Whether 'tis nobler in mind to print, or print even more …

Prior to Ben Bernanke's breathlessly awaited speech on Friday (which turned out to be the usual boring pablum in the end), the WSJ's Jon Hilsenrath, who is the designated 'leaker' used by the Fed to 'manage expectations' of imminent policy decisions, wrote an article entitled 'Fed Chief Gets Set to Apply Lessons of Japan's History'.

 

Back in 1999, from his academic perch at Princeton, Bernanke let fly a paper that berated Japan's central bank for its 'timidity' in combating that perennial bugaboo of deflation ('Japanese Monetary Policy: A Case of Self-induced Paralysis? pdf). Not surprisingly, the paper diagnoses Japan's problem as an 'aggregate demand deficiency' combined with 'an old-fashioned Keynesian liquidity trap'.

In view of these conclusions, the paper proceeds to demand that the Japanese central bank try just about anything to 'raise inflation expectations and thereby aggregate spending'.

As Hilsenrath writes:

 

At a conference at sponsored by the Boston Fed in Woodstock, Vt., that October, Kazuo Ueda, then a BOJ policy member, issued a warning to the largely American audience: "Do not put yourself into the position of zero rates," he said. "I tell you it will be a lot more painful than you can possibly imagine."

Mr. Bernanke shot back that Japanese policy makers might be making the same "extreme policy mistakes" Americans made in the 1930s—being too timid about reversing deflation. A few weeks later, in a blistering research paper, he said even though conventional tools were expended, there was plenty the Japanese could do to boost consumer demand, business spending and prices. Among his suggestions: Cheapen the yen by selling it in the currency markets; or buy long-term debt from the Ministry of Finance to finance tax cuts, something he said was akin to just dropping money from a helicopter. One objection at the time was that Japan's economic problems weren't the result of too little stimulus by the central bank but of structural problems in Japan's banking system and in protected industries. Mr. Bernanke said structural problems didn't negate the need to find ways to push up consumer demand and business spending. "Japanese monetary policy seems paralyzed, with a paralysis that is largely self-induced," he concluded. "Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn't absolutely guaranteed to work."

Mr. Bernanke was particularly troubled by Japan's emerging deflation. He argued that Bank of Japan officials had to aggressively manage the public's expectations, because convincing households and businesses that deflation wouldn't persist would help to spur economic activity. Mr. Bernanke felt that Japan's central bank needed to make a commitment to get inflation higher and keep policy accommodative until it increased. Among his proposals was a suggestion that the bank publicly adopt an inflation target of 3% to 4%.”


If you look at the paper, Bernanke demanded 'Rooseveltian resolve' from Japanese policy makers. In other words, 'they didn't do enough' in his judgment. Eleven years later, Japan has the biggest public debt-to-GDP ratio of any industrialized nation, and a central bank balance sheet that is even larger relative to the size of Japan's economy than the Fed's bloated balance sheet is relative to the US economy. Alas, it has nothing to show for it – its economy remains in the doldrums.


The strange fear of deflation

Is anyone else struck by how idiotic this demand to 'increase inflation' really is? It's bad for us, the consumers, when prices are falling instead of rising? How so? It seems a rather nice prospect actually, to see the real value of one's income going up. If your money were to go further, would you buy fewer or more goods and services?

In fact, demand for things that are falling in price tends to increase rather than decrease. Not only that, but the businesses that are 'beset by price deflation' tend to do rather well. The proof for this can be seen in the statistics describing the development of the computer industry (but also other industries with comparable productivity increases) – demand for computers has been rising every single year since the industry came into existence, while prices have just as consistently been falling. Is the computer industry in a 'liquidity trap'? Looking at AAPL's $287 billion (as of last Friday) market capitalization one would rather think it is a thriving business.

Japan meanwhile has to import all its raw materials – what mileage would it get from lowering the value of the yen? The strong yen has done nothing to lower its trade surplus, a sign that its export industries are well-versed in coping with it – selling prices must be contrasted with input costs after all.

Bernanke's 1999 paper, along with his famous 'anti-deflation speech' of 2002 must be viewed as a likely blue-print for Federal Reserve policy now that the big bubble (a.k.a. 'The Great Moderation') has burst. This is highly unfortunate, because the paper fails to properly analyze the situation and thus perforce recommends the wrong cures. As a little experiment, search the document for the term 'production', just to fact-check what we are telling you: it is nowhere to be found – it's not mentioned even once.

Production is however a crucial component of economic activity. There can be no consumption without it.

In Keynesian models everything is aggregated into homogeneous lumps, which leads to the erroneous conclusion that 'aggregate demand deficiencies' and 'liquidity traps' are at work. However, Japan's real problem is that the government's interference in the economy (no-one can accuse Japan's government of not having followed the Keynesian prescription) with massive deficit spending and loose monetary policy created an obstacle to realigning the production structure with actual consumer demands. Economic scarcity does not disappear when the central bank introduces a zero interest rate, and capital must be properly allocated to correspond with the demands of consumers – which can only happen when the interest rate is actually a free market determined natural rate.

As Benjamin Powell Notes (in 'Explaining Japan's Recession', pdf):

 

Japan’s problem, however, is not inadequate aggregate demand but a structure of production that does not meet consumers’ particular demands. Producing things that nobody wants and propping up malinvestments cannot possibly help any economy. This policy is equivalent to the old Keynesian depression nostrum of paying people to dig holes and fill them. Neither policy will revive the economy because neither forces businesses to realign their structures of production to match consumer demands.”

 

As a side note here, Powell recounts how Japan circumvented the moribund banking system with a 'direct lending program' to businesses, where credit was apportioned according to political considerations – which left businesses that would otherwise have gone bust eternally on artificial life support.


Understanding boom and bust

Anyone analyzing a bust must first have a theory regarding how the bust came about. The bust is after all not a 'force of nature' or merely an 'unhappy accident'. Its seeds were sown during the boom.

Interested readers are encouraged to compare Bernanke's analysis with that of John Cochran's and Noah Yetter's 'Capital Based Macroeconomics: Boom and Bust in Japan and the U.S.' (pdf), which leans heavily on Roger Garrison's work on Austrian capital theory. One of the immediately obvious differences: you'll find the term 'production' mentioned in it 21 times.

The essential problem facing Japan as well as the US is that the structure of production was distorted during the boom – even if one is not au fait with all the theoretical arguments, it should be clear that 'capital' and 'investment' can not be satisfactorily described by mere aggregations,  i.e. they're not a homogeneous blob just waiting to spring into action at the authorities' prodding. On the contrary, most capital is highly specific. It follows that if the complex production structure has become misaligned with actual consumer preferences that what must be sought is a realignment of this structure that happens as fast as possible.

Interest rates meanwhile are an essential price ratio that helps to coordinate production and consumption intertemporally – any policy-induced falsification of the natural interest rate thus must lead to discoordination.

In this context we want to point to an article by Roger Garrison 'Natural and Neutral Rates of Interest in Theory and Policy Formulation', which was written in the wake of the dot-com bust.

This essay essentially agrees with an analysis that we have previously presented: namely that during times of large productivity increases, the central bank's focus on 'price stability' is especially misguided, as it allows huge increases in money supply and credit to go unchecked. The result is both malinvestment and overconsumption, which as Garrison relates 'pull at the production structure from both directions', leading to capital consumption in the middle stages. In this article Garrison makes the additional point that the adoption of revolutionary new technologies – a feature of both the 1920's and 1990's boom – would normally tend to push interest rates temporarily upward, unless consumer time preferences were to change. As Rothbard notes in 'Man, Economy and State', there is always an array of new technologies 'on the shelf', however, whether they are adopted depends on available real resources, i.e. capital and the pool of real funding.

 

"Setting aside the problem of allocating production along the most desired lines and of measuring one product against another, it is evident that every man desires to maximize his production of consumers’ goods per unit of time. He tries to satisfy as many of his important ends as possible, and at the earliest possible time. But in order to increase the production of his consumers’ goods, he must relieve the scarcity of the scarce factors of production; he must increase the available supply of these scarce factors. The nature-given factors are limited by his environment and therefore cannot be increased. This leaves him with the choice of increasing his supply of capital goods or of increasing his expenditure of labor.

It might be asserted that another way of increasing his production is to improve his technical knowledge of how to produce the desired goods — to improve his recipes. A recipe, however, can only set outer limits on his increases in production; the actual increases can be accomplished solely by an increase in the supply of productive factors.”

 

It follows that the demand for funding that the implementation of a new technology entails would compete with the demands of consumers and other lines of production, thus temporarily pushing the natural interest rate upward.

As Garrison puts it:

 

“Movements in the natural rate are also critical to the economy's performance when changes occur in the availability of resources or in technology. Suppose that a technological breakthrough makes a time-consuming production process much more productive than before. Future consumption — even increased future consumption — can now be secured with less of a sacrifice of current consumption. People's choices in the marketplace will determine how much of the technological gain will be realized in terms of current consumption (less saving) and how much in terms of future consumption (in which the availability of a new technology more-than-offsets the effect of reduced saving).

A rise in the natural rate during the transition period is portrayed by the Austrian economists as an "interest-rate brake," a term we owe to Hayek (1933, pp. 94 and 179). The interest-rate brake moderates the rate at which the new technology is implemented and thereby allows for increased current consumption even during the period of implementation. Inventories are drawn down in late stages of production and some resources are reallocated toward less time-consuming projects.

In summary terms, the natural rate is seen as an equilibrating rate. It is the rate that tells the truth about the availability of resources for meeting present and future consumer demands, allowing production plans to be kept in line with the preferred pattern of consumption. By implication, an unnatural, or artificial, rate of interest is a rate that reflects some extra-market influence and that creates a disconnection between intertemporal consumption preferences and intertemporal production plans.”

 

He further notes that the interest rate targeting method used by the Fed, keying off the 'Taylor rule' and 'accommodating growth' interferes with the interest-rate brake during such transitional periods. This is precisely what happened during the dot-com boom. After this boom broke, the Federal Reserve fought the ensuing bust by increasing the supply of money and credit even faster than before and lowering its administered interest rate to what was then the lowest level of the post WW 2 period.

The result was the housing boom, which heaped additional distortions on the economy before the previous distortions even had a chance to be fully corrected. A major bust was the inevitable result – which began as soon as the Federal Reserve's policy became slightly more restrictive (the growth in money supply measures slowed down markedly in the years 2006-2007), thereby 'unmasking' the artificial bubble activities that could only exist while the loose policy persisted.

 

More of the same policy harbors ever greater risks

If the Federal Reserve acts according to Bernanke's 'demand deficiency' analysis and implements the 'innovative' inflationary policies he thought the BoJ should have adopted more fully in the course of Japan's long period of stagnation, it will amount to the same policy pursued after the dot-com bust, only bigger. If it 'succeeds' in engendering yet another boom, it will only invite an even bigger bust down the road. However, it appears likely that the last boom was already 'one credit boom too many' and that the structural damage to the economy has been so severe that no new boom can be immediately started. Instead we are likely to face a prolonged period of stagnation with brief inventory cycle based recoveries interrupting a string of recessions.

The BoJ has, after its own ill-fated experiments with 'quantitative easing' – which predictably failed to work – begun to adopt a far more cautious approach in recent years. This can be seen by the fact that Japan's money TMS measure lately only increased by 1.7% annualized, compared to the 10.3% latest year-on-year increase in US TMS (true money supply). The BoJ's most recent announcement of additional easing measures is fairly tame in scope and size, and seems more designed as a sop to politicians than a serious expansion of inflationary measures. One can not help noticing that the BoJ seems to have come to a different conclusion as to what its policy can or can not accomplish.

By contrast, if we take Bernanke's contentions as to what to do from his 1999 paper at face value, the Federal Reserve will continue to be far more aggressive with its policies. This means that attempts to 'reflate' the economy are likely to be undertaken that are unprecedented in an industrialized nation in modern times. This can ultimately have even more far-reaching consequences than merely delaying recovery.

We should of course not forget that the US government (with treasury and Fed acting in concert) is also propping up unsound credit and malinvested capital in the housing and financial sectors, so that the necessary realignment of the production structure faces several policy-induced obstacles at once – quite similar to what happened in Japan. If these policies continue to be implemented, the economy is bound to suffer even more structural damage. Once an economy's ability to produce desired goods and services is weakened beyond a certain threshold, a monetary policy of heavy 'reflation' runs a serious risk of suddenly veering out of control.

After all, the exchange value of money depends on both supply and demand. As long as people expect the currency's purchasing power to be relatively stable, economic weakness tends to engender high demand for money. Larger cash balances are held as a precaution against a future that suddenly seems a lot less bright than before. However, there is a limit to how far an increase in money supply can go before it exceeds this countervailing increase in demand. Judging from remarks made by Fed officials on the plans regarding the future 'withdrawing of monetary accommodation' in the event of recovery, they appear based on the expectation that rising prices and economic recovery will go hand in hand. This need not necessarily be the case – the general level of prices can and does rise in a weak economy if enough money is printed (we have previously commented on the uneven process by which monetary inflation's effect on prices percolates through the economy).

The sharp rise in precious metals and numerous other commodity prices indicates that at least some market participants are increasingly worried by the Fed's plans. As we have also previously noted, in a global economy with free capital flows that is using the US dollar as the primary reserve currency, the effects of the Fed's policies are not staying confined to the US – in fact, asset prices in emerging market economies seem to be entering 'bubble conditions' as a direct result.

William Dudley of the NY Fed and Charles Evans of the Chicago Fed, two regional Fed presidents firmly in the 'Bernanke corner', openly talk about 'price indexing' as a policy that should be adopted (this refers to raising the 'inflation target' to a higher level in time periods following periods of 'uncommonly low inflation' – so if e.g. the 'informal target' is a CPI increase of 2% p.a., and only 1% is recorded in a given year, then a new, higher rate of price increases must be set as the new target in order to 'make up' for the 'lost 1%').

This would likely involve enormous increases in money supply at the current juncture, and it appears to us that it completely ignores time lags. One could well argue that such an extreme inflationary policy is rarely more dangerous than at a time of a major economic bust – not only because it will further delay a genuine self-sustaining recovery, but also because its long range effects could lead to a complete breakdown of the monetary system if these effects are discovered too late.

There is of course some hope that the financial markets will actually help to reduce the chances of such an outcome by imposing discipline before things truly get out of hand, but numerous historical examples exist where well-meaning policy makers were led astray by bad economic theories to the bitter end.

As to what government should and can do in times of a severe economic bust, Murray Rothbard wrote in 'America's Great Depression':

 

There is one thing the government can do positively, however: it can drastically lower its relative role in the economy slashing its own expenditures and taxes, particularly taxes that interfere with saving and investment. Reducing its tax-spending level will automatically shift the societal saving-investment/consumption ratio in favor of saving and investment, thus greatly lowering the time required for returning to a prosperous economy. Reducing taxes that bear most heavily on savings and investment will further lower social time-preferences. Furthermore, depression is a time of economic strain. Any reduction of taxes, or of any regulations interfering with the free-market will stimulate healthy economic activity; any increase in taxes or other intervention will depress the economy further.

In sum, the proper governmental policy in a depression is strict laissez faire, including stringent budget-slashing and coupled perhaps with a positive encouragement for credit contraction”

 

This is plainly not what Bernanke and his supporters at the Fed have in mind. Their belief that it is possible to spend and print ourselves back to prosperity remains as firmly entrenched as ever.

There is no free lunch, as the saying goes, and there is thus no painless way for the economy to repair the damage done by the boom. However, contrary to what the supporters of interventionist doctrines hold, the only agency that can be trusted to do the job as quickly as possible is the free market. Any interference with its operation can only do harm and it unfortunately appears the authorities continue to be set on interfering as much as they can – even as they admit that they can not gauge the long term consequences of their experiments. We repeat what Bernanke said back in 1999 about the BoJ:

 

“Most striking is the apparent unwillingness of the monetary authorities to experiment, to try anything that isn't absolutely guaranteed to work.“



 


This cartoon from Eric Lewis depicts the Fed's current level of understanding regarding the long-range effects of quantitative easing….

 


 

 

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