Blinder, Summers and Monetary Policy

by Doug Noland

September 13, 2013

 Global equities were bought while precious metals and commodities were sold.

Next Sunday marks the fifth anniversary of the fateful day that investment bank Lehman Brothers filed for bankruptcy, signaling the start of a frightening financial meltdown. It’s a good time to ponder how the U.S. economy was nearly brought to ruin. But will we? Or are we already forgetting? Consider the stark historical contrast between the 1930s and this decade: Years of financial shenanigans in the 1920s, some illegal but many just immoral, conspired with a variety of other villains to bring on the Great Depression. Congress and President Roosevelt reacted strongly, virtually remaking the dysfunctional U.S. financial system, including establishing the Securities and Exchange Commission to protect investors, the Federal Deposit Insurance Corp. to protect bank depositors, and much else. The financial beast was comparatively tamed for almost 75 years. Years of disgraceful financial shenanigans in the 2000s, some ilegal but many just immoral, brought on the Great Recession with virtually no help from any co-conspirators.” Alan Blinder, Princeton University professor and former vice-chairman of the Federal Reserve, Wall Street Journal, September 11, 2013

Next Wednesday the Fed will reveal its much-anticipatedtaperingplans. Japan’s Nikkei news service Friday reported that the Administration “was set to nameLarry Summers to replace the retiring chairman Bernanke. And Sunday marks the five-year anniversary of the failure of Lehman Brothers. Well, it does seem “a good time to ponder how the U.S. economy was nearly brought to ruin” as well as an appropriate juncture to focus again on the role of Monetary Policy.

The above excerpt is from Alan Blinder’s Wednesday WSJ op-ed, “Five Years Later, Financial Lessons Not Learned.” Far from being tamed, the financial beast has gotten its mojo back—and is winning. The people have forgotten—and are losing. Here are four examples. There are others.” Blinder then laments the lack of reform in “mortgages and securitization,” derivatives, the rating agencies and proprietary trading. “In sum, the Dodd-Frank Act is taking on water fast. What can be done to help Americans remember the horrors that led to its passage?”

With stock prices near all-time highs and home price inflation back on track, who is keen to “remember the horrors”? Why would anyone today be willing to upset the applecart? With Washington fiscal and monetary stimulus having reflated the asset markets, what limited appetite that existed for so-calledfinancial reform” has virtually disappeared. It would be laughable if it weren’t so maddening. The GSEs still completely dominate mortgage finance, which implies ongoing market distortions. They are basically as big – and as thinly capitalized – as ever. The nation’s goliath banks have grown only more dominant.

With the Fed such a massive buyer of Treasuries, there has been no market discipline imposed upon a spendthrift Washington. A more than doubling of outstanding federal debt in five years (issued at record low market yields) implies broad market distortions and economic maladjustment. At a record (ballpark) $2.4 TN in assets, the historic inflation of hedge fund industry assets runs unabated. This has propelled the number of billionaires, along with skyrocketing prices for art, collectibles and trophy properties. And at $632 TN (from BIS data), the global derivatives marketplace is as unfathomably monstrous as ever. As for the rating agencies, truth be told, they have little impact on the global Credit Bubble.

Mr. Blinder and others would like to believe that we’ve been persevering through a post-BubbleGreat Recession” with parallels to the Great Depression – but with, thankfully, the benefit of wonderfully enlightened policymaking. Former Treasury Secretary Hank Paulson, discussing the 2008 crisis during a Friday morning CNBC appearance, referred to a “massive Credit Bubble that went bust” – “a 100-year flood with excesses building for years and years.”

At risk of soundinglunatic fringe,” the reality of the matter is we’re suffering these days from a period of mass delusion. U.S. and world GDP have never been greater. Fueled by record securities prices, U.S. household Net Worth stands today at a record level. U.S. total income in rather short order recovered from 2009’s modest decline. Real estate prices around much of the world are at or near record highs. Total outstanding debt – in the U.S. and globally – is at a record high and inflating. 

From a systemic standpoint, the notion of “de-leveraging” has been a myth. And for five years now unprecedented global imbalances have worsened. Chinese and EM Credit Bubbles and attendant Bubble economies have inflated to historic proportions. Indeed, there is a fine line between “frightening financial meltdown” and unleashing history’s greatest inflation of global securities prices. The only justification for the “100-year floodthesis is wishful thinking.

To be sure, the backdrop has virtually nothing in common with the 1930s. As I’ve written previously, if one is searching for parallels, I would look to the 1920’s. In a replay of errors at key junctures during the “Roaring Twenties,current monetary policymaking would be more appropriately focused on restraining Bubble excess. Instead, it’s the polar opposite approach with ongoing massive experimental inflationary measures.

I’m not a fan of Alan Blinder’s framework, and I am averse to historical revisionism: “The financial beast was comparatively tamed for almost 75 years. Years of disgraceful financial shenanigans in the 2000s, some illegal but many just immoral, brought on the Great Recession with virtually no help from any co-conspirators.” 

Seeds for the 2008/09 crisis were being planted many years prior to the “shenanigans in the 2000s.” Vulnerabilities associated with unbridled global Credit, “activistmonetary management and speculative excess go back to Greenspan’s aggressive post-1987 stock market crash reflationary measures. There were the resulting junk bond, M&A and real estate booms and busts that left a deeply impaired U.S. banking system in the early-nineties. There were the (post-reflation) bond market and derivative Bubbles that faltered in 1994. And we cannot forget the spectacular 1990s booms and busts in Mexico, SE Asia, Russia, Brazil and Argentina (to name only a few). The 1998 LTCM collapse exposed egregious leverage and derivative speculations. And then the decade concluded with a wild speculative Bubble in technology stocks and telecom debt. Somehow, in the face of increasingly apparent shortcomings, monetary policy became only moreactivist” and experimental.

It’s not credible to look at “2000s” (mortgage finance Bubble) excesses in isolation.No help from any co-conspirators”? Did not Bernanke’sgovernment printing press” and “helicopter moneymonetary ideologies play prominently in the 2002-2007 doubling of mortgage debt? Clearly, loosemoney” and monetary policyactivism” were fundamental to the previous 25-year period of serial booms and busts. And each bust provoked aggressive reflationary measures in the name of warding off the “scourge of deflation.” Every reflationary cycle further emboldened and inflated the “global leveraged speculating community,” a dynamic that ensured the scope of subsequent booms became bigger and more systemic. Has contemporary inflationist monetary policy not already proven itself immoral?

The most important unlearned lesson is that Federal Reserve (and global central bank) monetary inflation and market interventions carry great risks. For 25 years the Fed has repeatedly employed post-Bubble reflationary measures while inflating the greatest Credit Bubble in history. Back in the 1960s, it was said that Alan Greenspan associated the severity of the Great Depression with the Federal Reserve repeatedly placingCoins in the Fuseboxthroughout the Roaring Twenties Bubble period.

The latest talk is that the FOMC may be considering adding a lower bound inflation rate target to its list of factors for setting monetary policy. The experimental Fed last year employed the use of an unemployment rate target. So, the Fed could now perhaps state its intention of sticking with aggressive monetary accommodation so long as either unemployment is above a certain rate or inflation remained below a targeted level. The Fed continues its stroll down a very slippery slope.

The predominant view holds that an inflation rate of between 2% and 3% is constructive for the economy and supportive of financial stability. Virtually everyone - Fed official, economist and layman alikebelieves a modest and relatively stable level of inflation greases the economic wheels. Contemporary economic doctrine holds that moderate price inflation helps to ensure that borrowers will retain the capacity to service their (devalued) debt. It is taken as a given that any decline in the price level risks unleashing a horrific downward deflationary debt spiral and economic depression. And I would caution that because just about everyone believes something doesn’t ensure that it’s true.

It’s a myth that the Fed controls the “money supply.” It is simply a myth that there is some systemprice level” within the Federal Reserve's control. Traditionally, the Fed would increase or decrease bank reserves, in the process influencing intra-bank loan rates, bank lending and system Credit growth. And, customarily, bank lending accounted for a major portion of system Credit growth. Throughout much of financial history, inflation was a fairly decent indicator of general Credit conditions and related excess. Inflation, for the most part, provided a reasonable indication of the appropriateness of monetary policy, although it notoriously provided false signals during the “Roaring Twenties” and “Japan in the eightiesBubbles.

In our contemporary age of securitizations, repos, derivatives, GSEs, hedge funds, asset inflation/Bubbles, globalization, “digitalization” and the general proliferation of non-bank finance, focus on an aggregate measure of consumer prices as an indicator of Credit excess, general monetary conditions or the appropriateness of monetary policy is guaranteed to deceive.

Higher “inflationthese days doesn’t help ensure that borrowers will be able to service their debts. And I don’t believe the Fed and central banks can inflate away the massive (marketable securities) debt loads accumulated by governments around the globe. Rather, monetary policies incentivize behavior that ensures only more acute debt problems down the road. All the talk of nearfinancial meltdown” in 2008 ignores that the issue back then was chiefly a crisis of confidence in private-sector obligations. For the most part, sovereign debt was the target of panic buying. And virtually insatiable demand for Treasuries ensured massive financial, market and economic support from Washington. Especially with its move to $85bn monthly QE, Fed policy has been accommodating just the type of excess that risks a more systemic crisis of confidence.

There’s now more than 20 years of (recent) experience available to illustrate how massive destabilizing growth in Credit and problematic asset Bubbles can coexist with relatively contained inflation in an aggregate measure of consumer prices. As an indicator of financial stability, CPI has already revealed itself as a flawed indicator. At this point, any lower bound inflation target would essentially build upon an array of Fed policy tools, measures and indicators that work in concert to promote financial speculation and Bubbles.

And with the Fed prepared to ever gingerly begin pulling back on QE, there is newfound focus on the efficacy of “forward guidance.” The Fed is determined to avoid the 1994 scenario whereby a 25 bps rate boost incited a problematic spike in yields all along the yield curve. The thinking today is that assurances of a low Fed funds rate target for the foreseeable future will work to anchor longer-term market yields. There has even been Federal Reserve research concluding that QE purchases haven’t had a major impact on market yields.

Well, I would counter that QE has had enormous market impact. U.S. stocks have returned about 30% since the Fed began ballooning its balance sheet this past November. Junk bond issuance is poised for a record year, with likely the strongest expansion of business borrowings since 2007. Housing prices have jumped double-digits, as overheated conditions reemerge across many markets. Globally, a strong inflationary bias has propelled asset prices generally.

Returning back to “forward guidance,” I expect the market to take little comfort from the promise of ongoing near-zero short-term rates. Generally, faith in a persistently lowfed fundstarget would place a ceiling on long-term market yields. And, indeed, this dynamic has been in play for years now, in the process fostering major financial leveraging and other speculative excess. And especially after the past year’s broad-based risk market excesses, what really worries the markets these days is a bout of problematicrisk offde-risking/de-leveraging. The markets are comfortable with, and fully leveraged for, a Fed that won’t be hiking rates anytime soon. Major questions remain, however, as to the availability of a sufficient marketplace liquidity backstop in the event of market turmoil. 

I have argued that the “leveraged speculating community” – and securities markets more generally - have been bolstered (and hopelessly distorted) from 20 years of Washington liquidity backstops. The GSE's played prominent roles in accommodating bouts of speculative deleveraging starting back in 1994. In 2006, after revelations of accounting fraud had reined in Fannie and Freddie balance sheet growth, I posited that any serious bout of de-risking/de-leveraging would likely require a massive expansion of Fed holdings. Today, with the Fed’s balance sheet on the way to $4.0 TN – even in the face of ongoing market risk embracement and speculative leveraging – I’m contemplating Fed holdings in the, say, $6.0 TN range in the event our central bank chooses to accommodate a serious bout of speculative deleveraging.

How confident is the marketplace that the Fed would be willing to embark on yet another major escalation of QE? There’s been ample confidence that chairman Bernanke was willing to do whatever it takes. After all, he did recently state the Fed, even after embarking on “tapering,” would “push backagainst any market tightening of financial conditions. And the markets seem to be comfortable that Janet Yellen would have no qualms aggressively expanding the Fed’s balance sheet as needed to bolster employment and the general economy. Larry Summers? Well, he has already curmudgeonly stated his view that QE has limited benefits.

And, really, how cozy should we assume Mr. Summers would be to market speculation and myriad shenanigans? One would not expect him to fixate on arcane academic models and Bernanke’s monetary theories. I would tend to view Summers as a Keynesian inflationist – but no monetary nut-case. At this point, he’s more the real-world pragmatist than gun-slinging academic theorist. It’s been almost 15 years since the LTCM fiasco and the (joining Greenspan and Rubin on the cover of Time magazine’s) “committee to save the world.” I think Summers understands the game along with associated risks.

I’ve been assuming that, in preparation for storm clouds gathering on the horizon, the President would seek the services of a street-savvy, seasoned crisis-fighter like Larry Summers. If he is indeed the Administration’s choice, I expect the markets to be somewhat on edge. Will Summers convey that the Fed is willing to backstop the markets, much as his predecessor was so comfortable doing? “Helicopter Larry?” I don’t think so. But it would make for interesting confirmation hearings.

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