The Fed is already creating the next bubble

By Edward Harrison On Jul 9, 2014

Last week, I wrote a fairly comprehensive piece laying out some of the macro issues around the Fed and other central banks’ ultra-easy monetary policy. The gist of that piece was that, due to the political economy, monetary policy is now seen by policy makers as a good way to ‘steer’ the cyclical economy through peaks and troughs. Fiscal policy, while used effectively during the depths of crisis in 2008 and 2009, is largely off the table.

I would make the case that monetary policy is wholly inappropriate as a tool for steering against cyclical ups and downs exactly because it only has a secondary impact on the real economy and must act through the credit markets. As such, monetary policy is always about increasing credit in order to affect the real economy and, thus, is always at risk of creating financial instability. Does that mean it can’t be used? My answer is below.

I am going to make this a longer-form piece to cover both the analytical framework here as well as the current issues being debated. This piece is an outgrowth of the ongoing controversy created by the BIS’ latest warning about ultra-easy monetary policy and the defense of easy money proffered by those who see it as the only mechanism available to support economic growth and full employment.

History of the Political Economy

When the global economy collapsed into Depression in the 1930s, policy makers and economists ushered in a sea change in thinking about economics, economic policy, the financial system and financial regulation. The laissez-faire of the pre-Depressionary period was out and heavier macroprudential regulation was in. Classical economics ceded ground to Keynesianism as government intervention became de rigueur.

Eventually, however, during the 1960s the Bretton Woods global monetary system began to come apart, and with it the economic consensus. The Bretton Woods system collapsed in 1971 when the United States ended gold convertibility under President Richard Nixon. And within two years the global economy was hit with the first of two oil price shocks. The result from these two events was high inflation, uneven economic growth and high unemployment.

During this inflationary period, the West witnessed tremendous social unrest, bordering at times on anarchy. In the UK, for example, the RPI index twice peaked over 20%, shares dropped over 90% in inflation adjusted terms, and civil unrest and strikes were nearly daily. I would call it an inflationary Depression of a magnitude similar to the Great Depression’s deflationary one. For policy makers, it was a frightening period that broke the economic consensus and ushered in monetarism and neo-liberalism as the new economic paradigms to follow.

The key here is that using fiscal policy to steer the economy and heavy government control and intervention were out. Instead, the primacy of monetary policy with first money supply and then interest rate targeting as well as structural reform toward laissez faire were in.

The Asset-Based Economy

The result of the shift toward cyclical monetary policy steering was an asset-based economic model because monetary policy is dependent on credit markets for its transmission mechanism.

The fiscal agent adds net financial assets to the private sector by deficit spending. The issuance of government IOUs to the private sector without a corresponding offset in terms of taxation means net financial assets flow into the private sector as a result of fiscal policy. Net financial assets can also flow out of the private sector, when taxes exceed spending when the government has a surplus.

The central bank is never permitted to add net financial assets to the system. It can only conduct asset swaps as it does with quantitative easing, swapping base money for existing financial assets and changing private portfolio preferences for the types of liabilities it buys and sells and changing risk premia and term premia throughout the economy.* (*UPDATE: Stephanie Kelton notes to me in response here that interest on excess reserves at the Fed creates net financial assets in the private sector. So, I should not have said never. I would call this a quasi-fiscal operation though.)

Having said that, the principle way central banks conduct monetary policy is through interest rates. They raise or lower rates based on inflation, employment or economic growth. And these rates alter the supply and demand for credit generally and shift demand between different sectors of the economy or asset classes of the capital markets depending on private risk preferences. When the Fed sets rates below the prevailing yield and above the prevailing risk preferences for sectors, investors are forced into riskier asset classes to chase yield. At the same time, debtors can be enticed to leverage up based on lower debt service costs, something we now see in the US household sector with zero rates leading to generational lows in household monthly debt service costs.

This is the essence of monetary policy: it’s all about credit. And to the degree that monetary policy has any impact on the real economy, it is because credit has increased and debt service costs have decreased.

The result of using monetary policy to steer the economy cyclically then is an asymmetric policy that has debt levels growing on a secular basis through economic cycles. The economy becomes an asset-based economy by dint of the fact that growth becomes correlated to the ability to increase credit and leverage on a secular basis, using rising asset prices as collateral against that increased credit. When I took a brief look at the Asset-Based Economy at economic turns after the Great Financial Crisis, the policy asymmetry was clear. In every single sector of the US economy except the government sector increases in debt associated with cycle trough monetary stimulus was not unwound at the peak over a full three decades.

Now we are in a deleveraging cycle that, despite the present cyclical upturn, I believe will continue through more cyclical downturns such that economic growth will be poor and deleveraging will dominate the macro outlook for years to come. The attempt by the Fed and other monetary agents to steer the economy without the aid of fiscal policy and credit writedowns and to resist this private sector deleveraging trend will lead to severe crises during those downturns. Zero rates won’t fix this. No amount of quantitative easing will fix this. Instead, these policies will skew capital allocation to higher risk and higher yield sectors of the economy, pumping up asset prices, creating higher leverage and leading to more credit writedowns at cyclical downturns.

More below for subscribers.

Separation of Fiscal and Monetary Policy

When you hear hawks in Europe talking about quasi-fiscal policy and hawks in the US like Charles Plosser in the US arguing for a limited central bank, what they are arguing is that fiscal and monetary policy have different transmission mechanisms and they want to separate and narrow their roles as much as possible in order to provide the most effective macro economic policy possible.

For example, during the Euro crisis, I wrote the following:

So when Mervyn King talks about the ECB “buying sovereign debt of national countries, which is used and seen as a mechanism for financing the current-account deficit of those countries”, he is talking about a policy choice that helps the national governments achieve their fiscal aims, a quasi-fiscal role.

The ECB has balked at doing this – rightly so, I might add (in a brief role as policy advocate). Their position is that the fiscal agent is elected by a democratic process and must solely take on the responsibility of achieving macroeconomic objectives outside of price stability.

Plosser says this outright:

Good governance requires a healthy degree of separation between those responsible for taxes and expenditures and those responsible for printing money.

The original design of the Fed’s governance recognized the importance of this independence.

[…]

Such independence in a democracy also necessitates that the central bank remain accountable. Its activities also need to be constrained in a manner that limits its discretionary authority. As I have already argued, a narrow mandate is an important limiting factor on an expansionist view of the role and scope for monetary policy.

I don’t believe Plosser will have his way. The existing economic paradigm is still firmly entrenched despite the Great Financial Crisis. Given the weakness in the economy and labor markets and given the mandate of central banks to act against this weakness and given the reluctance to use fiscal policy as a ‘steering’ mechanism, we are likely to see even more aggressive policy until the signs of overheating due to asset price inflation and credit bubbles are all around us. This is exactly what we saw during the TMT bubble, during the global housing and credit bubble. And I believe we are seeing it now.

What would you have the Fed do?

The key here is fiscal policy. Look at the discussion in Europe. The periphery is still in a world of hurt and even Ken Rogoff is saying he doesn’t see this ending without government credit writedowns. But Dijsselbloem says no to relaxing fiscal rules. Juncker also says no. And what else would you have them say? After all, the national governments of the eurozone are currency users. Periphery yields are collapsing, yes. Nevertheless, they have zero ability to prevent default if markets develop another case of European periphery sovereign debt revulsion. Dijsselbloem and Juncker understand this and want to limit bad outcomes.

In the US, Japan or Britain where the state is sovereign in its currency, states can prevent default indefinitely. Japan has government debt to GDP at over 230%, more than double the level in the US and the UK. And there has been no default. And for those arguing that there is a default via the pernicious inflationary route, the opposite has been true. Japanese bonds had been increasing in value for well over a decade due to deflation. Only now are we seeing any inflation in Japan.

I would argue that the Japanese are the test case here. They have had the economic stagnation, the deflation, the government debt increase, and the demographic crisis before everyone else. What is happening there will happen in Europe and North America. And here’s what we have seen:

Early 1990s: a collapse in land, real estate and share prices, leading to economic devastation, bankruptcies and wide-scale deficit spending.
Mid-1990s: economic revival on a cyclical basis leading to the rise of deficit hawks, fiscal policy normalization and tax increases.
Late 1990s: A renewed downturn including another financial crisis, the renewed collapse in shares and real estate and land prices as well as the collapse in financial sector firms using these assets as collateral for loans to the private sector.
Early 2000s: a recognition that the mid-1990s revival was a fake recovery and that Japan now faced a deflationary depression complicated by poor demographics. This is when widescale QE first began.
Early 2010s: a recognition that QE was not enough to overcome the deflationary depression and a move to a consolidated balance sheet approach, with fiscal policy and monetary policy completely aligned, removing the fig leaf of bond vigilantes having any power to restrain government’s power in using its own IOUs.

Now, the Japanese have gone for another bout of fiscal policy normalization. And so we have to see whether its experiment with Abenomics, i.e fiscal and monetary policy alignment, has long-lasting effects. Even if it does, the Japanese are on a long road of effectively zero rates and huge government debt for years and probably decades to come.

So what should the Fed do, seeing all this – knowing that monetary policy is the only game in town? What should the ECB do – knowing that the fiscal agents’ hands are tied? That’s the real question here. The answer is more about the political economy than anything else.

My answer has and will continue to be that central banks must step into the breech. They have no other choice because all of the heavy lifting falls on them. The US and the UK have more policy space and so the cyclical recoveries reflect this. In Europe, the policy space is more limited but the ECB has felt the pressure to act again and again. And it has acted in exigent circumstances, cognizant that failing to act means a collapse of the Euro and economic depression. But how long can these central banks continue to act given the circumstances? I think until credit froth has become an obvious credit bubble.

The Fed’s new credit bubble

Despite what the naysayers will tell you, it is clear from the data that the Fed’s monetary policy has been asymmetric. The secular increase in debt across all sectors tell us that. Moreover, if you look at the differential in the the change in total debt and the change in nominal GDP in the United States from 1951-2008, the pattern takes an abrupt shift during cyclical peaks after 1982.

Before the monetarist experiment and the move to monetary policy’s primacy, nominal GDP always increased faster than total debt during cyclical peaks. After 1982 it did only for a brief period during the workout from the S&L crisis. The abrupt shift toward debt increasing relative to nominal GDP even at cyclical peaks is prima facie evidence of policy asymmetry.

And the Fed is at it again. All of you reading this know what I am talking about because I have documented the increased (and increasingly irrationally exuberant) risk taking again and again.

But here are a few headlines for you from the past few weeks:

Stephen Roach says the Fed could trigger the next bubble and crisis. I say the Fed is already triggering the next bubble. All of this talk about how increasing interest rates is not the way to deal with financial stability concerns is beside the point. Monetary accommodation in the form of interest rate reductions is a tool to unstick dislocated credit markets when credit flow is below what it should be because financial intermediaries cannot adequately perform their credit creation process. Central bank intervention then is a lender of last resort role in this instance.

To the degree policy makers should steer cyclical policy, fiscal policy is more appropriate, as it adds net financial assets to the private sector and does not skew capital allocation by acting solely through credit and asset markets and interest income channels. The right way to have dealt with economic malaise should have been monetary policy normalization offset by the increase in fiscal policy stabilization in an environment of credit writedowns, debt forgiveness and private deleveraging. But we are not using that economic model.

The Fed and other central banks are creating a new credit bubble as we speak because monetary policy is now the only game in town. Zero rates and more aggressive monetary accommodation has led to severe changes in private portfolio preferences toward risk, leverage. This will eventually result in financial instability and crisis as sure as day turns to night. Just as in 1999 and 2006, we should look for the signal for when the change occurs in the riskiest asset markets first. They are the canary in the coalmine for this asset-based economy. When they turn down decidedly, it is a harbinger of what is to come elsewhere. And when we see a feedback loop into the real economy, we will know dusk has come. We are not there yet. But we are well into the afternoon.