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The dismal failure of central bank
monetary policy
By Jack Crooks
"Credit expansion is the governments'
foremost tool in their struggle against the free market.
In their hands it is the magic wand designed to conjure
away the scarcity of capital goods, to lower the rate of
interest or to abolish it altogether, to finance lavish
government spending, to expropriate the capitalists, to
contrive everlasting booms, and to make everybody
prosperous."
- Ludwig von Mises
It
was a cold, dreary autumn day at the central bank. The
clocks struck 13. It was another reminder to visitors
that all is possible in the neo-Keynesian puzzle palace.
For he who controls the money controls the man.
It seems central bankers and their allies still
believe all things good flow from credit expansion. They
create fancy equations and theorems to justify and
rationalize their forays into the free market. It's
simply inflationism - which is the essence of Keynesian
economics - built upon an elaborate structure of
pseudo-science. George Orwell once said, "Man is the
only creature that consumes without producing." Sadly,
the modern central bank believed him - and the big news
this week is the adjustment of interest rates in China.
The results are a wholesale trashing of the
world reserve currency and rampant disregard for the
long-term external financial position of the United
States in order to stimulate "demand". You can see that
in the chart below.
The chart above compares the total amount of US
dollar debt held by the rest of the world (red line) - a
cool US$4.37 trillion - to the trade weighted value of
the US dollar (blue line). I have shaded on the chart,
2002 through the second quarter of 2004, showing the
massive US Federal Reserve credit-expansion campaign
engineered by the push down on the Fed Funds Rate (chart
below), dragging the dollar down with it.
 Sure, the
Fed was able to juice gross domestic product (GDP) by
flooding the globe with liquidity. But "expansion of
credit cannot form a substitute for capital", said
Ludwig von Mises in his classic, The Theory of Money
and Credit. And yet our most esteemed financial
commentators confuse credit and capital every day. But
it seems George Soros doesn't confuse the two. In his
classic book, Alchemy of Finance, Soros wrote:
The act of lending usually stimulates
economic activity. It enables the borrower to consume
more than he would otherwise, or to invest in
productive assets. There are exceptions, to be sure:
if the assets in question are not physical but
financial ones, the effect is not necessarily
stimulative. Bingo! "... If the assets in
question are not physical but financial ones, the effect
is not necessarily stimulative." It appears the
financial assets took on the bulk of liquidity. Below is
a chart of the S&P 500/Industrial Production:
And depicting the lack of
stimulus, the chart below shows US GDP divided by the
money supply - M3. If you examine the period from 2002
onward, you can see that despite all the money the Fed
has pumped into the economy, the stimulative impact was
scant, just as Soros warned.
But why didn't the credit expansion perform the
expected miracles? It's simple, but you won't find the
answer in modern economics textbooks.
Credit
expansion always disrupts the optimum operations of the
market processes, according to von Mises. Conditions may
seem desperate with millions unemployed and much idle
equipment, but such conditions never justify credit
expansion, von Mises warned. He went on to say that such
credit expansion will always necessitate a later
correction, generally known as a recession.
We are now
facing the stark reality of a country and its consumers
swimming in debt (household liabilities rose 65% faster
than nominal GDP between 2000 and 2003).
The job market is stagnant - new
jobs created are not enough to support the new entrants
into the labor market. The dollar is crumbling against
all major and many minor currencies. And we could soon
face the prospect of a world going on strike against US
dollar debt. Over the 12 months ending August 2004, 33%
of net foreign purchases of long-term US securities have
come from the official sector - double the 15% share of
the prior 12 months and over four times the portion of
the 2000-02 period, according to Morgan Stanley.
Private investors are turning their backs on US
securities and the buck. The Asian central banks are
still net buyers, for political reasons, but there are
signs that ball game is in its late innings.
Here are three major risks to the current
arrangement of Asians funding the US, as perceived by
Stephen Roach, chief economist at Morgan
Stanley.
1. The possibility of
protectionism. If Asians don't adjust their
currencies, ie, let them appreciate against the dollar,
Roach expects the euro will "bear the brunt of what
could be a very severe impact" and appreciate
considerably. This could force the hand of European
politicians and US politicians alike.
2. Rapid
accumulation of foreign exchange reserves. This
could cause financial instability in Asia.
3. The
endgame of Asian development. At some point Asia
will have to focus on stimulating domestic demand, which
will absorb its surplus savings - its role as
"export-led financier of American consumers" is in
doubt.
It's no wonder some expect the US to
revisit the stagflation of the 1970s. Morgan Stanley's
Joachim Fels recently gave these reasons:
1. The
world economy has to digest a major increase in oil
prices.
2. Just as in the 1970s, monetary policy has
been highly expansionary, with real short-term interest
rates in the major countries in negative territory for
an extended period of time.
3. Government budget
deficits rose, partly reflecting an expansionary fiscal
policy stance to overcome recession.
4. The
established industrialized nations in Europe and North
America faced major new competitors in world markets in
the 1970s, notably Japan and South Korea.
5.
Worldwide productivity growth slowed in the 1970s - we
could be on the tail end of the
information-technology-induced growth cycle that started
in the mid-1990s.
The Fed has flooded the globe
with credit. And it isn't working, to say the least.
But, amazingly, some believe the Fed has achieved
success. I would contend, any more of this kind of
success and we'll soon see the words "banana republic"
increasingly used in the same sentence with "the United
States".
A big-time market player keeps the
faith
A friend sent me this e-mail note: "Your
free-market fans will enjoy the following write-up by
Paul McCulley of PIMCO. With capitalists like this, who
needs socialists?" With that introduction, I read
McCulley's October missive titled "Managing It Forward"
with interest. I can honestly say I wasn't disappointed.
For the record, Paul McCulley is managing
director at Pacific Investment Management Co (PIMCO).
That may not sound like much, but if you consider that
the amount of money PIMCO controls would probably dwarf
the GDP of most medium-sized countries, you will begin
to understand why I refer to McCulley as a big-time
market player.
To put it mildly, I was stunned
by McCulley's zealous belief in central-bank omnipotence
and his zeal for monetary tinkering. If you are a
disciple of Keynes general theory, McCulley will make
you proud. But if you believe, as I do, that
central-bank tinkering is the primary cause of monetary
and business cycle chaos, McCulley's views read like a
Stephen King novel.
In talking about firms
de-leveraging their balance sheets in 2002, McCulley
said that if firms had become infected with "irrational
gloom" it could have led to a "debt-deflation spiral".
Interesting reasoning, I thought.
First, who is
to judge the market's gloom as rational or irrational?
What's the benchmark? Why was their gloom not perfectly
rational? And why do McCulley and almost every financial
commentator on Earth continue to believe deflation is so
terrible?
It is a common myth among laymen and
economists alike, that falling prices have a
depressing effect on business. This is not necessarily
true ... Deflationary credit contraction greatly helps
to speed up the adjustment process, and hence the
completion of business recovery, in ways as yet
unrecognized. The adjustment consists, as we know, of
a return to the desired consumption-savings pattern
... Credit contraction returns the economy to
free-market proportions much sooner than otherwise.
- Murray Rothbard, America's Great
Depression In short, deflation is the
means in which an economy cleanses itself. Yet the Fed
fights the deflationary beast and McCulley cheers them
on. He writes: "And so it was in the summer and fall of
2002, with capitalism itself being called into question
as a going concern. In such self-feeding, deflationary
circumstances, it is the unambiguous duty of the central
bank to:
publicly commit to use the printing press for (high
powered) money to reflate; and then, putting action to
words,
continue to print money until asset prices go up and
stay up.
"The Fed recognized this duty and
courageously rose to the challenge in November 2002 ..."
The heroes of this epic adventure of course are
Alan (irrationally exuberant) Greenspan and Fed governor
Ben (roll the printing presses) Bernanke. Riding in on
white horses with guns blazing, our heroes shred the Fed
Funds Rate to 1%. But this drama isn't enough for
McCulley - he wants more.
"Indeed, if anything,
the Fed, in my judgment, should have fired its
anti-deflationary weaponry sooner than it did, with more
gunpowder. In the matter of fighting deflationary risks,
the Mae West Doctrine applies: if a little is good, more
is better and way too much is just about right. The
Fed's 75-basis-point cumulative easing in 2002 and 2003
was somewhere between better and just about right,"
McCulley writes.
Because, of course, we can't
let the unhampered market operate without the wise
intervention of government, can we, Mr McCulley?
"Karl Marx was one of the first to maintain that
business crises stemmed from market processes. In the
20th century, whatever their great positive differences,
almost all economists - Mitchellians, Keynesians,
Marxians, or whatnot - are convinced of this view. They
may have conflicting causal theories to explain the
phenomenon, or, like the Mitchellians, they may have no
causal theory at all - but they are all convinced that
business cycles spring from deep within the capitalist
system," said von Mises.
Sadly, the views of
people like McCulley prevail when it comes to the
implementation of US monetary policy. And here is what
it's brought us: a couple of percentage points on the
GDP statistic, a debasement of the currency value,
soaring deficits, massive consumer indebtedness, asset
bubbles, structural unemployment, and a funding
arrangement with Asia that has effectively given away US
sovereignty of our financial future.
Don't worry. Just remember, 2 + 2 =
5.
Jack
Crooks has traded in global equity, fixed income,
commodity, and currency markets for more than 20 years.
He is president of Black Swan Capital, a currency
advisory firm - BlackSwanTrading.com.
(Copyright 2004
Asia Times Online Ltd. All rights reserved. Please
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