Why not create new banks from QE3?

Banks are unique to an economy. They are the creators of money, via the fractional banking system. How banks use their money greatly affects the way the economy runs.

Currently banks are sitting on $1.6 trillion in excess reserves. Excess reserves have always been a part of the banking system but not in the amounts seen since 2008 Q4. The sheer size of these reserves has hobbled monetary policy - every dollar sat on by banks in excess reserves is a dollar that has effectively been removed from the economy.

Why are the banks sitting on so much money? The answer is that they are suffering from an increasing amount of insolvency. They are Zombie banks, whose net worth is negative but who continue to operate. As Paul Krugman and others have pointed out, monetary policy is only effective in a liquidity crisis, not a solvency crisis.

Obviously these banks need to stop sitting on their reserves and begin lending again. If they lent their money out, the fractional system would gear up, increase money velocity and create enough money for the banks to operate their way out of insolvency. Ironically, the banks' response to the crisis is, in effect, perpetuating the crisis.

But there is a solution - new banks must be formed.

New banks, created without any solvency issues, have no real reason to sit on excess reserves. But new banks are usually created by the market itself. Since the market isn't creating any new banks, then new ones must be created by government: Congress, Obama and the Federal Reserve acting together.

Now it's not as though the government would own these banks long term. The idea would be to create them and privatise them as quickly as is practicable: onto the share market within 12 months of their creation.

But where would this money come from? Are we going to increase government spending and thus taxes? Well if the Fed is going to indulge in QE3, it might as well use the money it creates out of thin air to create something solvent and profitable, rather than prop up institutions that are insolvent and unprofitable.

The Fed's Quantitative easing program involved the Fed creating money out of thin air (by fiat) and then using that money to buy back government securities. Yet this process was hobbled by the Zombie banks because much of the money created in this process ended up in excess reserves. QE2, for example, resulted in excess reserves increasing from $971 billion in November 2010 to nearly $1.6 trillion today: that's around $600 billion in fiat money - the entire QE2 amount - that went nowhere.

But what if that $600 billion was spent capitalising a series of new banks? With no solvency issues to encourage excess reserves, these banks would've used their capital more freely. With QE3 a distinct possibility, why not direct the money at creating new banks?

There is a historical precedent here: The First Bank of the United States, formed in 1791 by congress (see pic above). Although this bank was essentially an 18th century version of a central bank, it did have direct market operations in lending money to the market, borrowing money from the market, and taking deposits. It was also created to be purchased by the market in the form of shares. Moreover, the precedent of creating a bank, coming almost immediately out of the formation of the first congress by the founding fathers, should prevent any complaints by political conservatives that such an action would be unconstitutional.

If we assume that these new banks do get created through the QE process, what of the Zombie banks still out there in the marketplace? My suggestion is that they should be allowed to permanently die - to be declared insolvent and shut down, with deposits (backed by the government) being shifted to newer and/or more solvent banking institutions. While killing off a Zombie bank would have a negative effect upon the market if it was done in isolation, killing them off while new banks are growing and blooming would be more sustainable.

(I wrote about this before in November 2010)

A Magical Method in the Money Making Madness

Inflation. No one likes too much of it, though there is some debate as to how much is good and how much is bad.

Inflation is often linked to money creation - though not always, since inflation can also result from supply shortages such as oil. Nevertheless history abounds with money printing experiments that ended up in hyperinflationary failure: Weimer Germany, Mugabe's Zimbabwe, Postwar Hungary and the Crisis of the Third Century being the best known ones.

Injudicious money creation will always create hyperinflation. If the Federal Reserve creates $1 out of thin air the amount of inflation it causes will be negligible. If it creates $1 Trillion the amount of inflation it causes will destroy the economy.

Of course money is created all the time through the fractional lending system. Most of this money is created by the commercial banking system. While some see conspiracies and unsustainability in this process, it has actually worked for millennia. Nevertheless the real heart of the fractional banking system is the role of the Central Bank, which, in the United States, is the Federal Reserve Bank.

Now I'm not going to go into the intricate details of how the system works. If you're unsure of how it works, go to the Wikipedia page. Using this as a basis, however, let me do some funny little experiments as to what injudicious money creation can theoretically do.

So here's graph no.1 showing how the system works in the United States. If we assume that the US economy is worth $1000 in total money supply, it looks like this:

This is, of course, identical to the Wikipedia page's graph.

But now let's begin playing. Let's say Congress and the President and the heads of the Fed suddenly suffer from a collective insanity... even more severe than the one they already have... and decide that they'll fix the deficit by simply creating money out of thin air. Now according to the latest data, the budget deficit is $1.2059 Trillion and represents around 8.11% of GDP. So what would happen if the powers that be decide to just create the money out of thin air, again assuming in our model that the US economy is worth $1000?

I've added the baseline there by way of comparison (the blue line). The yellow line represents the collectively insane decision.

That doesn't look too good does it? You're looking at a huge increase in the money supply and, as a result, a hyperinflationary situation probably similar to anything occurring through history.

But then let's take this even further. Let's say the US has been taken over by an Idiocracy... worse than the current mob... who decide that they'll just forget about taxes altogether and just create as much money as the government needs. Since the US Government represents about 25% of GDP, it would mean that an even greater amount of money would be added to the money supply:

Ouch. And that, my friends, is why money printing on the scale used by the Romans, the Germans, the Hungarians and Mugabe ends in abject failure.

But hang on, what's that thing called "The Reserve Rate"? - Well that's how much money commercial banks are forced to keep in reserve when lending. Adjusting the reserve rate is used by some nations (India and China for example) as a way of implementing monetary policy. If the reserve rate is increased, the money supply drops. If it is decreased, then the money supply is increased.

And so now my friends let me show you some real magic.

Let's go back to the US Government who wants to create money out of thin air simply to pay off the deficit, shown two graphs above, except this time we increase the reserve rate to 18.11%. Why 18.11%? Well it's the 10% reserve rate plus the 8.11% size of the deficit (in relation to GDP). So let's see what the outcome is:

What? Wait. Hang on? Is that possible? You're creating money out of thin air but not affecting the total money supply? Yes. How? By increasing the reserve rate.

Let me say this again: It is possible for large amounts of money to be created by fiat by a central bank and NOT induce inflation only if the reserve ratio is increased accordingly.

So what would happen in real life? Let's say the US Treasury, facing a shortfall in funds, approaches the Federal Reserve Bank for funds. The Fed then creates money by fiat, out of thin air, and gives it (not lends it) to Treasury. Treasury then uses this money to pay the bills. The Fed, however, increases the Reserve Rate accordingly to prevent the inflationary impact of this money creation.

Magic? No. Just a simple change to the equation - a change to the equation that was never thought of by Mugabe, Weimar Germany and others.

Don't believe me? Then do the spreadsheet yourself. Here is a screenshot of what I did with mine.

Long term readers of this blog might notice where I'm going here: My Zero Tax Idea. How would the graph look in the "Idiocracy" situation I described, where taxes are removed and the government is funded purely by money printing, except this time we adjust the Reserve Rate?

Yep. No increase in the total money supply and thus no inflation.

Is this mad? Does this completely misunderstand how the fractional banking system works? Or does this have the potential to revolutionise how governments work? It isn't Quantitative Easing, it's Quantitative Control.

Imagine: No taxes at all, but a completely functional government.

Note: This was discussed back in 2007 at Angry Bear. Megan McArdle at The Atlantic also examined it here. Since the math backs me up (as proven by the spreadsheet graphs), maybe we should seriously consider it?

EDIT: For nations that do not have a reserve rate (such as Australia) the baseline money creation would appear as a straight line going up at a 45% angle. In order for this system to work in countries that have no reserve rate, one must be introduced. This is how it would look:

But then what about nations with large governments? Take Denmark, for example, whose government represents 56.6% of economic output. How would this system react to such a large amount of central bank money? Would the fractional system still work? Yes:

A Recession indicator has been triggered

One measure of real interest rates went into negative territory after the release of last week's inflation figures. The history of this measurement clearly shows that a recession will follow. If my estimations are right, a US recession will occur in probably 16½ months (2012 Q4), with anything from 5 to 32 months possible.

This measurement of real interest rates is not the one I have been studying in my monthly recession watches, but another one which I have mentioned before on this blog.

The "Real Interest Rate" is usually defined as the nominal interest rate minus inflation. In the case of the US, this is usually measured as the Federal Funds Rate minus the annual inflation rate. Yet this measurement can be problematic since the Federal Funds Rate is controlled not by the market, but by the Federal Reserve Bank. So instead of using the Federal Funds Rate, I have often used the 10 year bond rate as the interest rate part of the equation. So in this case, it would be the 10 year bond rate minus annual inflation.

I initially dismissed this measurement of real interest rates because a quick glance at its history showed that recessions have occurred without this real interest rate turning negative. But after last week's inflation report, and the subsequent negative result for this real interest rate on my spreadsheet, I began to study it a bit more. Here is the data since 1954:

It's clear that there are a lot of recessions since 1954 that didn't involve this negative real interest rate. Recessions in 1954, 1956, 1970, 1982, 1991 and 2001 all occurred when real interest rates were positive. Yet this is not the whole story. What I discovered from this analysis is that while recessions can occur without negative real interest rates, whenever negative real interest rates do occur, they are always followed by an eventual recession. This occurred in 1957, 1974, 1980 and 2008.

The longest period between a negative real interest rate result and an eventual recession is 32 months, and that occurred in 2005, with the 2008 recession following it. The 2005 result may seem to be an exception to this rule, but when compared to similar recession markers from that period, the 2005 result pretty much correlates with the inflationary surge caused by Hurricane Katrina.

So what about the present? Last week US inflation for May 2011 came in at 3.4438% while Ten Year Bond Rates for that month were 3.17%, which meant that real interest rates dropped to -0.2738%. You can see this on the last graph above, with the line dropping below zero. If real interest rates rebound into positive territory for June, thus giving it a single negative month, it will be similar to the 2005 result (September 2005 came in at -0.54%, but with over 24 months of positive results after it). But if the June result continues to be negative, and if this continues into July, then the chances are that a recession will be sooner rather than later.

Of course despite the fact that data goes back to 1954, there is just not enough historical correlation to make a 2012 Q4 recession (or thereabouts) an absolute certainty.

As a tl;dr, remember this:

Whenever Negative Real Interest Rates (10 year bond rate minus annual inflation) do occur, they are always followed by an eventual recession.

US Inflation for February will be big

Here's a screencap of my spreadsheet.

Monthly M0 grew in February by 8.1%, which means an annualised increase of 97.24%.

There are only three other monthly results since 1954 (where my M0 figures begin) when M0 increased faster than this, and that was October 2008, November 2008 and December 2008 during the market panic of that period. Those three months were also beset with some very severe deflation. It was this huge increase in liquidity by the Fed which helped prevent a deflationary collapse. Put simply, the inflationary pressure caused by the increase in M0 was able to balance out the deflationary effect of the crisis.

Since we're not in a similar situation (ie not in an imminent credit crisis), February's sizable M0 increase (the fourth largest in history) would have a large inflationary effect.

On the surface, annual inflation is still benign:

• November 1.1%
• December 1.4%
• January 1.7%

Yet these annual figures hide the monthly results which, annualised, are:

• November 1.5%
• December 5.2%
• January 4.8%

All these figures you can see on the screencap link to my spreadsheet I've given. And if you have checked that out you will also see the notation "QE2" to the far right of the November row. QE2 is, of course, the announcement by Ben Bernanke that the Fed will create $600 billion of money by fiat and use it to buy back government bonds.

Oil prices have popped up, partly due to Libya but mainly due to supply issues (ie Peak Oil), which means that the inflationary effect of QE2 will run straight into the inflationary effect of high oil prices. Bad news for the recovery.

Bernanke's money printing idea is interesting - but I have a better one

I'm no fan of Federal Reserve chairman Ben Bernanke. Bernanke's response to the 2008 credit crisis was to first state that it wasn't happening and then, when it happened, to say that it wouldn't be too bad. Fail. Moreover he was one of the members of the Federal Reserve Board under previous chairman Allan Greenspan who approved of policy keeping interest rates too low between 2002 and 2005, thus creating the conditions for the property bubble. Epic Fail.

But credit where credit's due - the recent announcement of $600 billion in bond repurchases is a step towards a more effective form of monetary policy, though I do question whether it is needed.

Bernanke has the dubious honour of being labelled "Helicopter Ben" because of some comments he made many years ago about how radical monetary policy could have solved the Great Depression. Given the damaging, persistent deflation during that period, Bernanke surmised that increasing the money supply by seigniorage (money printing) and then handing said money out willy nilly to people and businesses would have wiped out deflation and stimulated the economy to begin growing.

Of course those who ran the world economy in the 1930s did not have the information that we do now, namely that inflation and deflation can be controlled through manipulation of the money supply by central banks. The problem with conventional monetary policy is that it focuses solely upon interest rates to achieve its goal - in the case of the United States, adjusting the Federal Funds Rate is the way interest rates are raised or lowered. Developed countries have similar tools while developing countries tend to increase or decrease the reserve ratio as a way to influence monetary conditions.

Adjusting interest rates affects the money supply: Increasing interest rates will remove money from the money supply while decreasing interest rates will add money to the money supply. If a central bank wants to reduce inflation, it removes money from the money supply by raising interest rates; if a central bank wants to increase inflation (to prevent deflation), it adds money to the money supply by lowering interest rates.

Unfortunately, conventional monetary policy is constrained by the natural limits of interest rates. While there are no upper limits to interest rates, the lowest rate is obviously zero. You cannot have negative official interest rates because depositors will simply withdraw their money from banks - hiding cash under the bed is a better investment than keeping it deposited at the bank. When interest rates reach zero there is nothing conventional monetary policy can do to stimulate domestic demand - Japan is a classic example of this, with interest rates near zero for the last 15-20 years.

The Federal Funds rate is currently 0.20%. It has been below 1% since 2008-10-15, which means that the US has, for the past two years, reached the limit of conventional monetary policy. Enter Ben Bernanke and quantitative easing, and you have a radically new monetary policy tool.

The thinking is rather simple:

• To create more inflation, the money supply needs to be expanded.
• Since conventional monetary policy has reached its limit, no more money can be added to the money supply through the lowering of interest rates.
• Therefore money needs to be added to the money supply through different means.
• Seigniorage (money creation by fiat) is then used to buy back government bonds, thus increasing the money supply.

Seigniorage has been used injudiciously in the past, most notably by Weimer Germany and Mugabe's Zimbabwe, and has created hyperinflation. Yet this is the same process Bernanke is undertaking now. The difference is that the amount being created is limited, which means that the inflationary effect will be similarly limited.

But there are naturally limits to even this level of monetary policy - it is limited by the amount of government bond holders (US treasuries). While the amount of money currently tied up US government debt is huge (over $9 trillion in public debt), in theory this amount may be brought down to zero. This is an important limit for nations like Australia and Norway, whose gross government debt levels are comparatively low (and are actually net negative). Such forms of quantitative easing (as this policy is now known as) do have natural limits that need to be taken into consideration.

So what's my idea then?

Back in March 2009 I wrote an article titled Thoughts on fractional lending and quantitative easing which outlined some ideas I had at the time about unconventional monetary policy. Here it is:

The Central Bank creates money by lending it to Commercial Banks.

This would take the form of a deposit. The central bank creates money by fiat, and then deposits this money in as many banks and financial institutions (institutions that are part of the fractional banking structure) as it can find. This won't be a bond buyback, but a simple deposit. It is not important as to whether the commercial banks pay interest on such a deposit since paying back interest is not important - expanding the money supply is.

Of course, with more money deposited, commercial banks would then have more money to lend out, thus alleviating any credit crisis. There is no money entering the money supply via any bond buybacks or stimulus plans. It's simply money appearing by fiat and being deposited into banks.

But what happens once the economy begins to recover, credit begins to flow again and inflation begins to rise? Well obviously the central bank could then withdraw all or part of its deposit with commercial banks. This would reduce the amount of money commercial banks could lend out and act as a contraction of the money supply.

And then I got thinking again - what if this form of quantitative easing replaced current monetary policy completely? So rather than money being removed or injected into the money supply through bond issues or buybacks - why not simply have the central bank deposit money into commercial banks or withdraw money from its commercial bank accounts? It would still be an open market operation, but one which doesn't require a government bond market to exist or even some form of centrally set level of interest - rates would be completely market controlled and dependent upon how much money the central bank deposits into, or withdraws from, commercial banks.

So, to summarise:

To stimulate growth in the money supply (to battle deflation and thus stimulate economic growth), the central bank creates money by fiat and deposits it into commercial banks.

To restrict growth in the money supply (to battle inflation and thus restrict economic growth), the central bank withdraws money from its commercial bank accounts.

In both cases, the money supply is affected by the ability of the commerical bank to lend up to 100% of its deposits - the more deposits, the more money is lent; the less deposits, the less money is lent.

----------------------

Naturally, Paul Krugman and others will point out that increasing the money supply during a solvency crisis does little (the "pushing a string" theory) and I would agree that some level of Keynesian stimulus might be necessary, but one which sources its money from central bank money creation rather than by borrowing from the market.

In this scenario, instead of Bernanke's $600 billion being used to buy back government bonds, it is used (for example) to build wind turbines all over the country. It is monetary policy (money creation) AND fiscal policy (increase in production) acting together, and it is aimed at bettering the environment. Of course the $600 billion could be used to build tanks and machine guns for the army, or it can be used to buy everyone in the US multiple cans of Coca Cola, or it can be used to build mansions for the rich, or it can be used to build houses for the poor - the possibilities are endless, as is the potential for both intelligent or stupid spending.

What makes standard Keynesian fiscal policy work is twofold: firstly, money is injected into the economy, and, secondly, goods and services are produced, leading to a multiplier effect. Modified forms of Keynesian stimulus - such as Bush's tax cuts in the early 2000s - have only a single effect, namely money is injected into the economy. Monetary policy, even of the unconventional (quantitative easing) or radical (my March 2009 proposal) variety, has a similar effect: money is increased, but its demand (money velocity) is not. What the market does with the money after it has been gained depends upon how the market is acting, which is why monetary and/or fiscal stimuli do lead to some level of economic growth, but not as much as that enjoyed by a true Keynesian injection.

So the question comes down to this: what will the markets do with the $600 billion that Bernanke injects into the economy through "QE2" (as many have called it)? That, of course, is the issue. Will the markets use that money to invest back into the US economy or will they do something else? The markets have already reacted to the announcement by dumping some of their US dollar holdings, so it may be that QE2 just leads to a dollar devaluation, with the fiat money instead being directed towards Japan, Europe and other major economies. Here in Australia the dollar has breached parity and made buying CDs and books from Amazon.com that much cheaper. Thanks for stimulating the Australian economy, Ben.

But then all this goes back to whether the money supply should be increased. While US inflation is low (currently 1.14%, year on year) deflation is hardly a problem just yet. Deflation hit the US economy very hard in late 2008 when the credit crisis hit, but since then prices have stabilised somewhat. Paul Krugman and others would argue that the US should actually target 4% inflation as a goal rather than as a limit, in which case Bernanke's policy is heading in the right direction. Interest rates have certainly bottomed out, but where is the deflation that can't be influenced by conventional monetary policy?

And this therefore calls to question the reason for quantitative easing. Is Bernanke aiming to stimulate the US economy or is he simply trying to maintain price stability? If it were the latter, then Bernanke is crazy since the US doesn't have a problem with price stability at the moment (unless you adhere to absolute price stability like I do, of course, but that's another topic!), which means that QE2, as an inflationary policy, is being implemented when prices are not in danger of deflating. This can only mean that Bernanke is aiming to stimulate the US economy, and this is problematic.

Who in government should be responsible for direct actions to stimulate the economy? In most nations this responsibility is undertaken by politicians - in other words, elected officials. The Federal Reserve Bank is not run by elected officials but by public servants. Most central banks the world over see price stability as their major, if not sole, concern. Stimulating economic growth should not be the role of a central bank, though central banks should be open to being co-opted by governments to produce outcomes aimed at stimulating growth (an example being my proposal of Bernanke's $600 billion being used to build wind farms above). But if any policies are pursued to stimulate economic growth, they must originate from, and be ultimately controlled by, congress or parliament or diet or duma.

The problem with having a dual role - as the Federal Reserve obviously has - is that it is more open to corruptive influences. "Stimulating the economy" may mean dumping $600 billion into the accounts of troubled financial giants whose incompetency is what drove them to the verge of bankruptcy; it's not a coincidence that these financial giants just happen to own a considerable number of US treasuries that they can sell to the Federal Reserve Bank for the $600 billion being offered. If the Fed was only concerned with price stability they could simply ignore these troubled corporations and only respond to price signals from the Consumer Price Index.

Nevertheless QE2 does open the doors to monetary experimentation, which should be welcomed by those who have been concerned with the limits of interest-rate-based monetary policy.

Update 00:15:00 UTC

If $600 billion were used to build wind farms, the result would be huge. The Cape Wind project will produce 454MW for $2.5 billion. Using simple maths, $600 billion could buy 253.34 GW of nameplate electricity generation. Since the US has around 1075 GW of nameplate electricity generation, you're looking here at 25% of the US electricity market. Obviously these are hard and fast facts and there are certainly limitations to this form of extrapolation, but the sheer amount of money involved here needs to be subject to opportunity cost: would $600 billion of fiat money be better spent constructing wind turbines or injected into the US bond market?

Crud from the Krugster

Paul sez:

What you have to ask is, What would happen if China tried to sell a large share of its U.S. assets? Would interest rates soar? Short-term U.S. interest rates wouldn’t change: they’re being kept near zero by the Fed, which won’t raise rates until the unemployment rate comes down. Long-term rates might rise slightly, but they’re mainly determined by market expectations of future short-term rates. Also, the Fed could offset any interest-rate impact of a Chinese pullback by expanding its own purchases of long-term bonds.

OSO retorts:

A drop in the value of US currency would increase the cost of imports while increasing external demand for US goods and services. Since the US economy is geared towards imports and not exports, any long term drop in the value of the US dollar would lead to a "retooling" period whereby internal demand drops while external demand increases. The mixture of higher import prices and higher demand for US goods will be inflationary which will either result in higher interest rates from the Fed to counteract inflation or (if the Fed is stupid) result in a long term outbreak of inflation which will devalue people's savings and force people to invest in non-monetary assets such as shares or property which will, in turn, lead to yet another investment bubble.

I personally hope the Chinese sell off US bonds and force the dollar down, but to assume this won't lead to the outbreak of inflation and a (potential) increase in interest rates is wishful thinking. So there.

Why didn't it work?

Marge, I agree with you -- in theory. In theory, communism works. In theory.
- Homer Simpson.

Communism failed for many reasons, not least due to the effects of Stalin's dictatorship. Yet modern communists are quick to point out that Communism as a theory doesn't exclude free and fair elections, nor does it by nature result in a dictatorship of the sort we saw under Stalin. And you know what? They're right. But there's no point protesting and saying "True Communism has never been implemented" when the simple fact is that a massive long-term communist experiment was tried in Russia between 1917 and 1991 and, while it did lead to many notable successes (Nuclear weapons, Space Program, recognised superpower) we need to remember that it did collapse.

One of the more interesting subjects I studied at Macquarie University was "Modern Russian History", taught by David Christian. Christian was a communist in his youth and did his post-grad work in Leningrad in the early 1970s. Over time he became a critic of communism - not so much because of an ideological shift but because he came to realise that, as an economic system, it failed to deliver what it promised. He pointed out that whenever the Soviet Union wanted to increase the production of goods (eg wheat, tractors, AK-47s) it would simply increase the amount of factories or farming land to achieve it. To put it mathematically, if x is the amount of land set aside for growing wheat, and y is the output of wheat, then the path to 2y is to 2x - doubling the output meant doubling the means of production. The problem arose when there was no more room for increasing output - short of felling Siberian forests and forcing women to have lots of babies.

Capitalism, by contrast, (and this is Christian's argument), sought to increase production by increasing efficiency and productivity - and the way this was done was through profit driven innovation. Rather than being content with 2x = 2y, capitalism sought to change the equation to read x = 2y, to increase production without increasing labour or space or equipment by the same proportion. Christian therefore concluded that, in the "war of ideologies" that typified the post-war world, Capitalism had won because it was able to (eventually) deliver better and cheaper goods and services for people. Christian did not embrace capitalism, though - he still saw within industrial capitalism the exploitation and suffering of workers and thus the seeds of dissent that Marx saw. (note: this is my summary from memory of what Christian argues in his book Imperial and Soviet Russia).

Christian's arguments are very cogent because he steers away from the Stalinistic dictatorship / loss of democracy line of argument that so many people today use to explain Communism's failure. While it is no doubt true that Stalin and the lack of democracy were serious blights upon communism, their presence alone did not lead to communism's collapse. There are three nations today which espouse communism - China, North Korea and Cuba. Of those three, only one (North Korea) has remained ideologically true. China and Cuba abandoned Communist principles decades ago, and these nations have essentially become undemocratic societies with varying degrees of free market activity and private ownership of wealth (anathema to pure communism). By contrast, North Korea continues to be the beacon of hope for the workers of the world, and what a terrible, inefficient, controlling and frightening beacon that has turned out to be.

So all hail capitalism? Not quite, of course. I have often in the past compared the misguided ideological purity of the communist party to the ideological purity of conservatism - especially political conservatism in the United States. This is one of those times.

Modern American Conservatism (modern) can be traced back to the election of Ronald Reagan in 1981. For the past 28 years, US political discourse has been dominated by conservative beliefs and ideals. Yet in that time we have not only seen lower GDP growth than the previous period, but also a massive shift of wealth to the rich. Real median household income growth since 1981 has, according to the Krugmeister, been around 0.7% per year. Moreover, US Census figures clearly show that median income has stagnated since 2000, while the top 5% of wage earners have increased their income by 25% over the same period.

Then we add to this the ridiculous level of credit market debt as a percentage of GDP, which shows just how much of America's current wealth is illusionary. Also add the massive expansion of public debt under Reagan and both Bushes, the financial corruption of conservative politicians in recent years, the FEMA debacle in New Orleans and, of course, the housing bubble and credit market collapse which has led the world into the worst economic downturn since the great depression. Not to mention the conservative controlled Federal Reserve Bank (Alan Greenspan and Ben Bernanke were both appointed by conservative Presidents. Alan Greenspan was a disciple of conservative philosopher Ayn Rand).

Conservatives will, of course, offer all sorts of retorts to these problems. Conservatism doesn't condone corruption; conservatism demands fiscal prudence; conservatism demands good government. Yet there is no doubt that conservatives held onto political power during the period of history in which corruption, fiscal stupidity and government incompetence occurred. Arguing that conservatism and free market capitalism wasn't really applied during this period is pretty much the same sort of argument as those who say that the USSR never practised "real" communism.

Nevertheless, I am sympathetic to those who do argue that conservatism and free market capitalism wasn't really applied. I am also sympathetic to those who say that the USSR never practised real communism too. Yet there is no doubt that the conservatives who today complain that conservatism wasn't really tried are the same conservatives who enthusiastically voted for conservative politicians over a long period of time and supported the conservatives in power when things appeared to be going well. When asking the question "why didn't it work?", conservatives need to examine themselves and their own failures rather than blaming others - in short, they should take responsibility for their own actions (or lack of them) rather than threatening civil war if they don't get their way.

Ultimately the answer, I think, lies in two areas:

1. No pure ideology can be practised, so we should embrace a more centrist political position (which is why I describe myself as an Ordoliberal).
2. Politics corrupts, so stricter anti-corruption policies should be initiated on politicians at all levels (which is why I like the idea of Demarchy).

In which the incompetent are rewarded by the incompetent?

Barack Obama is in the process of reappointing Ben Bernanke as governor of the Federal Reserve. This fact has led me to wonder whether Obama is either ignorant, a fool or an industry shill. There are no other choices.

Bernanke is one of the people responsible for the current crisis. As a member of the FOMC that approved injudicious interest rate lowering under Greenspan, he is jointly responsible for the property bubble which formed. I have argued that point here.

Bernanke has reacted to the crisis badly. First he didn't admit that there was a crisis and then, when the crisis was underway, argued that it was "contained". Again, look at the link above for the details.

Once he realised that things were bad, Bernanke, a student of the Great Depression, acted swiftly in increasing the money supply at a time when the money supply was tightening into deflation. This was not a terribly hard thing to do. Even I could've done it. In fact, since I was actually aware of the crisis years before Bernanke, I would've been able to take pre-emptory actions and done a better job. Yet it's Bernanke who gets the multi-million dollar salary while myself and others bang our heads against the wall in response to the stupidity of those who control vast sums of money.

So the question is - why did Obama not know this? Is he being shielded from reality by a bubble in a similar way that Bush was? Or maybe he has no idea of how economics works and thinks Ben has done a good job. Or maybe Obama is simply having his strings pulled by industry insiders. Whichever one it is is hardly encouraging.

A thought

Ben Bernanke is trying to wage war against the Great Depression.

The problem is, as many prospectuses say, "past performance is not an indicator of future performance".

I don't think Bernanke is factoring in the great possibility of capital flight from the US - a process that would leave the US Dollar in tatters.

Ben Bernanke predicts end of recession

Ben Bernanke, the man who did not foresee the crisis, is now predicting its end:

"It depends a lot on the financial system," he replied. "The lesson of history is that you do not get a sustained economic recovery as long as the financial system is in crisis. We've seen some progress in the financial markets, absolutely. But until we get that stabilized and working normally, we're not gonna see recovery. But we do have a plan. We're working on it. And I do think that we will get it stabilized, and we'll see the recession coming to an end probably this year. We'll see recovery beginning next year. And it will pick up steam over time."

Diversionary tactics:

Bernanke obviously knows that he is in the firing line of blame for this crisis. But look who he blames:

"Let me just first say that of all the events and all of the things we've done in the last 18 months, the single one that makes me the angriest, that gives me the most angst, is the intervention with AIG. Here was a company that made all kinds of unconscionable bets. Then, when those bets went wrong, we had a situation where the failure of that company would have brought down the financial system," Bernanke said.

"You say it makes you angry?" Pelley asked.

"It makes me angry. I slammed the phone more than a few times on discussing AIG. I understand why the American people are angry. It's absolutely unfair that taxpayer dollars are going to prop up a company that made these terrible bets, that was operating out of the sight of regulators, but which we have no choice but the stabilize, or else risk enormous impact, not just in the financial system, but on the whole U.S. economy," Bernanke explained.

AIG is one of many different financial institutions that made bad calls and ran close to the edge to gain more profit. Until the whole thing collapsed, we didn't know just how close to the edge these companies were. AIG, of course, deserves as much blame as it can get... but in Bernanke's case it diverts the attention away from his own failures.

Minimize failure:

"Does the Federal Reserve bear any responsibility for missing what was happening to the banks, as it was happening?" Pelley asked.

"Well, like other regulators, we probably could have done more. We've already done a lot of - put a lot of effort into reviewing our practices. And reviewing the bank's practices. We are trying to strengthen our regulation at every point that we can. So, I don't want to deny that we certainly could have done a better job, and others could have done a better job," Bernanke conceded.

Notice - nothing there about how the credit crisis caught Bernanke by surprise, asleep at the switch and with his pants down.

Why was it that so many of us knew that the whole thing was going to crash down while Mr B did not? He clearly stated in 2005 that there was no housing bubble.and when he finally admitted that one existed and had popped, he said that everything would be fine. Moreover, he still doesn't say much about Greenspan and the Fed's decision to pursue negative real interest rates between 2003 and 2005 (Bernanke was part of the Federal Reserve Board that made those decisions)

Bernanke is a smart man, but someone has to take the blame for the Fed's failure to foresee the current crisis. His errors of judgement are on the record. He must step down or be pushed.

Thoughts on fractional lending and quantitative easing

It's always good to have a mate you can disagree with. Dave has been emailing me lately about money creation. It seems that a large proportion of scientific non-economists (such as biologists, environmental scientists and the ilk) are of the opinion that fractional reserve banking cannot survive a move to a steady state economy.

But more on that at some other post. Every time I have a robust discussion about money supply, my brain begins ticking over at its possibilities and ideas pop up.

There are natural limits to fractional lending. Banks cannot, for example, lend out less than 0% of their deposits. Nor can they lend out anything beyond 100% of their deposits (reserve requirements notwithstanding). These are natural limits.

These limits are being felt now through ZIRP - Zero Interest Rate Policy. The problem with ZIRP is that it announces the limit of what monetary policy can do. Once central banks like the Federal Reserve lower rates down below 1%, monetary policy becomes increasingly ineffective. The problem is that once interest rates fall to that level, it is an indication that the demand for government bonds has sky-rocketed. Through the standard open market operations of buying back bonds, the central bank creates a profitable form of investment for the market - the price of bonds sky-rockets as the central bank begins to buy them and the market reacts by holding them even tighter. The end result is, unfortunately, no real addition to the money supply and a vicious cycle of government bond purchases that is, in the end, not unlike an investment bubble. ZIRP ends up preventing money creation - which is ironic considering that its purpose is to encourage money creation.

Of course, this wouldn't happen if interest rates could go negative. But negative interest rates are prevented by the natural limits of fractional reserve banking.

Given that this is the case, a new phrase has entered the economic vernacular - quantitative easing. For amateurs, this is essentially money printing - the central banks creates money by fiat and then somehow injects this money into the money supply.

From what I can gather, however, the result of quantitative easing is the same as standard monetary policy - bonds are bought back. Yet, as I have mentioned above about ZIRP, this procedure won't result in anything but a bond bubble and won't actually enter the money supply.

One solution is for the central bank to lend money to the government, who then uses it as part of any stimulus package. If we take the current Obama stimulus as an example, then we could see how the Fed could create money by loaning it to the Government, who then spends it on the stimulus.

Creating money out of thin air does, of course, have its risks - most notably the hyperinflationary experiences of Weimar Germany and Mugabe's Zimbabwe. But what is important here is that the amount of money created is limited by concerns over inflation. The Fed is hardly likely to create $15 trillion out of thin air and dump it into the economy because such an event would be hyperinflationary. But if the Fed created, say, $150 billion (10% of the previous amount), the inflationary effects would be less. Couple this with a deflationary environment and you have the recipe for modest price stability.

Yet there is more to Quantitative easing than simply lending it out to government. I would go one step further. And this is my idea:

The Central Bank creates money by lending it to Commercial Banks.

This would take the form of a deposit. The central bank creates money by fiat, and then deposits this money in as many banks and financial institutions (institutions that are part of the fractional banking structure) as it can find. This won't be a bond buyback, but a simple deposit. It is not important as to whether the commercial banks pay interest on such a deposit since paying back interest is not important - expanding the money supply is.

Of course, with more money deposited, commercial banks would then have more money to lend out, thus alleviating any credit crisis. There is no money entering the money supply via any bond buybacks or stimulus plans. It's simply money appearing by fiat and being deposited into banks.

But what happens once the economy begins to recover, credit begins to flow again and inflation begins to rise? Well obviously the central bank could then withdraw all or part of its deposit with commercial banks. This would reduce the amount of money commercial banks could lend out and act as a contraction of the money supply.

And then I got thinking again - what if this form of quantitative easing replaced current monetary policy completely? So rather than money being removed or injected into the money supply through bond issues or buybacks - why not simply have the central bank deposit money into commercial banks or withdraw money from its commercial bank accounts? It would still be an open market operation, but one which doesn't require a government bond market to exist or even some form of centrally set level of interest - rates would be completely market controlled and dependent upon how much money the central bank deposits into, or withdraws from, commercial banks.

So, to summarise:

To stimulate growth in the money supply (to battle deflation and thus stimulate economic growth), the central bank creates money by fiat and deposits it into commercial banks.

To restrict growth in the money supply (to battle inflation and thus restrict economic growth), the central bank withdraws money from its commercial bank accounts.

In both cases, the money supply is affected by the ability of the commerical bank to lend up to 100% of its deposits - the more deposits, the more money is lent; the less deposits, the less money is lent.

EDIT: I meant to write 1%, not 10% for the $150 Billion.

I still believe in inflation targeting

The current economic crisis - which has now lasted so long it should eventually require a name change - has naturally called into question deeply held assumptions and rigid ideologies. And that's a good thing.

One thing which has been questioned is the wisdom of "inflation targeting". The argument is that since inflation targeting was designed to flatten out economic growth and prevent booms and busts, then it is obviously a failure.

I still think that inflation targeting is needed for the following reasons:

• While the crisis is international, it began in the US. The Federal Reserve Bank certainly adjusted interest rates according to inflation, but there was no "inflation target" that was used.
• One of the basic rules behind inflation targeting is to ensure that real interest rates (interest rate minus the inflation rate) are positive. Under Greenspan between 2003-2005, real interest rates in the US were negative. Not only did the Fed not have an explicit inflation target, it did not even follow judicious monetary guidelines to ensure that real interest rates remained positive.
  
• The European Central Bank (ECB) was not consistent in its application of its own inflation target in regards to the Euro. For most of the ECB's life, inflation exceeded its 2% inflation target.
• Despite these problems, inflation in many Western countries in the past decade was low. Yet even low inflation rates did not avert the crisis from developing.
• The solution is not to abandon inflation targeting, but to actually practice and enforce it.
  

I am very well aware that one of the louder voices in this economic crisis is the one which says "capitalism has not failed because capitalism was never tried". Arguing that inflation targeting is still necessary makes me feel like one of these ideologues. Nevertheless I believe the clear evidence is that both the Fed and (to a lesser extent) the ECB were not involved in inflation targeting per se, either explicitly (by keeping inflation below an arbitrary level) or implicitly (by ensuring real interest rates remained positive). If "inflation targeting" is to be defined as the Fed's and the ECB's actions over the past decade then it must certainly be abandoned and replaced by a harsher, stricter inflation killing regime.

Let me rehash one of my typical arguments about Absolute Price Stability. Had inflation targeting been far stricter in the last ten years and aimed at neither inflation nor deflation, but rather a zero net change in consumer prices, then this crisis would never have occurred in the first place. Higher interest rates would have prevented a subprime bubble, it would have dampened economic activity enough to prevent ultra-high oil prices, it would have provided a reasonable alternative to investing in the share market and it would have prevented excessive lending and over-leveraging.

So the reason why I believe in inflation targeting is because, if it was actually tried and if Absolute Price Stability was its goal, the current crisis and mess would never have occurred in the first place.

A 20 basis point cut

Bumblurg:

The Bank of Japan cut its benchmark interest rate to 0.3 percent in a split decision to help stave off a prolonged recession.

Governor Masaaki Shirakawa cast the deciding vote to lower the key overnight lending rate from 0.5 percent after four of the eight board members dissented, the central bank said in Tokyo today. Three wanted to cut the rate to 0.25 percent, and one wanted to leave it unchanged, Shirakawa said.

Heresy! Don't these people know that the only way to change rates is to do it in multiples of 25 basis points? ie 7.75% to 7.50%, 8.00% to 8.25% etc etc.

Actually, to be honest I always wondered what would happen if someone did this. Imagine if the Fed dropped rates by 10 basis points, from 1.0% to 0.9%? Everyone would be sooooo confused.

It would be like the US Treasury issuing 20c coins instead of quarters. Hah! Who would ever do such a thing?

A Deflationless Depression?

Logic can be a bad weapon when the equation isn't finished.

Think back to the Great Depression. Long lines of unemployment, years of economic contraction, suffering, etc.

One big thing that happened during that period was deflation - a continual falling of prices. Goods and services dropped in value on a daily basis.

The problem was chronic, and policy makers at the time either didn't know how to cure it, or didn't really see it as an important issue. In hindsight it was. Keynes rightfully argued that a good response would've been for the government to expand its operations and run a deficit, thus increasing economic growth and reinflating. Monetarists rightfully argued that interest rates at the time were too high and that increasing the money supply by lowering rates would've been a good solution. Ben Bernanke, in his study of the Depression, declared that there was always the option of merely creating money ex nihilo and throwing it around until deflation disappeared (and thus was born his nickname "Helicopter Ben").

So... here we are on the cusp of yet another potential depression. Ben is doing his best to keep deflation at bay - interest rates have dropped again, a process which acts to stimulate money growth. If the problem gets any worse Ben may have to warm up his helicopter and begin money bombing.

But will this solve the problem? Will the simple process of creating more money - which is balanced out by the market's deflationary money hoarding - do the trick? Is it simply a matter of monetary policy?

The answer to that, of course, is no. It will certainly help prevent exacerbating the problem, but we need to remember that the Great Depression was not simply a failure to keep prices stable.

At present, I would argue that our current set of policy tools and economic understanding is quite capable of coping with an economic upheaval similar to that which caused the Great Depression. Yet I would also argue that the upheaval we are experiencing now is twice as worse as the share price bubble bursting in 1929.

The basis for this argument is the below graph, which I mentioned back in July and which was instrumental in changing me from an "optimistic financial doomer" into a "pessimistic financial doomer":

The graph is sourced from this article at Naked Capitalism.

There is always something terribly frightening about any graph showing exponential growth as it plots something in the real world. "What goes up must go down" is the rule - and the current market crash seems to be following this principle.

I still cannot believe that total credit market debt is equivalent to around 350% of GDP. If that isn't frightening enough, look back the great depression years - the "spike" on the left hand side of the graph. This may, of course, be simply a Propter Hoc scenario - two bits of information that appear to be linked but aren't - but I honestly doubt it since we are comparing stats from the same area of study.

(Note: an example of a Propter Hoc fallacy would be to say that the decline in popularity of Spirographs has occurred while childhood literacy has dropped - thus creating the impression that declining literacy rates could be stopped by buying more Spirographs. The two areas of study - developmental psychology and sales figures - need more to link them than just sheer coincidence. In the case of the graph above and the instance of economic downturns, the information is linked in the area of financial statistics, thus making the correlation between the two more reliable).

If the graph is correct (and I trust Yves), then we are facing a financial situation many times worse than that which hit in 1929. Debt-based asset price bubbles (such as property or shares), when they go bust, leave a trail of deflationary and expanding debt.

It is important to look at the above graph and compare the Depression years with the years since 1980. The depression years saw debt increase to around 170% of GDP before the crash. The increase of the debt to 260% of GDP occurred after the crash and is most likely due to the deflationary spiral that the world economy went into (debt levels remained the same while GDP contracted sharply, thus increasing the share of debt to GDP).

What we have seen since 1980, however, has been a build-up of credit market debt to a level representing 350% of GDP. That is around twice the comparable amount of debt that was present before the 1929 crash. This means that we have further to go.

Think of it like this: The economy is a car ("automobile" for you yanks). In 1929 the car hit the wall at 100kph and crashed. Unfortunately no one knew how to fix the car properly after the crash, which meant that the problem got worse. Moreover, it took years of research and study to determine the best methods of fixing the car properly. Now that the car has hit the wall again, it is tempting to say "well we know how to fix it now" - except this time the car has hit the wall at 200kph.

And that goes back to the title of this article - a deflationless depression. I am absolutely certain that we have learned from the policy mistakes of the 1930s and we are able to prevent the world from going into a 1930s-type deflationary spiral. But we must also remember that our economy has hit the wall harder and faster than in 1929. We cannot assume that this will be of no consequence.

Monetary policy is, of course, an essential tool for running an economy properly. But monetary policy is best used as a preventative rather than a cure. The most effective form of monetary policy occurs when interest rates are raised or lowered in response to price signals while the economy is running along relatively smoothly. Emergencies like deflationary spirals or stagflation do require monetary intervention - but they still remain emergencies. It is obvious that central banks like the Federal Reserve need to step in and provide emergency assistance to an economy that has hit the wall - but the work that monetary policy does in those cases is not a cure, but merely a bandaging of wounds and a setting of broken bones. At some point the market ends up having to cure itself with bed rest.

It is entirely possible to have a deflationless downturn - just as the 1970s showed us that it is possible to have an economic contraction and high inflation at the same time. Whatever the Fed or the US government will do in response to the current crisis will never be enough to cure it but hopefully will be enough to limit the damage. After all, the last thing we need is for policy mistakes to make the situation worse.

America has no room for fiscal deficits

It says:

Wall Street rose more than 4 per cent overnight after US Federal Reserve chairman Ben Bernanke supported the implementation of another US Government stimulus package.

Dr Bernanke told a US Congressional committee that it should consider measures to help improve access to credit by consumers, businesses, and other borrowers, as the North American economy faces a protracted slowdown.

This is precisely the area that I differ with in regards to other econ-bloggers. A month ago I argued that the time had come to follow The Washington Consensus. This called for nations that in economic trouble to enact "fiscal policy discipline".

It's not as though I reject Keynesian policy at this point - in fact, I think the idea of running a deficit during hard economic times is an essential activity, all things being equal. The problem with this in America's case is that things are not equal.

It is popular for many econ-bloggers to remind us all of Hoover's mistake. Faced with the biggest economic collapse in history, Hoover exacerbated the situation by insisting on tax rises and spending cuts to ensure that the US government ran a balanced budget. At the same time, the Federal Reserve kept interest rates too high, making the situation even worse.

Thus, the logic goes, insisting on fiscal discipline during a recession is deadly. Paul Krugman thinks so, as does Ben Bernanke.

Well, allow me to disagree with the Nobel Laureate and the Reserve Chairman.

The situation the US finds itself in now is not completely analogous to the situation in 1930 onwards. For starters, the US in 1930 did not depend upon the actions of foreign investors as much as it does now. In 1930 (as far as I know) US treasuries were not being bought and sold by sovereign investors like the Bank of Japan or the Bank of England. Around $2.7 Trillion in US treasuries were owned by foreign investors - a number which represents approximately 20% of GDP.

The second problem that faces the US now is that public debt is already way too high. $6.06 Trillion in federal government debt is owed to the public - around 44% of GDP (and likely to get higher as the bailout, reduced tax revenue and contraction in GDP will increase that percentage).

Again, let me say that I am not against running deficits during recessions in ordinary circumstances. Hoover's decision to balance the budget was a wrong one, to be sure, as was ultra-tight monetary policy from the Fed in the 1930s as well.

But what I am saying is that the circumstances that the US is in today - namely already huge levels of public debt and a dependence upon foreign investors - makes the current economic crisis even worse. The fact that the US government already has unsustainable amounts of debt (due to a combination of Reagan and GW Bush) allows little, if any, room to move.

I have pointed out in earlier posts the danger of capital flight - when foreign investors flee from a country and, in the process, crash the currency. This happened to Russia and many Asian countries in the mid-late 1990s and the result for them was horrible. I vaguely remember the Russian central bank lifting rates to 100%.

If the US should increase its level of net government debt, the danger of capital flight will be increased markedly. There is every reason to believe that foreign investors' love affair with the US dollar might come to a sticky and bloody end if the US continues to borrow money to boost consumption.

Many might argue, however, that the US Dollar is too big to fall. The US Dollar is, after all, the world's reserve currency. All I can say to that is to look at the example of Enron or Lehman Brothers or Washington Mutual - huge companies that were in the top 30 biggest companies in the US. If these big companies can go bankrupt and collapse, then it stands to reason that international investors may eventually raise the level of risk associated with investing in the US, causing the Dollar to drop in response.

I have to say that too many American economists have been blinded by their Americocentricity - they have lived and studied so long within the US "bubble" that they are unable and/or unwilling to step outside of it and see the bigger picture. This is why Krugman and Bernanke - amongst others - are arguing so vociferously for more stimulus programs and bigger deficits. The fact is that they can't see how public debt levels are already unsustainable and the danger this poses both in terms of future fiscal restraint and US dollar values.

If capital flight does occur and the US dollar does crash, the result will be disastrous - what I often refer to as "financial armageddon". If you think the problems of the present are bad enough, they will be made 100% worse if the US dollar crashes.

Let me finish off here with a market example.

Let's say that Widgets Banking Corp, a nondescript but medium-sized efficient US bank, decides to purge itself of its debts, lay off half of its staff and cut costs. What would this do to its share price? Investors, seeing that the company has taken steps to minimise its losses, would reward this effort with higher share prices.

In the same way, if the US government made steps to purge itself of debts by slashing costs and increasing its revenue stream, international investors in the US Dollar would react by valuing the currency even more.

You see, the problem is that traditional Keynesian thinking has the government acting within a closed economic system. The problem is that the system is open. If the US government goes ahead with Bernanke's advice and runs even bigger deficits to boost consumption, the result is likely to be capital flight.

Frying pans and fire come to mind here.

Reducing Risk

Think back oh, I don't know, fifteen years. It's 1993. The world has just recovered from a recession and economic growth is finally on the up. But unemployment remains too high for comfort and people talk about a "jobless recovery" while a young(er) Bill Clinton begins to contemplate strategies for reducing public debt.

And Nirvana, of course, releases In Utero.

It was definitely a strange time. In Utero was released after the success of Nevermind catapulted Nirvana from alt-rock trendiness to mainstream success. Overnight a struggling band had become millionaires and the music world was changed forever. But... In Utero? What went on there? It wasn't as though the album wasn't a success - it was (it reached no. 1). Nevertheless there was a sense of disappointment that many new Nirvana fans felt. Gone were the Gen-X anger anthems, replaced by a depressed sense of self loathing that made the band more British than American.

In retrospect, however, In Utero is Nirvana's most critically acclaimed work. It has stood the test of time and is deservedly viewed by fans as the band's creative and musical peak. At the time, though, it was a risk.

Risk and reward are two very obvious and very common concepts that our society uses. Most of the time it is an unconscious decision. In the financial and economic world, however, risk is a quantifiable condition that governs how much should be lent out and at what terms.

And fifteen years ago, risk aversion certainly affected the economic world as it climbed out of a recession and into a jobless recovery. The early 90s downturn was not as vast or as damaging as the early 80s one, but it did serve as a reminder that even the best efforts of exuberant Reaganomics could meet natural limits.

But between then and now, something happened. First a tech bubble popped, leaving the US in recession in 2001, and then the subprime bubble popped in 2006, leading to a credit crisis in 2007 and then the proto-depression that we are going through now. At some point between 1993 and 2001, the market's ability to accurately measure risk disappeared. Yet no one seemed to learn and risk analysis went off the rails yet again as the housing bubble promised heaven on earth and delivered hell on earth instead.

You've seen people who get into destructive relationships and then, after a period of healing, enter into another destructive one? Well, that's pretty much what has happened in the last ten years with risk analysis.

I was interested to read at Mark Thoma's site today the story of Nassim Nicholas Taleb. Taleb said that Bankers “are not conservative at all; just phenomenally skilled at self-deception by burying the possibility of a large, devastating, loss under the rug”.

Taleb sounds, of course, like an angry Austrian - he doesn't use mathematical equations and Gaussian somethings - instead he uses what appear to be unprovable axioms and, from those, basically states that these people are idiots (more or less). Pre-2007 and Taleb was written off. Post-2008 and people are noticing.

One problem with modern understandings of how risk works is that often it is predicated upon historical performance. Take periods of economic growth and recession - the so called "peaks and troughs" that typify modern economic evidence. It is very easy to see these events in a closed system and as a cycle - which they are. What we may not be able to see, though, is the bigger picture. We don't factor in variables enough, resulting in a "Salient Oversight" that ends up like a sabot in an industrial machine, causing a sudden, damaging halt in the process. Taleb, along with many others, could see that the financial and economic machine was going to shut down painfully because the designers and maintenance workers of the machine - banks and financial institutions with complex risk-management equations - were blissfully unaware of their impending doom. The level of risk, therefore, was a lot higher than it appeared to be.

What do we do? If we're going to learn from the smoking, screeching machine that this economy has become, what policy goals, if any, need to be implemented?

The first area that needs to be worked on is the most obvious, and yet it is probably the least important - regulation. It was obvious from the outset that the entire financial industry became lazy during the late 1990s. Risk wasn't important while share prices soared. Instead of basic questions like profitability and p/e ratios and long term goals, the focus instead was upon candlesticks and lines of resistance and Fibonacci sequences. In other words, the focus of finance was upon the practice of finance, rather than the companies that needed finance.

Which is why the US economy then began to be mainly a "financial" economy - high share prices created paper profits which created higher share prices until a very impressive house of cards was built. Better regulation would certainly have helped the focus stay upon real-world measures of wealth and may have helped reduce the pain that many are suffering now.

But it is the second area that I want to focus upon here - the importance of interest rates in determining risk.

Whenever interest rates increase - and by this I am talking about the Federal Funds rate (or foreign equivalent) - the entire market for lending moves towards a more risk-averse environment. This is because, by increasing rates, the Federal Reserve is essentially increasing the competition for the investor dollar. Since US government bonds are (rightly) seen as a risk-free security, any increase in bond rates will make other forms of investment more riskier by comparison.

Conversely, whenever interest rates decrease, the environment becomes more risk-friendly. By lowering rates on government bonds, other forms of investment become more attractive.

So, in summary:

• Increasing rates = less riskier investing.
• Decreasing rates = more riskier investing.

I'm not one of these people who somehow sees debt and risk as being bad things - they're good things, but only when balanced with savings and safety. Just as over-borrowing and investment in high risk ventures can result in economic carnage, so can over-saving and investment in low risk ventures result in a low-speed, sluggish economy.

The issue here, though, is balance. The market should be allowed to invest in riskier ventures if it sees it as being profitable while also being given allowances to be conservative.

The problem, though, is when interest rates remain too high or too low. I have argued that since 2002, the Federal funds rate was too low. This resulted in negative real interest rates and the creation of the subprime bubble.

And because interest rates were too low, the market responded by investing in an area that seemed reasonable and profitable at the time, but was eventually proven to be too high a risk - the property market. Had interest rates been higher, and had real interest rates been positive from 2002 onwards, the chances are that the subprime bubble would have popped earlier or maybe not even formed at all. In fact, the higher the interest rate was, the less chance a bubble would've been formed in the first place.

All this goes back to what I have been arguing about the importance of maintaining value in a currency. As I said before, currency is unique in that it is both a unit of measurement and a commodity that is bought and sold. When money changes in market value, its usefulness as a unit of measurement is ruined. In practice, inflation forces the market to over-invest in high-risk ventures. By contrast, deflation forces the market to under-invest in ventures that are not very risky at all.

In order for the market to make more rational decisions, money must remain a stable and predictable unit of measurement while still being bought and sold as a commodity. To find the balance between risk-friendly and risk-averse, interest rates must act as a compensator to prevent the market from going too far in either direction. Absolute Price Stability (neither inflation nor deflation over the long term) should therefore be seriously considered as the means by which central banks run monetary policy.

Risk will always be a part of modern financial investment and behaviour. As I have said before, risk is not wrong - but too much of it is. Neither is conservative investment wrong - but too much of it is.

Economic Crises still need price stability

I admit it - I'm not an inflation hawk, I'm an Inflation Mushroom Cloud Layin' (insert crass Oedipal phrase), (insert crass Oedipal phrase)!

I have spent the last few years arguing on this blog of the necessity of controlling inflation over and above what many policy makers would think is reasonable. On my own I developed the theory of Absolute Price Stability, which is the #1 Google search for the phrase, even though others had actually invented the idea long before I did.

To quickly summarise what I have said (in case you haven't been turned off yet by my recent goings-on about it), I believe in the following axioms:

• The value of money is solely due to its ability to determine the cost of goods and services and to be used as a way of exchange. It is a way of measuring the worth of economic activity in a quantifiable manner.
• Over-investment and under-investment bring about economic harm to a society.
• Investment in the wrong place and the failure to invest in the right place also bring economic harm to a society.
• When the value of money changes, the market (as households, businesses, individuals and government) will inevitably make poor decisions in regards to what to buy and sell, and what to invest in and borrow for.
• While the market will always be prone to errors in judgement, ensuring that the value of money remains constant will help minimise this risk.
• In order for the value of money to remain constant, monetary policy should now be focused upon Absolute Price Stability - whereby the value of money is affected neither by inflation nor by deflation.
• In practice, Absolute Price Stability is not about price fixing, but inflation fixing. Monetary policy should always ensure that neither inflation nor deflation permanently affect the value of money over the long term. Short term experiences of inflation and deflation are to be expected, but over the long term, monetary policy should ensure that money's average value remains constant.

At present the economic world is suffering a massive credit crunch. In the past I have argued that inflation will continue to bedevil the world even though a recession takes place. I was wrong. I was predicting a different recession to the one now being experienced. Moreover, the one being experienced now is far more dangerous because it now seems to be an unwinding of the entire financial system that the world has been operating for decades. In this sense, the recession was always going to arrive. Moreover, two of the conditions of the recession that I was predicting (fiscal irresponsibility by the US government and the effects of Peak Oil - see here) are still major threats that need to be taken into consideration.

Absolute Price Stability, however, doesn't just mean no inflation. It also means no deflation. Financial conditions have deteriorated so badly in the last month that the only real result will be deflation.¹ While the stupidity of the Fed between 2002-2005 and the fiscal ineptitude of the White House and Congress between 2001-2008 has allowed inflation to grow, we are now seeing the results of those decisions - essentially what goes up (inflation) must come down (deflation).

If the Consumer Price Index begins to show increased deflation (as I think it will - the September figures are due soon) then the only real solution is for the Fed to begin seigniorage - money creation. This is the emergency solution that Ben Bernanke has written about previously, from which he derives his nickname "Helicopter Ben" - the idea being that deflation can be solved by simply throwing money everywhere.

In theory, a central bank can create and control an infinite amount of money. Bernanke and others in the Fed could, if they choose, create $100 Quadrillion dollars out of thin air. The idea that deflation can't be solved is incorrect.

And this is where Absolute Price Stability comes in. If this sort of policy is introduced, the Fed (and other central banks) could quite easily control deflation by creating money and buying back bonds. This would not be done randomly or stupidly - the last thing we need is a Weimar America - but certainly the sterilizing effect of deflation can be balanced through judicious seigniorage. In fact, some of this money creation could be used in the form of stimulus checks or given to the unemployed - it doesn't have to go towards corporations or financial firms.

I'm saying all this not just to push my idea of Absolute Price Stability (which I think will help solve the current crisis and prevent many from occurring ever again) but also to point out that while I have described myself as the "Inflation Mushroom cloud laying (insert crass Oedipal phrase), (insert crass Oedipal phrase)!", the reality is that I am just as opposed to deflation as inflation. I am not advocating some form of permanent deflation - that would be crazy - but instead the belief that money itself is best used when it retains its value.

Moreover, I believe that such a policy is best practised universally. There is only one country which practices Absolute Price Stability and that is Japan (Mark Thoma confirmed that with me once on a comments thread at Economist's View) - yet Japan is sliding into recession too. The reason is that Japan, despite practising Absolute Price Stability, is strongly connected to the world market - which means that a problem in the world market will also affect Japan. But if all countries practised Absolute Price Stability - and made it into an international treaty - then the world would be far less likely to suffer the sort of upheavals that we are experiencing now.
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1 - Unless the US Dollar crashes of course (see Krugman!). But let's ignore that for a moment.

Crisis prevention in hindsight

I'm in dot point mode today. Let me start with this one.

• If interest rates were higher in the past, the current crisis would not be so dangerous.
• If interest rates had been higher for the past 2-3 decades, this crisis would have been averted entirely.

Now, why do I say this? Well, let me just point out one important fact:

• Higher interest rates lead to higher rates savings because money becomes more valuable in relation to the goods and services it is exchanged for.
  

That, of course, is a point I argued in yesterday's post. Now one of the great ironies of economics is that problems are often solutions, and solutions are often problems. Sometimes in order to prevent something from occurring, you need to encourage it to occur. Now that might seem strange, but let me point out another important fact:

• The current crisis is occurring because the market has now decided to start saving.

Yes, that's right. The US economy has decided that it has had enough with spending and it has now decided to start saving. It has decided that it has had enough of borrowing.

But hang on! If I've been arguing that higher interest rates and thus increased savings rates would have prevented the crisis, am I now saying that the current crisis is due to increased saving? Well, yes - the solution is often the problem.

But let me explain this further. Imagine if the current crisis could be diluted somehow - so rather than one enormous credit crunch and market crash hitting now, that somehow this pain and misery could have been stretched out and diluted. If we give a 20 year time line, for example, imagine if this economic crisis was broken up into 20 pieces and then issued to each year of the past 20 years.

Keep that thought in mind - and that is what higher interest rates would have done.

Look at the following graph. This graph shows the effective federal funds rate (interest rates) in blue, while inflation is in red:

Now let's imagine that interest rates were higher since 1980. This would result in a negative relationship with inflation, with interest rates going up and inflation going down. In terms of the graph the blue line would be higher and the red line would be lower.

But I would argue that had monetary policy been more stricter, and inflation been lower, since the end of the 1980s recession, the result would have been, at the very least, mild recessions in the early 1990s, early 2000s and the one occurring now. In fact, those three recessions might well have never occurred.

And that is why I am an inflation hawk. A recession is always a period in economic history when, for whatever reason, the market rushes back to save money. If interest rates were higher and inflation rates lower, the market would never have needed a recessionary correction in the first place. The price to pay for this would be lower GDP growth but, in hindsight, that is a good thing. So here's another dot point:

• Higher interest rates = lower inflation = lower GDP growth = less chance of a recession.

Over the years many central banks have instituted inflation targets. While the Federal Reserve did not have one, in practice the Fed did raise rates when inflation approached 4% or more.

But if we assume that recessions could have been reduced in severity or even completely negated if interest rates were higher and inflation rates lower, then the usefulness of inflation targets needs to be reassessed. In hindsight, it now seems clear that these inflation targets were actually too accommodating.

And that leads to my last dot point for today:

• Absolute Price Stability - an inflation rate that averages zero over the course of the business cycle - should be the ultimate goal of monetary policy.

For regular readers, you saw that coming didn't you?

This morning as I lay in bed I was listening to comments made by some person from The Daily Telegraph, one of Rupert Murdoch's tabloids here in Australia. In the past year or two, the Tele has been waging a war against the Reserve Bank. The person on the radio this morning spoke disparagingly about the usefulness of monetary policy, saying that it was a crude tool like a hammer. He also said that monetary policy was relied upon too much in the past and is no longer working.

In the current crisis, monetary policy has only limited usefulness - that much I agree with. But I would argue strongly that the age of monetary policy is not over yet. Monetary policy is not intended to "solve" any crises, but to prevent them from occurring in the first place. Moreover, the current crisis was not due to an inherent failure in monetary policy, but a failure to use monetary policy wisely.

To use an analogy - the car has crashed and people are lying dead and injured. People like me who support monetary policy would blame the driver. Others who disparage monetary policy blame the design of the car.

In the midst of the current crisis I am absolutely certain that no government or central bank has the ability to stop the market stampede. Steps can be made to reduce the pain, but this crisis cannot be solved. What we can do is learn from it to ensure that no similar crisis occurs again.

Absolute Price Stability is a way to ensure that such a crisis never repeats. If this monetary policy was implemented worldwide, the result would be a stronger and more sustainable international economy.

Discouraging saving = encouraging poverty

I've just been reading Mish. He has a classic line:

Worrying about this economy slipping into recession is like worrying that your pet goldfish is going to die when it is floating dead on top of the tank.

I love Mish - he's fearless and forthright even though I disagree with him on important issues. Here's some more of Mish, following the above quote:

Economists should to be thankful that consumer spending is dropping. Unemployment is soaring, people have been living beyond their means, and if consumers keep spending recklessly, eventual defaults and bankruptcies will be that much higher.

From the point of view of retailers, this Christmas season may well be one of the worst for decades. From the point of view of an economic recovery, reduced spending is actually a good thing, not a bad one. It's long overdue for the "gotta have it now" generation to show a little fiscal restraint given the pool of savings sorely needs to be replenished.

The US needs to become a nation of savers once again, and that is just what is going to happen, whether Bernanke or anyone else likes it or not.

I've been thinking through this issue and I think that one attractive narrative that people have latched onto is the idea that some level of moral failing has caused this financial mess. Mish helps perpetrate this in these paragraphs, describing a "gotta have it now" generation who have "spent recklessly". The recent footage of Richard Fuld from Lehman Brothers appearing before a Congressional committee reminded many of the Enron fiasco.

There's no doubt that people have been reckless in the face of cheap credit over the last few decades, but I really don't think that this recklessness is somehow to blame, or that an entire generation of people can be classed as reckless and spendthrift.

The problem is that the road to financial ruin isn't always well signposted. "Abandon all hope ye who enter here" was not the signpost that people recklessly ignored. On the contrary, the signposts actually read "walk this way if you want to be financially prudent".

Take the tragic case of this man and his family. An MBA in finance and experience working for major accounting firms was not enough to prevent Karthik Rajaram from losing his job, wallowing in a pit of depression and then taking a gun to himself and his family. While the responsibility for this tragedy lies with Rajaram and him alone, I would nevertheless argue that, had things been different and the current economic crisis not happened, he and his family would still be alive today and he would probably still have a reasonably good job. While it is true that Karthik Rajaram's reaction to his plight was monstrous, I do not believe that his plight was brought about by financial recklessness on his part.

So too do I see the current plight. It is not the moral failing of America as a people that caused this crisis. While I don't see Americans as being paragons of virtue I don't see them as devils in disguise either.

So what is the problem then? If not morality and greed then what? It is structural - America's (and the world's) economy created this crisis because something within the system created the conditions that led to this disaster. This is important to realise because, when the time comes to stop reacting to daily crises and start examining why the failure occurred, there will arise a series of solutions that will help prevent a similar event occurring again.

It is not as though market capitalism has failed - as far as I am concerned market capitalism fails all the time. Abandoning capitalism for, say, Communism is about as judicious a decision as eating pebbles to cure an infection that has developed a resistance to antibiotics.

Put simply, the current crisis was caused by people with lots of money who invested it in the wrong thing. The people thought they were doing the right thing because the numbers looked right, the ratings agencies gave AAA ratings, the majority of respectable financial analysts said is was the best thing to do and the Joneses next door were making a killing from it. Herd behaviour? Yes. But herd behaviour that had careful planning behind it.

The structural problem resulted in the market investing unwisely. Investments were made in particular areas (shares, property) that seemed wise at the time but ended up going bad. While we may expect high return investments to be highly risky, the same could not be said for low return investments - which are now in free-fall too.

Mish nails it on the head when he says that "The US needs to become a nation of savers once again". I fully agree. Moreover, the historic, long-term drop in savings rate is the main cause of this current crisis.

But let's just go back a few years. If Mish and I are right in arguing that America should save more, what would people 3-4 years ago have said in response? "I am saving" they would say, "I have a mortgage and I am investing in my house, which is rising in value". And there the problem is - investing in housing had replaced saving.

It's at this point that I have to point out what saving actually is. It is not using your surplus cash to invest in shares and property. It is not using surplus cash to invest in managed funds. Savings means retaining your surplus cash as cash - it sits in your bank account or in a cash management trust or time deposit.

Cash ought to be the safest form of investment. There has to be some sort of low or zero risk investment that people can make. It's not wrong to invest in shares or property - it's just important that a percentage of surplus cash remain in cash form.

Having money tied up in cash is not very sexy. The interest you gain on it is nowhere near as potentially rewarding as a higher risk investment. Yet the issue is not whether cash investments replace other investments - but having a healthy mix of the two.

Cash investments are meant to be safe. They are not meant to reduce in value. If you have $10,000 sitting in a cash management trust you are not meant to watch it drop down to $9000. Any cash you have sitting in an account that remains uninvested in anything else should, at the very least, have the same value when you withdraw it as when you deposited it.

And cash - savings - is useful as a "safety net" when things go wrong. Everyone knows the importance of having more cash flow available than what you need normally because of the danger of unforeseen events. The best place to access this cash flow is from interest-bearing accounts that you have saved up over time (rather than, say, maxing out your credit card).

Yet here is where the structural problems come in: Americans (and many others) did not invest their cash surplus in savings but put them into risky investments that have since lost money. This was not a moral failure, but a practice that the entire economy encouraged.

I argued early in September that negative real interest rates under Alan Greenspan between 2002 and 2005 was the cause of the housing bubble. I remain convinced of this despite what others may say about the influence of Fannie and Freddie or policies under Jimmy Carter or the alignment of the planets. Yet the housing bubble seems to have triggered a wider contagion - one that I believe has been waiting to occur for about a quarter of a century.

The housing bubble occurred precisely because Alan Greenspan and the Fed ran negative real interest rates. This punished anyone who kept cash, since rises in inflation outweighed any interest gained (and interest rates on cash management accounts depend upon the Federal funds rate). The only choice for the economy was to invest in something that increased in value - and let me point out that this was rational behaviour. The intent was certainly rational, but the direction of investment was not. Instead of investing in property between 2002 and 2005, it should have been more attractive to increase personal savings (increasing the amount of money saved up in cash). The only way for this to have happened was for inflation to be lower than interest rates.

This is the reason why it was so important for Alan Greenspan and the Fed to have raised interest rates after 2002. Not only would this have lowered inflation and increased the attractiveness of saving, but it would have also resulted in positive real interest rates. Had the economy siphoned funds to savings rather than property then the current crisis would not have occurred. Yet the reason why the economy did not do this was because rational behaviour dictated that money should only be invested in something that increased in value - by keeping rates low and running negative real interest rates, the Fed made saving irrational.

But go back a few more years - back to the tech boom of the late 1990s and the subsequent popping and recession in 2001. In the years that the long boom grew, the market obviously made rational decisions to invest less in saving and more into tech shares. Yet during this period, real interest rates remained positive.

But again the problem remained - the market rushed to invest in something that would increase in value despite the fact that real interest rates were positive. I would argue yet again that if the Fed had chosen to keep rates higher during that period, the market would've siphoned more funds into cash rather than creating an investment bubble.

So what is the problem then? What is this structural problem? It is that interest rates have been kept too low, encouraging the market to put too much money into investments that eventually failed.

In summary, therefore, are my solutions:

1. Ensure that real interest rates are positive at all times.
2. Monetary policy should be geared towards ensuring absolute price stability - that is, zero inflation - to encourage savings rates and discourage too much investment in high risk ventures.
   

Had this been the Fed's policies from the early 1990s onwards, there would not have been either the tech boom and bust nor the subprime mortgage crisis and today's credit crunch. GDP growth during this period would have been lower, certainly, but considering the potential cliff that GDP is likely to plummet in the present, this would have been a better outcome. Moreover, savings rates would have been high and credit market debt would have been more sustainable (especially in light of this frightening graph).

I honestly don't know what is going to happen to the world economy over the next day, month or even year. What I do know is that, once a recovery is underway, new policies and paradigms will need to be explored to prevent this financial horror story from occurring again. Increasing household savings is one major step in this direction - and this is best handled by using interest rates to affect broad market behaviour rather than creating legislation to force people to save.

And that is a far better solution that complaining about the supposed moral failures of CEOs and a whole generation of people.