt happen. The question is why not.

First off, at that time, the commercial banking system did not have the requisite regulatory solvency (an excess of asset values relative to deposits) to expand balance sheets if they had the risk tolerance. That is, today’s excess cash reserves of $1.5 trillion held by banks and a commercial bank money supply multiplier of say 10 would normally result in $15 trillion of lending and spending. A surge in bank-financed spending could roughly double the present $15 trillion annual flow rate of GDP and, with it, inflation.

The predicted proportionality of prices to money didn’t occur, as spending not only failed to increase appreciably with more central bank base money, but fell short of the economy’s supply potential so that deflationary forces from excess capacity still exist today. (This same phenomena to monetarists would be the explanation for the decline in the velocity of money.)

So the issue of inflation depends to a large extent on the ability and willingness of commercial banks to run with the base money given to them. The most recent reading of that is not encouraging to either the growth of spending or inflation, as the graph above shows.

Despite having been given a stealth capital buildup via an essential zero cost of funding program (in addition to the TARP subsidy), the commercial bank books claim solvency, but lending contracted in the first quarter. The Keynesian notion of the liquidity trap is still alive and festering with banks pointing to a lack of borrowers and borrowers pointing to a lack of willing lenders. The problem, more than loan risk analytics, is likely behavioral. As aptly discussed by Kevin Flynn:

“For the last 50 years banks have been behaving the same way — turning a profitable sector into a credit fad and then drowning it in the name of market share, management bonuses, takeover avoidance, or whatever. Once they blow a sector up, nobody wants to hear about lending to it again for another generation of CEO management, which runs for about five to 10 years (the last thing that managers brought in to replace disgraced managers want to do is more of what got their predecessors sacked). Banks finally got around to blowing up housing, so now we have a generation of bank executives in place whose unifying feature is the determination to avoid a housing bust that won’t happen again for another 70 years or so. The Fed can’t do anything about it.”

Given these impediments to produce monetary expansion and lending through banks, there are other routes by which the Fed might reach its inflation objective. Without bank follow-through, the impact of monetary expansion is limited to the Fed’s first round of financial purchasing power. This limitation of its firepower is what turned the Fed to large scale QEs, since there would be no commercial bank follow–through: They had to do the job themselves. But since the Fed is not a commercial lender, it mainly relies on what is known as a Pigou effect — a generalized market value of wealth spreading from bonds to equities and other assets that in turn induces limited spending but not at a rate sufficient to create inflation.

Another approach to inflation (which the Fed scoffs at) is un-lovingly called helicopter money. This was the first thing done when the financial meltdown occurred, in the form of the Fed putting money more directly into the hands of spenders (as opposed to financial asset markets). That is, rather than just continuing more of the same Fed expansion, helicopter money delivers fresh spending power directly to the end user (the consumer) over the heads of the moribund banks.

Believe it or not, this was implemented in the dark days of 2008, when the Fed purchased Treasury bonds that enabled the Treasury department to mail out an equal amount of government green checks directly to spenders. It flew under the radar screen as the checks were called tax rebates, and few knew the source of the funding. However, a wider distribution of government green checks coming from the Fed or the Treasury would require a more obvious money gift that would create contentious comparisons of need. To further rule out more green checks to consumers (especially voters), the Republican Party platform is now at odds with at grossly expansionary Fed tendencies, and the Fed is not likely to expose itself to legislative constrains to its independence.

If the government wishes to depreciate its debt and consumer debt with inflation, a more likely inflation alternative would be for the Treasury Department to turn to treasury currency, the United States Note. As previously explained, the government used this tactic to pay its bills during the Civil War.

In this case, the financing of government spending is facilitated by Treasury currency printing rather than Federal Reserve printing. Treasury currency would have a greater inflationary impact as it directly finances spending in goods markets. In this case, inflation would be a fiscal byproduct rather than a central bank contrivance.

Treasury currency would be more effective as it goes over the heads of the blocked banking system and reluctant spending units, and on behalf of the taxpayers, goes directly into the spending stream when the government pays for entitlements such as Medicare. As such it is a kind of super-helicopter money delivered to the goods markets rather than the financial markets or even to the consumer to be used for debt reduction as the new currency is injected into the spending and income stream.

When political leaders are pressed to “do something, it seems that this would be the “something” that could simultaneously finance entitlement spending, reduce the size of the fiscal cliff, and reach a desired inflation target. This is a something for nothing policy solution that politicians who take the path of least resistance would find difficult to ignore–and its in the law.

What an irony.  Despite the accusations being made, the Fed in these circumstances is only able to produce inflation expectations whereas Fed generated inflation is dependent upon a generational replacement of commercial bankers.

It seems the notion of an inflationary future one way or another is still alive and ticking. Recently, inflation adjusting assets including energy pipelines, gold, income producing real estate and infrastructure are now moving up in the markets and fixed income assets are moving downward. Though the Fed has struck out on the inflation front, the bet has switched at least at the margin to the government doing “something” in the long run to ultimately reach an inflation target. Keep tuned to see how these improbable policies and events work out.

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The Bond Market Rocket and Fiscal Unsustainability Are On a Collision Path

Recently, the bond market has been in rocket mode. It has achieved liftoff and slipped the surly bonds of earth. And some believe it will keep going.  The price of the U.S. Treasury 10-year bond recently reached an all-time high, generating yields at all-time lows. Moreover, the market yield on the British perpetual bond is reportedly at a 300-year low.  Bond mania has even spread to the sovereign debt of Denmark and Singapore and others where negative yields exist.  More astonishing is the ability of France to issue short-term sovereigns with negative yields!

The U.S. has eclipsed the record interest rates that prevailed when the 1930s Depression era came to an end with the onset of World War II, as shown in the chart to the right.

To get to the previous low yields of early December 1941, the U.S. economy had experienced a decade of depression with cumulative deflation of 30 percent.  With that decade-long trend influencing expectations, the future seemed to call for more of the same.  In that environment, investors favor long-term fixed income that appreciates in real terms as a result of deflation if the long bond is successfully paid and retired despite depression circumstances.  Hence the asset category of choice in a deflationary depression is survivable high quality debt.  In the ’30s, this also included surviving corporate debt that appreciated along with Treasuries, and the AAA-Treasury spread narrowed over the depression years.

Since we presently are in an era of Federal Reserve QEs, you might suspect that the Fed was possibly behind the rising Treasury prices and lowest yields of that era.  However logical it might seem in today’s context, the Fed was nowhere to be found on the buy side of the Treasury market during the depression (something Bernanke seeks to not repeat). Indeed, the money supply declined by 30 percent over the course of the depression, so the bond market did it all on its own, without Fed support. Indeed, being in a pre-Keynesian world, the rationale or desire for manipulating the interest rate or credit conditions was not part of the Fed’s understanding of how to run a central bank.

Then as now, the private market participants price the expected risks and costs of holding a debt instrument over its life, and they require additional yield for each risk and cost they anticipate will materialize.  They generally make this assessment of risk by extrapolating previous trends or by finding a similar historical episode to benchmark the likely gains or losses in value that might take place. Today we find many forecasts (even on this blog) citing the withering force of deleveraging due to over–indebtedness, which takes down an economy and softens demand and prices for goods.  Hence, today’s natural historical model for bond pricing would seem to be the 1930s.

However, while there are similarities, there are also big differences. Today it is the government that is over–leveraged, whereas in the l930s it was the corporate debt sector which makes today’s long Treasury yields suspect.   Though the economy is weak today, we are not in a decade-long depression, and while inflation is low, it is not in a cumulative deflation.  And while the Fed held back this week, they still have a commitment to positive inflation.

The greatest difference is today’s checkmated body politic, which is unable to resolve an ultimately un-financeable Federal deficit. This week we had another episode of kicking the can down the road, with the agreement to run the debt meter another six months before facing the music. This is all in sharp contrast to a much lower government debt load and an obsession to run a balanced fiscal budget despite the depression that prevailed in the 30s.

While the growth/inflation profile is different in the two eras, it is more important to note the difference in long-term fiscal sustainability.  Somewhere during the unfolding drama there will be an unspoken need (not mentioned in legislation or treaties) for the Fed to pull a “Super Mario” Draghi — who, last week, signed up to “do whatever it takes,” which apparently meant ignoring the ECB mandate and directly supporting Spain’s bank and government debt because the market no longer will.

Indeed, in the U. S. at the outset of WWII, the Fed presented the patriotic idea of wartime bond support to the Treasury, not the other way around. Central banks are not shy in the ultimate moment of money needs.

In what should be considered a “white paper,” the Fed’s role in these dire circumstances is recently discussed by Renee Haltom and John A. Weinberg in the Richmond Fed Annual Report, 2011, titled Unsustainable Fiscal Policy: Implications for Monetary Policy. In a rare Fed admission they indicate that “a central bank can reduce the government’s debt burden by creating inflation that was not anticipated by financial markets.  Inflation allows all borrowers, the government included, to repay loans issued in nominal terms with cheaper dollars than the ones they borrowed.”

Indeed, if the Fed were to create inflation, it would not be totally unanticipated.  This is the outcome seen by many observers, including Bill Gross of PIMCO.

And Bill Gross is not alone, as the bond-buying public seems to believe little of the fiscal sustainability story.  Indeed, the flow of funds data, at least for 2011, indicates that the private sector purchased a minority of net new government debt issuance.  Hence, private investors are not the leading purchasers of U.S. Treasuries, causing the all-time depressed bond yields. The graph indicates that the Federal Reserve is buying the lion’s share of net new Federal debt, and foreign investors are in second place. That market thrust no doubt represents a flight from European sovereign exposure, which is in a more advanced state of fiscal decay at the moment.

No doubt some have bought the1930s deflationary depression story as a model outcome to justify buying and holding sovereigns, but this time around it doesn’t lead to the necessary conclusion that sovereigns will appreciate from here.  At today’s entry point of taxable low nominal yields and negative real yields, betting on both a deflationary depression with fiscal sustainability is not only a long shot but is mutually inconsistent.

A deflationary depression doesn’t generate government tax revenues to reach fiscal sustainability unless the voting public is willing to accept a substantial entitlement haircut. Moreover, if the low bond yields were to be maintained it would systemically cause defined-benefit pension plans to underperform.  They would become forced sellers of sovereign bond holding to meet payouts — as is now finally occurring with Japan’s Government Pension Investment Fund.

The bond market rocket can glide for a time, perhaps years, until it collides with fiscal unsustainability. At that time it will be revealed plain enough for all to see when the private demand evaporates, much as it did with Spain this week. At that time, the U.S. Treasury is no longer a riskless debt instrument, nor is it immune from inflation.

(That being said, it leaves open the question of whether intentional inflation is bravado in the absence of bank lending, which will be addressed in a subsequent blog.)

When the market comes to understand that sovereign bond strength from a central bank is a mixed blessing — as it both purchases government bonds but also intentionally seeks to create “unanticipated” inflation —the bond market rocket is susceptible to the gravitational pull of Earth.

When that happens, there will be a large debris field for those who entered this untenable crowded trade (or stuck with it) so late in the game, supported not by the bond-buying public but only by a central bank wishing to do its patriotic duty — which includes inflation generation.

This indeed is not the 1930s.


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Denial, Default or Treasury Currency: the Hobson’s Choice

Spain’s financial vulnerability has been in the spotlight recently. The trickle-down from a single bank’s insolvency gives us a glimpse of how country funding shortfalls are likely to be handled in the coming decades.

The Spanish bank in question, Bankia, was short $23 billion of regulatory capital — small change compared to Spain’s existing debt and additional debt to make good on future baby boomer entitlements over the next four decades.

To plug the hole in Bankia’s capital shortfall, the Spanish government offered a promissory note to Bankia, which to the bank is an asset. To pay for this asset, Bankia offered equity shares of Bankia in favor of the Spanish government. With ownership of the bank shifting to the government, bank “nationalization” was alleged to have occurred.

The financial trickery became more interesting when Bankia attempted to turn the Spanish government IOU into ECB currency by borrowing from the central bank and using the Spanish government note as collateral. Perhaps this plan could have worked with a cooperative ECB, which might have gone along with the scheme, as it is constantly lowering collateral standards in order to spread financial resources over Europe’s government and bank needs.

However, the ECB demurred in outrage with Spain’s scheme to access an ECB currency loan on grounds that the collateral was not suitable. The issue was not so much the collateral but the fact that the transaction would have set a precedent for how the individual governments of the Eurozone could get control of the Euro printing press for their own bailout needs.

It was a nice try, if you ask me, to put Spain in control of Euro monetary policy to fund its own bailouts — a practice called “monetary finance,” which the ECB insists was not part of its obligations to member nations.

But the scheme did indeed recapitalize the bank in question, allowing Spain to honor its financial guarantee to an insolvent bank, though it just couldn’t take it the next step to turn country IOUs into Euro currency.

However, in the U.S., using fiscal schemes to turn country IOUs into currency to pay the government’s bills is a far more straightforward operation with no “independent” central bank to say no.  Indeed, during the Civil War, when the government was faced with wartime expenditures well beyond its limited taxing authority and a limited market for its debt, the National Banking Act of l862 empowered the U.S. Treasury (not a central bank) to issue “money” to pay the government’s bills with payment to the soldiers being the most pressing expense.

Since it was unclear whether the Treasury possessed the Constitutional authority to create money to pay its bills, there was a workaround less complicated than Spain’s attempt to turn country debt into money.

The U.S. Treasury issued zero-coupon, infinite-maturity debt stylized as United States Notes, which are bearer notes denominated in dollars and, most importantly, had the sacred government-bestowed status of “legal tender.” This meant that these paper IOUs satisfied all private and public contracts, thus turning debt into currency.

The designation of legal tender can be seen in the fine print in the below image of a U.S. Note. To verify the point, merely take a look at the Federal Reserve Notes in your wallet and read the identical fine print regarding legal tender status.

The modern version of this U. S. Treasury debt stylized as currency looks familiar. It still exists (and circulates) 150 years later, though most of the Notes are locked up in numismatic collections.  The Treasury currency is similar in appearance to Fed currency designated as Federal Reserve Notes except the Treasury currency is designated as United States Notes across the top of the bill. Both are printed by the Bureau of Engraving and Printing which resides in the Treasury Department.

Now sit back and think of the possibilities presented by the Treasury’s direct money option to pay the government’s bills. This would allow the U.S. to cover the next four decades of baby boomer entitlements (which are well beyond the ability to finance in conventional style) and would also make the existing government debt load significantly more manageable.

It would free the Federal Reserve from the pressure to monetize government debt in round after round of QEs over the next four decades. The Fed could confine itself to matters associated with growth and employment and would be free of the stigma that it created the inflation that would no doubt occur.

In fact, in monetary finance, purchases with Treasury money would be for Medicare, Medicaid or Social Security flowing directly into goods markets rather than financial markets as the Fed conducts its operations. That is, the inflation would be goods inflation, not financial price inflation as we presently have with Fed QEs, which provides little spillover into goods markets.

How difficult would this be to carry out? Well, it would take getting a one-sentence bill through Congress and a Presidential signature to amend the National Banking Act to raise the Civil War maximum issuance of U.S. Notes from $300 million to some number in the trillions. Indeed, it could be treated as correcting a spelling error from millions to trillions, skipping billions altogether. It might even fly under the radar screen and only be a subject of interest to monetary wonks who pay attention to these things (such as the author) and Representative Ron Paul. A final detail that needs to be addressed is moving forward the time limit for new issuance of the currency.

What a game changer that would be, and not just to the prospects of avoiding an actual U.S. debt default down the road — which would happen if the baby boomer bills were to be paid conventionally with interest bearing market debt.  It would also eliminate the entangled political web of attempting to decide which promised (and in some cases paid–for) entitlements to cut and which taxes to increase. It would be more consistent with a growing economy, though the cost would be the damage done by 40 persistent years of inflation. Entitlements would be paid but watered down in real terms without further debate and we could refocus of attention to growth instead of income redistribution.

This is certainly not a first best policy. But it is offered as a forecast of what will be the way out of denial and debt strangulation. It does beat frozen government, an appalling deflationary economic contraction, and an almost certain government default down the road unless the same debt is monetized by a compromised Fed.

The major question would be the inflation rate and the damages and redistributions from it. Certainly it would be beneficial to debtors at the expense of creditors which is consistent with a Fed policy of a positive inflation rate.

From the stroke of the pen signing into law the enabling legislation of raising the authorized issuance, fixed income securities would dive in value, gold would salute and real return instruments would soar. Parenthetically, it would cure the housing price decline and consumer wealth decline almost instantaneously and cause the economy, though inflationary, to function better than it presently does.

While Spain attempted monetary finance this past month, the U.S. could pull it off without a central bank veto. While this would undermine the currency value though not so much in relative terms as most countries will gravitate to the same solution, it is better than destroying all faith in the government and its institutions in these days of government denial and paralysis.

This is a pragmatic look at the detestable Hobson choice facing the electorate and its government. It could be shortly or years down the road. All it would take is a Solomon P. Chase to focus on the art of the possible, perhaps known henceforth as the sesquicentennial solution to deal with the unfunded baby boomer entitlements. It’s a solution that’s been around for a long time and likely to be the only remaining option short of default on the entitlements or default on the debt to fund the entitlements.

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Financial Repression: The Unintended Consequences of Saving the Sovereign

What’s new has often been lived before, but sometimes it’s not pretty. Presumably that’s what Clarence Darrow meant when he said, “History repeats itself, and that’s one of the things that’s wrong with history.”

It is becoming increasingly clear that developed-world countries will attempt to go down a path followed before by governments facing similar debt loads… and it’s not pretty. In this case it’s not a wartime debt rollover, but a combination of lofty promises made to provide a social net to a burgeoning population demographic. And this follows years of fiscal sloppiness both here and abroad derived from an attitude best expressed in the infamous and thoughtless words of Dick Cheney, “Debt doesn’t matter.”  Well, Dick, it does.

With the U.S. and many other sovereign’s debt levels reaching or exceeding the 100% ratio to GDP, governments are in a mad scramble to line up financial resources to keep the debt thing afloat.

Europe (Greece in particular) continues to be the poster child for the illusion that a government can keep itself going by leaning on its citizens and others to create bailout funds, or by changing the accounting, regulatory or legal rules, or by engaging in other funny–money schemes. Europe has just concluded the 16th summit of its leaders in less than two years to solve the Euro debt problem once and for all — and all they do is create more debt (the ESM permanent fund) to solve an over-indebtedness problem.

Some of these efforts have brought a temporary reprieve from financial meltdown, but they do not provide a meaningful adjustment process to regain prosperity or debt sustainability. Basically, the horse is out of the barn. There is now so much debt and so many additional scheduled debt commitments that austerity on the rest of the budget will not contain the debt problem.

It would almost be an amusing soap opera if we, the spectators in the audience of this high-theatre drama unfolding in the daily financial tabloids in both Europe and the U.S., could sit back and enjoy the comedy, but unfortunately the bottom line is the actors in the comedy will soon be passing the hat around the audience — at first for voluntary contributions and later for mandatory contributions to the cause.

Moreover, we the audience will ultimately need to ante up less in direct contributions (whatever form of taxes you care to name), but more so in the loss of our income base and market value of wealth. All of this begins with the redirection of scarce capital to finance governments at terms favorable to the debtor government. When that is not enough, next comes the systemic raiding of banks and private resources to finance government debt.

Given the lack of will by the government actors in this soap opera to stop the entitlement game made by previous irresponsible governments, it appears that we will soon be learning the ultimate cost of attempting to keep the entitlement promise. The promise will not be delivered, but we will go down trying.

The cost of trying is not calculated in terms of the present value of the unfunded entitlement liabilities or in the cost of escalating government debt service that we can directly measure. Rather, the cost will be in the more difficult to calculate income, output and wealth losses as a result of a country’s undersupplied and misdirected capital resources. In the environment of attempting to keep the faith in entitlements, income flows and job growth occur at a diminished rate. The economic engine is stuck in low gear when a higher priority is given to financing the sovereign rather than the private sector.

All of this goes by the name of financial repression, a term that has resurfaced in the economic-financial policy lexicon in the last months and is becoming chic in the financial policy press. It’s a term that I am familiar with in that my Ph.D. Chairman, Professor Edward S. Shaw, along with Professor Ron McKinnon of Stanford University, invented it as an explanation of why the Less Developed Countries were less developed for about five decades. Now we get to view it in living color as the nightly news shows us how it is being applied to and affecting the developed economies of the world.

The idea of financial repression presented to me as a graduate student didn’t resonate then, but it does now as I view it and its side effects. It sometimes takes a while for ideas to sink in, and because history is repeating, I get to watch it live the second time — or the third, or however many times it’s been around. What needs to be understood is that financial repression is the unintended consequence of government efforts to suck private capital resources at favorable terms into the financing of government debt. It could just as well be called economic repression because that is what results.

While the general objective for a debt-stressed government is to induce or coerce the buying of its debt, it also needs the buying to take place at a cost the government can afford — not just zero, but even below zero. This occurs when the real interest rate (the nominal rate paid less the inflation rate) is held in negative territory. The cost becomes negative in real terms when a positive inflation rate depreciates the bond’s real value to a greater extent than interest is paid to the holder of the debt.

To pull this off requires a cooperative central bank to create the negative real rates. It’s been quite amazing how the “independent” central banks — made independent to provide checks and balances to prevent reckless government spending sprees — have been co-opted to play an essential role in financial repression. They do so by providing a negative real interest rate for governments by both targeting simultaneously both near-zero nominal rates of interest on government debt and a positive inflation rate.

Given this perspective it should be little surprise that the Fed has recently extended its near-zero nominal interest rate forecast (target) through 2014 and talk of another round of QE is alive both here and in Europe on top of all the others that have occurred in the last three years. While this cheapens government finance at the expense of the holders of the government debt, it also provides disincentives to save and accumulate capital for private uses, hence our near-zero saving rate.

A government’s central bank is its first line of defense in maintaining its ability to pay entitlements. The second line of defense consists of the banks and financial institutions that are coerced to hold greater proportions of government debt in the name of rising liquidity and capital requirements — but with almost zero nominal rates earned on this sizable asset class, they pay virtually nothing for deposits. Hence the banking system and financial institutions in general are also offering negative interest rates on deposits and are in a state of shrinkage, allocating smaller and smaller proportions of their portfolios to the private sector.

We the people will be the third line of defense as the government crams its debt down the throat of the unsuspecting and the unwilling. This generally takes the form of voluntary programs for debt purchases, as the WWII-era poster above suggests. Later this will be accomplished through a mandatory program, with mandatory purchases in the form of swapping “risky” private assets in an IRA for “secure government debt” to finance a private retirement.  This has just occurred in Hungry and Poland, and that discussion has been launched in the U.S. and is contained in the Annual Report of the White House Task Force on the Middle Class (p. 27).

But what do depressing government bond yields do to non-government financial prices? As discussed in my previous post Liquidity and Asset Bubbles: How Long Will the Dam Hold, the lowest interest rates in U.S. history promote a carry trade that finances the purchase of higher quality debt and higher quality dividend-paying equities that investors hope will survive a sovereign meltdown. By extending the time period of its zero interest rate policy out to three years, the Fed reduces the funding risk of the carry trade and ramps it up further.

There is substantial financial buying power to be spread out: the Fed and the ECB’s liquidity transfusions of operation twist, on top of swap financed lending to euro banks, on top of LTRO, on top of another LTRO in the works, and ad hoc ECB direct sovereign purchases, and now with just plain old out-and-out QE3 rumored to be on its way. Furthermore, QEs are also in operation with the BofE and the BofJ and other central banks concerned that capital flight to their currency will undercut their terms of trade. Hence, there is global impetus for central bank buying and money issuance in large numbers as depicted in the accompanying figure.

The equity price run up the last few months is fun while it lasts, but ultimately and fundamentally, if the government interest rate anchor for the financial markets is reduced to a rate that does not reflect its risk, and if further price distortions are introduced into the pricing of equity so that P/Es become transparently unsupportable by fundamentals (if anyone remembers what that is anymore), then expect to see investors seek to place their capital elsewhere.

If the government then attempts to head that off with capital outflow restrictions and more mandatory funneling of capital to the government’s cause, then we are into a full-fledged financial and economic repression. Europe is certainly much closer to that than the U.S., but if there is a buyers strike of government debt here (China has removed itself from accumulating Treasuries), it will eventually repress the economy here as well. We will be no different than the LDCs that self-inflicted decades of pain, as explained by professors Shaw and McKinnon, and history will indeed have repeated.