PrintJune 28, 2009
The Fed: Our economy's protector?
Some Wall Street analysts suggest investors now plan for "an economic recovery in a post-bubble environment." Encouraged by the recent stock market rebound, they are convinced the economic downturn will sooner or later be over but are worried about the strength of the coming upturn.
A New York Times writer frets that any recovery promises to be weak. According to him, "a sudden credit contraction" caused the downturn in economic activity. But the real start of the downturn was a dawning realization that asset prices, typified by home prices, were unsustainably high. This caused lenders to feel queasy and borrowers to think twice. According to the Times writer, however, somehow a credit contraction came upon us, applying a "chokehold" to the economy. The good news, he adds, is that the contraction has relented, but the bad news is that merely "...allowing a person to breathe may not be enough to restore him to health."
Let us just say it would be a good start. Still, it would be interesting to know exactly who now feels "allowed to breathe." Do the remaining executives at GM and Chrysler? (We won't mention the stockholders or creditors.) How about the nominal bosses at Citigroup -- are they getting the oxygen? How chipper are medical doctors after the Obama AMA speech, and how carefree the bankers, hedge fund managers or the so-called non-bank lenders after the Administration's new regulatory proposals? How easy is the breathing of Mr. and Mrs. Taxpayer as they contemplate record government spending plans and projected deficits?
We do all seem to be questioning the assumed recovery. When will it occur? How strong will it be and how long will it last? It seems especially problematic considering the universally acknowledged need for the Fed at some point to "reduce its balance sheet" (i.e., sell the assets that it currently considers it imperative to acquire) when aggregate spending revives. This is the famous "exit strategy" that can be defined as the Fed's secret plan to reverse its ineffectual policies as soon as they have worked.
But let us ask a different question: is the bubble even over?
There has been a curiously subdued muddle of finger pointing to the cause of the financial crisis. Apparently, after the Administration and Congress finish legislating appropriate remedies, at some point they will convene a blue-ribbon commission or some such to determine what actually caused the problem. In the meantime, we cannot remind ourselves too frequently of the real cause of the asset price bubble and especially of the fact that the bubble itself was the cause of the current economic crisis. The bubble was the problem -- not the failure to sustain the bubble by either adding more monetary air to it or by omnisciently regulating business.
The asset price bubble came to us in the way usual for a large modern economy, as it had to, i.e., via a careless, unconscious sabotage of the financial system by government-sanctioned expansion of the supply of "credit money." Credit money is so-named because it comes into being merely by banks' decisions to lend rather than by, say, mining and processing companies' extracting precious metals from the ground and forming them into bars and coins. Credit money partially or entirely lacks "backing" by bank reserves or cash in its vaults. That is to say, credit money is the money of systems of fractional reserve banking.
The Achilles heel of fractional reserve banking is that, if holders of demand deposits all try to withdraw their money at once, only some of them will succeed. When buttressed by certain legislation-legal tender laws, the outlawing of gold as a monetary option, deposit insurance, etc.-fractional reserve banking becomes a superb engine of money supply increase. However, these modern money system innovations have a disastrous drawback: from time to time, large portions of the supply of credit money can threaten to disappear virtually overnight. Credit money disappears when the conditions supporting its existence disappear, namely, the ability or willingness of lenders to lend or borrowers to borrow. To the chagrin of central bankers, exactly this ability and willingness are the factors likely to vanish when an asset bubble collapses. Such a disappearance of money happened in the Great Depression, contributing to an extraordinary drop in aggregate spending. The fear of a dramatic drop in the money supply from bank failures haunts the Fed in today's crisis, prompting its frantic efforts to bolster bank reserves and capital and to encourage growth in the money supply. This, in turn, has created a companion fear of a possible hyper-expansion of the money supply.
Now the word "bubble" is just a metaphor, and we do well not to take it too literally. For one thing, it implies that the most obvious area of price increase (and subsequent crash) is the main problem-that Internet stocks were the problem in the late 1990's, that real estate was the problem from 1998 to 2006, and so on. But asset bubbles cannot help but affect all prices-just some more visibly than others. Let's not forget how not just real estate, but also securities and many commodity prices fell dramatically in the last two years. Analysts with a sense of economics know that even prices that were steady in recent years would likely have declined in the absence of the bubble. Secondly, "bubble" implies that, once burst, it is gone entirely. In real life, how are we to know when an economic bubble starts or when it is over-truly over?
It turns out there is a test for knowing if a bubble has started or if one is completely over. The decisive test for the absence of a bubble in asset pricing is the existence of a non-inflationary money, i.e., for practical purposes, the absence of a central bank and of the associated government regulation of money and banking. It is difficult to conceive that the money supply under such "free banking," would consist of anything but precious metals (gold and silver). Such a monetary system would imply an extremely stable money supply. Any annual increase in world money supply would be very marginal when compared with the already existing amount of gold and silver since it would be subject to the usual difficulties of mining and the costs of processing and minting. (This would be the system's way of preventing general asset price bubbles.) Money supply would not decrease in any but trivial amounts. (This feature of the system would prevent modern style banking crises.)
A notable future of such a system of "hard" money would be that virtually the entire burden of price and wage variations would fall to the "goods side" of the price system. Price changes induced from the "money side," so familiar to our world with its continual currency depreciation, would virtually disappear. This would imply a persistent stability in prices, if not a downward trend, instead of an upward movement such as we have experienced since the close of the gold standard era at the start of World War I. Under the "classical gold standard" (1880-1914), price increases reportedly averaged only 0.1% annually. According to one estimate, from 1920 to 2008 prices have increased at an annual rate of 2.7%. Now this is a large enough difference; but compare it to the annual price increases supposedly experienced since 1960, amounting to 4.1%
The point is that prices set under government regulated money and banking are prices of either a bubble phase or a bubble re-imposition phase. But, you could ask, what about house prices? Isn't that bubble over? Well, we don't know that. Perhaps, if house prices start to go up from here, we could say that a phase of the housing bubble is over. But house prices remain even now under the influence of a government-manipulated money supply. ("M2," for example, is up at a historically high 9 % annualized rate in the last 12 months). So it is impossible to declare that the housing bubble has run its course from a longer-term perspective. Consider that the average prices of "existing homes," under a "hard" money, such as precious metals, would likely decline persistently, as houses age. Only long-sustained increases in money supply have created the phenomenon of houses as "investments" expected to appreciate. At a more general level, the widespread price increases that we observe in a bubble are produced by a regime of central banking. These increases would instead be mild price declines without government influence over the money supply. In a collapsing bubble, moreover, price declines would occur more swiftly without government "stabilization" efforts, including money supply increase. "Stabilization," in current policy jargon, is a virtual synonym for delaying the arrival of market clearing prices.
The purpose of every central bank is to inflate, to make the money supply grow at a rate faster than it would grow if it consisted only of precious metals. The task of the Fed is, in effect, to create asset bubbles, but to do so in a politically pleasing, sustainable manner, i.e., ideally, to create a never-ending bubble. The bubble is for the convenience of government. It facilitates tax collections. It eases the burden of deficit financing (on the government, not on the people). By creating rising aggregated economic statistics, it deludes the populace into thinking politicians and their economic advisors promote "economic growth." The never-ending bubble is the financial wizardry behind the never-ending growth of the welfare state.
It is, thus, an amazing irony that the Obama Administration touts the Federal Reserve System as the logical choice to become a new "systemic regulator." Having recently financed the asset bubble that undermined the financial system, the Fed is the only institution that has the power to cause similar catastrophes in the future. Quis custodiet ipsos custodes? This will be our economy's protector? More like its worst nightmare.
Mikiel de Bary works in the financial services industry and is a freelance observer of macroeconomics in contemporary society.
