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The Dire Societal Consequences Of Stability-Obsessed Keynesians
Submitted by Eugen von Bohm-Bawerk via Bawerk.net,
One of the most reliable indicators of an imminent recession through recent history has been the yield curve. Whenever longer dated rates falls below shorter dated ones, a recession is not far off. Some would even say that yield curve inversion, or backwardation, help cause the economic contraction.
To understand how this can be we first need to understand what GDP really is. Contrary to popular belief, GDP only has an indirect relation to material prosperity. Broken down to its core component, GDP is simply a measure of money spent on goods and services during a specified period, usually a year or a quarter.
However, since money itself is a very fleeting concept we need to dig deeper to fully understand the relation between the slope of the yield curve and GDP. The core of money is its function as the generally accepted medium of exchange, but today that is much more than the cash in your wallet. For example, the base money, provided by the central bank, consist of currency in circulation and banks reserves held at the central bank.
From these central bank reserves the commercial banking system can leverage up, through fractional reserve lending practice, several times over. It is important to note that broader money supply measures, such as M2, is merely a reflection of banks leverage on top of base money. As a bank makes a loan to a borrower the bank creates fund which can be used as means of payments to whatever the borrower wants to spend the newly acquired money on. Obviously, these money claims will in turn create new deposits, which can be used to create new loanable funds and so on ad infinitum.
In addition, money is not consumed during the transaction as goods and services do, it merely changes hands and can thus be used several times within the specified period of time used to measure GDP. Velocity is thus an expression of household and businesses spending patterns.
If aggregate demand is total money spent on goods and services, aggregate demand equals GDP.
However, if aggregate demand (AD) is an expression of money flowing throughout the economic system we can write;
This relationship is essentially the Quantity Theory of Money developed by the School of Salamanca and later re-discovered by Ludwig von Mises and Irving Fisher in the 20th century.
From this equation we can express GDP growth derived purely from the underlying monetary components. The first chart show how central- and commercial banks together with household and businesses “create” GDP growth.
Source: National Bureau of Economic Research (NBER), Bureau of Economic Analysis (BEA), Federal Reserve (Fed), Bawerk.net
It is interesting to note from the chart above how both the Great Depression and the Great Financial Crisis were both driven by commercial banking deleveraging and increased demand for cash balances by households and businesses. The major difference between the two periods is obviously the massive intervention by the Federal Reserve in the latter period to maintain nominal GDP growth. Keep in mind that GDP properly defined have nothing to do with real prosperity. No, GDP is nothing more than a very broad measure of inflation, defined as an expansion of the money supply. The only link between GDP and real prosperity comes through prices paid for goods and services. GDP growth is inflation, but to the extent prices does not increase correspondingly, there must have been an increase in production of goods and services. In that sense, GDP correlates with prosperity, but there are no causal link between the two concepts. When Keynesians say
they are right in the sense that spending by the government can increase inflation through a forced increase in velocity. Deficit spending, funded by the central bank (QE) will be even ‘better’ as its increases both the supply of money and its velocity.
But we digress, the question we try to address is basically the link between GDP/inflation and the yield curve? Going back to the identity above and the chart we see that the two most important components in the GDP calculation is commercial bank leverage (the money multiplier) and spending patterns as expressed through household and business purchases (velocity) and this the former is directly affected by the yield curve while the latter indirectly.
Noting that commercial banks borrow short and lend long, a process that create additional deposits which can be used for further lending, it is obvious that short rates must be lower than longer dated rates for the bank to make a profit.
As the yield curve flattens, banks net interest margin falls and they start to curtail lending which lowers inflation and by extension price pressure, which help bring the yield curve even lower until it eventually inverts. At this point banks’ balance sheets shrinks as loans get repaid while new ones trickle to a halt. The recession (measured by GDP) ensues shortly.
We will be the first to admit that yield curve inversion is not the only factor causing recessions, but through the credit channel it can be an important contributor. Depending on the importance of the credit channel, the Federal Reserve, by pegging the short term rate at zero, have essentially removed one recessionary market mechanism that used to efficiently clear excesses within the financial system.
While stability obsessed Keynesians on a quest to the permanent boom regard this as a positive development, the rest of us obviously understand that false stability breeds instability. The Soviet Union had only one recession after all; the one in 1991 which collapsed an empire. The misallocations that had perverted that particular system never got corrected, as a market based system would do on a regular basis. Instead, the distributional perversion lingered on for decades until the whole edifice imploded on itself. In other words, the longer a system disallow corrections the more fragile it becomes. When central banks stop short corrections through their market manipulative shenanigans instability grows exponentially as one misallocations leads to the next.
That said, we still believe there will be a recession in the US soon, yield curve inversion or not, (presented here and here) as inventory excesses need to be liquidated at some point. However, if the financial system see no reason to scale back, funding for working capital / inventories may be present for longer than usual. The shale oil boom is a perfect case in point.
Source: Federal Reserve of St. Louis, Bureau of Economic Research, Bawerk.net
As can be seen from the chart above, the yield curve inversion have a perfect track record when it comes to predicting recessions, mainly because it, to some extent, causes the recession through a reduction in the money multiplier and inflation (which defines GDP through nominal aggregate demand). However, when the short-end is pegged to zero it is impossible for longer dated rates to fall below shorter dated, and banks net interest margin will remain positive.
To substantiate our inventory liquidation theory we look at where the yield curve would stand if the FOMC had followed a so-called Taylor rule, which defines the Fed Fund rate as presented in the Humphrey-Hawkins Full Employment Act. We use the following for our Taylor Rule calculation
The 2 per cent PCE goal is “set in stone” as any deviation from that magical number would obviously lead to unprecedented catastrophe, but the 4.5 per cent unemployment “target” is generously applied as the non-recession average unemployment rate has been 5.8 per cent since 1948.
Calculating the term spread from the Taylor rule give us an idea of where the yield curve would be if the Fed had actually followed its own rule. A prudent FOMC, following the congressional mandate they always use as an excuse to not look at asset bubbles, would have pushed the yield curve deep into negative territory by now.
In the chart below we plot the difference between the actual Fed Fund rate and the Taylor rule. When the area between the two are red it means actual target rates are below the Taylor rule. While we are no big fan of the arbitrarily set Taylor rule, it has proven to provide a warning sign in times when the FOMC ignore it for longer periods. In the late 1970s and 2000s the result was obvious for all to see. Financial crisis, misallocations and subsequent capital reallocation (recession) were necessary. Today the FOMC is doing the exact same mistake again. The red area in the chart are growing ever larger as bond, stock, EM and who knows what are priced to perfection.
Source: Federal Reserve, Bureau of Economic Analysis, Bawerk.net
It is clear to us that the FOMC in its quest to maintain stability is breeding instability and that previous attempts at the same failed miserably with dire consequences for society. We are sure it is only a matter for time before it happens again.
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"While stability obsessed Keynesians on a quest to the permanent boom regard this as a positive development, the rest of us obviously understand that false stability breeds instability"
A cycle has no stability and never will. Fighting a cycle does not eliminate a cycle, it only distorts it. Day and night cycle 365 days a year- except on leap year. Except a flat line, everything is cyclical. Christmas comes around once a year. Winter spring fall and summer. Pay checks once a week. Full moon once every 28 days.
There can be no permanent boom or even economic expansion. Expansion and contraction complete a cycle.
Empires rise and empires fall. The U.S. is now in the latter category, having risen to its peak as being the only super power.
This year's World Series champion will eventually sink toward the bottom of their division.
The interesting thing is that all these economic academics will say that they believe in science, yet they keep trying to fight the laws of math, science and nature.
When you've already got yours, stable growth is your whole plan.
Good point, TBT. Stability is not a virtue, at all. Stability means the winners of today are the winners of tomorrow. It means Kim will rule N. Korea forever and the work camps will remain full.
It means if you are a loser today you will be tomorrow.
Even on the positive side, stability prevents change. The Americans do not revolt, the Roman Empire is still in charge, the USSR still control half of Europe.
Stability is overrated.
Fed Funds Rate vs Taylor Rule
How many cycles in that chart? No flat line there.
Term Spread
How many cycles in that chart? No flat line there.
All these academics are anti science.
let me guess. this guy has a hair piece and a bow tie in his closet.
"they are right in the sense that spending by the government can increase inflation through a forced increase in velocity. Deficit spending, funded by the central bank (QE) will be even ‘better’ as its increases both the supply of money and its velocity."
Velocity has declined as the national debt has doubled to 18 trillion dollars under QE.
"To understand how this can be we first need to understand what GDP really is."
GDP is an economic invention. What can academics artificially add in order to artificially goose GDP? Is prostitution counted in GDP? Is yard work counted in GDP? Is volunteering counted in GDP?
What is GDP when debt is subtracted? What we are told is real GDP, isn't.
Look at the FED rate. Practically ZERO since some time in 2008.
That is effectively what the real GDP has been for the last 7 years.
That is why it feels as if the recession never ended. In real terms it hasn't.
stability is an obsession of those who rule, for destabliization means an end to their rule.
IT IS PERFECTLY RATIONAL. what is sad is that the obsession of the banksters with unceasing amounts of criminal profit is actually far more destabilizing than the concerns about destabilization themselves.
keynsianism is just another 'ism' to describe rulership.
when criminals steal everything, the rulers are in a bind. then the rulers also steal everything. and sometimes the rulers and crminals are not entirely separate and cooperate with one another.
it's a messy thing. but in the end, when there is a threatened calamity-------that is when the shelves of the supermarkets go dry and the hoarding begins. the stealing begins as well. and everyone can become a criminal theif if things get bad enough. this is the law of the jungle homo sapien hive. it always has been and always will be. there are no isms that will chnage it.
The Taylor Rule is just a simple description of how central bankers actually behaved up to 2005---raise rates when (official) unemployment went down and wages started rising, lower them when unemployment got high enough that even the MSM could no longer ignore the problem. It can't tell you what they should do.
That, of course, is to:
1. Do away with fractional-reserve banking. Do that and you make a lender of last resort unnecessary.
2. Wind up the central bank and return the right to determine what to use in exchange to the people involved in the exchange-gold, paper claims to gold, bitcoins, whatever.
3. Go find a more honest line of work. Like payday lending. (There's a lender of last resort for you!)
Stability is no problem, you just have to get rid of the banksters and 1%
http://www.chinadaily.com.cn/china/2015-10/28/content_22301457.htm
Q to Robert Shiller
The main enabler of sizable asset price bubbles is ...
See the only Comment here (early October):
https://yalealumnimagazine.com/events/667-los-angeles-ca-an-evening-with...
Too many do not understand...keynes was never to help the economy. It was a way for the bankers to get as much money as possible, as quickly as possible, to control the world and to set up a world police state. When it crashes, they are all set up. If the likes of Paul Krugman to Jim Cramer are making tens of millions of dollars then they can buy a bunker etc. This was all planned, and keynes was never meant to help the economy...Get over it. Altho, may the people who supported and made fortunes from this, die in hell forever....I use to think there was not a hell, but now I hope there is one :-)
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This is getting comical... Mises monks keep making blatant mistakes.
Here is one:
For example, the base money, provided by the central bank, consist of currency in circulation and banks reserves held at the central bank.
NO!
Virtually all money in circulation today is on-account money that sources as bank loans. This idea that there is a base of reserves to then control the credit is complete nonsense.
For christ sakes, even the bank of england has written a paper calling you guys out. Cut it out, you are confusing the sheeple.
http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/...
BANKS LOAN FIRST AND FIND RESERVES LATER. BANKS ARE NOT RESERVE CONSTRAINED. THE IDEA OF BASE MONEY IS NO LONGER OPERATIVE. jeeez
The central bank does provide for reserves when banks cannot find them on overnight market. That's all.
Instability mises monks rail about is a function of the debt cycle.
Credit is recalled to the ledger for destruction. It happens in cycles, credit can be issued too fast per unit time, thus inflation, then it get recalled later as loans are paid down.
The output of credit system is a SAWTOOTH. Credit builds up in the economy, and then collapses rapidly.
Rapid collapse is due to positive unwanted feedback, where banks stop making loans, or even calling in loans. This accelerated credit destruction, and economy goes into depression.
Additonally, all credit loans have counterparties. It then causes contagion as one loan after another starts to become non performing.
Keynes understood that exogneous money had to be counterspent into economy to overcome these INHERENT defects in the private debt based credit money system. Keynes lived in a time when the great depression had sucked all the credit out of the economy, and there was little money left over for doing daily transactions.
Gold pays credit (debt instruments) so it too was harvested out of the money supply to pay bankers.
I thought GDP was: Government Spending+ Private sector spending + (exports-imports).
The problem with this formula or any that equates government spending is that it makes money spent by government equal to private sector expenditures. I think they should be heavily discounted and even considered a loss. When you go to the DMV you produce very little of actual market value. In fact, you are a drag the economy. IRS filings, accountant hours, regulatory compliance, and a hundred other things detract from income and producing goods and services. If not, you could theoretically go full Commie and GDP could remain the same.
I think if you use traditional GDP it is at least wise to compare the size of the two and worry if government spending begins to exceed private.