The Federal Reserve under Fire, Part Two
President Eisenhower, in the face of the relatively mild recession of 1958, resisted the harangue of Republicans in Congress to cut taxes and, in so doing, was able to oversee a government that had several years of balanced budgets. He argued that the huge tax cuts of 1954 had been enough in the way of fiscal stimulus, and he was proud to point out that the majority of the money from that round of tax cuts had gone to people of more modest means. The fiscal discipline he imposed as chief executive officer of the United States would prove exceptional, particularly in light of the howl from his own Republican Party as it obsessively paraded its pandering wares for the low-taxes crowd of that day.
President Kennedy, fully infused of a more enlightened Keynesian advisory slate, and with the excuse of having inherited from Eisenhower a sluggish economy, actually appealed to Congress for legislation to cut taxes. At the same time, he was laying out plans to take the country onto the entrance ramp of a long, wide highway of massive growth of government. His vision was dutifully and honorably fulfilled by his successor, President Johnson, who knew full well, as did his ill-fated predecessor, that a completely compliant Federal Reserve stood ready to monetize what would become a spiral of expenditures far beyond the means of even the United States, especially in the face of inadequate tax revenues. The Great Society (Johnson's follow-on to Kennedy's New Frontier) and the Vietnam War (Johnson's high-octane version of Kennedy's advisory actions in southeast Asia) would together become, first, the engine of fiscal policy permanently masked as economic stimulus; second, the wedge by which the public sector would become permanently entrenched as an integral and significant part of the American economy; and, third, a means by which monetary and fiscal policy distinctions could be better and more systematically blurred on a nearly permanent basis.
Duties and Tools of the Federal Reserve
In principle, the Federal Reserve has three functions, the first two of which it has carried out with what has arguably been a considerable degree of clarity and strength. The Fed regulates and supervises banks; the Fed provides banking services for banks (as a competitor with private financial institutions that offer the same); and the Fed conducts monetary policy.
Regulation and Supervision: The seven Governors, appointed by the President with the advice and consent of the Senate, of the Federal Reserve Board construct bank regulations. Sometimes, as with many federal agencies, these rules rise to the level of regulatory law; in other circumstances, the regulations are interpretations of federal laws enacted by Congress. The application and enforcement of these regulations created by the Board of Governors is the responsibility of the 12 Reserve (or "District") Banks, each overseeing the banks in its own geographical region. Application and enforcement is carried out through bank audits, dissemination of information, and other activities. In summary, regulation is carried out by the central Board of Governors, and supervision is carried out by the Reserve Banks.
Banker's Bank: Just like any other business enterprise, a bank needs a place to deposit its money and get other important financial services. The Federal Reserve offers the entire range of such services a bank might need, but the Fed operates as only one possible financial institution banks may use for such purposes. Certain private, commercial institutions offer the same services, and the Fed's participation in this market is generally to ensure a degree of competition and encourage innovation.
Monetary Policy: Technically speaking, the Federal Reserve has three tools by which it can conduct monetary policy. One is the "required reserve ratio," the fraction of demand deposits a bank must keep on hand to satisfy claims on its customers' checking accounts. The level at which this required reserve ratio is set has the consequence of determining the factor by which new money entering the system will multiply as the result of loans and deposits. A higher required reserve ratio will slow down the multiplier effect; a lower required reserve ratio will increase the multiplier effect. As a tool of monetary policy, this required reserve ratio is blunt in the sense that relatively small changes in it can have fairly dramatic effects on how fast the money supply grows; as such, the ratio is set primarily for its function of imposing upon member banks a minimum amount of money that will be in the vault for customers and for those bearing checks from customers. In times when people have worries about the banking system and their money, the Fed might set the required reserve ratio higher than in times when people are quite confident about the economy and its banking system.
The second tool of monetary policy is the "discount rate," which is the interest rate at which the Federal Reserve, itself, would lend money to member banks. The Board of Governors sets the discount rate about eight times a year, moving it up and down, or leaving it alone, to signal broader Fed policy intentions. Typically, banks would prefer not to step up to the so-called "discount window" for a loan because they can borrow from each other in the "Federal Funds market," even though the "Federal Funds rate" (or "Fed Funds rate," for short) is higher. The Federal Reserve sets the discount rate (logically, because it is the lender at the discount window), but it cannot "set" the Fed Funds rate because this rate is driven by the supply of and demand for lendable funds in the banking system.
The Federal Reserve does set a target for the Federal Funds rate, and it tries to move the actual rate toward the target rate by the third of the three tools of monetary policy, the so-called "open market operations" (OMOs), which are executed by the Domestic Trading Desk at the Reserve Bank of New York (the "Empire" bank). These OMOs are carried out every day, and they are the activity of the Federal Reserve in the financial markets that powerfully affects the supply of money in the banking system. Policy expressed through the open market operations is set in meetings of the Federal Open Market Committee (FOMC), on which the seven Governors are voting members, as well as the presidents of four Reserve Banks on a two-year, rotating basis, and the president of the New York Reserve Bank on a permanent basis. The FOMC makes decisions about how much liquidity the banking system should have at a given time, and the directives to add liquidity to or drain liquidity from the system are transmitted to the Desk in New York for execution by traders who then enter the open market for Treasury securities and offer to buy them from or sell them to member banks. If the Desk is a net buyer, that causes demand for Treasuries to increase, which drives their prices up (which pushes their yields down), and the result is that banks receive money from the Fed for the Treasuries they sell to it, induced as the banks are to sell some of their Treasuries because they can fetch the rising prices of them. On the other hand, if the Desk is a net seller of Treasury securities, that causes the supply of those Treasuries to increase in the open market, thus driving their prices down (which pushes their yields up), and the result is that banks surrender money in exchange for the Treasuries they are buying, induced as they are to buy some Treasuries because the falling prices are making them more attractive investments.
In the case where the Desk is a net buyer of Treasuries from member banks, money is flowing into the banking system as the Desk pays the banks for the assets it has purchased, so the cash is being deposited in Federal Funds market in the names of the banks the Desk is paying. This makes the Fed Funds rate drop because the supply of lendable funds is rising, meaning the system has more cash money to lend. In the case where the Desk is a net seller of Treasuries to member banks, money is flowing out of the banking system (and into the vault or shredder at the Fed), making the Fed Funds rate rise because the supply of lendable funds is decreasing, meaning the banking system has less cash money to lend, since it spent money buying those Treasury securities the Desk was offering. The result of these open market operations is that the liquidity of member banks' asset portfolios is altered: when the Fed is pursuing expansionary monetary policy, the asset portfolios of member banks is becoming more liquid (tilted toward more cash that can be lent), causing interest rates banks charge for loans to drop; when the Fed is pursuing contractionary monetary policy, the asset portfolios of member banks is becoming less liquid (tilted more toward Treasuries, which cannot be used for lending), causing interest rates banks charge for loans to rise.
The Purpose of Monetary Policy: Theory and Reality
Ideally, in carrying out its duties to conduct monetary policy, the Fed has one and only one goal: maintain the stability of the aggregate price level. That means the Federal Reserve, in managing the money supply, is charged with preventing inflations and deflations, especially those that would persist long enough to embed expectations of future continuations of price increases or decreases into wage levels, interest rates, and prices for goods and services. To that singular goal of maintaining stability of the aggregate price level, the Fed would oversee a growth rate of the money supply that matchedand did not go above or belowthe real growth rate of the economy. In other words, sound monetary policy would be to the exclusive and singular end of ensuring that the money available to the American economy was just enough, no more and no less, to provide the cash the economy needed for its transactions. This would mean that the money, itself, was completely neutral with respect to effect and did not, because of an over- or under-supply of it, distort growth, expectations, aggregate demand, or aggregate supply.
Unfortunately, monetary policy can affect the short-term real growth rate of an economy, and the neo-Keynesians have not been afraid to use this as a tool of intervention in the business cycle, particularly to the end of stimulating the economy, whether or not the economy needed any stimulus. President Kennedy's Fed was certainly not the first to understand that excessive growth of the money supply can create a short-run stimulative effect, and the Federal Reserve came in the neo-Keynesian era to embrace an expansive understanding of the goal of monetary policy (and, by implication, of the authority of the Fed) that included "assisting" the economy in times of economic hardship. The worst part for the Fed of abandoning a more parsimonious goal of controlling the aggregate price level was that, once it had become an instrument of fiscal policyindeed, of social and public policiesits Board of Governors found itself less and less able to stop the integration of the Fed into the machinery by which the U.S. Treasury funded government operations.
The Federal Reserve of the Nixon years continued this abandonment of the mission of the central bank, which arguably culminated when the Board, under the chairmanship of Arthur Burns, monetized the price shock of the OPEC oil embargo of 1973. As excess money was already spreading through the American economy, causing general and escalating inflation, the solution proffered by Nixon and the federal legislature of the time was to impose wage and price controls, which are essentially the legislative version of curing inflation by putting a cork into the wound of a person bleeding profusely from a gunshot to the abdomen. With the Fed pumping money into the system to keep aggregate demand strong, inflation accelerated; far worse, however, expectations that the inflation would continue and accelerate started to set in.
For Nixon's successor in office, Gerald Ford, that meant keeping the money printing presses rolling to forestall the gathering and inevitable storm of a recession that would be caused in part by interest rates rising because of the expected inflation premium in them starting to embed and grow. Ford's solution, facile as it was, had as its hallmark a public campaign to "Whip Inflation Now," as if it would be by some decision of the economy's consumers, workers, and merchants that inflation would abate and expectations of it would vanish.
It was then left to President Carter to do what had to be done. At first, he approached the problem much as Ford had done, putting the burden on the economy's participants to deal with the matter. He dubbed his campaign the "Moral Equivalent of War," which has the unfortunate but telling acronym "MEOW." Carter was not, however, a stupid man by any means, and he did understand what had to be done. In 1979, he appointed Paul Volker as Chairman of the Federal Reserve Board and gave him the charge to do what was necessary: crush the money supply, which would send real interest rates (the actual price of money) through the roof because the expected inflation premium already in those rates was sky-high, and draining liquidity from the banking system would put those interest rates into nose-bleed territory. Sure enough, Volker's Fed sent the U.S. economy into a brutal recession, in part because the peanut farmer from Georgia understood that the pain of austerity was the prelude to rebirth of an American economy able to carry on in the last two decades of the 20th Century. By the end of Carter's one term in office, he was overseeing budget deficits that were minuscule, even in inflation-adjusted dollars, compared to what his successor, Ronald Reagan, was about to allow, encourage, and use to the purpose of inappropriately projecting American military and financial power.
At first, Volker's attack on the money supply did nothing to dampen expected inflation, and this was because no one actually believed the Fed really was Hell-bent on killing inflation; after all, Presidents had for years been promising to deal with it, and yet it had just kept getting progressively worse. The price spiral of something close to hyper-inflation began to abate only after just about everyone became convinced that old "Tall Paul" Volker did not care how badly the economy suffered under constrained liquidity. Finally, as President Carter was swiftly vanishing into history as some kind of pariah to economic pundits and short-sighted historians, expected inflation premiums began to disappear from interest rates, from wage and salary demands, and from prices of goods and services. The falling interest rates, in and of themselves, began to breathe life into what had been a moribund economy.
Ronald Reagan rode into office in 1980 on the strength of what had been done by his immediate successor, and the Gipper was able to stride to the podium in his first address as President to gravely announce, "We're in an economic mess," affording him the populist high ground for his tax cuts to be passed by Congress, attended as they would be in the years that followed by rising budget deficits and a return to neo-Keynesian policies heavy on the interlocking relationship between industry and government, but with a Republican twist of no "countervailing force" (as economist John Kenneth Galbraith called it) of powerful unions to ensure the rights and wages of workers in the final plunge toward the 21st Century.
Government unable to resist the whine of greedy, pandering Republicans for tax cuts coupled with big government spending on government/industry projects: this is the legacy of Republicans from Richard Nixon forward. Government unable to resist the equally tiresome whine of greedy, pandering Democrats calling for a government war solution to everything from poverty to communism in southeast Asia coupled with big spending on government/industry projects: this is the legacy of Jack Kennedy and Lyndon Johnson, but the legacy ended there: both Carter and Clinton oversaw controlled government spending and tax rates that brought in sufficient revenues to meet government expenditures; and Bill Clinton actually oversaw budget surpluses in his last years in office, notwithstanding the still-noisy bleatings of historical revisionists trying to find some shred of equivalence between President William Jefferson Clinton, who reined over the longest peacetime expansion in modern U.S. history, and President George W. Bush, Jr., who collaborated with his Republican-led Congresses to initiate, prosecute, and consummate the recklessly irresponsible fiscal policies of the period from 2001 to the end of 2006 that have finally brought the American economy to the brink of deep recession.
Morning in America, Nightfall of Empire
Jack Kennedy was no Dwight Eisenhower, who stood firm against tax cuts, industrial policy, and monetization of government excess. For that matter, no Republican since Ike Eisenhower has been an Ike Eisenhower. The idealized versions of everything from Jack Kennedy and "Camelot" to Ronald Reagan and "Morning in America" are the fine stuff of American mythology, but the blindness to realities and complexities of the economic leadership these men provided the American people clouded a firm understanding of the long-term consequence of short-term policy actions they and their ilk pursued, particularly those policy actions funded by expansionary monetary policy actions by the Federal Reserve as it persistently strayed into management of the economy. This blindness to consequences is still happening: most Americans have not the slightest clue as to what has caused this nation to now stand at the precipice of an economic chasm of severe recession attended by high inflation. Quick fixes of massive infusions of liquidity are not going to work, and neither are fawning tax rebates; yet, these are the solutions being pursued right now by the United States government. Both the wildly excessive infusions of money and the too-late-to-matter tax cuts will make the problems worse and the subsequent, reparative fiscal and monetary policy actions extraordinarily more painful.
The current Fed Chairman, Ben Bernanke, is no Paul Volker; and George W. Bush is no Jimmy Carter, who stood firm against the economic mess that nearly two decades of decadent use of the Fed had finally produced as the lasting legacy of both Democrats and Republicans who could not keep their whims of Empire and its glory from infecting prudent central bank policy. The United States has now, in seven short years, returned to the brink of the brutal combination of recession and inflation happening at the same time, a mix for which the cure of sustained, contractionary monetary policy will hurt the American people like Hell and politically damage the President who has the courage to put into place a Federal Reserve Board of Governors with the will to administer the near-lethal regimen.
The American people of today will soon have to deal, as the people of Mr. Carter's time did, with the awful and painful solution to the reckless malfeasance and incompetence that will have been the legacy of irresponsible leadership. George W. Bush might be able to depart the White House before the full force of disaster of his economic recklessness becomes apparent to the American people, but even that is not assured: already, many believe that the U.S. is in a recession, even though the majority of Americans have yet to feel much pain other than high fuel prices and the discomfort of getting scared by stories of other people losing their homes in foreclosure. In truth, the American people have not yet even begun to feel a real recession.
But they will. They'll get their paltry tax rebate checks, and when they go out and blow that Fed-printed (and foreign-lent) money to make themselves feel better in their own households, they will see the economic equivalent of tossing tens of millions of lit matches onto a smoldering sea of gasoline that is the excess liquidity by which this Federal Reserve has been keeping the U.S. economy alive even as Mr. Bush and his Congress were digging its grave over the past seven years.
When the economic downturn actually does hit, the American people will scream bloody murder, and they will want the head of the President who is in office when the word "stagflation" comes into vogue, once again. George W. Bush might not be as lucky as, say, John F. Kennedy, the latter having been long in his tomb before the consequences of neo-Keynesian policies he started and his successors continued led to the last round of debilitating stagflation.
For those who reminisce fondly about Jack Kennedy, the good news is this: President Kennedy is a footnote in history; as such, all manner of greatness can be ascribed to him that is nothing more than the expression of fantastic minds imagining a better time than now. President Bush, on the other hand, will suffer the unfortunate advantage of being not a footnote in history, but instead the very definition of the trajectory of the 21st Century for this nation. Kennedy and Bush are, however, of a kind in that the repair of their errant policies will be in the hands of a successor. The United States was most fortunate that several stood to the task in the wake of Kennedy and his otherwise failed successors.
For the President who will succeed George W. Bush, history will allow no breathing room to govern and leave office without facing either the fury of economic disaster or the wrath of an American people who cannot imagine that they must, as part of their citizenship, pay for the failure a prior leader who finally became apparent for the incompetent, dense, prevaricating war-monger that he had always been.
The time of reckoning is soon; but as bad as the economy may get, the worst part is this: not one of the candidates running for President of the United States in 2008 is a Dwight Eisenhower, a Jimmy Carter, or even a Bill Clinton; to that extent, then, the American people will get what they deserve.
Unfortunately for the next President, that same American people will surely want someone other than themselves to blame for the insufferable outrage of inevitable consequences.
The Dark Wraith welcomes readers to the comedic tragedy of Empire in its final act.
The Federal Reserve under Fire, Part One
Although Rogers' prediction of the severely adverse consequences of current Federal Reserve policy is entirely accurate and consistent with predictions made in numerous articles and videos here, his prescription of eliminating the Fed is not going to happen, nor should it. The Federal Reserve system is deeply embedded in the overall banking structure of the nation and far too highly integrated into the broader financial matrix of the larger world; it cannot be removed, either by law or by circumstances. Moreover, far too many people (and Jim Rogers should not be one of them) who call for dispensing with the Federal Reserve seem to be utterly clueless that monetary policy is only one aspect of the Fed's overall mission and activities. No responsible person in his or her right mind would actually leave the United States without a central bank: for one thing, the previously regulated banks in this country would run amok; and if that is not bad enough, more importantly, the United States as an economic entity with sovereign currency would be eaten alive, especially right now with the dollar under such siege because of the Bush Administration's years of hopelesslynow, just about catastrophicallyincompetent policies.
People think terrorists are bad when they knock down $31 billion worth of property on continental U.S. soil? Watch what would happen if every industrialized nation of the world saw the opportunity to turn into a fast-moving, viciously efficient, mercantilist predator feeding on the carcass of a nation that had no central coordination to control currency flows and no central bank to enforce and define its currency. Although the current Fed Chairman, Ben Bernanke, is a lousy incompetent cut from the same mold of political fealty as everyone else President George W. Bush hires, Mr. Bernanke's choice to debase the American dollar is a whole lot different from a willful choice by the government, itself, that would turn the greenback into carrion abandoned in the field for every manner of predator and scavenger to carve up.
And speaking of terrorists, a worthwhile question, albeit one that will go unanswered, is thus: Where were both Bill Clinton and George W. Bush while the Chinese were sucking the American economy blood-dry by pegging the yuan at a mind-numbingly low rate to the U.S. dollar? The criminal madmen comprising the diffuse lore of convenience called "al-Qa'ida" are utter pikers compared to what the communists in Beijing have done to the economy of the United States under the guise of much-heralded "free market reforms," a feel-good term the Sino-gerontocrats have used and U.S. politicians have swallowed to the magnificently effective end of keeping the Americans from breaking the back of the Chinese currency manipulation strategy that for years pegged the yuan-dollar exchange rate at a ridiculous level of 8.28:1. (The Chinese are still pegging, but it is now looser, thereby giving the impression that some kind of float is happening.) For well more than a decade, the Chinese have been using the United States as their wet nurse, all while leading gullible American politicians and financial controllers to believe that, somehow, the "free markets" concept exists somewhere in the same universe with exchange rates fixed at levels radically divergent from purchasing power parity.
The naïve chain of logic that free markets lead to an expanding middle class that then demands greater civil freedom falls apart immediately when the entire predicate of free markets is nothing more than a ruse to bluff Westerners into a false mentality that currency manipulation on a grand, multi-year scale is other than a policy of mercantilism being pursued by entrenched authoritarians who shoot peaceful demonstrators by the thousands and brutally crush dissent in their occupied territories. The rulers in Beijing are not stupid enough to pursue any economic policy that might ultimately threaten their strangle-hold on absolute power; but the application of that basic axiom of authoritarianism seems to have been persistently, oddly, and perhaps tellingly absent from U.S. trade relations with China through several Administrations in Washington.
No, the United States will not abolish the Fed, nor should it, despite the central bank's history of surrendering its independence in conducting monetary policy. It will be the next regime at the Federal Reserve that will have to undertake the unenviable work, cruel as it will be to average Americans, of cleaning up the mess this Fedfirst under the progressively addled leadership of Alan Greenspan, then under the obsequious hand of Ben Bernankehas had a major hand in creating.
One good part about the draconian, contractionary monetary policy regime to come is that a Leftist writer like Naomi Klein can write a sequel to her breathless tome, Shock Doctrine, in which she may continue her curiously selective story of the evils of those who have to crush the money supply to finally fix the economic catastrophes created by neo-Keynesianism gone mad.
The great part about what is to come in terms of cure will be to see how John McCain, Hillary Clinton, or Barack Obama faces the awful news that actual leadership will fall on his or her shoulders, and real leadership requires meting out pain on a scale the American people have not come even close to feeling for a very long time.
A fun sideshow would be to watch a Hope-'n-Change sort of President trying to figure out why soaring rhetoric doesn't fix real economic problems.
Then again, the sales pitch in this election cycle seems to be all about believing in the future. Apparently, the past seven-plus years have not taught Americans much of anything about the difference between hope and reality.
This series will continue and conclude with a brief overview of Presidents, their fiscal and monetary policy regimes, and the consequences thereof.
Readers are encouraged to remain in good spirits as they follow this series (despite all reasonable evidence that such an attitude is sheer folly).
Prelude to Finale
The truth of the matter is that U.S. policies and their consequences are so intertwined with China's that no wall of economic or political logic can be built that would separate what China has been doing for years with respect to international trade and what has ultimately come about here in the United States as a result. I will explain this in technical detail (and the technical aspect is surprisingly simple to demonstrate) in the upcoming, fourth and final part of my series, "The Economics of Wreckage," Part Three of which was a fairly rigorous survey of neo-Keynesian economic policy and the consequences of the Bush Administration's overuse and misuse of it. However, as a leader for the final installment of my frontal assault on both neo-Keynesianism and the Bush Administration's economic policies, I herewith offer a series of brush strokes concerning why China and its actions are inseparable from what has happened in this country.
Exchange Rate Manipulation
The poorly understood, if nothing less than spectacular, center piece of Chinese trade policy with the United States has for years been the yuan-dollar exchange rate. If China had not been "pegging" the yuan against the dollar (and doing so at an exchange rate so removed from purchasing power parity reality that even I cannot help but grin at the decade-plus highway robbery) a few minor things would have been different. In my February 2006 graphical post, "A Walk-Down Primer on the U.S. Trade Deficit with China," I set forth the chain of policies and consequences on both sides of the Pacific that were inexorably taking us to a very grim period, one now just about at hand.
We would not have lost millions and millions of American jobs. While our nativists have been ranting about those brown people from Mexico overrunning our borders with actual, real human capital to feed our demand for cheap labor, the Chinese were sitting back, running a currency gambit that sucked the very life out of our economy by making our stuff expensive in China and their stuff ridiculously underpriced here in the United States. This was discussed in Parts One, Two, Three, and Four of my video series, "Exchange Rates." Yet, somehow, not one serious word has ever been mentioned about erecting punitive fences to stop the madness of China buying dollars and paying for them with yuan to keep the dollar artificially strong against the yuan. And to make this pegging trick happen requires constant, consistent, conscious policy actions by the Chinese central bank, all while both the Clinton and Bush Administrations were too stupid to deal with the war-by-trade the Chinese were waging against our industrial base. Instead, it has been easier all along, on the one hand, to swallow the bilge the communist rulers in Beijing have pumped out about "market reforms" and, on the other hand, to point fingers at the scourge of Paco and Manuel sneaking into this country, what with that strong U.S. dollar they could earn, to work at jobs most precious Americans wouldn't even consider doing. We'll believe murderous communist thugs and let them suck our economy blood-dry; but, by God!, we shall be safe from Hispanic brown-skins taking our highly sought-after, minimum-wage jobs. (To be fair, it is always more exciting to organize a mob than to hold a class in macroeconomics.)
Second, Asset Values
The real estate price run-up that began in the 1990s would not have happened nearly to the extent that it did. As explained in my May 2005 article, "Exchange Rate Regimes," when greenbacks flow out of this country through international trade, they eventually land in the central banks of our trading partners. That flow of short-term dollars in exchange for short-term goods and services is called the "current account." When we import more than we export, there is a net outflow of greenbacks, and we are said to be running "trade deficits," and, as a consequence, those central banks overseas build up "foreign reserves" of greenbacks; but the only place U.S. dollars can be spent is in the U.S., which means those dollars have to return as long-term investment here by foreigners. This backflow, which matches in size the current account, is called the "capital account." Hence, if we have a negative current account, we'll have a positive capital account of the same magnitude; and this is how the debt-fueled economy of the United States was getting its power juice: foreign central banksChina's, the Arab countries', Japan's, and those of other countries all over the worldwere pouring the greenbacks they had earned into everything American, including consumer loans; mortgage-backed securities; corporate debt, from bonds to commercial paper; municipal bonds; land; and stock in IPOs, secondary offerings, shelf registrations, and secondary market equity. As set forth in my article, "Seven Principles of Macroeconomics," it was a propulsion system driven by foreigners who were selling us cheap, short-term consumer goods in exchange for us, in the long-run, selling them claims on our future expected cash flows. As long as just the private sector and mere municipalities of the U.S. economy were holding out their hands for this money, the system functioned well, and the debt allowed the United States as a macroeconomy to realize what are called "gains to leverage" without incurring substantial increases in risk that can ultimately attend too much of that leverage.
Nevertheless, it was all that money in foreign reserves focusing down on the American economy that allowed us to use so much debt to live beyond our means, compliments of foreign lending sources paying us in the here and now for our land, for our shopping malls, for our buildings, for our wars, for our research and development, for our meds, for our groceries, for our nice cars, for our municipal bonds to build sports stadiums and pretty greenspaces, for our theme parks, and for every other manner of desire we have to be profligate in our pleasures and patterns of lifestyles. In exchange, all we ever had to do was surrender our future cash flows, and those of our children, and those of our children's children.
Third, Industry Consolidations
Among the many excesses we were allowed as a debt-sopping nation, our corporations were able to use money they could not possibly have generated through the old-fashioned means of merely selling their wares. The debt available to corporate America through combinations of our own Federal Reserve printing money and foreign lending afforded the more entrepreneurial of corporations the ability and funds to go on buying sprees of other corporations, and the most pernicious of these excesses resulted in consolidations into oligopolies of what otherwise could have been relatively competitive industries. The most obvious example of this is in telecommunications, but that is by no means the only place it has happened: well beyond the radar of most Americans has been consolidation in all manner of other sectors, from agriculture and banking to information technology and distribution.
The Bush Administration has run staggering budget deficits every year, save for 2001, when it was still facing the daunting task of overcoming the year-over-year budget surpluses it had inherited from the Clinton years. It was the constant, reliable, predictable presence of foreign central banks at the fire-sale Treasury auctions (where the government raises money to cover the shortfall between tax revenues and government expenditures) that kept the consequences of Republican profligacy from constricting capital markets enough to send shock waves through the economy; but as long as foreigners were at those auctions ready, willing, and able to lend hundreds of billions of dollars to the government, the private markets did not get hit in any obvious way with the consequences of capital scarcity, even though the constrictions on available global capital were starting to show more than a few years ago, although back then, the cracking infrastructure of global capital flows was not noticeable other than as odd features like the rapid ascendance of sub-prime mortgage instruments and curious but barely noticeable loosening of rules regarding lending practices and banking risk exposure allowances.
Now, those raging budget deficits have cut so severely into the global supply of capital funds that the "sub-prime mortgage crisis" has occurred, and this is overwhelmingly the result, when all is said and done, of the largest government on Earth going on a multi-year, borrow-and-spend spree that has finally collapsed the ability of those world-wide capital markets to feed both the private and public sector debt follies of this nation.
Finally, Visions of Empire
The overwrought, fevered plans of world control foisted by neo-conservatives into overriding foreign policy by the Bush Administration's warhawks would long ago have slammed head-long into the hard reality of a public being denied its credit-based consumerism had our very own Federal Reserve not been printing money like it was going out of style. As I showed in Part Three of "The Economics of Wreckage," the U.S. central bank, even after it claimed it had stopped doing so, was pouring staggering billions of dollars into the economy at a rate that would make the most proliferate counterfeiter blush. The only measures of self-control to which the Fed was able to hold true were that it stopped printing the highly liquid money ("M1," as it is designated) used by common people and it stopped reporting its stunningly irresponsible growth rate in the kind of money ("M3," as it is designated) that can be used by high-end banks.
But here's the secret. Recall above that the Chinese were pegging the yuan-dollar exchange rate by entering global currency markets to purchase dollars with yuan (through the easy route of the People's Bank of China simply taking the dollars their merchants were earning and giving the merchants far more yuan than they had actually earned in dollars). Of course, this will ultimately cause severe inflation in Chinaa spiral which is now just beginning and which readers following links above to my articles and videos will see that I unambiguously predicted would occuras all those yuan it has for years been pumping out come washing back to its shores; but a far more immediate opportunity came to the minds of the geniuses at the Fed and in the White House: if the Chinese are hammering the global currency markets, buying up dollars to make them strong and paying for those greenbacks with yuan to make the Chinese currency persistently weak, what is to keep the United States from ramping up its printing of dollars, knowing as it does that the Chinese central bank is going to sop them up as soon as they hit the global currency trading streets? This calculus by the White House and its rubber stampers at the Fed had all the elements of a symbiotic relationship made in Heaven: the Chinese wanted to keep the dollar strong against the yuan to keep Chinese imports in the United States cheap, and the government of the United States wanted a ready buyer for debt of any kind, so why not supplement those auctions of Treasury bills, notes, and bonds with some of that special, green paper we call "U.S. currency" (which is nothing other than Federal Reserve debt backed by the full faith and credit of the United States of America)? That is one of the reasons why, in the graph of the growth of the money supply aggregates, republished below, the growth rate of M3 has been skyrocketing.
Illiquid money aggregates are perfectly suitable for use in global currency trading, and our U.S. Treasury, in coordination with what is suppose to be an independent Federal Reserve Board, has been double-dipping into the global capital river. Instead of stopping the Chinese from playing their currency manipulation games, the Bush Administration has been using the Chinese pegging to keep its own game of unsustainably low taxes and out-of-control, misdirected spending from reaching the crisis stage.
And Now, Ladies and Gentlemen, the End Game
Unfortunately, the game clock is running out before President Bush can exit the White House and leave the blame to the next President, who will have to clean up the terrible mess with draconian policies we haven't seen since President Carter dealt with similar (although not nearly as severe) problems at the end of the 1970s. For those who don't keep up on historical trivia, Mr. Carter was a one-term President, principally because he did what had to be done, which hurt like Hell and deeply offended the sensibilities of Americans who like their dire consequences without the dire part.
The bottom line is clear, though: responsibility for the problems we are now facing can be laid right smack at the doorstep of the Bush Administration, where those problems will now trip up not just the neo-conservatives trying to slip out to resume their lives as unregistered foreign agents, but will also trip up the Chinese government, which has been working in concert with a White House that is not only too stupid to understand the destructive, long-term consequences of its foreign policies, but is even too incompetent to hold off the shockwave of those consequences long enough to get out of Washington before all Hell breaks loose.
The good news for Mr. Bush is that it is still illegal for a mob to chase down and hang the President. The bad news is that the global capital markets have no such qualms about doing that to the American people who were led by such a fool.
The Dark Wraith will return later with further instructions on how to be scared to death of what is to come.
The Economics of Wreckage, Part Three
The graphic at left illustrates the aggregate demand curve for a national economy. Like its microeconomics cousin, which is called a "market" demand curve (for a single good or service), the aggregate demand curve slopes downward, but that is where the similarity ends. A market demand curve is downward sloping because of the Law of Demand, which asserts that, as the price of a good or service rises, consumers will tend to buy a lesser amount of it because its price relative to substitutes is rising, thereby inducing consumers, to the extent that they can, to substitute away from it. In the national economic frame, however, when the aggregate price level rises, households cannot substitute away because the model is encompassing all goods and services of the economy, meaning that no substitution effect can occur. The national, aggregate demand curve slopes downward simply because, as the aggregate price levelall prices in the economy taken as a wholerises, national income of households must be spread over a higher overall price base of goods and services, meaning that less total output can be purchased.
The graphic at left illustrates the Keynesian short-run aggregate supply curve. Once again, like its microeconomics cousin, which is called a "market" supply curve (for a single good or service), the aggregate supply curve slopes upward, but the similarity ends there. A market supply curve slopes upward because of the Law of Supply, which asserts that, as the price of a good or service rises, producers will re-allocate productive resources toward making and selling that good or service because not doing so means incurring the rising opportunity cost of continuing to use those productive resources for goods and services whose relative prices are now falling with the rising price of the good or service under consideration. The overall, aggregate supply curve cannot be upward sloping for this same reason, though, because, again, the entire output and price level of the whole economy is being represented, which means the aggregate amount of output being supplied is not responding to shifts in productive resources away from other goods, since all goods are under consideration to begin with. The aggregate supply curve slopes upward for another reason, and this is where the Keynesian short-run scenario diverges from the long-run view held by the previously dominant, so-called "Classical" school of economics. Keynesian economic theory holds that, as the aggregate price level rises, in the short-run, producers can make greater profits because not all of the input factors they use will be getting an immediate and commensurate share of that inflationary price run-up. The founder of Keynesian economics, John Maynard Keynes, called this phenomenon "sticky wages," because labor contracts do not have instant adjustments for inflation, so workers who are facing rising prices for the goods and services they buy have to work harder, at least in the short run, to keep up with inflation. This effect affords businesses the ability to make more money because they can charge higher prices for their output, but they do not immediately have to pay their workersand possibly some of their other productive factorshigher wages, even thought they, the producers, are making extra money because of the price run-ups in the products they produce and sell. Hence, in the Keynesian short-run economy, an increase in the aggregate price level actually causes an increase in real output. This means the graphical depiction of a short-run aggregate supply curve represents it as upward sloping; and, quite importantly, that slope is very shallow in the short run because only a small amount of inflation at the retail level will drive producers to create considerably more output since workers will ramp up their productivity smartly in the face of the need to make more money to maintain their lifestyles in the face of rising retail prices and stagnant wages and salaries.
The graphic at left depicts how an economist of the Classical school of economics would depict the aggregate supply curve. Focusing on the long-run, a Classical economist would point out that it would be entirely illogical for any model to assert that a mere aggregate price level increase could possibly affect real (inflation-adjusted) aggregate output. Any short-run "stickiness" of wages or compensation to any factor of production would surely be temporary; in the long-run, every factor of production must command its share of an aggregate price level increase (otherwise, it would not be an "aggregate" price level increase, anyway), which consequently and necessarily means that the aggregate supply curveat the very least, the long-run version, which is all that matters to a Classical economistsimply has to be completely insensitive to inflated prices once the inflation has settled into the overall, aggregate price structure and level of the economy. To this point, a true Keynesian would most likely agree; although John Maynard Keynes is famous for his statement, "In the long run, we're all dead," Keynesian economics as policy guidance certainly was not intended to play a short-term trick to death lest it lose its effect. Unfortunately, this is exactly what happened; neo-Keynesians and their Presidents in the 1960s and 1970s kept trying to stimulate the economy over and over again with short-term punches of money, providing liquidity for everything from social programs and war on through to amelioration of the OPEC oil embargo price shock.
With the aggregate supply/aggregate demand model in place, the first panel below depicts the Keynesian short-term economy as a robustly downward-sloping aggregate demand curve and a very shallowly rising ("highly elastic," in the terminology of economics) aggregate supply curve. At their point of intersection, the aggregate price level is just sufficient for the aggregate amount of output being produced by the national economy to meet the amount of national income able to afford to consume that output. At an aggregate price level higher than equilibrium, more output would be supplied than could be afforded, and the aggregate price level would have to back down as inventories built up; at an aggregate price level lower than equilibrium, national income could buy more, which would cause inventories to be wiped out too quickly, and the aggregate price level would be bid upward to the equilibrium aggregate price level.
The next panel, below, gets down to the Keynesian policy action. Fiscal stimulus supported by printing money in excess of the real growth rate of the economy is enacted. Because this is demand-side policy initiative, it kicks the aggregate demand curve outward from AD0 to AD1 as the demand side of the national economy as a whole feels the effect of what appears to be greater national income. The aggregate price level rises a little bit, which is the same thing as saying that a small amount of inflation ripples through the economy, and this is the real bite in Keynesian economic policy: the aggregate supply curve is so flat because labor cannot immediately get its share of the inflation being created by the injection of excess money into the economy, so businesses can increase real output and make higher profits because one of their big costswages and salariesis not being paid more even though what they produce is commanding inflation-pushed, higher prices in the marketplace. That's why the aggregate price level in the short run does not shoot straight up to exactly reflect the excess money that was printed: labor is actually being forced to higher productivity instead of higher pay, which means inflation does not get out of hand, and real outputgross domestic product, by one measure and standardgoes up.
The third panel, below, is when the piper starts to get paid. Some of those previously "sticky" wages start coming unstuck as businesses, producing more output, have to start bidding for workers and have to deal with existing workers' contract renewals. Other factors of production previously not getting their share of the inflation settling into the economy start demanding their fair share, too. All of this means that the aggregate price level rises more aggressively. With more inputs costing more money, businesses find that the greater profits they were previously realizing with higher output prices and fixed input costs are eroding, and aggregate output begins to ease back. A further problem emerging is that, whereas that jump in real GDP might have been attended by lower unemployment, now that real GDP is pulling back, unemployment is retracing its steps back upward. This was the difficulty faced by neo-Keynesian policy in the 1960s and 1970s: fiscal stimulus designed to push the unemployment rate down to some target would do so only for a while; then unemployment would start rising again, which gave Congresses, Presidents, and ever-willing-to-help Governors of the Federal Reserve the impetus to hammer the economy with more stimulus, continually chasing an elusive, desirable "natural unemployment rate" that kept slipping away into stronger and stronger spirals of inflation.
The next panel, below, takes the long view the Classical economists had described. At the end of any series of short-run plays to push real GDP higher by stimulating aggregate demand, the end result will be that all factor prices will finally impound their share of the inflation created by fiscal stimulus paid for by increasing the money supply at a rate faster than the growth rate of the real economy. The so-called "monetarist" school of economics, in its modern form, asserts that a central bank should have one and only one duty with respect to monetary policy, and that duty is to rigorously maintain the stability of the aggregate price level. To this end, propping up the pandering fiscal programs of Presidents and Congresses, helping out the economy when recessions are looming, and all manner of other excuses for manipulating the money supply to one intended purpose or another will lead to one and only one thing: inflation. In another vein of modern conservative economic thought, the so-called "supply-side" school of economics points out that, if the long-run aggregate supply curve really is vertical ("perfectly inelastic," in the terminology of economics), then aggregate demand-management policies are exactly useless except to create inflation; on the other hand, stimulating the aggregate supply curve to shift to the right would not only cause real output to increase, but would also cause the aggregate price level to decrease, meaning that supply-side fiscal policy would increase GDP and deflate prices. (The part the supply-siders avoid discussing at length is the very real possibility that, just like aggregate demand-management policies have a consequential, show-stopper effect on the supply side, aggregate supply-management policies might very well have a similarly consequential, show-stopper effect on the demand side.)
The fifth panel, below, shows the short-term view of what will ultimately come about from the best efforts of policy-makers to use excess growth of the money supply to prop up the economy. The aggregate price level is now higher, GDP has returned to what it was before the fiscal stimulus was executed, and the aggregate supply curve is steeper, reflecting the inevitable expectations in factor markets that hints of price increases in output markets have to be matched as rapidly as possible by commensurate increases in compensation, meaning that producers have less room to increase real output to make higher profits before the factors of production start demanding higher rewards. Although businesses can postpone this era of reckoningand with the help of certain Presidents and Congresses, they havethe eventual effect is that even the short-run aggregate supply curve becomes more and more inelastic, to the point where inflationary expectations become so embedded that factors of production act with forethought to anticipated excess growth of the money supply, and no one believes the Federal Reserve when it claims that it has stopped accommodating uncontrolled spending and irresponsible tax cuts.
As mentioned above, the Keynesians certainly understood the long-run effect of excessively expansionary monetary policy and would have prescribed using growth of the money supply only in a disciplined, counter-cyclical manner. Unfortunately, the temptation for most Presidents and their yes-men has been too great, and such expansionary policies have rarely abated and, as would have been prudent, reversed during economic booms. As the shining example of where this leads, the result was that the short-run aggregate supply curve became less and less elastic through the 1970s, and markets for labor, as well as for other factors of production, became so proactive that inflationary monetary policy actions in support stimulative fiscal policies came to be expected in advance of their actual occurrence, so, by the end of the '70s, large and increasing "expected inflation premiums" were finally being impounded into wage increases, into price increases of final goods and services, and into interest rates on loans. The effects became utterly debilitating: interest rates were impounding such high expected inflation premiums that they were causing a major slowdown in the U.S. economy, and the government had no more room to use fiscal or monetary policy as a countervailing force. The short-run aggregate supply curve had become every bit as perfectly inelastic (vertical) as the long-run version, so any stimulus to push the aggregate demand curve outward resulted in nothing but pure inflation from the get-go. In what arguably stands as the sublime example of a U.S. President falling on his sword, President Jimmy Carter in 1979 appointed hard-core monetarist Paul Volker to head the Federal Reserve. Volker immediately set about crushing the money supply, commencing a long, grueling process of absorbing all of the excess greenbacks that had been pumped into the economy from the era of Jack Kennedy on through to Gerald Ford. Because interest rates are the price of money, when the Fed rapidly contracted that money supply, interest ratesalready high because of the expected inflation premium being impounded in themwent into orbit. Mortgage interest rates. for example were in the 25 percent-plus range. Worse, because labor, capital, wholesale, and retail markets did not believe for a minute that the Fed was finally serious about defeating inflation (Ford's "Whip Inflation Now" campaign comes to mind), the expected inflation premiums in interest rates and other price increases did not vanish, certainly not until everyone finally grasped that Volker meant business and did not care just how close to death the economy was getting in the regime of interest rates that, in another time in history, would have gotten bankers burned at the stake.
Eventually, after the American electorate kicked Carter out of office for being such a terrible President, the expected inflation premiums began to vanish from interest rates and other prices, and the economy got back on its feet and grew fairly comfortably throughout the first part of the 1980s. The aggregate supply curve, which had become so perfectly vertical, settled back to a more flattened, Keynesian short-run profile, and modest counter-cyclical policies by the government could once again work. A sustained stewardship over monetary policy by Governors of the Fed who considered their exclusive job as maintaining stability of the aggregate price level allowed markets the confidence to view the aggregate supply and demand conditions as reflecting far more of the real, normal, private activity of the economy than the dynamics caused by opportunistic government intervention.
Interestingly, as shown in Part One of this series, the years of the Bush Administration have been hallmarked by yet another factor of production experiencing "sticky" compensation: the stockholders, themselves, of publicly held corporations have had flat to negative real returns on their investments during the period from 2001 to present, indicating that common shareholders, be they investing in blue-chip stocks or run-of-the-mill NASDAQ equity, are losing to inflation. This means that businesses have had not one, but two resources from which they have been profiting through increases in productivity: both human capital and financial capital have been contributing to real economic growth in which they have realized little, if any, inflation-adjusted reward. The aggregate supply curve is not vertical in the short run only to the extent that suppliers are able to achieve real increased profit by raising prices and increasing output without having to pay labor more. As was demonstrated in Part Two of this series by the very fact that wages and salaries have persistently and consistently lagged general inflation throughout the last half-century, at least for several generations the short-run aggregate supply curve has been relatively flat for considerable periods; but now, in these first years of the 21st Century, that short-run flattening effect has been boosted by the depletion of real gains by not one, but two factors of production, labor and equity capital. This goes a long way toward explaining why rewards to other factors like land, physical capital, and the human capital of top managers have been rising so aggressively: they have had extraordinary leeway to absorb part of the share being lost both by rank-and-file workers and by similarly rank-and-file equity investors.
But surely, one might argue, a President as conservative as George W. Bush, buttressed by a solidly Republican Congress, would not have gone hog-wild with using monetary policy to prop up fiscally irresponsible spending and taxation policies just to keep the American economy growing. Unfortunately, the recordthe part the Federal Reserve still reportsspeaks otherwise. The last graphic, below, tracks the three broad monetary aggregates, M1, M2, and M3, with the reporting of last of these, M3, having been suspended by the Fed in early 2006 for reasons that are rather immediately obvious.
In the Summer of 2004, the Federal Reserve Board, under the leadership of its new Chairman, Ben Bernanke, intoned that the central bank would no longer pursue an "accommodative" monetary policy, which was taken to mean that the Fed's excessive printing of moneyfirst, to blunt the recession of 2001, then, later, to prop up massive tax cuts and a global war on terror, among other thingswas at an end. The graphic above tells a decidedly different story.
By way of brief explanation, the three money stock aggregates go in order from money that is the most liquidthat is, the most easily traded for goods and serviceson through to money that is relatively illiquid. M1 reports the amount of cash and currency, plus demand deposits (bank checking accounts), Travelers Cheques, and negotiable order of withdrawal accounts (such as "checking" accounts at credit unions). M2 includes M1 and money market accounts, small time deposits, and smaller savings accounts. M3 includes M2 plus large time deposits and very large savings account-type instruments, institutional money market accounts, short-term repurchase agreements, and other large deposits like those in eurodollars. In the money aggregates graph, above, the Fed was, indeed, serious about clamping down on growth of the money supply, as long as "money supply" is taken to mean M1, the cash, currency, and checking accounts most normal people have; in fact, by 2006, the central bank had brought the year-over-year growth rate of this money stock down to an average of about zero, indicating a strict monetary discipline in line with an anti-inflationary policy regime.
However, the growth rates of the broader money aggregates render compelling evidence of a far different Federal Reserve when it comes to money in the larger metrics. After what appears to have been a spirited contractionary effort at the beginning of the post-accommodative period, the central bank let loose of M2 and M3. The growth rate of M2 has been slowly accelerating to the point where it stands at better than five percent, which is unquestionably much higher than that of the economy. But the big not-so-secret secret is M3, the aggregate the Fed stopped publishing in March of 2006. This broad, huge money stock, representing everything in M1 and M2, plus giant institutional deposits, eurodollars, and others masses of big money, has been growing at an accelerating rate that now tops fifteen percent a year, roughly five times the most optimistic estimate of the growth rate of the American economy; and this has been going on since long before the recent, widespread talk of a looming recession.
Worse yet, all three of the aggregates were growing well above the growth rate of the economy throughout the Bush Administration, with the growth rate only of M1 finally being cut to nearly zero in order for the Fed to show grave dedication to fighting inflation.
Recall the explanation above about what happens to the aggregate supply curve when economic stimulus through expansionary monetary policy continues for too long. Once that curve has become highly inelastic, all the demand-management policy initiatives in the world will do no good to pump up real GDP; and with a Federal Reserve allowing the total money supply to grow at an ever-accelerating rate, the inevitable spiral of inflation will most assuredly come, and it will be the next President, his or her Federal Reserve Board, and the Congress that must take the drastic, painful, awful steps necessary to rectify, repair, and clean up what will by this time next year be an economic catastrophe created by the stupefyingly irresponsible policies of George W. Bush, his Federal Reserve, and a Congress controlled for most of his Administration by Republicans who, in retrospect, appear to have had no grasp of the long-term consequences of their economics policies.
As John Maynard Keynes said, "In the long run, we're all dead." For the United States, the long run is about to arrive.
The Dark Wraith trusts the American electorate to vote for a President thoroughly capable of managing the economics of wreckage.