Fed recoils from 1937 tightening error as jobs evaporate
The American economy has shed 347,000 jobs over the past two months, roughly comparable with the rate of loss seen during the Great Recession. It is remarkable that the US Federal Reserve should even have been thinking of phasing out life-support in such circumstances.
By Ambrose Evans-Pritchard
9:00PM BST 18 Sep 2013
US labour force participation rate (percentage)
Fortunately the hawks did not prevail. It is likely that vice-chair Janet Yellen played a key role, insisting that the jobless rate is nowhere near the "NAIRU" (non-accelerating inflation rate of unemployment) inflexion point, the level at which inflation starts to accelerate, the gauge she tracks as her lodestar.
Labour specialists say chronic lack of demand in the US is the real villain is this jobs slump. "The problem is not that the labour market is under performing; it is that the recovery has been very slow," says Stanford's Edward Lazear. A record 20.2pc of US households are now on food stamps. That is how they survive.
The economic growth rate over the past three quarters has been 0.1pc, 1.1pc and 2.5pc. This is below the Fed's own "stall speed" indicator - 2pc averaged over two quarters.
The economy has weathered the most draconian fiscal tightening (2.5pc of GDP this year) since the end of the Korean War remarkably well, helped by shale gas, but it is not yet at "escape velocity". The fiscal squeeze goes on.
The International Monetary Fund has advised Washington to go easy, citing an "output gap" of 4.6pc of GDP. The Dallas Fed's measure of core inflation was 1.2pc in July. Growth of the M1 money supply is the slowest in two years, while growth of broad M3 has slowed to the point where it could turn negative without QE. The alleged inflation threat is a fiction of febrile imaginations.
It would be a grave error for the Fed to taper bond purchases at all at this juncture, given the risks for Brazil, India, Turkey, South Africa, Indonesia, Ukraine and others already facing a turn in the credit cycle, and given the danger of another eurozone debt spasm, as happened at the end of QE1 and the end of QE2.
The Bernanke Fed has twice misjudged the global effects of premature tightening already, each time precipitating a credit and stock market crash within weeks, and each time forcing the Fed to capitulate. Third time lucky?
Weakening US money supply
One suspects that some hawks want to end QE for reasons that have nothing to do with jobs or inflation. A paper by former Fed governor Frederic Mishkin, "Crunch Time", warns that the Fed will struggle to extract itself from QE if it delays until 2014. It may drown from losses on its $3.6 trillion of bond holdings as yields rise.
Above all, their real motive seems to be fear that QE is stoking another asset bubble, and that the risk of this game now outweighs the rewards. This is a legitimate worry. As the Telegraph reported earlier this week, the Bank for International Settlement's former guru William White says the global debt structure is more dangerous than ever.
“This looks like to me like 2007 all over again, but even worse. All the previous imbalances are still there. Total public and private debt levels are 30pc higher as a share of GDP in the advanced economies than they were then, and we have added a whole new problem with bubbles in emerging markets,” he said.
Lest we forget, it was Mr White who saw the debacle of 2008-2009 coming with crystal clarity. The latest dash for subordinated debt, "leveraged loans" (I kid you not), "cove-lite" lending, "CoCos", and so on, are all too like those infamous "CDOs" and "CLOs" last time.
The question is whether the public welfare is best served by popping the bubble and allowing Austro-liquidation to purge the toxins, or whether this would be ruinously destructive. Many readers think it is past time to dynamite this edifice. I have much sympathy with this view. Yet in the end, I prefer magic.
The root of our global crisis is the $10 trillion reserve accumulation by the emerging powers, massive over-investment in China, and extreme levels of inequality within the West as the "Gini Coefficient" goes off the charts. The combined effect is to create excess capital, and lack of consumption, pushing the global savings rate to a record 25pc. This chronic disorder keeps blocking economic recovery. It is embedded in the structure of globalisation.
Be that as it may, if QE as conducted is causing asset bubbles, then we should deploy central bank stimulus more creatively, should it prove necessary. We know how to do it.
The methods were pioneered by Takahashi Korekiyo, who pulled Japan out of the Great Depression early in the 1930s. His brilliant feat is now the model for what Japan is (covertly) doing again under Abenomics.
Takahashi turned the Bank of Japan into an arm of the treasury - "fiscal dominance" - and ordered it to finance the budget deficit. You can deploy QE in any way you want. It could be used to build houses, injecting the money into the veins of the economy, instead of the veins of hedge funds. There is no reason why it cannot be administered by an independent Fed or Bank of England, choosing the calibration level as they see fit.
Lord Turner, the former chief of the Financial Services Authority, is tentatively pushing this idea, asking what is to stop the Bank of England writing off its Gilt portfolio, financing "prior" deficits. This could be done with a flick of a switch, reducing Britain's sovereign debt to a manageable 67pc of GDP at a stroke. The US could do much the same.
Pedants will scream. The central bank priesthood will talk of Hellfire and damnation. But if you can conjure away this debt without inflation, the objections fall away. For the sake of decorum, the Gilts could be converted into zero-coupon bonds with no expiry date. The certificates could be burned one Sunday, during a World Cup Final.
Such unorthodox action might even be desirable in strict monetary policy terms, making it easier to restore interest rates to normal levels earlier in the recovery cycle, to the benefit of savers. It is a victimless crime, or no crime at all.
Or if we want to be really radical, we can dust off the 1936 Chicago Plan, lately revived by the IMF's Jaromir Benes and Micheal Kumhof. They argue for a return to the pre-Stuart system, before the English Free Coinage Act of 1666. This would strip banks of their power to create money out of thin air, returning to state-created money.
The IMF paper argues that if lenders are forced to put up 100pc reserve backing for deposits, this could - by complex legerdemain - eliminate all public debt in the US, UK, Germany, France and perhaps even Japan.
My point is not to endorse Lord Turner's plan, or the Chicago plan, or any other particular plan, but simply to say that fear of asset bubbles is not a good reason to shut off monetary stimulus prematurely, if the economy still needs it.
Whether the Fed or the US policy establishment is willing to think so far out of the box remains to be seen. At least it has backed away from a repeat of the great 1937 error of premature tightening. There is slightly less risk that it will tip us back into another leg of the Long Slump. We have dodged a bullet.