A low volume, high quality source from the demand side perspective.The podcast is produced weekly. A transcript is posted on the day of.

Sunday, July 8, 2012

Transcript: 509 Monetary Policy Hits the Wrong Target - WSJ

Today on the podcast, the ill-conceived monetary policy of the Fed is doing no good for a great deal of bad.

A couple of notes before we begin.

First, to be clear on the clearinghouse concept we introduced last time on the podcast. This is from long-time Post-Keynesian thinker Paul Davidson, of the University of Tennessee. What it does is set up a clearing mechanism for international capital flows.
Listen to this episode

Capital flows are the problem. We think of Germany and China as great virtuous nations, with their export surpluses and healthy economies. But it is because they are importing the jobs and exporting the goods. As Keynes said at Bretton Woods, it is the strength of these export nations and the weakness of the importers that is the root of the dysfunction of global trade. Capital has to flow to the deficit country. The capital is rarely a good thing. Witness the Asian currency debacle, or the troubles of the southern periphery of Europe today. The U.S., of course, sees the capital flows as huge debt owed to China and others.

If trade were balanced (what a concept), jobs in both nations would be stimulated. Borrowing to consume from another country does not stimulate your domestic economy, either now or later. One way to balance trade is to have flexible exchange rates that adjust the prices of goods. That method is frustrated by the Chinese pegging of rates and the single currency euro, within the Eurozone.

Another way to balance trade is to monitor capital flows and require the surplus nation to purchase goods, directly invest, or just donate to the deficit nation. Since nations would likely not choose option three – donate – there would be direct foreign investment spurring jobs and development in the deficit nation or there would be simple purchases of goods, spurring job growth. Of course, they could donate. That would likely create a few jobs, too.

This is done not in the hurly-burly of exchange of individual commodities, but after the fact, when the balances are toted up. It is do-able. If the Europeans were serious about stability, it is what they would do rather than require a super-national authority to dominate the domestic policy of its 17 nations. AKA a fiscal union.

Plus the clearing union has its ancillary benefits of facilitating control of drug money, terrorist finance and simple tax evasion. AND, my favorite, it is the perfect facility to collect the Tobin Tax, the financial transactions tax, on the trillions of hot money rushing around the globe looking for microscopic arbitrage opportunities.

So, a clearing union. Put it in the category of something that would work, that is easy to understand, and that will not happen until and unless the current corporate controllers of finance and public policy wake up or lose control.

A second note. We just sent out to the printer the final first edition of Demand Side the Book. Much better. Thanks to those who commented. We will be sending an e-mail with the appropriate code for you to get your free copy of the final. We look forward to offering some sort of discount to the rest of the patient podcast listeners, and we should mention our gratitude for the kind comments and postings greeting the Review and Comment Edition. We really do appreciate that stuff. It is useful just to know we're speaking the same language.

We look forward to that being available by sometime mid-month. E-books about the same time. Probably an enhanced Kindle. And we have the audio book in the can in raw form.

Now, on to the Fed.

Unlocking the dysfunctional policy via an article in the Wall Street Journal.

Tuesday, June 19
Jon Hilsenrath

Fed Wrestles with How Best to Bridge U.S. Credit Divide

We had to come back with a look at Jon Hilsenrath's piece last month in the WSJ.

Quoted near the end is Paul Willen, a Boston Fed Researcher,  
“You want money to go to people for whom credit is an issue. Monetary policy is having no effect on the vast majority of people.”


And we're going to give away the punch line right now. You want money to go in the form of income, not additional debt.

But let's start from where the Fed starts, and I don't mean with a misunderstanding of money and credit or an ineptness of policy. Though that is where they do start.

If those who are in the credit squeeze could refinance their mortgages at the low Fed-sponsored rates, the extra two or three hundred dollars per month (or more) would make a difference in their lives. Those who can refinance, as displayed by a wonderful visual on page A-10, are those who don't need the money.

“If you don't need the money, you can get it all day long. Thank you Ben Bernanke, said human interest element Chris Hordan, who also provided the clues to what IS happening with the Fed's easy money. Hordan took his savings from refinancing and put it in gold, European bank bonds, and U.S. stocks.

And clearly, from the charts in Hilsenrath's piece, it is this group who is being benefited, the group who doesn't use the money for real economy stuff. The plus 760 FICO folks have greeted each new multi-hundred billion dollar Fed scheme with a wave of refis. The rich get richer, as have the corporations, by trading high cost debt for low cost debt. Thank you, Ben Bernanke.

So this is the Fed's effort to address unemployment? How does it work? Well, it doesn't work. Gold stocks or ETFs don't stimulate demand. Even if the middle class could get the new mortgages, they likely wouldn't go on a spending spree. Even if they went on a spending spree, there would likely be more cheer in China than in Chicago.

It's the same reason tax cuts haven't worked. First, those which go to corporations or the wealthy don't affect hiring because spending and demand is not affected. Second, those which DO go to the middle class or lower go to pay down debt, mitigate straitened times, or buy the occasional Chinese import.

At the end of the day, the question is one of incomes, and the Fed is making it a question of debt. The Fed has actually gouged interest incomes with its low rates, squeezing pensioners and their prospects, causing them to rein in spending. And it has put – the Fed has put – their money – OUR money – behind payoffs to the banks and the top end.

“Even though we have the greatest monetary policy stimulus in the history of the Fed, we really have not managed to lower the funding costs for a large swath of people, said David Zervos, a bond strategist with Jefferies Inc., a Wall Street investment bank. He called the Fed efforts “monetary policy for rich people.”

Fed officials said they have a long-standing congressional mandate to minimize unemployment and inflation, not to micro-manage the distribution of wealth, income or credit. “That is expecting the Fed to do way more than it can possibly do,” said Ms. Duke.

The Fed's interest rate lever, Mr. Evans said, "Is a blunt instrument.”

Phooey, says Demand Side, the micro-management is proceeding apace, targeted directly at the big banks and the wealth effect, which is the wealthy effect. The problem is that this doesn't do anything for unemployment or growth.

So when Hilsenrath correctly says,
The U.S. recovery is hobbled by an economic divide that separates Americans not by income or wealth but by their access to credit.
The housing bust left behind millions of people with credit records damaged by plunging home prices, lost jobs, past overspending or bad luck. Many are now walled off from the low interest rates engineered by the Federal Reserve to spur the economy and remedy the aftereffects of the borrowing boom.
Millions with good credit, meanwhile, are taking advantage of the easy money, a windfall in many cases for people who don't especially need it.

he is right.

This is Fed theory. They just haven't noticed that there's a limit to debt. It's absurd to think that loading up on more debt is a way to long-term steady growth. Households don't want it. Banks don't see the profit in it. It only burdens future incomes with more dead weight.

But it is the single-minded purpose of monetary policy. Pushing lenders and investors into more risk by cutting off the returns to low risk. It's not happening, or when it is, that risk is financial bets like the $2, $4, or $10 billion “hedges” that go bad.

What would happen if the government loaded up on debt to finance infrastructure, education, climate mitigation? That would be incomes to people who worked in those areas, and spending that would go down through the economy. It would be sturdy, higher-interest bonds for the pension funds and other investors. And it would create the value that is needed to pay back the debt.

Hire people to do things that need to be done? The Fed could guarantee infrastructure bonds as easily as it does mortgage bonds. In fact, why mortgage securities are favored to the tune of $1.25 trillion and counting is a question to me. I suspect it is because MBS holders sat on the Fed's board.

Impeach Jamie Dimon.

Oh, that's later.

The $600 billion of QE II would have paid 5 million people $30,000 for four years, eliminating the unemployment problem overnight, with the multiplier. This would take the strain off unemployment payouts and the social safety net on one end and return a little positive flow to the revenue side, particularly important for states and localities.

Monetary policy as now practiced does not work, will not work, cannot work. More risk does not mean more productive uses of capital.

We have the impression that although this might not be a surprise to you, it is a surprise to the monetary authorities. Their massive – and it can only be termed "massive" – support to banks was supposed to prevent the breakdown of banking, and as Hilsenrath says here, "by reducing interest rates – the cost of credit – the Fed encourages household spending, business investment and hiring, in addition to reducing the burden of past debts."

"The central bank has said it planned to keep short-term interest rates near zero through 2014. It also has purchased more than $2.7 trillion worth of government and mortgage bonds to reduce long-term interest rates in less conventional fashion..."

and still later.
"Some officials worry about the effect of the credit divide. 'I've taken a position of some skepticism, at least under the current conditions, that more policy would make that much of a difference," Dennis Lockhart, president of the Federal Reserve Bank of Atlanta, said in a May interview."

So hiring comes in here at the end, household spending, business investment and hiring. Only it never comes in, because businesses are rational, too, and faced with uncertainty will not and are not investing or hiring. They are instead cutting costs, by refinancing or cutting workforces.

The Fed's policy is basically to make it cheaper to be irrational, or alternatively, expensive to be rational. Instead the government should become rational, increase incomes, reduce uncertainty, sponsor organized writedowns of debt, make profit in real economic activity possible, invest in high return public goods, be ruthless with those who themselves are ruthless and who demanded ruthlessness in the name of market discipline until it came to their turn.


On our way by, we should note another casualty of the current historical experiment, RIP Anna Schwartz. That is the idea that investment is facilitated or even driven by savings. If people saved more, there would be more for investment. Not the case. Is it? Savings rate goes up. Investment stagnates.

Investment is – as John Maynard Keynes said so long ago (see even his Treatise on Money Volume II) "It is not thrift that occasions investment, but the prospect of profit." We can subsidize investment through the nose, or through the tax code, but we only end up bringing forward in time investment that would already have been made or getting too much of the wrong kind. See excess capacity.

We could invest in ... What's that? ... Yes, High return public goods ... rail, renewables, conservation, education, climate change mitigation, an enormous need ... There is your return on investments, your profit, your investment validating thrift.

And as long as we're in digression mode, the inflation Chicken Littles, er, hawks, should review Keynes Treatise and its survey of the depression and price deflation of the 1890s, when they had real money – gold – increasing in quantity in the UK at the same time prices were going down. Keynes calls it the "old fashioned quantity theory of money" RIP.

One more element of Hilsenrath's piece deserves attention. This is a second chart, separated from the medley of those displaying how credit is easy if you don't need it and the trend for that being in a direction the Fed apparently did not anticipate. This second chart is a display of the Federal Reserve's interest rate target from 1980 to present. Let's call it the OOOOPs chart. Maybe four or five O's in that OOOOPs.

the rate in 1980 to '85 was high. Target Rate. Above 8%.

Well, let's set the context. From the beginning of the postwar period to the end of the 1970s, the interest rate was relatively low, particularly in real terms, and relatively stable, becoming less so over time as the Fed became increasingly captured and decreasingly responsive. In the late 1970s, under the influence of Milton Friedman's Monetarism (RIP Anna Schwartz) and faced with oil price inflation, Paul Volcker started playing around with the money supply. The high rates from that period, the early Volcker period – 20% in 1981 – are really reflecting this money supply target, not an interest rate target. Prior to Volcker, not on the chart, relatively tame interest rates. So now Volcker, inflation, 20% rates, presto, the 80-81 recession. Ooops. Killed the economy. Forget this money supply stuff. Cut them all the way down to 8%.

1985. High deficits. 1986, Tax reform – Reagan raises taxes. Fed cuts rates all the way down to, whoa – 6%. Think of the prime rate as three percent higher. Only briefly, though. Enter Greenspan in 1987. Begin the Mayan pyramid steps. Here comes inflation from oil prices. Hike interest rates, but a step at a time. Back to near 10% in 1989. OOOOPs, recession. Down, down, down, down, down. Now below 6% in '91, below 4% in '92, not hurt by the Clinton Budget Act, and boom goes the economy. The first re-fi boom. All those lucky folks paying through the nose for 12% mortgages refinance and see cash flow positive results, lower unemployment, low oil prices, and well – rising interest rates. Not quite 6%, but near in '94-2000. EXCEPT, as inflation is coming down in this high growth period and real rates are going up, oil prices begin to rise. Inflation fears follow. Greenspan walks up the steps to the sacrificial altar, setting rates to what are now historically high real levels, rivaling those of even the Volcker Period, yes the 18% nominal rates were about the same level as the rates at the start of the 2000s. OOOOPs. Recession. Greenspan scuttles down some very steep steps, over 6% at the start of 2001, below 2% by the end. Not a symmetric pyramid.

Flattening out to 1% even long after the jobless recovery begins and ending only with Ben Bernanke and a Greenspanian trek back up. Yes, oil prices alongside. Only this is a climb Alan Greenspan can only envy. Even, sequential steps. 2% at the start of 2005, 4% at the end, up to 5-1/2 or so by mid 2006. Flatten out at this level. BIG OOOOPs. Big recession. Jump off the side of the pyramid. This one has a side. Just before the start of 2008 we're at the 5-1/2% highs. By the end of 2008, we're at zero to .25. That's zero point two five. Now flat for three years. These are the subterranean vaults of the pyramids. Plus the QE's. Buying up bad mortgage-backed securities, loading up on mortgages and bonds to try to drive down long rates and elicit some private investment.

Please. Leave the rates alone. Let them be low and stable, say two or three percent. Give people some certainty. Give pension plans some return. If you want to limit credit, do it by limiting credit, not by fooling around with the price of credit – the interest rate. If you want to stimulate credit. Don't. Let the fiscal side expand credit opportunities in public goods or increase credit-bearing ability by hiring directly. What you've done is load the world up on debt that seems cheap at the time, but cannot now be rolled over or serviced.

So there you have it, the Demand Side podcast brought to you by the Demand Side Forecast, bouncing along the bottom with downside risks of crises. Particularly now in Europe. Hopefully we've gotten the book out before the banks bring down the monetary union. Look for the full extended forecast there.

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