At a superficial level, the zero-interest-rate and easy-money policies have produced the intended outcomes. Stock prices more than doubled from 2009 to 2014, and housing prices began rebounding sharply in mid-2012. After four years of trying to manipulate asset prices, the Fed appeared to have succeeded by 2014. The wealth was being created, at least on paper, but to what effect?
America is today witnessing its third stock bubble, and its second housing bubble, in the past fifteen years. These bubbles do not help the real economy but merely enrich brokers and bankers. When these bubbles burst, the economy will confront a worse panic than occurred in 2008, and the bankers’ cries for bailouts will not be far behind. The hubris of central bankers who do not trust markets, but seek to manipulate them, will be partly to blame.
These local money-printing policies cause inflation in the trading partner economies. U.S. inflation is muted because Americans import cheap goods from our trading partners.
While inflation was quite low from 2008 to 2013, it was not zero, yet growth in personal income and household income was close to zero. This meant that real incomes declined even in a low-inflation environment. If the Fed had instead allowed deflation, real incomes would have risen even without nominal gains, because consumer goods prices would have been lower. In this way, deflation is the workingman’s bonus because it allows an increase in the living standard even when wages are stagnant. Instead, real incomes declined.
Part of the Fed’s design is to penalize savers and discourage them from leaving money in the bank, and to encourage them to invest in risky assets, such as stocks and real estate, to prop up collateral values in those markets.
when the Fed distorts the interbank lending market by keeping rates too low, it deprives small business of working capital loans and hurts their ability to fund job creation.
Investment is one of the four fundamental components of GDP, along with consumption, government spending, and net exports. Of these components, investment may be the most important because it drives GDP not only when the investment is made, but in future years through a payoff of improved productivity. Investment in new enterprises can also be a catalyst for hiring, which can then boost consumption through wage payments from investment profits.
Krugman began with the basic point that growth in any economy is the result of increases in labor force participation and productivity. If an economy has a stagnant labor force operating at a constant level of productivity, it will have constant output but no growth. The main drivers of labor force expansion are demographics and education, while the main drivers of productivity are capital and technology. Without those factor inputs, an economy cannot expand. But when those factor inputs are available in abundance, rapid growth is well within reach.
As Krugman points out, this labor-capital factor input model is a two-edged sword. When the factors are plentiful, growth can be high, but what happens when the factors are in scarce supply? Krugman answers with the obvious conclusion—as labor and capital inputs slow down, growth will do the same. While Krugman’s analysis is well known to scholars and policy makers, it is less known to Wall Street cheerleaders and the media. Those extrapolating high growth far into the future are ignoring the inevitable decline in factor inputs.
China has not proved adept at inventing new technologies despite its success at stealing existing ones. The twin engines of growth—labor and technology—are both beginning to stall in China.
components contributes to growth in the economy. How does China appear to increase these components when the factor inputs are leveling off? It does so with leverage, debt, and a dose of fraud.
In the United States, consumption typically makes up 71 percent of GDP, while in China, the consumption component is 35 percent, less than half the United States’. Conversely, investment typically makes up 13 percent of U.S. GDP, while in China investment is an enormous 48 percent of the total. Net exports are about 4 percent of the economy in the United States and China, except the signs are reversed. China has a trade surplus that adds 4 percent to GDP, while the United States has a trade deficit that subtracts 4 percent from GDP. In concise terms, the U.S. economy is driven by consumption, and the Chinese economy is driven by investment.
Evidence from recent years is that China’s infrastructure investment involves massive waste. Even worse, this investment has been financed with unpayable debt. This confluence of wasted capital and looming bad debt makes the Chinese economy a bubble about to burst.
The new financial warlords are addicted to the profits of infrastructure, even as economists lament the lack of growth in services and consumption.
Too often in politics everything is short-term, and the long run is ignored.
China has no market discipline to slow down these interests or redirect investment in more beneficial ways. Instead China has an elite oligarchy that insists that its interests be served ahead of the national interest.
In the end, if you build it, they may not come, and a hard landing will follow.
Bank sponsors of WMPs address the problems of nonperforming assets and maturity mismatches by issuing new WMPs. The new WMP proceeds are then used to buy the bad assets of the old WMPs at inflated values so the old WMPs can be redeemed at maturity. This is a Ponzi scheme on a colossal scale. Estimates are that there were twenty thousand WMP programs in existence in 2013 versus seven hundred in 2007. One report on WMP sales in the first half of 2012 estimates that almost $2 trillion of new money was raised.
If GDP were reduced by the amount of malinvestment, the Chinese growth miracle would already be in a state of collapse.
China’s “rebalancing moment” may have come and gone.
the ideal moment for China to shift to a consumption-led growth model was the period 2002 to 2005.
oligarchs prevailed to press interest rates, exchange rates, and wages below their optimal levels. A natural demographic boost to consumption was thereby suppressed and squandered.
China’s weak consumption crisis is now locked in place.
The New York Times published a story on Latvia in 2013 that accurately captured the trajectory of steep collapse and strong recovery that used to be typical of business cycles but is now mostly avoided by Western governments at the expense of long-term growth:
At heart, a dollar is money, money is value, and value is trust consistently honored. When one buys a bottle of Coca-Cola anywhere in the world, one trusts that the original formula is being used, and that the contents are not adulterated; in this respect, Coca-Cola does not disappoint. This is trust consistently honored, meaning that a bottle of Coke has value.
The Federal Reserve System, owned by private banks, is the issuer of the dollar. The Fed asks for our trust, but how can one verify if the trust is being honored?
In a rule-of-law society, a customary way of verifying trust is the written contract. A first-year law student in contracts class immediately learns to “get it in writing.” The beliefs and expectations of the parties to a contract are written down and read by both parties. Assuming both parties agree, the contract is signed, and from then forward, the contract embodies the trust. At times, disputes arise about the meaning of words in the contract or the performance of its terms. Countries have courts to resolve those disputes. This system of contracts, courts, and decisions guided by a constitution is what is meant by a rule-of-law society.
So the dollar is money, money is value, value is trust, trust is a contract, and the contract is debt. By application of the transitive law of arithmetic, the dollar is debt owed by the Fed to the people in contractual form.
All three theories agree that money does not have to have intrinsic value as long as it possesses extrinsic value supplied by the state.
gold is the collateral or bond posted to ensure satisfactory performance of the money contract. If the state prints too much money, the citizen is then free to declare the money contract in default and redeem her paper money for gold at the market exchange rate. In effect, the citizen takes her collateral.
The money price of gold is therefore a measure of contractual performance by the Fed and Treasury. If performance is satisfactory, gold’s price should be stable, as citizens rest easy with the paper-money deal. If performance is poor, the gold price will spike, as citizens terminate the money-debt contract and claim their collateral through gold purchases on the open market. Like any debtor, the Fed prefers that the citizen-creditors be unaware of their right to claim collateral.
The Fed prefers that investors not make this connection, but one investor who did was Warren Buffett. In his case, he moved not into gold but into hard assets, and his story is revealing.
Buffett’s acquisition is best understood as getting out of paper money and into hard assets, while immunizing those assets from a stock exchange closure. It may be a “bet on the country”—but it is also a hedge against inflation and financial panic. The small investor who cannot acquire an entire railroad can make the same bet by buying gold.
This evaluation asks whether the Treasury can pay its outstanding debts as agreed. If the answer is yes, the market will gladly accept more Treasury debt at reasonable interest rates. If the answer is no, the market will dump Treasury debt, and interest rates will skyrocket. In cases of extreme uncertainty due to lack of funds or lack of willingness to pay, government debt can become nearly worthless, as happened in the United States after the Revolutionary War and in other countries many times before and since.
Analysis of government debt is most challenging when the answer is neither yes nor no but maybe.
Debt can be ruinous if it is used to finance deficits, and with no plan for paying the debt other than through additional debt. Debt can be productive if it funds projects that produce more than they cost and that pay for themselves over time.
Debt used to finance government spending is acceptable when three conditions are met: the benefits of the spending must be greater than the costs, the government spending must be directed at projects the private sector cannot do on its own, and the overall debt level must be sustainable.
Difficulties arise when costs and benefits are not well defined and when ideology substitutes for analysis in the decision-making process.
This history shows that certain government spending can be highly beneficial when it jump-starts private-sector innovation. ARPANET had fairly modest ambitions by today’s standards, and it was a success. The government did not freeze ARPANET for all time; instead, it made the protocols available to private developers and got out of the way. The Internet is an example of government leaving the job to the private sector.
An example of destructive government spending is the 2009 Obama stimulus plan. The expected benefits were based on erroneous assumptions about so-called Keynesian multipliers.
The Obama stimulus is an example of government spending that does not pass the cost-benefit test.
a gold standard was one way to limit discretion and reveal when monetary policy was off track. Under the classic gold standard, gold outflows to trading partners showed that monetary policy was too easy and tightening was required. The tightening would have a recessionary effect, lower unit labor costs, improve export competitiveness, and once again start the inward flow of physical gold. This process was as self-regulating as an automatic thermostat.
if economic output minus interest expense is less than the primary deficit, then over time the deficits will overwhelm the economy, and the United States will be headed for a debt crisis, even financial collapse.
To a point, what matters is not the debt and deficit level but the trend as a percentage of GDP. If the levels are trending down, the situation is manageable, and debt markets will provide time to remain on that path. Sustainability does not mean that deficits must go away; in fact, deficits can grow larger. What matters is that total debt as a percentage of GDP becomes smaller, because nominal GDP grows faster than deficits plus interest.
Think of nominal GDP as one’s personal income and the primary deficit as what gets charged on a credit card. Borrowing costs are interest on the credit card. If personal income increases fast enough to pay the interest on the credit card, with money left over to pay down the balance, this is a manageable situation. However, if one’s income is not going up, and new debt is piled on after paying the old interest, then bankruptcy is just a matter of time.
Changes in one BRITS component can cause changes in another, which can then amplify or negate the desired effect of the original change.
If the United States is on an unsustainable path as revealed by PDS, and that downward path is accelerating with no end in sight, then the markets may suddenly and unexpectedly cause interest rates to spike. The interest-rate spike makes PDS less sustainable, which makes interest rates higher still. A feedback loop is created between progressively worsening PDS results and progressively higher rates. Eventually the system can collapse into outright default or hyperinflation.
The U.S. economy is like a sick patient, with politicians as the concerned relatives at the patient’s bedside arguing over what to do next. The PDS framework is the thermometer that reveals whether the patient’s condition is deteriorating, and bond markets are the undertaker, waiting to carry the patient to her grave. Into this melodramatic mise-en-scène walks Dr. Fed. The doctor may not have the medicine needed to provide a cure, but newly printed money is like morphine for the economy. It can ease the pain, as long as it does not kill the patient.
the absolute level of debt to GDP is not what triggers a crisis; it is the trend toward unsustainability.
In the absence of higher real growth, either politicians must reduce deficits, or the Fed must produce inflation. There is no other way to avoid a debt crisis.
Money that sits in banks as excess reserves does not produce inflation. Price inflation emerges only if consumers or businesses borrow and spend the printed money. From the Fed’s perspective, the manipulation of consumer behavior to encourage borrowing and spending is a critical policy component. The Fed has chosen to manipulate consumers with both carrots and sticks. The stick is an inflation shock, intended to scare consumers into spending before prices go up. The carrot is the negative real interest rate, designed to encourage borrowing money to buy risky assets such as stocks and housing. The Fed will ensure negative real rates by using its own bond buying power, and that of the commercial banks if necessary, to suppress nominal interest rates.
The Fed’s form of theft from savers has a name: it’s called money illusion by economists. The idea is that money printing on its own cannot create real growth but can create the illusion of growth by increasing nominal prices and nominal GDP.
Stein himself warns that if banks do not take the hint and curtail risky financial engineering, the Fed might force them to do so with increased regulation. The Federal Reserve has life-and-death powers over banks in areas such as loss reserves, dividend policies, stress tests, acquisitions, capital adequacy, and more. Bank managers would be foolhardy to defy the Fed in the areas Stein highlights. Stein’s paper suggests a partial return to an older kind of financial repression through regulation.
The Rubin web is more a fuzzy network of like-minded individuals with a shared belief in the superiority of elite thought and with faith in their coterie’s capacity to act in the world’s best interests.
Zhu believes the world is in a true depression, the worst since the 1930s. He is characteristically blunt about the reasons for it; he says the problems in developed economies are not cyclical—they are structural.
A cyclical downturn is viewed as temporary, a phase that can be remedied with stimulus spending of the classic Keynesian kind. A structural downturn, by contrast, is embedded and lasts indefinitely unless adjustments in key factors—such as labor costs, labor mobility, taxes, regulatory burdens, and other public policies—are made.
In the United States, the Federal Reserve and Congress have acted as if the U.S. output gap, the difference between potential and actual growth, is temporary and cyclical. This reasoning suits most policy makers and politicians because it avoids the need to make hard decisions about public policy.
A central bank has three primary roles: it employs leverage, it makes loans, and it creates money.
Its ability to perform these functions allows it to act as a lender of last resort in a crisis. Since 2008, the IMF has been doing all three in a rapidly expanding way.
The IMF functioned for national economies the way a credit card works for an individual who temporarily needs to borrow for expenses but plans to repay from a future paycheck.
It was curious that just as Federal Reserve officials were publicly disparaging gold’s role in the monetary system, the president felt the need to mention gold to the Congress as a confidence booster. Despite disparagement of gold by academics and central bankers, gold has never fully lost its place as the bedrock of global finance.
that when one nation issues the global reserve currency, it must run persistent trade deficits to supply that currency to its trading partners; but if the deficits persist too long, confidence in the currency will eventually be lost.
Because of its purity, uniformity, scarcity, and malleability, gold is money nonpareil.
Gold’s long history does not mean that it must be used as money today. It does mean that anyone who rejects gold as money must feel possessed of greater wisdom than the Bible, antiquity, and the Founding Fathers combined.
Outright physical gold ownership, without pledges or liens, stored outside the banking system, is the only form of gold that is true money, since every other form is a mere conditional claim on gold.
Commodities are consumed as food or energy, or else they serve as inputs to other goods that are demanded for consumption. In contrast, gold has almost no industrial uses and is not food or energy in any form.
Those who believe that bank deposit risk is a thing of the past should consider the case of Cyprus in March 2013, when certain bank deposits were forcibly converted into bank stock after an earlier scheme to confiscate the deposits by taxation was rejected. This conversion of deposits to equity in order to bail out insolvent banks was looked upon favorably in Europe and the United States as a template for future bank crisis management.
The first myth is that gold cannot form the basis of a modern monetary system because there’s not enough gold to support the requirements of world trade and finance. This myth is transparently false, but it is cited so often that its falsity merits rebuttal.
If global money supply were limited to $1.7 trillion of gold instead of $48 trillion of M2 paper money, the result would be disastrously deflationary and lead to a severe depression.
the quantity of gold is never an impediment to a gold standard as long as the price is appropriate to the targeted money supply.
The second myth is that gold cannot be used in a monetary system because gold caused the Great Depression of the 1930s and contributed to its length and severity.
Most important, nations had to choose a conversion rate between their currencies and gold, then stick to that rate as the new system evolved.
The sequence of events from 1922 to 1933 shows that the Great Depression was caused not by gold but rather by central bank discretionary policies. The gold exchange standard was fatally flawed because it did not take gold’s free-market price into account.
The Bank of England overvalued sterling in 1925. The Federal Reserve ran an unduly tight money policy in 1927. These problems have to do not with gold per se but with the price of gold as manipulated and distorted by central banks.
The Great Depression is not an argument against gold; it is a cautionary tale of central bank incompetence and the dangers of ignoring markets.
The third myth is that gold caused market panics and that modern economies are more stable when gold is avoided and central banks use monetary tools to smooth out periodic panics.
Panics are neither prevented nor caused by gold. Panics are caused by credit overexpansion and overconfidence, followed by a sudden loss of confidence and a mad scramble for liquidity.
Panics are a product of human nature, and the pendulum swings between fear and greed and back to fear. Panics will not disappear. The point is that panics have little or nothing to do with gold.
In practice, gold standards worked well in the past and remain entirely feasible today.
In fact, a well-designed gold standard could work smoothly if the political will existed to enact it and to adhere to its noninflationary disciplines.
A gold standard is the ideal monetary system for those who create wealth through ingenuity, entrepreneurship, and hard work. Gold standards are disfavored by those who do not create wealth but instead seek to extract wealth from others through inflation, inside information, and market manipulation. The debate over gold versus fiat money is really a debate between entrepreneurs and rentiers.
gold standards come in many forms and that their success or failure is determined not by gold per se but by the system design and the willingness of participants to abide by the rules of the game.
Student loans are the new subprime mortgages: another government-subsidized bubble about to burst.
Annual borrowing in all undergraduate and graduate student loan programs surged to over $100 billion per year in 2012, up from about $65 billion per year at the start of the 2007 depression. By August 2013, total student loans backed by the U.S. government exceeded $1 trillion, an amount that has doubled since 2009.
the program has morphed into direct government pump priming, in the same manner that historically productive home lending programs morphed into a housing bubble between 1994 and 2007.
Student loans now pose a similar dynamic. Most of the loans are sound and will be repaid as agreed. But many borrowers will default because the students did not acquire needed skills and cannot find jobs in a listless economy.
Chinese ghost cities and U.S. diplomas are real, but productivity increases and the ability to repay the borrowings are not.
A record 21 million young adults between ages eighteen and thirty-one are living with their parents.
Unfortunately, there are growing signs that confidence in the dollar is evaporating.
Demand for physical gold bullion, a measure of lost confidence in the dollar, began rising sharply in mid-to-late 2013, another sign of a weaker dollar.
Volcker was right in his assertion that confidence is indispensable to the stability of any fiat currency system. Unfortunately, the academics who are now responsible for monetary policy focus exclusively on equilibrium models and take confidence too much for granted.
CIA and the FBI had specific intelligence linking terrorists and flying lessons but failed to share the information or connect the dots.
New York Times columnist Tom Friedman offered the best description of what went wrong: “Sept. 11 was not a failure of intelligence or coordination. It was a failure of imagination.” Friedman’s point was that even if all the facts had been known and shared by the various intelligence agencies, they still would have missed the plot because it was too unusual and too evil to fit analysts’ preconceived notions of terrorist capabilities.
The 9/11 attacks demonstrated that the failure to imagine the worst often results in a failure to prevent it.
In effect, the impact of declining prices more than offsets declining nominal growth and therefore produces real growth. This condition has almost never been seen in the United States since the late nineteenth century. But it is neither rare elsewhere nor impossible in the United States; in fact, it has been Japan’s condition for parts of the past twenty-five years.
Despite possible real growth, the U.S. Treasury and the Federal Reserve fear deflation more than any other economic outcome.
Why is the Federal Reserve so fearful of deflation that it resorts to extraordinary policy measures designed to cause inflation? There are four reasons for this fear.
The first is deflation’s impact on government debt repayment.
The second problem with deflation is its impact on the debt-to-GDP ratio.
The third deflation concern has to do with the health of the banking system and systemic risk.
The fourth and final problem with deflation is its impact on tax collection.
Since inflation favors the government and deflation favors the worker, governments always favor inflation.
In summary, the Federal Reserve prefers inflation because it erases government debt, reduces the debt-to-GDP ratio, props up the banks, and can be taxed. Deflation may help consumers and workers, but it hurts the Treasury and the banks and is firmly opposed by the Fed.
Most Japanese government debt is owned by the Japanese themselves, so a foreign financing crisis of the kind that struck Thailand in 1997 and Argentina in 2000 is unlikely.
The benefit of a severe depression in 2009 is not severity for its own sake.
The point of a severe depression in 2009 is that it would have prompted the structural adjustments that are needed in the U.S. economy. It would also have diverted assets from parasitic pursuits in banking toward productive uses in technology and manufacturing. It would have moved unit labor costs to a new, lower level that would have been globally competitive when higher U.S. productivity was taken into account. Normalized interest rates would have rewarded savers and helped strengthen the dollar, making the United States a magnet for capital flows from around the world. The economy would have been driven by investment and exports rather than relying on the lending-and-spending consumption paradigm.
there was a failure of imagination to see that the economy’s problems were structural, not cyclical.
Japan reached the crossroads first; it opted for Abenomics. The Fed needs to look more critically at Japan’s putative escape from depression. If it follows the Japanese path, both nations will be headed for an acute debt crisis. The only difference may be that Japan gets there first.
Risk management is possible with the right combination of complexity tools and another essential: humility about what is knowable.
In capital markets, regulators too often do not stay safe; rather, they increase the danger. Permitting banks to build up derivatives books is like ignoring snow accumulation.
The regulators suspect as much but play along, often in the hope of landing a job with the banks they regulate.
Metaphorically speaking, the bankers’ mansions are high on a ridgeline far from the village, while the villagers, everyday Americans and citizens around the world, are in the path of the avalanche.
Financial avalanches are goaded by greed, but greed is not a complete explanation. Bankers’ parasitic behavior, the result of a cultural phase transition, is entirely characteristic of a society nearing collapse. Wealth is no longer created; it is taken from others. Parasitic behavior is not confined to bankers; it also infects high government officials, corporate executives, and the elite societal stratum.
Modern economists spend their time looking for the subatomic particle while ignoring the critical state of the system. They are looking for snowflakes and ignoring the avalanche.
Official gold sales that depressed gold prices were practiced extensively by Western central banks from 1975 to 2009 but came to an abrupt end in 2010, as gold prices skyrocketed and citizens questioned the wisdom of selling such a valuable asset.
Once the rebalancing is complete, probably in 2015, there will be less reason to suppress gold’s price because China will not be disadvantaged in the event of a price spike.
The Fed avoided a measure of pain in 2009 with its monetary exertions and market manipulations, but the pain was stored up for another day. That day is here.