Boozing with central banks

In mid to late 2007, I had a couple of beers with a very impressive individual who had just returned from a rather important US Federal Reserve conference. Apparently, the conference had been abuzz with discussion and dark rumour of an ensuing economic accident. My drinking partner told me that there was a distinct possibility that the US would lose a major bank and that the Federal Reserve was ready to stand firm in the face of the trouble to come and not cut interest rates.

I said at the time that I agreed with the first half but on the second suggested that my compatriot had perhaps had too much to drink.

To understand why the Federal Reserve may have at least been thinking this way in late 2007, let’s turn to some history. I wrote the following passage in The Great Crash of 2008, co-authored with Ross Garnaut:

The story of the great Anglosphere asset bubble begins with an atypical period of economic calm. Western economists and officials began to note in the late 1990s that volatility in their economies was in decline. By this they meant that the frequency and depth of swings between periods of growth and recession had diminished. Inflation was under control and there was less need to raise interest rates to high levels. This phenomenon was called The Great Moderation by the economist James Stock of the Kennedy School of Government, Harvard University.

The term caught on.

Central banks around the world claimed that The Great Moderation was the result of their increasingly competent use of interest rate policy. However, Stock attributed the decline in volatility as much to the good luck of living through a period with limited external shocks, such as commodity price spikes induced by supply disruptions. Other explanations for The Great Moderation have included the mitigating effects of information technology on the inventory cycle; the anxieties and competitive pressures of globalisation deterring labour unions’ pursuit of higher wages; the increased role of services in the economy and the corresponding reduction in the potency of the ‘stock cycle’; and the disinflationary effects of expanding exports from China and other developing countries with low labour costs.

Whatever the mix of forces that produced subdued consumer price inflation through the early 1990s, the calm enabled a new set of central bank practices to emerge. Liberated by the apparent defeat of inflation, the United States Federal Reserve under Alan Greenspan adopted a ‘risk management’ approach to monetary policy during crises. Greenspan, who had been appointed chairman of the Board of Governors in 1987 and held the post for a record period of almost twenty years, repeatedly shifted US interest rates lower in response to financial and other shocks. He did so following the 1987 stock market crash, the first Gulf War, the Mexican debt crisis, the Asian Financial Crisis, the Long Term Capital Management crisis, Y2K, the ‘tech wreck’ stock market crash and the September 11 terrorist attacks. No matter what the crisis, Alan Greenspan, his sagging, impish face supporting oversized spectacles, emerged to announce remedial interest rate cuts.

The markets loved him for it. The phrase ‘Greenspan put’ was coined to describe traders’ confidence that Greenspan, who became known as ‘The Maestro’, would always boost liquidity to prevent falls in asset prices following a shock. Over time, this lifted asset valuations, narrowed interest rate premiums on riskier loans, and led to lower pricing of risk generally. If a multitude of forces worked together to subdue economic volatility in the early 1990s, the ‘Greenspan put’ continued the calm throughout the latter 1990s and into the new millennium as asset prices rose and rose.

John Taylor, a Stanford University economist, makes the point that by keeping their interest rates low, US authorities caused interest rates in other countries to be lower than they would have been. This played a role in the swelling of the technology stock market bubble, as well as in the expansion of the housing bubble that began at the same time and continued well after the former had ended.

In short, through two decades of easy money, Greenspan transformed US central banking from the practice of taking away the punchbowl when the economic party got too crazy, to the practice of spiking the punchbowl whenever the folks tried to leave the party. In 2007, according to my drinking buddy, the Fed under Bernanke was determined to restore some of its former sobriety.

To describe this as too little, too late seems the understatement of the century.

Fast forward to today and the US Federal Reserve faces a similar test. As we approach the end of QE2, the US economy is sputtering once more. The causes are myriad: the ongoing housing collapse, subdued credit, high unemployment, a structural shift away from labour’s share of national profits and a steady but slowing revival in US manufacturing.  The question is, what will the Fed now do about it?

On the one hand, with unemployment now rising again, Bernanke could justifiably argue that there is little chance of inflation or inflation expectations rising sustainably. And, with further fiscal stimulus under a cloud, the US economy could very easily stall as the rest of the world slows, notwithstanding some recovery in Japan. This is an argument for more stimulus.

On the other, it is surely self-evident that the effects of the ‘Bernanke Put’ are now far more pervasive even than those of his predecessor, with risk premia flattened across most of the global economy, mass correlations across asset classes and real asset prices very inflated following QE2. Here’s the CRB Index:

The choice of the Federal Reserve is clear to my mind. They can continue two decades of  spiking the punch bowl when financial markets get a bit tired and, in doing  so, bring on a blowoff round of commodity inflation. That may stoke foreign demand in the short term but will quickly prove self-defeating as nations exposed to the commodities complex, on the demand and supply side, stamp on the monetary brakes all at once (Australia included). It’ll be a spectacular boom and bust.

Or, the Feds can do what they are supposed to do. They can take way the punch bowl (though at this point, it’s more like insisting party goers drink from a glass than stay face down in the Wedgewood).

The result may well be slow global growth, but that’s the better alternative.

Will it happen? It’ll take real cojones. Perhaps Bernanke can brace himself with a bit of Dutch courage.

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Comments

  1. Nice piece, H&H. What strikes me is the irony that Greenspan did what he did to avoid the US suffering a similar fate to Japan’s. That was the fear that drove it. And what happened? A fate similar to Japan’s. It is saying something about late stage capitalism, it seems to me. The only bright spot is the mid stage capitalism of the emerging world.

  2. Very interesting piece. I agree re the Fed. Unfortunately they are going to be put in a very tough position if this nonsense with the debt ceiling continues and Congress overdoes it on the fiscal tightening.

    • “this nonsense with the debt ceiling continues and Congress overdoes it on the fiscal tightening.”

      overdoes it on tightening…haha…14 trillion and counting…?

      • Yes. The US has a long-term fiscal problem, which is almost entirely due to soaring medical costs (thanks to an extremely inefficient system designed to funnel money into the hands of private insurance companies). The fiscal problem is made worse by irresponsible tax cuts. Some time in the future, this will cause inflation if the US continues to run large public deficits when the economy is back to full capacity. But we are so far from full capacity it just isn’t funny.

        If you tighten fiscal policy in a recession, you make the problem worse.

        • The US has a fiscal problem which is almost entirely due to high medical costs????

          You cant be serious

          • I’m completely serious. Are you?
            Look at any of the long-term budget projections and they will tell you exactly the same thing.

            The biggest long-run issue is the rise in projected liabilities for government healthcare programs like Medicare and Medicaid. This isn’t controversial.

          • From memory, the US spends more than double than its nearest nation on GDP per head on healthcare – something like 20%, yet gets an outcome that is worse.

            We are slowly moving down that track if we are not careful….with health premiums going up 6-7% a year (on average), and Medicare/Old Age Pension costs at similar rates, its inevitable.

          • So are you saying that if medical costs had risen as forecast by the US they would be in a strong fiscal position??

            To say that their fiscal problems are almost entirely to soaring medical costs is being far too kind and dismissive of their gov spending policies of recent times.

            I agree their medical system is very inefficient and healthcare costs are a large chunk of gov spending but there are a lot of other reasons why they have fiscal issues other than rising healthcare costs.

            The US’s fiscal problems are due to their unsustainable fiscal policies. Continually running budget deficits year after year while jawboning deficit reduction measures that have done nothing to reduce the deficit – combined with poor forecasting, reductions in GDP and resulting tax revenues.

            As it stands the US needs to continually borrow to carry on and this has been their MO for a while. This path was always going to end in fiscal problems unless someone stepped up and tightened spending, which till now has not happened.

          • Stacks — I am talking about the long term here, which is what really matters if you are worried about budget “sustainability”.

            But even in the shorter term, it is not the stimulus spending that is the issue. The Bush-era tax cuts and the wars in Iraq/Afghanistan have had a much bigger budgetary impact. On top of this there is a large nondiscretionary portion — tax revenues will always plunge in a recession, while automatic stabilizers (unemployment benefits, food stamps, etc) rise.

        • The three wars the US are fighting and the massive bailout of the private sector in 2008 also played a part in racking up that 14 trillion…in my opinion.

          You say:

          “If you tighten fiscal policy in a recession, you make the problem worse.”

          What is the problem? Unemployment…yes you will. This doesnt mean you shouldnt tighten. BEcause the alternative of tightening is a Krugman-inspired deficit spending spree by crooks and cronies that only distorts people’s investment decisions and leads to malinvestment of capital.

          How long until the Keynesians just give up and admit they dont understand the economy in 2011

          • You’re right about the wars, etc, but I was talking about the longer term. And in the longer term, it’s medical spending that is the biggest issue.

            Why does the alternative to fiscal tightening have to be a “Krugman-inspired deficit spending spree by crooks and cronies”?

            There are a million things you can do. Retraining programs for the unemployed. Cut payroll taxes. Fix the country’s shoddy infrastructure, etc etc.

            You talk about malinvestment, but there is nothing more destructive and inefficient than having a large portion of your workforce sitting idle with their skills wasting away.

          • …and people could just admit that we can’t even largely escape the consequences of root problems that lay way back in time…

            Much talking about “what can and should be done” is really just shuffling deck chairs on the Titanic.

            Many (not all) problems lay in the fundamental nature of the systems themselves – and the CANNOT be regulated without Totalitarian oversight.

            Deflation and default are THE BEST tools we have going forward – we need to stop trying to escape and re-distribute the consequences of our collective (past and present) actions.

            In that sense, one of the core roots is poor morality and accountability.

            If we keep going the way we are going (ie. persisting with the types of systems we have), then we are not just looking at drawn-out Stagflationary Depressions, but the abandonement of the market economies and free-societies themselves.

            My 2c

    • fiscal tightening will ultimately cause a double dip which is probably what the republicans are hoping for. Despite Obama’s limp dud-acality re:economic policy there is no obvious viable republican alternative leader so they need things worse.

      • Its not a double dip….there was never a recovery to begin with. It was a mirage…fuelled by Government deficits making up for falling demand…pure KEynesianism…AND IT FAILED!

        It delayed the great recession, but never beat it.

        This is what the Austrians said would happen. But hey, people love their ‘stimulus and bailouts’…until we become Ireland and Greece

        • You conflate so many issues.

          By definition if you cut back government spending then GDP falls unless the G cutbacks are matched by private sector (or external sector) increases. That is just arithmetic without any value judgements about whether cutbacks are good or bad. I’d invite you to visit the USA and see for yourself if you actually think private sector spending is going to increase any time soon. And the US runs large trade deficits.

          Ultimately job growth has to come from the private sector and as of when I left there a few months ago there wasn’t much sign of that and the stats haven’t changed much. In the absence of private sector spending do you let things get worse? It might have helped if the government ramped up infrastructure spending rather than bank welfare.

  3. The FED don’t understand the structural shift in the US economy, and what might have worked before probably won’t now. It goes all the way from manufacturing to education. The statistics of students in the US now capable of advanced degrees is dropping dramatically. That has an impact on an economy that algorithms don’t look at. If you work in the US in any big corporation the percentage of locally born staff is very low. Bill Gates, and many other industry leaders keep asking for increases in H1B visa, but caps, and terror concerns make it hard to grow a company inside the US. That has benefits for countries like India etc., but it’s one of the structural problems. In manufacturing for example, you’re got the outsource everything to keep the quarterly figures within expectations, and over a period of time you’re created a wasteland. My explanation is simplified, but there are many examples like this you can research.

    I’ve worked and lived in the US for a long time, and there are many great companies there, and that will continue, but the survive by being adaptive not through good policy.

    I don’t believe that the FED can fix this current problem, and it’s not if, but when we’ll see the fall out. The politicians won’t consider real fiscal measures so what can the FED do now?

    Unfortunately, Australia, and every other nation is going to be hit by the US’s problems as the global monetary system is not fit for purpose. We’ll just keep tinkering with it until the wheels fall off.

    • Great points, Adrian. It’s been increasingly obvious for two cycles now that the tools of Fed have lost their mojo. Would have been the same here too without mining.

      • The sad thing is that the US could make the cuts and get back on track, but it’s 99% likely they won’t. They can’t do spending cuts, or austerity.

        Totally agree on the mining. I can’t get it out of my head however, when Ken Henry said that mining didn’t save Australia during the GFC. Now he’s working for Julia as an adviser.

        What I do know on mining is our sovereign risk is much higher now, and the MD’s I talk to see the mining future outside Australia. The Government are clueless on this. When they see the results it will be too late. It takes 10 years to get a big mining project going here, and five years elsewhere, and with all the compliance it’s hard for small companies to make that jump without being taken over. These guys are into big government, and no vision. I’m not sure the Libs are any better, but they generally won’t send us broke like this incompetent lot.

        On another topic a big chunk our farming land will be foreign owned before long as well. The threshold is about AUD 250M before anyone takes a second look. [Food security] is worth a blog if you haven’t done it already.

  4. Brilliant HnH…

    What I would say is that the Fed, RBA and all other central bankers seem to be cut of the same ilk. None of them want to be known as the one in charge that allowed deflation of asset prices through the rising of rates.

    They will NEVER willingly allow this to occur…they will have ot have it forced upon them by inflation of political forces.

    Its the same with Western welfare states. As Greece and soon Portugal and Spain will show, austerity will never be accepted by the public. They will have to have it forced upon then by external forces (bond vigalantes, IMF, EU etc…)

    This is the sad realisation that has turned me into a libertarian…there is very rarely ‘good public policy’

    • I love the foresight in hindsight!

      I’m totally in agreement with Stavros. Is the systemic problem that as a society if we leave the hard decisions in the hands of a few, they’ll never be made unless forced. The old adage that its better to ask forgiveness than permission comes to mind as well??

    • …agreed: no one wants to be the one to oversee mega-deflation: inflationary policies will be used to kick the can down the down (in effect) until high (or even hyper) inflation looks is being experienced, and the social and political pressures are “too great”.

      Makes sense, really, given that the current economic and monetary paradigms are not actually about economic responsibility and quality in and of themselves, but actually an arbitrary means of achieveing certain social and political goals…

      …and, yes, i’m pretty sure i’ve read that in official prublic docs, such as at the RBA! Agh!

  5. Good article. The only thing I would say is that low interest rates during the 90’s and 00’s weren’t due to easy money.

    As Milton Friedman said “Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy”

    The low nominal rates were a reaction to extremely tight money during the 80’s. Where Volker basically said to the markets: “We will raise nominal rates to what ever level necessary to crush inflation expectations”. Since the markets believed this message, central banks were able to anchor expectations at a very low level for the next 25 years by adopting low inflation targets.

  6. You co-authored a book with Ross Garnaut!? Haven’t you also been pushing the carbon tax/credits with Mr Coyote?

    A couple of weeks ago you wrote (at least I think it was you) what I thought was a good article regarding the market & its ‘milk money’, showing a decent understanding of market dynamics, yet here you are on the one hand saying “they can take way the punch bowl…that’s the better alternative” while on the other supportive of a carbon ’emission trading scheme’. This ETS is as big a punchbowl as has ever been conceived in the back offices of Macquarie Bank.

    Maybe this ambiguity is derived from your statement, “The story of the great Anglosphere asset bubble….Inflation was under control”.

      • You seem on the one hand to be aware of, and critical of, central bank credit induced ‘asset bubbles’, yet on the other you are supportive of what will be one of the biggest bubbles ever conceived, apart from the dollar itself.

        I have read your comments in Mr Coyotes articles, you seem supportive of ‘carbon credit’. My apologies if I have misread your comments, however the fact you have collaborated with Ross ‘carbon credit bubble’ Garnaut makes me doubt I have.

        • Well…

          a) I am supportive of pricing carbon through a market, yes, I think you and I along with everyone else will do a better job of finding mitigation solutions than any beaurocracy can.
          b) Part of that should be rigorous reguation of said carbon market.
          c) One of the reasons I am so critical of the Greenspan Fed was its libertarian support for deregulating the financial system.
          d) I therefore don’t see a contradiction…

          • HnH

            In relation to c) – do you think that the financial system was working in a pure libertarian way during 2002-2006?

            Also, do you support the role played by Fannie May and Freddie Mac in the crisis?

            I dont see too many Libertarians supportive of the US financial system.

            In fact, the whole sham is affront to the idea of small Government and the promotion of individual responsibility.

            You obviously consider yourself some form of free-market, social democrat, progressive….etc..

            But please don’t denigrate Libertarians by blaming us for the GFC….its totally misguided.

          • re: (c), HnH…

            …I picked up SoN on this same sort of comment…

            Most liberatarians would not really support the paradigm much at all, as it just has too many “non libertarian” aspects, such as the central setting of the price of money.

            So, at best it could be called “weak” (or even ignorant) libertarian practice.

            I would personally call it a belief is the Efficient Market Hypothesis, rather than a strong libertarian application.

            my 2c

    • Sam Birmingham

      @JMD One could mount a decent argument that it is the *absence* of a price on carbon which is the environmental equivalent of the financial sector’s “punch bowl”.

      If you accept that there is the slightest risk that mankind is exploiting the Earth in an unsustainable manner which has not been factored into the prices that consumers pay, then what we have is a negative externality. We can mitigate that by charging for the externality.

      Just because banksters will do their darnedest to find a way to make a buck in that process doesn’t mean it’s not worth considering.

  7. Another great post, but all I could think about was where can I get one of those great punch fountains!

  8. Alex Heyworth

    Why can’t the Fed recognize the basics? Monetary stimulus stimulates asset prices. Fiscal stimulus stimulates increased production. When capacity utilization is as low as it currently is in the US (under 70 per cent, IIRC), fiscal stimulus is the only useful response. For those concerned about the debt level, increasing capacity utilization will enormously boost tax revenues, as well as reducing outlays.

  9. Am I the only person who remembers Greenspan talking about ‘Irrational Exuberance’? Or the inverted yield curve? The fall of the Soviet Union? 911 and the war in Iraq? It’s never just simply a question of ‘taking away the punchbowl’.

    Under Greenspan, the US Fed believes that market boom and bust is unavoidable. The role of the Central bank is to keep an eye on inflation, and then prevent economic collapse by flooding the market with money in the event of a crisis. It worked after 1987 market crash, it worked after the dot-com boom, however it didn’t work for the GFC for two reasons : the size of the bubble, and the amount of US foreign debt. (over 50 trillion)

    US household and corporations have been borrowing money to fund increased consumption even when their economic production declines due to the aging population. A central bank can only set interest rate, it can’t alter demographic realities.

    • It can price credit.

      I have some small sympathy for Greenspan from 2005, when he discovered the bond market conundrum just as I have now for Bernanke for the same reason: the pegged yuan. But he still didn’t hike and shoulda.

      There’s always an excuse. The whole point is you gotta be mean.

      • “The whole point is you gotta be mean”

        And here in lies a great weakness of our system of ‘democracy’.

        As far as I see what the ‘people’ want and will vote for is often not what they actually need.

        And if your job and income is reliant on keeping folks happy with your decision, where is the incentive to make the tough decisions on the hard issues. The damn MSM tries to make every solution into a simple soundbite. Some of these things are very complex issues and there is no easy way out.

        Just because it is popular doesn’t mean it is the correct course of action with the best outcome for the maximum number of people.

        I guess none of us want to be the losers in the game, but there are always going to be winners and losers in any decision. And sometimes we, as a society, have to swallow the nasty medicine to make thing better, even if it sucks at the time.

        I wish I had a solution (I don’t), but I think our current system is not one that leads to optimal outcomes if it is based on what is most popular with the most number of voters.

        But this does sometimes keep me awake at night.

  10. The main thing that has been happening in the world economy has been the unimpeded growth of the financial sector such that it now totally dwarfs the real economy.

    Perhaps this would not matter so much, but financial “services” are mostly just highly developed forms of speculation that, allowed to go unchecked, brought us perilously close to system-wide collapse in 2008. The losses associated with endemic and officially-approved speculation are now having a sclerotic effect on the real economy: on jobs, social services and public assets, especially in those countries with the most highly-articulated financial sectors.

    Financial power has usurped political power in almost every respect. Even the mighty US Government no longer has autonomous power.

    The only way out of this is to reform the financial sector – regulate, down-size, tax and deflate the monster before it consumes us all!