Thursday, February 11, 2010

Economy Update and The Causes of Boom-Bust, Part 1

Due to the record setting winter storms and freezing temperatures, evidently caused by global warming, Federal Reserve Chairman, Ben Bernanke, was not able to deliver testimony to the Congress in person. However, his statement was published online and it provides an excellent chance to analyze the current state of the economy and analyze some present and historical causes.

Bernanke separates the Fed's response to the crisis into two parts:

First, our financial system during the past 2-1/2 years has experienced periods of intense panic and dysfunction, during which private short-term funding became difficult or impossible to obtain for many borrowers. The pulling back of private liquidity at times threatened the stability of major financial institutions and markets and severely disrupted normal channels of credit.
To the modern intellectual, such an economic state appears to be an unprecedented mystery without cause or explanation (as does every other action in the universe). After all, such panics have been occurring regularly for hundreds of years. They appear to be a random phenomena associated with markets. Wasn't the Federal Reserve system created to deal with just these types of "panics"? Bernanke continues:

In its role as liquidity provider of last resort, the Federal Reserve developed a number of programs to provide well-secured, mostly short-term credit to the financial system. These programs, which imposed no cost on the taxpayer, were a critical part of the government’s efforts to stabilize the financial system and restart the flow of credit. As financial conditions have improved, the Federal Reserve has substantially phased out these lending programs.
Let's put aside Bernanke's contention that these programs "imposed no cost on the taxpayer" and his contention that "conditions have improved" and take a wider perspective. What he is describing is a "credit crunch", a classic economic effect associated with government caused boom-bust cycles.

Government induced credit expansion or inflation, which occurred in dramatic fashion in the years preceding the crisis, causes two primary effects. Quoting
Dr. George Reisman (see Capitalism, p.938-940):

Inflation does two critical things. It superinflates people's revenues and incomes, while making them correspondingly illiquid, and it leads them to pile up substantial debts against those revenues and incomes.
In other words, the rapidly expanding base of money induces illiquidity by incentivizing firms and individuals to hold smaller cash balances. This is because funds are easily available and it becomes extremely profitable to borrow. Reisman continues:

Inflation in the form of credit expansion encourages borrowing by holding down the rate of interest in relation to the rate of profit. It makes borrowing exceptionally profitable; and the more so, the more leverage the borrowing provides. Another important way that inflation encourages debt is simply by leading people to borrow in anticipation of rising prices. Housing purchases are a prime example of this effect of inflation. People go heavily into debt to buy houses at already inflated prices, because they expect housing prices to go on rising. The same thing happens with business spending for plant and equipment and inventories. [emphasis mine, keep in mind, this book was published in 1993]
Why does this ultimately lead to a "credit crunch"? Eventually, once the inflation stops, prices and revenues stop rising, individuals must raise their cash holdings to repay their debts.

As a result, spending and the velocity of circulation fall, with the further result that people's money revenues and incomes fall. The effect of this, in turn, is that they cannot pay their debts. A substantial number of business and personal bankruptcies occur.
This causes a credit death spiral

as the assets and capital of banks which have lent to such borrowers is correspondingly reduced, and many of them also fail.
Reisman's next passage is very important (as it hints at the problem of fractional reserve banking.)

The failure of banks, of course, causes the money supply to actually be reduced, since the banks' outstanding checking deposits are part of the money supply. The reduction in the money supply then leads to a further decline in spending, revenues, and incomes and thus to still more bankruptcies and bank failures.
He points out that this process feeds on itself to the point of potentially destroying all fiduciary media

The reduction in the quantity of money can be avoided only if the government is prepared to create additional fiat standard money to whatever extent may be necessary to guarantee the fiduciary media of the failing banks. But this lays the foundation for a still greater expansion in the supply of fiduciary media in the future.
Note, that this is exactly what Bernanke is describing in his testimony. Another reinforcing factor is that the inflation causes malinvestments, which Reisman defines as:

investments which are only profitable on the basis of inflation itself. When the inflation comes to an end, the unprofitability of the malinvestmets is revealed.

Anyone who bought a home at the peak of housing prices several years ago understands this effect. Inflation leads to depression by reducing the availability of real capital:

This is because the existing capital funds of many enterprises, are made inadequate by the rise in wage rates and material prices caused by the previous injections of credit in the form of new and additional money. The consequence is that firms requiring credit turn out to need more credit than they had planned on, while those firms normally supplying credit turn out to be able to supply less than had been counted on , and may even need credit themselves in order to meet the requirements of their own internal operations at these higher wage rates and prices. Thus, as the need for credit surges and as suppliers of funds become demanders of funds, or at least supply less funds, firms that had counted on borrowing money, or on refinancing their existing borrowings, find that they are unable to do so.
Reisman summarizes "the essence of the inflation-depression process":

The critical factors are: artificial inducements to illiquidity and to a corresponding superinflation of revenues and incomes; the piling up of a mass of debt against these superinflated revenues and incomes; and then a contraction in spending, revenues, and incomes following the end of the inflation. The contractions phase leaves people with no means of paying the mass of debt they have accumulated, and can operate to produce a self-reinforcing downward spiral of deflation of the money supply.

So, is the inflation-depression process a mystery? Evidently not. The governments arbitrary creation of paper money which becomes leveraged or pyramided through the fractional reserve banking system sets the stage for this inflation-depression process. Of course, the particular nature of any given crisis will depend on other factors as well. For example, during the dot-com boom, the inflation found its way into stock prices. In the aftermath of that crash, inflation found its way into the housing market due to government tax and regulatory incentives as well as direct government support through agencies like Fannie Mae and Freddie Mac which underwrite mortgages.

Given these facts, do you think that it would be prudent for the government to understand how its fiat money credit expansion coupled with fractional reserve banking coupled with market distorting tax and regulatory policies leads to boom-bust cycles? Do you think that this understanding could be used not only to solve the current crisis, but to make sure that such a crisis never occurs again?

Bernanke continues:

Second, after reducing short-term interest rates nearly to zero, the Federal Open Market Committee (FOMC) provided additional monetary policy stimulus through large scale purchases of Treasury and agency securities. These asset purchases, which had the additional effect of substantially increasing the reserves that depository institutions hold with the Federal Reserve Banks, have helped lower interest rates and spreads in the mortgage market and other key credit markets, thereby promoting economic growth.
So, the Fed has driven short term rates to zero by creating money out of thin air, in particular, by purchasing over $1 trillion of mortgage backed securities thus helping to prop up the mortgage market which serves to encourage home buying more than otherwise. In other words, it's response to the crisis has been to engage in the very policies which caused the crisis!

[To see this in detail, see the Fed's most recent balance sheet. On the asset side, note that they have purchased $970 Billion of mortgage backed securities and $164 Billion of federal agency debt. They paid for this by creating reserves (printing money). When the Fed creates money, it creates a corresponding liability. In this case, since only a small amount of the funds have gone directly into the banking system, which shows up in the line "Currency in circulation", the funds must show up in the item "Reserve balances with Federal Reserve Banks". Currently, this item is over $1.1 trillion. The money is still on "reserve" at the Fed because the Fed began paying interest on these reserves under a newly created policy - a policy designed for this very purpose, i.e., incentivizing banks to keep their money at the Fed instead of lending it.]

If Bernanke does not realize that the very act of this money creation is a problem, he does realize that the trillion dollars that has been created out of thin air does represent a potential problem.

Although at present the U.S. economy continues to require the support of highly accommodative monetary policies, at some point the Federal Reserve will need to tighten financial conditions by raising short-term interest rates and reducing the quantity of bank reserves outstanding. We have spent considerable effort in developing the tools we will need to remove policy accommodation, and we are fully confident that at the appropriate time we will be able to do so effectively.
In other words, "at some point", he is "fully confident" that the Fed will be able to simply remove the money they have created without any negative repercussions. And just how will he accomplish this?
In subsequent parts, I will discuss the real cure for the economy including a discussion of the Fed's so-called "tools" for tightening monetary policy, how its current policies are exacerbating the problem, and the history and essential problem of fractional reserve banking in causing crises that provided justification of the creation of the Federal Reserve system and the overthrow of the gold standard.

12 comments:

Kevin said...

I enjoyed this article and agree with most of your comments about the source of the boom/bust cycle. It's hard to escape the fact that these cycles are a direct result of manipulation of the money supply multiplied by the effects of fractional reserve banking (FRB) and human psychology. The only area where I have some disagreement is with regard to fiat money.

While clearly the direct expansion of the money supply through fiat expansion (real printing) is a possibility, almost all of the expansion prior to the recent fed actions (dating back for decades) has been accomplished through debt-based expansion and not any kind of direct fiat monetary expansion. Also, non-fiat money systems have historically had boom-bust cycles as well. At times these have been deliberate, and at others perhaps not. Non-fiat money systems (gold or silver backed), are all subject to manipulated by non-governmental entities (like large banks and foreign governments) and so carry certain side risks as well.

From my standpoint I see debt and FRB as the bigger issues. I'd be happy with any solution that limited the federal government's (or anybodies) ability to manipulate the supply. For example, a fiat system with built in inflation (some fractional percentage per year) would be fine as long as congress wasn't able to reach in and fiddle with it (perhaps only a constitutional amendment would prevent that).

Harold said...

Thanks for this, glad to see you're writing again. Personally, I've begun to think seriously about putting some savings into things like physical silver (maybe gold).

Doug Reich said...

Kevin,
Thanks for your comment.

You said:"almost all of the expansion prior to the recent fed actions (dating back for decades) has been accomplished through debt-based expansion and not any kind of direct fiat monetary expansion"

I'm not exactly sure what you mean, but I think you are referring to the fact that banks create money when they make loans which is the essence of fractional reserve banking. In other words, they use checking deposits as reserves and loan out a multiple of these reserves, thus creating money out of thin air.

You are foreshadowing my next post where I will discuss this issue, but I will say the following. FRB serves to multiply the money supply through the process just mentioned. However, without actual expansion of the monetary base, this multiplying effect would be necesarily limited. In other words, if the monetary base is 100 and you multiply it by 10 then you get 1000. However, if you then increase the monetary base to 1000 and multiply by 10 then you get 10,000 and so on.

FRB has served to multiply an ever increasing monetary base. However, I disagree with your claim related to the fiat money supply. The Fed has indeed increased the money supply, massively through its purchases of government bonds over the years. However, you are right that banks have been able to leverage this monetary base against an ever declining reserve ratio.

I will discuss this more in the follow up.

You also said: "non-fiat money systems have historically had boom-bust cycles as well." Again, I will address this exact point later. In fact, it is a common argument against gold that under the gold standard there were panics.

I agree, but these panics were caused by FRB and the governments willingness to suspend banks' legal obligation to convert notes to gold. The solution, as I will try and show, is to understand why a) FRB results from a misapplication of property law and therefore should not exist and b) the state should simply uphold banks contractual obligation to redeem in gold.

Historically, this was the cause of the panics, not gold. In fact, it was gold which prevented the problem from being even worse as it is now. Notice, that even during these panics, we had nothing equivalent to the Great Depression of the 1930's. Furthermore, prices did not generally rise throughout the entire 19th century. Prices only began chronically rising after the advent of the Fed in the early 20th century. Virtually every major hyperinflation around the world occured in the 20th century.

So, although FRB is bad, it is really fiat money and the government's continual credit expansion which has caused the severity of these booms and busts.

There is no justification for the government to be involved in the monetary system just as any other sector of the market, so I disagree with yout contention that fiat money could be allowed. The market decides what constitutues money and I completely oppose legal tender laws. No one should be forced to accept payment in fiat currency.

The Constitution already addressed this by making gold and silver the only valid method of government payment. Article One, Section 10

No State shall ... make any Thing but gold and silver Coin a Tender in Payment of Debts;...

Doug Reich said...

Harold,

It's never too late...

Galileo Blogs said...

Thank you for your interesting comments, Doug. I look forward to the next parts.

C.W. said...

It is good to see someone who understands these issues.

Regarding 19C American "bank panics", each event was occasioned by large amounts of paper currency being issued. Both the First and Second U.S. bank were involved in more than one each. The only time that price increaces weren't associated with some sort of government activity were the gold rushes, which did increace the money supply, temporarily.

Regarding the Fed, one function that you did not address, at least in your first Part, is that the "Reserves" that each bank must have deposited with the Fed, is the foundation of the Fed's power. As the Fed adds to the deposits, to keep interest rates low, the bank may withdraw the money and loan it, but either way, as the deposit increaces, also increasing is the amount of loans/demand deposits the bank is legally allowed to have, and thus the expansion of credit. The Fed also controls the credit expansion by manipulating the percentage of demand deposits required to be held in "reserve" at the Fed. That percentage is currently near, if not at, the historical low.

It is true that the interest paid on reserves is a reason why banks are not expanding their loans. It is also true that banks are not finding many actually good opportunities to loan money either. If credit worthy borrowers start showing up, the credit expansion will begin again. Actually, since we are exporting inflation, in the form of our trade deficit, some credit expansion is going on.

C.W.

Doug Reich said...

C.W.,

Thanks for your comment. I address just the issue you raise re 19C panics in part 3, which I recently posted.

I have discussed the Fed machinations in previous posts, but in upcoming part 4, I will update on the various issues you raised - particularly the state of the Fed's balance sheet in terms of how they have created the reserves and what Bernanke is proposing to do about it.

Look forward to your comments

C.W. said...

I notice that in my earlier comment I left out a few words where I meant to include the function of the Fed's "reserves" as a means to expand bank credit. If there is another $1000 in the reserves, the bank can legally loan out another $9000. They don't, at least not that vigerously, but it is the means to inflation.

Speaking of credit expansion, an article in the "Economist" reports that bank lending has significantly declined this year. (http://www.economist.com/blogs/buttonwood/2010/02/credit_contraction_and_growth?sa_campaign=facebook) Other than direct insertions of money, e.g., Medicare, "job" creations schemes, and the federal payroll, inflation is almost non-existent. It is the calm before the storm. The storm promises to occur when the Fed begins to try to remove excess reserves. Hense, your Part 4, Doug.

C.W.

Brad Williams said...

Hi Doug,

Thanks for your blog!

"So, although FRB is bad, it is really fiat money and the government's continual credit expansion which has caused the severity of these booms and busts."

I don't follow the logic here. Booms and busts existed with FRB over gold. The booms and busts are worse when there is FRB without a "gold standard". That much is true, but does that give the conclusion that the lack of a "gold standard" is the *greater* contributor (over FRB) in the "severity" of booms and busts? I see that they are both factors. What is the evidence that one is the greater factor in severity? Because another hypothesis is that booms and busts could hardly occur if there was NO FRB and only a modest amount of printing -- i.e., that it is the multiplier effect of FRB that is the greatest contributor to the business cycle.

I'm out of my depth here, so pardon if I'm missing something.

(PS: I put gold standard in scare quotes, because IMO FRB is incompatible with a true gold standard, which would be: the money supply (money + credit) maps precisely to the amount of gold in the world.)

Doug Reich said...

Brad,

This is a great question.

The reasoning for my claim was really just that the 19th century (FRB + gold standard) was a bastion of price stability compared to the 20th century (FRB + no gold standard) and so it appears that it is the ability of the government to infinitely print fiat currency rather than the multiplication through FRB.

For example, if the money stock is 100, then FRB can multiply to 1000. But if the government begins printing and the money stock goes to 20,000 then FRB can multiply to 200,000. The FRB multiplier is effectively capped, whereas the expansion of credit through printing presses is infinite.

Under an FRB + gold, the effect would be especially limited since as long as the government forces banks to uphold their contractual obligation to redeem in specie, a bank would have difficulty multiplying beyond a certain amount without being punished by the market and competition with better, sounder banks.

FRB got out of control in the 19th century, mainly because the states allowed banks to suspend their obligation to redeem whenever they got in trouble. I address this in Part 3.

In the 20th century, you have the double whammy of FRB then multiplying government engineered credit expansion. The various hyperinflations of the 20th century all rested on this foundation. (see Peter Bernholz, Monetary Regimes and Inflation).

I think there is one interesting aspect of this. Under a strict gold standard + FRB, the tendency for this to end really, really badly initially exists simply because banks must ultimately redeem in gold and the fear that they could not would cause a run on the banks. This is exactly what happened in the 19th century.

Unfortunately, the takeaway was not that banks should stop FRB or that if the state strictly enforced the gold redemption obligation, the market would naturally limit the problem. Instead, banks said "we want to FRB and these runs are getting to be a real problem" so let's go towards a "lender of last resort" system like the Federal Reserve that can arbitrarily create money...and therefore, these panic/runs won't be as severe.

Right after the Fed was created, the government tried the triple whammy. They took control of the money supply which was still backed by gold. So, then we had government created money expansion, FRB, plus an obligation to redeem. This led to the 1929 crash and the 1930's Great Depression.

So, its hard to say practically or empirically which would be more "severe" in a narrow sense.

Essentially, a gold standard limits the growth of the money supply at its source.

FRB causes a tendency toward a boom-bust business cycle even under gold although it would be more limited for the reasons I cited.

Fiat currency expansion with no FRB would still cause a boom-bust cycle because the government would print money to fund its deficits which would lead to price inflation, then it would stop, etc.

Fiat currency + FRB is the worst because there is no limit.

hope that helps.

Brad Williams said...

Thanks.

What do you think of Steven Keen's "roving cavaliers of credit" article? He summarizes some "endogenous money" work thus:

"Their empirical conclusion was just the opposite: rather than fiat money being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and fiat money was then created about a year later"

Winston Smith said...

Hi Doug

I enjoyed your piece. One point you might want to look at is that asset bubbles can build up for a variety of reasons. As you point out, the government induced credit expansion occurs when central bankers reduce the money rate below the rate of profit. This was Von Mises original argument. However, Hayek in Theory of the Trade cycle pointed out that the natural rate of profit can also increase due to productivity increases. This idea was later expounded by Schumpeter. Either way the issue as you point out is the relationship between the nominal rate of interest and real return on capital. Until central banks stop targeting inflation or the money supply, this will happen again and again and again. Here’s a link to some empirical work we have published.

http://www.thehamiltonsociety.com/blog/_archives/2010/3/1/4469313.html