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Dear Firstly I would like to say thank you for giving me the opportunity to lead the Bank of England for another term. Now that I am securely in post, I feel I can relax a little and say more of what is on my mind. Of course that may not sit comfortably with you but I am sure you agree that I have to be seen as independent from the Government, which may entail the odd snippet of bad news. Speaking of bad news, it looks like I am going to have to keep interest rates at the current levels. In fact, I may have to raise them if prices continue to rise. One the positive side, banks will be able to make higher profits by borrowing short and lending long and the consumer still doesn't understand that inflation causes rising prices rather than the other way around. I am sure the Prime Minister will see that with prices rising and wage levels stagnating, the Bank of England is able to conduct the wealth withdrawal policy that his government had to drastically reverse the other day. On balance it could be seen that the current "inflation" that is reducing consumer discretionary spending is a net offset from the re-introduced tax hand outs. This can only be good for the medium term. Indeed if further public monies are introduced into the economy, a counterweight rise in inflation would be welcomed by big business and banks. We must however ensure that the public is not surprised by this redistribution of wealth from the poor to the rich. Therefore a continuing blizzard of pro-inflationary propaganda should be encouraged until the public shows signs of capitulation. By then we fully expect most banks to have recapitalised their reserves. A good example of how to accomplish this is the following quote, where we blame the end of the good times on a bumpy road, rather than the policies of the Bank or the Government:
This helps the public to focus ahead, rather than reviewing past actions and deflects attention from any current policy "mistakes". I would congratulate Caroline Flint for the marvellous placement of the "bad housing outlook" into the public's mind, a masterstroke of using the paparazzi combined with product placement. She should be considered for advancement. As you can see from my statement, I have ruled out doing anything to help the situation. Instead I have pointed out how dangerous such action would be and how it might stop me from focussing on inflation. Of course the icing on the cake is the threat of one or two periods of negative growth. Some call it recession, it's a very good tactic to use when you want to put the skids under job prospects. It helps keep wage demands down. All in all, I think the policy of stripping wealth out of the general economy and concentrating it amongst the banks and financial institutions is going well. The only fly in the ointment is the stubborn refusal of gold to climb to new highs. As long as the public don't notice this counter indication, the policy should still run smoothly. It is at this point I have to warn you that the following chart should have a 30 year gagging order placed upon it. As you can see, we think inflation is peaking, if the public find out and decide to start saving, gathering higher interest now to use in a "cheaper" future environment, we could ignite a consumer spending deflation pattern. Of course we would have to blame the instability in Government taxation policies for causing such a scenario.
Yours,
Merv. PS. Inflation is above 3%. 
With the US Federal Reserve cutting its Fed Fund Rate to 2%, presumably to aid the cost of borrowing and allow an expansion of lending that will lift the US economy from the doldrums you would expect to see an expansion of bank business. Not so according to the latest Fed's Senior Loan Officer Opinion Survey which shows that banks are now actively avoiding the expansion of credit and it can be shown are deliberately causing a credit contraction. This has profound meaning for the US and the wider global economy. Let's look at the evidence. The following 3 charts show the Bernanke Conundrum as it applies to business. Yes, business - its not just consumers getting squeezed:
How important is this? Very, I mean crash imminent (Q2/3) very important. It is clear to see that borrowing conditions for business have not improved even with the Fed liquidity/solvency actions and the cutting of rates. Around 60% of domestic banks are making it difficult or impossible (likely the latter for all but the highest quality of business) to borrow. In fact conditions for business requiring credit have deteriorated substantially even in the face of a higher demand since the last survey. Why am I worried about a crash? Simply this, notice the increase in demand for loans (third chart above) is a good leading indicator of the direction of the economy and the markets. This is probably a function of using credit to expand business / productivity in anticipation of an acceleration of growth overall. Having said that and looking at the chart above you are probably wondering why I am not saying the good times are just around the next quarter or 2. It would seem foolish to say its different this time. Yes, you guessed it:
This is the same information up to Q1 2003, just before the last Bull market took off. Notice the striking difference? Rising demand for loans occurred in a benign environment of looser lending standards and cheap credit as priced by the banks over their borrowing costs (Low risk). Q2 '03 is even more benign. The problem for Bernanke is made no easier by the same predicament facing consumers:
So as consumer demand picks up do the banks take the business? No, they do not. Loans and credit cards have tightening standards and there is no willingness to allow consumer instalment loans. The bottom of the consumer barrel has been scraped and there is no wish to return for the crumbs. Am I saying its different this time? Oh yes, without a doubt. Look again at the charts above, focussing on the last quarter of '99. Look how lending standards and costs rise as we tipped over into the weakening economy and eventual recession to come, yet lending demand from business contracted. This is the "natural" state of affairs, even back in '90/91 when demand for loans and the price above the banks borrowing costs rose, standards were dropping rapidly, business could borrow, it just cost more. This is clearly not happening now. We have an environment were business needs to borrow but banks are unwilling or unable to lend. Bernanke's conundrum is simple to see, after all the easing of rates and invention of facilities to enable credit markets to continue and even with the de facto underwriting of the whole fiat monetary system, banks will not lend. How big a problem is this? Unless business can borrow (either to offset costs, rollover previous borrowing or get ready for expansion) then 1929-33 looms large. This though is not the final state we have achieved. By now all market participants know that the Fed will go to extraordinary lengths to keep the current system operating. The conundrum for Bernanke is what can he do to make banks loosen standards and lower costs? You see, For Ben Bernanke the current situation isn't "news" Bernanke has already studied the conundrum. I quote from "Non-Monetary Effects of the Financial Crisis in the Propagation of the Great Depression" as used in "New Keynsian Economics"(Mankiw and Romer Ch 29):
Bernanke then goes on to state that as the real costs of intermediation rose some borrowers found credit to be expensive and difficult to obtain. He then states:
Bernanke goes on to identify various problems from the '20s that made the 29-30 downturn, which included the expansion of debt and in 1930 the move by banks out of the loan markets into more liquid instruments. Indeed the 1932 National Industrial Conference Board survey of credit conditions reported that the
It looks to me that Bernanke has already instituted the measures he believes will help avoid a repeat of '29-'33 by delivering the medicine now rather than later. As we have seen earlier in this article, the medicine does not seem to be affecting the patient. Credit availability continues to contract due to the policies of banks. Ben Bernanke now finds himself in a situation where he has delivered all he can to no avail. Does he sit back and wait for a change in credit conditions to become apparent or is there more that he can do? Whatever he does, unless lending conditions change markedly and rapidly in this quarter, it will be ineffective. Bernanke will no longer have to refer to history to see a deflationary depression, he will be living it.
The past three Occasional Letters have been quite an in-depth discussion about the path taken by the Federal Reserve and recently by the Bank of England in their attempts to deal with the deflationary forces unleashed by the credit crash. Since those discussions we have seen evidence that supports my view as seen recently in the Weekly Reports. This Occasional Letter will further expand upon that evidence and show why the plan, which I dubbed Eggertsson Theory, may already be showing signs of failure. Firstly a little recap to refresh readers memories. GB Eggertsson wrote a paper for the Federal Reserve in which he supported the Monetarist view that deflation could be avoided by a combination of fiscal and monetary expansion combined with a credible expectation that the polices were inflationary. This would lead the private sector (business and consumer) to act in a manner that reflected such expectations and to respond to them accordingly. As I mentioned in the previous articles, the Ben Bernanke Fed along with the US Govt and Treasury have adopted the measures espoused by Eggertsson and have implemented them. We have ample proof of the stimulus, tax rebates and new Fed Facilities, all designed to add liquidity in the form of cash and credit enabling structures to stave off a slowdown. During this period we have had constant reiteration of a hawkish view on inflation and the possible decoupling of inflation expectations to the upside. Importantly then, have we seen an increase in inflation expectations in the people and the private sector? April Consumer Confidence as measured by The Conference Board dropped to 62.3 from 65.9 showing that the economy has yet to bottom. Within the report were 2 interesting figures:
Does this mean consumers expect to spend more? No it does not and as we shall see later, it would appear that rather than consumers stepping up to higher prices, they are buying less. Here are a couple of snippets from the Consumer Confidence report that show more evidence of a lack of spending power and an increasing fear:
Now expectations are one thing, actual changes in habits are another. We can see that the public perception of inflation is growing and by some measures could be viewed as having decoupled from the Fed expressed inflation expectations. This could only be seen by most as highly inflationary and that rises in workers compensation would have to go up to maintain equilibrium. A self fulfilling prophesy, engendered by Fed/US Govt policies, that causes a rise in compensation and prices and a move away from deflation seems to be in the throws of creation. If we take the consumer inflation expectation at 6.8% and compare it to Fed Fund Rates at 2.25% then real rates are a negative 4.55%. Yet the consumer does not seem to be interested in grasping this opportunity, even to fund a holiday.
More from Thompson financial:
Consumer spending grew at 1% yet reported Personal Consumption Expenditures rose 3.5%. Core PCE rose 2.2%. Now we have a dilemma for the Fed, in that although inflation expectations have risen, PCE and core PCE have not. In fact it they slipped back by 0.2% and 0.1% from Q4. (core excludes food and energy) So by the Feds own measures, (it prefers core PCE) inflation is moderating. Now before I get a bunch of emails about using Fed data let me explain one thing. The Fed use Fed data. If you want to know what the Fed are thinking don't impose statistics that the Fed doesn't use. So what does this tell us about consumers? It tells us they have stopped spending. Goods might cost more but they are not being bought in the same quantity. Remember, you can put whatever price you want onto an asset, it doesn't mean someone will be willing (or able) to pay it.
Blue = Real retail and food services sales. Red = CPI all urban consumers, all items. Green = CPI all urban consumers less energy. What about business, did it continue to view the economy as it did in Q4?
No, it did not. Business decided to replenish inventories in Q1 '08 despite the evident slowdown under way and it wasn't to boost exports. Why would business do this, why change tack before real signs of change in the economy? Again we have to look at the Fed and US Govt and the constant rhetoric that favoured upside surprises in growth and inflation. It looks like business took them at their word. That might prove to be an extremely costly mistake if that inventory cannot be passed on to consumers. The following chart shows why I am puzzled by the way Business conducted itself in Q1:
Clearly something has changed in the accounting of unfilled orders. Is it a ruse to push forward production into the accounts without actually realising the sales? Secondly, new orders and shipments are stagnating or declining and would not be conducive to an inventory build.
Even if the consumer is wrong, the expectation that jobs are under threat or that finding a job has become much more difficult will cause a retrenchment in spending. The tax rebate cheques hitting doormats may well find their way into savings accounts or the pay down of non secured debt rather than being used to buy consumer goods. If this does happen, business will find itself with a large inventory overhang and a lack of orders going forward. Which brings us to cause and effect. What caused the consumer to retrench, to slow spending growth to below that of PCE? Simple, someone turned off the credit tap. Without doubt we are not seeing spillover effects from the credit crunch into the real economy, we are seeing a flood, a deluge of deflationary waves crashing into the cliffs of consumer spending. We know what happens next, the cliff crumbles and the waves move further inland, threatening greater erosion. You see deflation is not just a negative reading of money/credit production or even a reading of falling prices. Deflation and inflation can be seen as the amount of money/credit available to purchase goods and pay for services. It does not matter how the availability of money is affected, the result is the same. Taking money out of an economy, either through higher taxation, higher interest rates, higher prices or increased savings reduces the amount of money available to be spent on discretionary items or services. Only the basic necessities can have pricing power and even then the consumer may decide the necessity can be cut back. Savings under an Austrian model economy are only useful if they are used to invest in production. For instance if the savings are hoarded, to bolster capital requirements, then no expansion of useful production is possible. In a deleveraging credit based economy, where the accumulation of capital is the highest priority, then credit based expansion becomes impossible. We have seen this with housing and automobiles and now we are beginning to see it with all purchases outside of the service sector (BEA):
The economy is stumbling along on one good leg. If it twists the overburdened limb it will come to an instant and painful stop. As the consumer "drives" GDP we need to see what the trend is in their habits (BEA):
Spending less, saving more. The economy now finds itself staring at the last true hope for salvation, the tax rebates. Will the consumer spend those tax rebates or will the money, delivered directly to the consumer (as per Eggertsson Theory) be used to pay off debt and/or be placed into savings? It is clear that even the Fed/US Govt isn't sure on the outcome. Yet another "save the mortgage" scheme is being muted:
For the Fed et al time is running out. With PCE inflation measures showing signs of moderation the credibility of the touted inflationary policies becomes more difficult to defend. Consumers have been fed a diet of higher inflation expectations and are reflecting as such but there seems to be resistance to actually commit to higher spending. That resistance will grow if signs of further moderation in inflation appear and spending will be suspended until prices fall to acceptable levels. If spending does not increase business may decide that the Feds inflationary expectations are misplaced when compared to what their till receipts tell them. If business then decides to cut overheads and raise productivity by cost savings, allowing prices to fall to attract sales, the Fed will have failed and a deflationary environment will be established.
Having written 2 in-depth articles about the rationale behind the Federal Reserve and US Govt plans to bail out the financial system some readers of the last couple of Occasional Letters may well have wondered if I was about to change my outlook. This article should put paid to any such thoughts. Previously I looked at the evidence that supported the view that the Fed and US Govt (along with the Bank of England) are following a monetarist approach, adapted by GB Eggertsson , to attempt to re-inflate the economy through non traditional means. As we have seen, especially recently in the UK, all the mechanisms required for the plan are in place and are being instigated. In this article I want to look at why the monetarist approach will fail and what the results of that failure will be. (Yes, this is the article you have been waiting for). In doing so, I may quote from others but I shall make it clear when I am doing so. First and most importantly, I must stress that my long term outlook remains unchanged:
Now the next bit might sound a little patronising for which I apologise in advance, I know my readers are a clever bunch and this could be seen as pointing out the obvious. Read the scenario again. Within it is a wisdom that could form a theory all of its own (I know, I'm getting carried away) and would explain many of the observations about the economy and stock/bond markets. Here is the patronising bit. To circumvent the final outcome of the scenario, which is the biggest fear of the Fed et al, the central planners have a "cut out". Simply put, when they judge circumstances may lead to the dreaded conclusion; they stop the process by resetting it to the beginning. They rewind the tape. It is the infinite Ponzi scheme. Whereas a normal Ponzi scheme requires investors to keep ploughing in new money, the infinite scheme is only regulated by the pace of newly created money introduced to the scheme as the fiat system guarantees supply. Let us see this in action by examining other periods when the tape was rewound. Firstly here is a chart of inflation/deflation swings from Jan 1914 - Mar 2007. Although a year behind, it shows well the current long term trend (Dept of Labor/BLS):
Most noticeable is the smoothing of inflation peaks and deflation lows, with the elimination of deflation by the mid-50's. This remarkable achievement is even more apparent in this chart (using McCusker to 1913 then as per previous chart):
Never has the elimination of deflation or such a sustained period of inflation been seen in the past 350 years. We truly are in an age of innovation. Without doubt, it is the elimination of deflation that is the Fed mandate, accomplished by a continuing inflation which is controlled in its acceleration by the application of interest rate policies:
Now for most that read my Letters none of this is particularly earth shattering news, for the uneducated public though this would come as a shock. The recognition that the past 50 years are aberrant, not the norm, is like saying the deflationary outcome of the 30's crash was "unexpected". There is no doubt that the deflationary period in the Great Depression was not unusual. What is unusual is the persistence of inflationary conditions since the mid-50's. Although both points could offer contributory causes to the current inflation, it would not explain the acceptance and appearance of both inflation and deflation prior to the mid-50's. What may explain the disappearance of deflation is the rapid and innovative use of debt. Who initiates and allows the accumulation of debt?
The above chart show recessions marked with gray columns. You can now see why I compared the current Fed conundrum to 1937 and not 1933. Notice the acceleration of debt at each recession. The one time that debt accumulation slowed, in the very late 90's, it led to the closest meeting with deflation since....the mid 50's. It is the increase in debt, the enabling of "easy money" coupled with a falling real interest rate environment that allows a new wave of inflation to begin. The trigger is any threat that a deflationary period might occur, regardless of the cause of the recessionary events. Why, in the face of such evidence, do I then hold onto a deflationary outcome? Am I saying "its different this time" ? Or have you already forgotten that the current conditions have only existed for the past 50 years? Unlike any period since the 30's we are now living with a credit contraction, were even extraordinary measures carried out by Central Banks and Governments are only able to keep the status quo. Expansion of debt from its originator is now used to shore up positions (the Bank of England has forbidden any new positions be taken with Treasuries borrowed from the latest scheme) rather than initiate a further velocity of lending, a fractional enlargement of debt. Current debt is being rolled over, with the new collateral provided by the Central Banks. The acceleration of debt has been massively retarded, if not stopped completely. It is this that has caused such extraordinary manoeuvres to have happened over the past 8 months, leading to a socialisation of the capitalist system. It is not bank losses or even closures that worries the Fed, it is the breakdown of the benign inflation mechanism by the withdrawal of credit mechanisms from the economy. The following excerpt is from the August 2000 FOMC minutes (pg 82):
Some readers might remember the Mogambo Guru published a similar extract in one of his articles some time ago. It was I who sent it to him. You noticed the laughter. It is poignant as much as alarming. It shows that the committee accept the words of Mr Jordan as a truism. It also means that any threat to an inflationary environment is seen as a threat to the very existence of a fiat money system. The Fed is no inflation hawk, it is no defender of inflationary expectations. Inflation is a necessary tool to keep the monetary system alive. The Fed is a fighter of deflation, not inflation. Inflationists are even now pointing out that all the Fed/US Govt needs to do is create new money or nominal interest rate bonds (as put forward by Eggertsson/Bernanke/Friedman) to allow new credit to be created. Indeed I fully expect such measures to be taken in the future. There is however one difference between the current situation and that of the 30's. I give you this as an example:
The implications of such actions by importers cannot be under-estimated. This is Japan turning down a staple food requirement for its populace because the price is too high. The reasoning is not important, it is the action and the implications for other exporters of other commodities that is. We are seeing the beginning of price controls by buyers. If Japan is successful and eventually gets its rice at a cheaper price, the lesson will not be lost on other purchasers and not just those buying food stuffs. If such actions become commonplace, price inflation and therefore inflation expectations would decouple from the requirements of the Central Banks. If prices start falling price inflation measures, already at peak y-o-y readings would drop drastically, undermining the Feds inflation rhetoric and therefore its plan to raise inflation expectations would lose credibility. It is this loss of a credible inflation threat that would make further debt issuance by the Fed untenable. I refer you to this from "The Future Actions of The Federal Reserve And US Govt Are Known":
The private sector will not expect inflation in the face of declining prices, if buyers follow the actions begun by Japan. During a period of recession it would be politically unacceptable to try and stop prices from falling from their currently elevated levels. It would not matter that the public and private business did not recognise the difference between price inflation and monetary inflation. Because of the carefully nurtured confusion over the 2 forms, the Fed would have great difficulty explaining why it was attempting to raise (monetary) inflation in a recession. The Eggertsson plan would fail and deflationary forces would prevail sounding the death knell for the infinite Ponzi scheme. Unless, of course, the Fed entered the commodities markets and bought everything it could. Then again, I doubt the US Govt has the stomach to be blamed for mass-starvation.
An Occasional Letter From The Collection Agencypresents It is 1937 for the Federal Reserve This Letter is a follow on from my article The Future Actions of The Federal Reserve and US Govt are known in which, using the work of GB Eggertsson, we showed that the Fed/US Govt is following a plan to stimulate the economy and avoid a deflationary episode. Essentially the plan is to avoid the mistakes of the Depression and those of Japan in the 90's by using increased Government debt, monetized by the Fed, targeted directly at consumers. By employing a credible threat of an inflationary stance the Fed/US Govt hope to raise inflation expectations and therefore raise the price of assets. Whilst the groundwork for such actions are already in place as discussed previously, I now wish to concentrate on the effects such actions will have in the future. Again, I have to write this article without recourse to my own thoughts to keep an objective viewpoint. I will be using GB Eggertsson again as a reference point. Although it would appear to narrow the perspective the fact that his Theory is in play and he is a member of the New York Fed staff would lend weight to his other work in this regard. In December 2005 Eggertsson published a paper entitled "Great Expectations and the End of the Depression" in which he laid out how the policies of President FD Roosevelt allowed the economy to depart from a deflationary environment. What I want to show is that Eggertsson has based his theory on the successful polices and methods employed by FDR and what effect those policies had on the economy. Within the paper Eggertsson lays out arguments that support the FDR policies as the only credible approach to economic stimulus during a period of deflation. I believe that those policies are now being used to circumvent the current threat of a deflationary period caused by the credit crash. Before we begin, I would like to show you a quote from the time as FDR enacted his policy change, referred to as a "regime change" (Sargent 1983 and Temin & Wigmore 1990):
Cited in Davis (1986), p. 107. (3)These included Lewis Douglas. The acting Secretary of the Treasury, Dean Acheson, was forced to resign due to his oppisition to unbalanced budgets and the abolishment of the gold standard. Clearly it was not the end of western civilisation at that time. What we do see is the turmoil that was created by adoption of the new regime. Such events could be compared to the arguments put forward by the recently retired US Comptroller General David M Walker. History Without going too deep into history we need to compare the performance of the overall economy during the FDR presidency with the previous 4 year period. Within the following quote from Eggertsson is an interesting observation about the growth of the monetary base: ffect of the FDR regime shift is clearly evident in the data. When FDR was inaugurated in March 1933 excessive deflation turned into modest inflation. There was little change in the trend growth of the monetary base around this turning point. Money growth did not start on a sustained upward trend until several months after prices started to rise. Similarly, the fiscal expansion happened with a substantial lag. This evidence suggests that the recovery was driven almost exclusively by expectations about future policy. The comparison between FDR’s first term in office (1933-37) and President Herbert Hoover’s last (1929-33) is striking. Hoover’s last term resulted in 26 percent deflation, while FDR’s first registered 13 percent inflation. Similarly, output declined by 30 percent from 1929-1933. This was the worst depression in US history. In contrast, 1933-1937 registered the strongest output growth (39 percent) of any four year period in the US history outside of war." As can be seen in the following table (Eggertsson) 1933 marked the end of the contraction in GDP in dollar terms and the beginning of a large scale expansion of public debt. Noticeable is the acceleration in the growth of the monetary base that begins in 1934, lagging the increase in public debt:
This would support the argument that the increase in debt raised inflation expectations, leading to an increase in monetary demand. Form this we can infer, without reference to historical writings, that FDR was seen as credible in his regime change. it was this credible approach that allowed inflation expectations to be seen as correct and for monetary requirements to change accordingly. The Effects As FDR took office, there was a noticeable turnaround in expectations. Firstly, lets see what the baseline was, according to Eggertsson:
Or as I said, why spend today when it will be cheaper tomorrow? It is clear that to make the Eggertsson Theory work, the baseline conditions of the economy should be depressed before allowing the already prepared stimulus to be released. Compare the conditions in 1933 to those today:
With current 3 month yields at at 1.13% and inflation measures well above, it can be seen why the Fed/US Govt fear a deflationary scenario. The requirement for a credible policy that will result in rising inflation expectations is absolute, to ensure that neither the consumer or business is discouraged from spending or investing. (This has far-reaching consequences, for instance it would not be in the Fed interest to suppress the price of gold) With this in mind, let us look at some of the effects that FDR policy regime change had post 1933: Price Levels
Investment
Commodity Prices
Stocks
Again, it is clear to see that the expectations of rising inflation based on a credible policy had an almost instant effect on assets and prices before fiscal and monetary policy had time to make their actual changes felt. Comparisons to Today This also backs up my assertion that the Fed/US Govt have been following Eggertsson's Theory for longer than most realise. Here are the same charts for today: CPI
CRB Index - Commodities
S&P 500 - Stocks
It would appear that inflation expectations are building, despite the evident slowing of the economy (GDP). What is most noticeable is that current conditions are not comparable to the situation in 1932/33. Whilst there has been a fall in stocks and overall commodities, we have not seen a drop in CPI and certainly not the deflationary contraction of the period. Why then are the Fed/US Govt pursuing the current course? It is here we have to begin to realise that the Fed/US Govt are following a preventative course, rather than applying Eggertsson Theory as a recovery programme. With Ben Bernanke well versed in the Depression and Japan 90-current, it can be assumed he would act quickly to prevent the full effects of a credit based deflation from taking hold. It could be said he has "jumped the gun". As we saw in my previous article, this would be by appearance only, the Fed has been actively planning for a breakdown in credit markets for sometime. Current new policy innovation is the second stage of the plan, one that began back in 2001/2. The reflation under Alan Greenspan has much more in common with 1933 than the current circumstance but started from a higher base. It could be seen that the use of innovative mortgage solutions and equity withdrawal from 2002 onwards is comparable with the cash/asset swap carried out by FDR with his gold purchase programme, a way of exchanging savings for a direct cash injection. What we are seeing today is more akin to the recession in 1937/8. This becomes important as the causes of the '37/38 recession were not dissimilar to the reasons for the current situation. Here again from Eggertsson: flation and output losses. This explanation is often criticized on the grounds that banks were already holding large excess reserves so that imposing these requirement did not have any real effects (interest rates rose only modestly in response). The model of this paper, however, supports Friedman and Schwartz’s hypothesis and to some extent strengthens it by taking the expectation channel into account. The increase had such a disastrous effect because it changed expectations from being inflationary to being deflationary. It was the expectation that the Federal Reserve would stand ready to stamp down any further inflation that caused the collapse in 1937-38 rather than the new reserve requirement itself. Interestingly, the disastrous effect of this policy had already been predicted by market participants as early as 1935. S. Parker Gilbert, a partner in J.P Morgan & Company, warned the Federal Reserve in the New York Times in December 1935 that an increase in reserve requirements would strangle the recovery because it would be interpreted as if the Federal Reserve had reversed its inflationary policies.23 The recovery did not resume until 1938, when FDR forced the Federal Reserve to reverse its policy and the Treasury simultaneously embarked on further fiscal expansion" Like today, it was a change in bank reserve requirements that caused a rapid reversal of economic fortune. Whilst in 1937 it was the Fed who mandated such a change, in 2007 it was the implementation of Basel 2. Again from Eggertsson:
Although we have yet to see massed calls for the reversal of Basel 2 regulations there has been dissent and recent advice from the US SEC in how to price certain assets:
In other words if the bank decides prices are due to forced liquidation or distressed sales it does not have to mark assets to observable prices. When placed into context with 1937/8 it allows a relaxation of capital requirements as did the pressure placed upon the fed to reverse its decision. Has the Fed/US Govt laid the groundwork for a critique of Basel 2? Indeed it has, in " Basel 2: The Roar That Moused " by George G Kaufman, written under the auspices of Loyola Univ Chicago and The Federal Reserve Bank of Chicago 2003.
It should be expected that a campaign to reverse Basel 2, removing the requirement to comply for the largest "internationally active banks". It also shows that the current targeting by the Fed to bolster reserves and capital assets of Banks and Primary Brokers may well be the first step to undermining Basel 2, removing the restrictions and allowing previous practises to return. Policy changes designed to feed cash or equivalent assets directly to consumers via tax rebates or Federal and Govt sponsored "respite" programmes along with the undermining of Basel 2 "restrictions" would appear to be the main weapons in use in an attempt to cushion the effects of the current recessionary tendencies that might interrupt the recovery from 2000-03. The cooperation of the Federal Reserve, US Treasury and the Government in fighting against any deflationary forces resulting from the credit crash is the biggest regime change seen since 1933. Whilst the policies are now in place and active, showing a credible approach to re-inflation, the real test lies ahead. Will the concerted actions have the desired effect upon consumers and business and allow their inflation expectations to grow? We shall see.
Introduction. This is going to be a long letter. It will attempt to explain the rational behind the current and future US Federal Reserve intentions from the point of view of Central Bank thinking. Firstly, you will need a coffee, a comfortable chair and an open mind. I am going to take you on a journey which will require many explanations. You will have to concentrate but you will be rewarded by gaining knowledge of what the Fed is doing, why its doing it and how it will affect the future. I intend to make extensive use of Federal Reserve material and will be quoting extensively. Remember, the views and assumptions you see in this article are not necessarily in agreement with mine. This is an attempt to get inside the thinking of the Fed. Background. Without doubt the current methods being employed by the Fed are on a par with those seen in the 1930's. There is fear at the Fed felt specifically with Ben Bernanke that, through inaction or policy mistakes, another re-occurrence of a deflationary recession/depression is allowed to happen again. We remember Bernanke apologising for the mistakes in the 1930's and promising (Friedman) that they wouldn't allow it to happen again. It is my intention to show that this fear is the main driving force behind recent Fed actions and will shape the future path of monetary policy in the future. The Federal Reserve Makes a Choice. We can assume that Bernanke is fully aware of the risks and is shaping policy to ensure an outcome that will be neither a Japanese '90s or '30s America scenario. He has studied both periods extensively and probably feels he can chart a course through the hard times and ensure an equitable outcome. To do this he will try to enact Fed mechanisms that allow counterbalancing forces to be released to combat any deflationary threat. We know that this is his course of action because of decisions already made and suggestions put forward. Is Bernanke following a Keynesian or Friedman (monetarist) approach in the solution of the current problems? (Here we have to assume that Bernanke sees a problem, current use of new Fed Facilities would reinforce this view). Although this sound a rather academic based question, it is central to understanding Bernanke's approach. From G B Eggertsson "The Deflation Bias and Committing to Being Irresponsible" the fundamental question is:
Remember, I do not intend to get into the rights and wrongs of Keynesian/Monetarist approaches here, I am attempting to uncover the path that Bernanke has chosen. If Bernanke was following a Keynesian approach then any attempt to improve liquidity would be doomed to fail: As GB Eggertsson put it:
If Bernanke had been following a Keynesian solution then he would have believed that any increase in money supply would have been ineffective. Yet we see constant attempts to increase liquidity flows. It is clear then that the policies evolving to combat the threat of credit and liquidity contraction are monetarist based. This makes Bernanke’s apology the first signpost on his intended path. Many attribute Bernanke with the nickname "Helicopter Ben" in reference to remarks he made in a speech about how to combat deflation. It is oft used by those who rail against inflation to paint Bernanke as an inflationist. However, this is misplaced. Bernanke was in fact quoting Friedman. What many don't realise is that there is an assumption the Friedman was invoking Keynes in this approach. This isn't true. Keynes did not believe such an approach could work with low nominal interest rates whereas Friedman believed that changes to both fiscal and monetary policy could allow government control of prices.Therefore we cannot look at the actions of the Federal Reserve alone. Any action by the Fed would, according to monetarists, be futile without support from the Government. It also supposes that deflation is caused by a negative demand shock that the then current policies where unable to combat. Indeed the current circumstances in credit markets are seen as a Minsky Event, an unexpected shock to the financial system. However, it would appear that the Fed and the Government were already enacting policies prior to the credit market dislocation last summer. What happened after the dislocation was not an attempt to stop the problem occurring but was the second required tranche of policy that could only be enacted when the problem surfaced. Let me explain why, for the Fed and Government, there was no "Minsky Moment" but rather a progression of an already foreseen problem. To do this we need to look at why the Japanese Government and Bank of Japan failed to break out of a deflationary scenario. Again I quote from G B Eggertsson:
At face value the remarks above would seem to support the Keynesian approach, that at low nominal interest rates, Government deficit spending and quantative easing failed to ignite the inflation required to break out of a deflationary spiral. Within the quote though is the important point of inflation expectations. It is here that the importance of Bernanke's discussion of a targeted inflation rate and subsequent Fed warnings about inflation expectations remaining anchored becomes central to the main thrust of policy direction. As we have seen, since 2000 the US Government has run a deficit whilst enabling tax cuts and rebates. The Fed allowed looser lending standards and brought down interest rates, in response to a business led recession. Rather than attempt to hide any inflationary tendencies inherent in these policies, the Fed has become more vocal about inflation ranges with the rhetoric pointing to overshoots of the target range. Inflation expectations amongst business and consumers have, somewhat naturally, been kept high. The Fed is often measured by its inflation fighting credentials. I believe this is misplaced. The Fed should be viewed as a credible deflation fighter. The Fed had to establish an inflation target, either implicit or within a range, to ensure that further inflation was to be expected in the future. Why? It is all down to inflation expectations. Japan is unable to break out of its deflationary scenario because no one expects inflation to happen and therefore business, credit and the consumer act accordingly, ensuring demand is constantly put off to a later date. (Why buy today if it is cheaper to buy tomorrow). Again, I quote from G B Eggertsson: (the Markov equilibrium is covered later in this letter)
Because of raised inflation expectations, deficit spending by the US Government has the same effect as dropping money from helicopters. It is expected that because assets have been introduced into the economy inflation must rise. (It is useful to have a few members of the Fed that are inflation hawks and vocal in warning about increased spending leading to inflationary pressures). However, if such funding is directed straight into current money supply it will not increase prices. Again I have to quote from G B Eggertsson:
Dropping money from helicopters and cutting taxes are not the only options available and the following paragraph from Eggertsson may jog a few memories:
As an aside, you can see why this paper is central to my article. It is clear that a copy of it sits on Bernanke's desk. It is becoming clear that Fed and US Govt policy have been in lockstep for some time and that the groundwork for fending off a deflationary attack was laid out over 7 years ago. The actions we have seen since August '07 are not the beginning of the attempted fix but the second stage. Since 2000:
Since mid 2007:
I believe at this point I have made a good case that I have identified the policy and framework that the Federal Reserve and the US Govt are pursuing and that such policies are co-ordinated and have been in place for much longer than most suspect. It is the expectation that such actions are inflationary in nature that encourages spending and investment (Buy today because it will be more expensive tomorrow). The Future We now turn our attention to the future. At this point we have to examine something previously mentioned in our article, a Markov equilibrium. Again from Eggertsson:
Essentially policy is either forward looking and adaptive or it works only in the "here and now" and cannot innovate. Clearly my reading of the current situation is that the Fed and US Govt is committed to a future policy in its actions and has displayed the ability to be adaptive. Therefore we shall take that path to find what future developments may await us. Again we rely on Eggertsson to lay out the groundwork:
It is without doubt the most forward looking statement I have seen. Or is it? Again we must look at this from behind Bernanke's desk to truly appreciate what we are reading. The statement is forward looking because it has been adopted as policy. We are living with these actions right now and we know that they will exist for at least 6 months as has been made clear in statements from the Fed. Expectations of a continuing inflationary bias must be deeply entrenched in the psyche of anyone connected to asset markets. Eggertsson continues:
If Bernanke and Co keep with the blueprint (it would be difficult to see how they could deviate now without destroying carefully implanted expectations) we can expect to see continuous and expanding intervention in what was previously thought to be off limit areas. Treasury bond issuance should rise and does not have to have a defining limit. Tax rebates will continue and grow, expanding beyond traditional areas. Use of current GSEs to expand government debt will be encouraged and may well lead to the formation of "Super GSE's" that could take on second lien loans on property, for example. The Fed will expand its facilities, including more market participants and widening the range of assets that can be used, including stocks. The facilities will become permanent but will be allowed to run down in use as circumstances dictate. It will be imperative to remove any stigma associated with the use of such facilities, possibly by converting the facilities to a type of GSE, or more likely, a Fed Sponsored Enterprise. Concerted and possibly international intervention in Forex markets should be given a high level of probability. This will allow a slow and orderly re-pricing lower of the dollar and a continued bias toward inflation. A campaign of "anti-inflationary" bias will continue and be ramped up if necessary. Rates could be raised without affecting the fight against deflationary forces because expectations would require such a move. A constant attempt will be made to anticipate a move higher in growth. Is the path hyperinflationary? To be blunt, no. These are anti deflationary measures that will give the Fed credibility in fending off the dreaded scenario. The threat to the policies is an acceptance of deflationary expectations by private money and consumers. Hyperinflation would be unable to form as an expectation as long as the Fed continues to display a hawkish approach to inflation. As we have seen the delivery of fiscal debt, in the form of "helicopter drops" would bypass the pricing mechanism. Expectations of hyper-inflation would be negated. Conclusion. Is it working? It is at this stage that I can happily say that it would be unfair for me to judge whether the policy is working or not. This because the whole scenario, the playing out of the policy, is to do with perception. The only way that it can be measured by individuals when attempting to answer the question is to screen what they see through this article (or G B E's Fiscal Theory). As the writer if I answer the question I might colour an individual's perception. What I can say is that with the framework exposed and on public view we have the advantage of spotting potential failure of policy. The potential for failure is increased by discussion and the recognition of the long term policy objectives (avoiding deflation) if such discussion raises the expectation of deflation. I should remind readers that this article is my interpretation of G B Eggertssons' work. I believe it is the blueprint being used by the Fed and US Govt. Therefore I claim no superior knowledge to Eggertsson, just an understanding and the ability to navigate. What should be remembered is the title of G B Eggertsson's paper: In other words the future actions of the Fed and US Govt may appear "wrong" unless we understand what they truly fear. A Reply to John Mauldin’s Outside The Box - Let’s Get Real About Bear
I have been, and still am, a long time fan of John Mauldin (JM). I enjoy his take on the bigger picture, even if there are areas I disagree with, from time to time. Generally my disagreements are more to do with the severity of a particular problem or the benefits of a highlight. For instance, JM might allude to a recession but think that it will be mild and happen over a certain time scale, fitting his “muddle through” model. I would agree with the talk of recession but not necessarily the depth, timing or effect. You get the point. However the JM article “Let’s Get Real About Bear” has somewhat shocked me at a fundamental level and it deserves a reply. Let me say this from the beginning, I do not intend to start a war of words or change JMs thinking. Neither approach is constructive or conducive to open discussion of a truly fundamental part of the US and Global economy. This not a good vs. bad scenario, I have little or no doubt that JM is a well read, intelligent, honest and thoroughly nice bloke. I am a trader/blogger that very few have heard of or know, using the internet to foster thought. (As an aside, I asked JM to have a look at my writings and consider maybe using an article in the OTB edition. The answer is within his Bear article. Sometimes trying to be a “platform start up” has its knock backs. So no hidden agendas and yes, I fully expect to be viewed as the “Darkside”. Ahh the fun of blogging.) Here is a link to the JM article at Investor Insight. Please read it before going further. I am not going to discuss the 2 other articles appended to JMs writing. JM is an investor/advisor who looks to get real returns beyond the effect of inflation. He operates in the free markets, looking for advantages that return above the “norm”. He searches for new, innovative technology that may become the “next big thing”. He is a capitalist, using the capitalist mechanism. He knows the risks and tries to avoid being on the wrong side or if that fails to mitigate the risk to his capital. I do the same as do most investors and traders. It is the way of the financial world. There are upsides and downsides, we know the risks and rewards, and the rules of the game are simple. Unless, that is, you decide that the rules can be bent to accommodate failures, to mitigate the downside. Such an approach leads to tyranny, it destabilises the system causing feedback loops, encourages excessive risk taking and allowing that risk to be ignored and causes confidence in the financial structure to erode. This is big picture stuff. It is not about 17000 jobs at Bear Stearns; it is not about a loss on share portfolios suffered by employees. Protecting a company and its share price is never a reason for intervention and the introduction of moral hazard. Bear and its employees would not be in their current circumstances if they had obeyed the rules and understood the game. Bear Stearns went bust because of a lack of confidence in its collateral used to finance its lending. Customers and Lenders walked away because the risk of staying was perceived as too great. It was the risk that Bear Stearns took using its business model and allowing exposure to be greater than its ability to pay. The Capitalist System did its job; it rooted out a bad business model and laid it low. If you took losses, I am genuinely sorry for you but you knew the risks. We all take a loss sometime. If it wiped you out then you did the same as BS, you allowed exposure to a risk to grow well beyond acceptable limits. Does this sound harsh, a bit heavy-handed? It probably does but it isn’t me saying it, it’s the free market shouting loud as it does every trading day. JPM have stepped in and offered $2 a share for BS. We have seen such action before, a fast move to grab assets perceived as cheap. It happens in the capitalist marketplace. The risk is transferred to JPM equity holders, JPM write-down $6Bn to acknowledge that risk. The trouble is the whole JPM move was not a function of the free market. Without The Federal Reserve accepting who knows what BS assets as collateral on a $30Bn loan this deal would not have taken place. Even worse JPM get rewarded by asset grabbing at an extremely cheap price. (I suspect we have not heard the last of that either). JM contradicts himself within the article as he attempts to align the adoption of allowing a moral hazard to exist within the market. I quote: “And I can understand the sentiment, as it appears that tax-payer money may have been used to bail out a big Wall Street bank that acted recklessly in the subprime mortgage markets. But that is not what has happened. This is not a bailout.” But just a few lines later he is forced to acknowledge the underlying fear his readers have emailed him about: “Yes, tax-payers may eventually have to cover a few billion here or there on the Bear action. But the time to worry about moral hazard was two years ago when the various authorities allowed institutions to make subprime loans to people with no jobs and no income and no means to repay and then sold them to institutions all over the world as AAA assets. And we can worry in the near future when we will need to do a complete re-write of the rules to prevent this from happening again.” You cannot expect market participants to accept such reasoning unless you believe intervention is right and proper. If you do think that way then your perception of risk has to be misplaced. So, it is more than possible that Tax-payers will face a bill for this bailout. The moral hazard, as the UK Govt discovered after Northern Rock is that if you “cover one bet, you cover them all”. The extension of liability and assumed enlargement of risk becomes burdensome and affects the fundamentals underlying the national economic base. Today in the UK, there are rumours, denied by the BofE and the bank in question, that a Bank may or has a requirement for emergency funding. Regardless of the truth or otherwise, this has directly affected Sterling vs., of all things, the dollar:
The ellipses are the main points when rumour surfaced and re-surfaced. This is what acceptance of a moral hazard can do to a currency. I picked the $ as a comparison because it is weak, it shows the inherent weakness of Sterling under such circumstances. This is not a theory of mine, based around musings of economic facts and figures. This is market action telling us a story. Ignore the tale at your peril. Should Bear have been allowed to go bust? Without doubt the answer is yes and to some extent JM agrees: “If it was 2005, Bear would have been allowed to collapse, as the system back then could deal with it, as it did with REFCO. But it is not 2005. We are in a credit crisis, a perfect storm, which is of unprecedented proportions. If Bear had not been put into sounds hands and provided solvency and liquidity, the credit markets would simply have frozen this morning. As in ground to a halt. Hit the wall. The end of the world, impossible to fathom how to get out of it type of event.” A very scary (and quite possible) scenario. JM is saying that current market conditions are not conducive to failure of a Financial Institution. Well I’m sorry but these events happen because of the prevailing circumstances. Banks don’t go broke at the top of the cycle, failures occur when times are getting hard. It is the nature of the beast. To say the System cannot tolerate such an event is to deny the reality of capitalism. It encourages the acceptance of a safety net, a guarantee that regardless of the poor decisions and risk calculation taken there will be no failure. This is truly a refutation of a capitalist, free market. No wonder CEOs take what seem to be enormous risk free assumptions about the future and the effects of their actions and decision upon the prospects of the company. They have nothing to fear. CEOs get their compensation, shareholders get a ride, and all is well. Until the cycle turns. The CEO has departed by then, either as part of a merger or retirement with an enormous compensation package. The shareholders are the weak hands, the strong hands sold at the top. Who cares what happens to the weak hands? Moral hazard isn’t just about tax payers. JM quantifies what he thinks the damage to stock markets could be: “The stock market would have crashed by 20% or more, maybe a lot more. It would have made Black Monday in 1987 look like a picnic. We would have seen tens of trillions of dollars wiped out in equity holdings all over the world.” Again, I agree that losses of 20% or more could happen and still might. The reason it would have made Black Monday look like a picnic is because it was a picnic. In 1987 we didn’t have the massive expansion of innovative financial instruments, back then Futures and Options were complicated! If the free market decides it needs to provide a re-pricing then it should be allowed. After all, no one worries about the same mechanism working to the upside. Would credit markets have closed, seizing up under the financial stresses? We don’t know. Let us assume that they would. So what? The weak debt would have been expunged, albeit on a massive scale. Would there be pain? Yes, massive amounts of pain would ripple through the global economy. Would it be the end of the world? No, it would not, prices would reset on the re-opening, risk would have been priced in - in full. Markets would continue to function, even if the players had changed or some disappeared. Eventually all this will happen and the outcome will be the same, we are living it right now. Delaying the inevitable whilst a transfer of liability occurs does nothing but risk the underlying fundamentals of the economy to further attacks and stress. Does the acceptance of an enormous level of moral hazard have a justification? Again I quote JM: “But for now, we need to bail the water out the boat and see if we can plug the leaks. Allowing the boat to sink is not an option. And get this. You are in the boat, whether you realize it or not. You and your friends and neighbors and families. Whether you are in Europe or in Asia, you would have been hurt by a failure to act by the Fed. Everything is connected in a globalized world. Without the actions taken by the Fed, the soft depression that many have thought would be the eventual outcome of the huge build-up of debt would in fact become a reality. And more quickly than you could imagine. As I have repeatedly said, recessions are part of the business cycle. There is nothing we can do to prevent them. But depressions are caused by massive policy mistakes on the part of central banks and governments. And it would have been a massive failure indeed to let Bear collapse. I should note that this was not just a Fed action. Both President Bush and Secretary Paulson signed off on this.” Quite simply (and JM touched upon this) intervention has exacerbated the conditions we live in. What was a normal business recession has been morphed into a possible depression. Not by capitalism or free markets but by centralist, socialistic interference. Remember, last year when Bear closed down and re-capitalised the failed Hedge Funds? This was viewed as one of the problems that required action by the Fed. The intervention failed. All it achieved was a redistribution of risk to the Tax payer and JPM shareholders. The risk is not diminished; adding capital to a margin call does not make the position “safer” or profitable. It just risks more capital. Trying to justify intervention by invoking fear may work at a human level but free markets ignore such reasoning’s. As far as the markets are concerned the game rules say you are responsible for your own risk management. If you fail to play the game well, you will lose or be given a disadvantage. Attempting to change the rules to favour one side breaks the game. The consequences of that are with us now. JM defends his stance by pouring scorn on those who believe in free markets. It may also be the reason he didn’t like my writings. (This is fair enough, not every viewpoint that is contradictory to your own needs to be accepted).JM: “I repeat, this was a good trade from almost any perspective, unless you are from the hair-shirt, cut-your-nose-off-to-spite-your-face camp of economics.” I am a bear in the current climate, I have been a bull in the past and I trade both ways. In other words I am a realist, I may be bearish on macro-economic fundamentals but I can ride an uptrend when I see one. To use such an expression as JM has written to pooh-pooh those who believe in free markets shows a lack of argument. I have news for you all, regardless of your economic “bent”, unless you are prepared for events now you will all have your noses cut off. Finally we look at the outcome of the current turmoil. Again JM is specific: “It is precisely because the Fed is willing to take such actions that I am modestly optimistic that we will "only" go through a rather longish recession and slow recovery and not the soft depression that would happen otherwise.” Does that qualify as “muddle through”? JM was looking for a muddle through scenario until very recently. I don’t think a longish recession and slow recovery qualifies. Muddle through to me was below average growth not contraction. There is no blame to attach here, it is just recognition that realism is useful and has a place in financial thinking. It is realistic to believe that if a moral hazard in the UK can affect the worth of that country’s currency, the same should be applied to any other government that accepts moral hazard can be introduced into the game rules. As we have already seen, intervention begets a further expansion of intervention. JM makes a final point that the problem is so large and the effects on the “small guys” would be so great (i.e. small guys do not know about risk?) that a true re-pricing event would cause devastation. He also says that a lack of intervention caused the current turmoil. Other than a non-acceptance of capitalist free markets as a true reflection of worth, the blame appears to land at the door of the Government and the Fed. Boy they can’t win in this discussion. Regulation is what JM is alluding too, or the lack of it. At what level though, the relaxation of credit lending standards? (Surely a bank decision). A lack of oversight in mortgages? (Greed from all parties overrode risk appraisal, including the consumer). A lack of transparency in credit markets? (Transparency is there, you just have to pay for it). What exactly were the Fed and Govt agencies supposed to do? Regulate every transaction? Greed finds away around regulation, be it loopholes or flat out illegality. You can regulate for every function but it does not stop attempts to circumvent it. If you want to correct an interventionist prone capitalist system then allow it to purge itself and reset the boundaries of its influence based on truth. If you want to get a rating on a debt package you wish to sell in the marketplace then tell the truth. Open the books, show the risk and accept the price that the market sets. You even save money on not paying a Ratings Agency. Only this will restore confidence in the markets. If it means prices are lower (or higher for the good stuff) so be it. Its not the price that wipes you out, it’s the re-pricing when the truth comes out. Attempting to interfere and tinker will just cause greater imbalances and risks and lead to further opaqueness. Maybe JM has forgotten how he worried about the costs of today being visited upon future generations. Intervention will ensure that such passing on of the debt will happen.
My thanks for your time if you have read this far, I appreciate it. Now, I may be inundated with emails after this article (or not!). Please don’t be offended if I fail to reply to them all. Please remember, I have written this letter not to ignite feelings but to open up an important debate. On Sunday I will be reading and enjoying JMs email, as usual.
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