Submitted by Jeff Snider, President of Atlantic Capital Management, Alhambra Investment Partners
Mystery Solved: The Fed Indicts And Absolves Itself
Given that the economy markets have once again fallen into their annual rut it would make sense that policymakers would attempt to explain their persistent failures. After all, this is not the recovery we were promised. Not only is the real economy decelerating in the US, Europe is in re-recession (and a dark one at that) while China flirts with levels that a few years ago were considered the Chinese equivalent of economic suicide. On top of the real economy, trillions in new currency units all across the world have not ended up in a re-liquification of the global banking system. With academic measures of narrowly defined theories, central banks have implemented one dose of liquidity poison after another, perfectly ensnaring their intended target in the opposite circumstances than intended. For every US treasury bond purchased by QE, that meant depletion of as many as four (according to IMF estimates of interbank collateral velocity) equivalent funding arrangements as the chain of rehypothecation was stressed. The ECB repeated the mistake in its LTRO’s, creating nearly a trillion new euros that somehow ended up subtracting from general liquidity due to what seems to be a recurring blind spot of rehypothecation ignorance. In short, there has been a lot to answer for recently, yet somehow capitalism is taking both the populist and elitist beating.
The lack of promised recovery and functioning banking system is still a minor issue when compared to 2008. There has been hand wringing and hearings, papers and ink spilled over the topic in a less-than-determined effort to flesh out just how the crisis could have evolved in such a sophisticated, modern system. In a July 12, 2012, essay in the Federal Reserve Bank of St. Louis’ Economic Synopses magazine, author Daniel Thornton, Vice President and Economic Advisor at the bank, appears to make an admission that monetary policy was a failure, or at least irrelevant, perhaps answering some of the critiques that continue to plague the US central bank regime. Titled “The Efficacy of Monetary Policy: A Tale From Two Decades”, the paper makes what looks like a refreshingly honest summation of cumulative failure:
“The fact that there is little difference in economic performance during the past two decades despite a marked difference in the stance of monetary policy is consistent with the theoretical and empirical evidence that monetary policy has no permanent effect on real variables and with skepticism about the efficacy of the interest rate channel of monetary policy more generally. It also raises a question about the possible effectiveness of the FOMC’s commitment to maintain the funds rate target at zero through late 2014.”
Mr. Thornton’s regression analysis demonstrates that despite a relatively tight monetary stance in the 1990’s (according to his assumptions and definitions) and a relatively loose monetary stance in the 2000’s, there was little change in the overall behavior of either inflation or unemployment. It was as if monetary policy was invisible or ambivalent to the behavior of either variable:
“Absent recessions and the financial crisis the stance of monetary policy appears to have had essentially no effect on output growth or the unemployment rate.”
But what sounds like an admission of ineffectiveness is really a sly transformation into absolution of culpability. One way to read this conclusion is that the scale of economic dislocation in 2008 could not possibly have been the Federal Reserve’s fault because the Fed’s monetary policy is inept in the real economy. Since monetary policy has been shown “with the theoretical and empirical evidence that monetary policy has no permanent effect on real variables”, there is no way monetary policy could have contributed to both the Great Recession and the Great Waiting (for recovery).
That theoretical evidence comes from the hardened philosophy of mainstream economic canon that money is neutral. It is taken as a proven fact that outside of the short run, changes in money are neutral to the wider economy. Mr. Thornton’s paper appears to back that assertion with empirical evidence. But, just like the central bank blind spot over rehypothecation, there is every reason to doubt the “empirical” evidence owing to the modern mathematical tendency toward GIGO (garbage in, garbage out).
The potential for monetary nonneutrality is not captured by mathematical variables and assumptions – neutrality is already baked into the models as “settled science”. For one, while Mr. Thornton is comfortable removing recessions and the financial crisis from the data set to empirically validate his conclusions, logic alone cautions against such comfort. If you believe, as he does, that recessions and the financial crisis were caused by unexplained exogenous factors outside the scope of inquiry, then it might make sense to remove them. But if you were at all aware of the logical link between real estate prices, consumer spending and the explosion then implosion of shadow credit markets, at least moving beyond the simple mathematical assumptions can plausibly offer a more comprehensive pathology.
As troubling as asset inflation has been in and of itself, monetary nonneutrality is far more sinister. On a previous occasion, I wrote about what might be the worst aspect of this idea of nonneutrality. For mainstream economics, of both the Keynesian and monetarist persuasions, the idea of aggregate demand is uncontroversial. Upon closer inspection, the idea that any and all economic activity is a perfect substitute for any and all economic activity falls apart on its face. Can anyone actually make the case that a government paying workers to build pyramids in the desert is exactly the same as WalMart hiring the same proportion of workers to work in its stores – even assuming the wage rate is exactly the same for both? These two sets of economic activities would appear exactly the same in the economic accounts (DPI and GDP would adjust higher accordingly) but are carried out for far different reasons and intentions. Conventional economics does not care nor distinguish since it is an accepted assumption that economic activity is uniform, and thus perfect substitutes.
The real economy apart from the academic framework, however, takes place far outside the here and now, and intent is all-important. Maybe there is some equivalence to those kinds of activities in the very short run, but a healthy economy needs productive activities that are both profitable and sustainable. True wealth is a measure of sustainable production beyond the here and now. But as more money is pulled toward the government fill of “automatic stabilizers” in the absence of “private demand”, more productive capacity is transferred away from where it is most useful for future sustainability. While some commentators call this crowding out, I think there is more to it than just that.
Not all economic activity is the same, and the difference in the make up of the economy, meaning finding the right mix of activity, is what creates economic health (or repairs economic disruptions from dislocations, i.e., a recovery). As much as money and monetary policies foster the “wrong” mix of activity, that speaks directly to nonneutrality. If monetary policies can distort current activity away from the range of optimality as it pertains to sustainability, then it cannot be said that money exhibits neutrality because that will impact the longer-term trajectory of economic potential directly. There likely exists (which I argue as highly likely) a very real opportunity cost for the types of activities that are sought out by short-run monetarism (and Keynesianism for that matter).
As the opportunity cost of the “wrong” mix, dictated by activist monetarism or fiscalism, grows relative to organic activity, you would expect the longer-term trajectory of economic potential to decline proportionally since the artificial, substituted growth contains little to no emphasis on sustainability. The possibility that generic economic activities are not perfect substitutes across the broad spectrum of possibilities cannot be modeled by current techniques, even if it was considered and absorbed into the theoretical framework of existing monetary “science”. Neither can potential innovation.
As much as the worship of aggregate demand places a distorting emphasis on the short-run goal of activity for the sake of activity, monetary nonneutrality can potentially impact the vital role of innovation, and the related role of productivity. As bad as the single-minded and narrow focus on aggregate demand is, nonneutrality in productivity and innovation may actually be far worse, and perhaps offers a far more complete theoretical structure for the Great Recession and the Great Waiting.
A capitalist system needs competition. Competition itself should naturally arise out of the ambitions of economic agents. However, due to differences as diverse as talent, weather, regional characteristics, or just plain luck, competition is often reduced by the repeated successes of “winners”. Some businesses are just plain “better” than others, and therefore can succeed at levels that outpace competitors. Part of being “better” is innovation; those that can successfully innovate and incorporate innovation will win the race to the top.
The process of competitive innovation is what we call productivity, the ability to use inputs better or cheaper than others. Successful innovation-driven productivity leads to an economy of scale as businesses successfully compete for market share. The economic system, and society as a whole, benefits from this competition-driven productivity. But the system has well-known limitations, especially as the economy of scale gets more and more concentrated. As the “winners” of the race for scale and market share accumulate ever more scale, they begin to set marginal prices well below the ability of competitors to survive. Eventually, given a large degree of difference in potential productive prices and scales, the system ends up with cartelization or monopoly (this is what happened in the agricultural sector to a large degree). It is the central paradox of capitalism – successful natural productivity innovation through natural competition will eventually lead to anti-competition, and therefore disruption and long-term malfunction.
Fortunately there is a natural check on this paradox: disruptive innovation (anyone thinking the FTC was actually the check on cartelization has not been paying attention). Disruptive innovation is where new products or even industries arise out of the successful ambition to challenge the steady state of an industry, or even an economic system. The true animal spirits in an economy are not financial. Despite modern modeling techniques that assume otherwise, these animal spirits are not formulaic reactions to mathematical manipulations of financial inputs, they are the very human desire to build a better mousetrap that is wholly unrelated to the real rate of interest or the shape of the yield curve. We see disruptive innovation at work in the so-called life cycle of businesses. Small startups supplant “mature” and established businesses that were once the disrupters themselves. The endless parade of disruptive innovation is the engine for re-establishing competition, checking the natural tendency toward asymmetric scalability.
A healthy capitalist system, then, features both productivity innovation and disruptive innovation at the same time. Too much productivity innovation leads to the stagnation of cartelization, while too much disruptive innovation leads to chaos and disorder (potentially). Just like the financial economy needs a healthy balance of speculation and investment, the long run trajectory of real economy potential rests upon the balance of these types of innovation. Anything that disrupts that balance (and this is not a static equilibrium, it is a dynamic concept of human interaction) disrupts economic potential. Both elements of productivity need the razor’s edge of dynamic competition.
As much as conventional wisdom posits the Great “Moderation” as the apex of modern economic understanding and the intersection with soft central planning, it featured a rather striking dearth of disruptive innovation. Sure the Internet came of age during the period, but the Great “Moderation” was really just the payoff of earlier innovative work. The tech darlings of that period, from computer and telecom companies to biotechs, got started in the 1970’s and 1980’s. Where are the new innovative darlings that got started in the 1990’s and 2000’s?
For quite a period of time, the developed world (starting with the US) enjoyed a run of disruptive innovation that spawned new industries and productive capacity that could not have been dreamed of by the preceding generation. It was matched, seemingly step for step, by productivity innovation as technology served to create new industries while simultaneously advancing the growth potential of many existing sectors. Since the Internet revolution, however, there has really been nothing of that scale, no brand new industries to take the real economy into the next phase of productive potential. Is it coincidence, then, that this donut hole of disruptive innovation has occurred at exactly the same time as the apex of monetarism?
Certainly correlation is not causation, but there is undeniable logic to this line of inquiry. One of the striking features of the Great “Moderation” has been, again, rapid asset inflation. This kind of monetary inflation has many pathways for sustaining itself, not the least of which is central banks intentionally turbo-charging the credit production system. The methodology of circulating credit overstimulation determines the ultimate pathway for that inflationary money.
For example, in the early and mid-1980’s, the US financial system saw its first real asset bubble in the junk bond space. Junk bonds were especially useful as the means to finance privatization and merger activity (the birth of the over-indulged LBO). In terms of asset inflation, these kinds of credit-based processes furthered the rise of asset prices by being conducted at hefty market premiums, while at the same time withdrawing or reducing the supply of equities. In the real economy, the junk bond bubble was just the first application of asset inflation intrusion into the paradox of productive innovation. Rather than helping disruptive innovation cull the herd of enlarging firms as they reduced productive price points through growing economies of scale, this kind of merger craze pushed the process of cartelization further upward, certainly beyond where it would have been without the monetary boost. Big businesses got bigger, in many cases, solely because there was an artificial abundance of credit. Access to Wall Street largesse was more important than successfully incorporating innovation and productive potential.
The mania of mergers and productive economies of scale has continued almost uninterrupted since the early 1980’s. Digging into the Federal Reserve’s own Flow of Funds data (Z1) it is very clear that the marginal surge of money in the US system is not into equities, it is away from them. To put it another way, these credit-based activities finance the withdrawal of ownership from the dispersed pool of individual investors to the concentration of larger and larger businesses among a smaller and smaller cohort of owners (generically speaking). For all but a few years of the Great “Moderation” (1983-2007) there were negative flows to equities as credit money was used to extract ownership rights for productive capacity. Since this process was accretive to asset inflation and the assumed “wealth effect”, it was encouraged by the regulatory framework and the tide of soft central planning. Businesses no longer had to out-compete their competitors. They could use cheap financing and over-abundant credit to simply buy them up without having to go through the trouble of actually innovating their way to the mature stage of the business cycle.
The reduction in competition and the diminished marginal level of innovation also bled past the productive innovation processes that were never born, into the vital arena of disruptive innovation. So much of disruptive innovation is a result of competitors fighting for every last basis point of market share, as necessity breeds individual genius. By removing competitive obstacles through the unhealthy shortcut of easy money, the monetarist impulse stifled the razor sharp edge of a healthy competitive, and thus innovative, environment. Once competition was reduced without innovation, cheap credit served mature businesses as they sought to acquire or beat back potential disruptive rivals before they ever got going (i.e., Microsoft vs. Netscape). The tide of monetarism was a blunt instrument to protect the vested interests of mature-stage businesses (what have those tech darlings done in the 2000’s, except defend their own turf?).
The bluntness of monetarism also extended into individual incentives. Before the age of the activist central bank, the only clear path to untold riches was through the creation and building of a real productive empire. Since the 1980’s, but especially the last two decades, the path to untold riches has been asset management and the financial economy. The tycoons of the past were industrialists that created something from nothing. The tycoons of today are hedge fund managers and Wall Street’s vast sales staff. The pool of available individual talent has been skewed away from real productivity toward the financial economy – Ivy League math wizards who might otherwise have put themselves to good use creating new real economy technologies were pulled irresistibly into the Wall Street nexus of quant trading and “risk management”.
Even outside the perceived top ability level, marginally in the last twenty or so years individuals have been drawn away from the real economy to the lure of financial money. Instead of starting productive businesses, they became day traders and real estate flippers. The scale of the asset bubbles meant that the opportunity cost to the real economy in favor of the financial economy just may have been a massive talent drain. Thus, all the vast financial innovation of the past two decades was likely accomplished at the expense of innovation in the real economy.
On the whole, as the monetaristic drive into asset inflation further fueled the rise of bigger and bigger businesses, it drained the real economy of marginal actors who may have contributed to the much needed disruptive innovation that might have succeeded in breaking the paradox of capitalism. In doing so, this rampant monetarism has superseded and replaced true capitalism with cartelization and cronyism by removing its own self-correction mechanism. To that end, perhaps the most potent and reprehensible aspect of this very clear nonneutrality has been how monetarism has paved the way for big government.
The growing spending monster of the federal system in the US, and the more aged systems in Europe, would never have reached the heights they did without a huge boost of easy credit and asset inflation. The combination of fiat money, the potential for vast fractional credit expansion due to the shift to interest rate targeting, and the embedded regulatory favor of “risk-free” government debt essentially withdrew any market self-correction from the growing global Leviathan. Putting the regulatory imprimatur onto government debt incorporated a statutory level of demand that skewed the real cost of government borrowing, allowing borrowing levels to exceed any reasonable threshold by free market standards. In fact, the monetaristic rise of the financial economy was perfectly aligned with the growing tentacles of political reach. The banking system and the political system operated in a near-perfect symbiosis of monetary flow and regulatory favor.
Monetarism is really a perversion and distortion of free market capitalism, where that perversion is the fingerprints and fragments of nonneutrality. It has led to this state of rising cartelization, concurrent to the exponential growth of the public sector. The system that prizes aggregate demand above all else will eventually find the path of least resistance to that end: cartels and government spending. But such a system that seeks only generic, short-term activity will eventually find itself with too many people waiting to build those desert pyramids; it really is better that they work at WalMart. Sustainability and the intent of economic actors matter more than activity for the sake of activity. The backfill of automatic stabilizers and induced monetarism through credit only serve to fill the grave that the economy is already standing in. The lifeline out of that grave is disruptive innovation and true wealth creation, but those are longer-term processes that don’t offer the easy answers of the distorted capitalism, and they don’t fit into the mathematical box of modern monetarism. True capitalism is antithetical to any form of aggregate demand and central planning.
Now in the twilight of the apathy generated by the anesthesia of the Great “Moderation”, the status quo must be maintained at all costs: once interests become entrenched, they must be served. The models may not incorporate it, but aggregate demand and the perversion of capitalism, like true capitalism itself, have very real limitations. The Great Recession was really nothing more than the failure of asset inflation to be irrevocable. Without the mask of asset inflation, the atrophy of the productive capacity of the real economy in the US and Europe was laid bare. The domination of the financial economy, due to nonneutrality, has led to the lack of productive and disruptive innovation to check the supremacy of cartelization at the margins (which are not insignificant), while eroding the razor’s edge of competition and productive capacity and the ability of ingenuity to break free. The Great Waiting is nothing more than that diminished capacity matched to the echo of over-extended valuations of unanchorable fiat money.
There is no mystery to the “headwinds” that continue to plague and mystify monetary policymakers. The global economy is not pulled into re-recession by some unseen magical force, conspiring against the good-natured efforts of central bankers. Instead, the very thing central banks aspire to is the exact poison that alludes their attention. Conventional economics will continue to believe and empirically “prove” that the theory of the neutrality of money is valid, giving them, in their minds, unrestricted ability to intervene and manipulate over any short-term period (though it is getting harder to argue that these emergency measures are “short-term” nearly five years into their continued existence). The occurrence of panic in 2008 and the unresolved and unremoved barriers to recovery in the years since, however, fully attest to nonneutrality, an ongoing form of empirical proof that their models will never be able to refute. And we are all condemned by it.