From Excess Stimulus to Monetary Mayhem.

• Author: Dowd, Kevin

Three hundred years ago, the Scottish financier John Law embarked on an interesting monetary experiment in France that foreshadowed recent central bank policies. It included money creation, quantitative easing (QE), debt monetization, low interest rates and audacious financial engineering. It worked for a while but then collapsed. Large numbers of people were ruined, and Law fled the country in disgrace.

Law's mistake was to think that he could manufacture prosperity by printing money. In the aftermath, difficult lessons were learned about the dangers of the uncontrolled issue of paper currency and of responding to short-term economic problems with wild monetary experiments. France reverted to a metallic monetary system and the resulting horror of paper currency and banks lasted a long time. Those hard-won lessons were then forgotten. In the 1790s, France embraced the Assignats with the same enthusiasm as she had earlier embraced Law, and the result was another disaster. Similar episodes recurred throughout the 19th century and prompted Sir Robert Giffen (1892: 465) to observe:

For a good money is so very difficult a thing to get, and Governments, when they meddle with money, are so apt to make blunders (and have, in fact, made such blunders without end in the past, of which we have had so many illustrations lately in the experience of the United States, the Argentine Republic, Russia, and other countries), that a nation, which has a good money should beware of its being tampered with, and especially should beware of any change in the foundation--the standard for money. Forward to recent years and we have unlearned those lessons again. Modern monetary policymakers are prone to make several major intellectual errors. The first is their fixation with the belief that if there is, or appears to be, inadequate macroeconomic performance, then that must be due to inadequate aggregate demand and their only solution is to stimulate demand. Such thinking is reminiscent of the man with a hammer, to whom every problem looks like a nail. Other diagnoses and solutions--such as the need to address structural problems in the banking system and to address labor market, tax and regulatory reform, and fiscal sustainability--are swept under the carpet. Fundamental problems then remain unresolved, and Keynesian policymakers are left wondering why their policies are not working as they expected.

Their second intellectual error is deeper and might be described as instrumentalism. Instead of seeing the monetary system as a spontaneous social order whose sole purpose is to serve its participants as they go about their business, it sees the monetary system as something to be controlled for some allegedly higher end. So the interest rate and the supply of money are not seen as the products of markets but as control instruments to be determined by some central authority. Analysis of the monetary system as a self-organizing social order gives way to control and optimization analysis--that is, how best to manipulate these "instruments" to achieve some arbitrary central bank objective. In Herbert Frankel's words, there is

the belief that a free monetary order is irrelevant and has now become an anachronism, a relic of the past, and an impediment to the allegedly more "rational" policies of the present: the free monetary order should be abolished wherever it has not already been abolished.... It is surely significant that currently--even in the free world--the notion that people are entitled to use money as they please, is regarded with considerable scepticism [Frankel 1977: 4, 14].

From this perspective, more instruments are always to be preferred to fewer, and the inbuilt constraints that protect a free monetary order--such as constraints against the overissue of money--are merely hindrances that prevent central banks from achieving their objectives, that is, doing as they please. Underlying this error are deeper ontological ones: they assume that they understand the economy and presume to think that, if they understand it, then they can control it (W. R. White 2015). Unfortunately, they don't understand how the economy works, and they don't know how to control it.

The Establishment of the Fed and the Managed Monetary System

Before the Fed, prices, interest rates, and monetary aggregates were constrained by the gold standard. Banks issued currency convertible to gold at a fixed price, monetary aggregates were largely determined by the public demand to hold money, and interest rates were determined by supply and demand in financial markets--all subject to the rules of the gold standard. There was no monetary policy and no central bank to operate one. Once the Fed was established, however, it began to manage the system and, in so doing, to undermine it. As Ralph Benko (2016) has observed, "Congress delegated weights and measures to the National Institute of Standards and Technology, which is doing a stunningly great job of it. Congress delegated the power to regulate the value of the dollar to the Fed, which is making a botch of it."

To illustrate, according to official BLS CPI data, the U.S. dollar had lost 83.2 percent of its 1914 purchasing power by the time the last vestiges of the discipline of the gold standard were abandoned in 1971. Since then, thanks to the Fed, its purchasing power has fallen by 95.8 percent relative to its 1914 purchasing power.

Under the classical gold standard, interest rates were bounded by the rate of time preference and the expected return on capital: if they fell below the former, no one would lend, and if they went above the latter, few would borrow. Interest rates were also highly stable during the gold standard: government bond yields were generally between 2 percent and 4 percent. (1) Over time, however, the Fed acquired more control over interest rates--the most important prices in a market economy--and for the last 45 years they have been entirely determined by the whims of a committee, the FOMC, and have been far more volatile. The Fed's control over interest rates led to wild swings as the Fed lurched from monetary excess to restraint and back again, creating one boom-bust cycle after another.

The Fed's Serial Bubble Machine

Forward to 1996, and Alan Greenspan famously warned of "irrational exuberance" in the stock markets before easing monetary policy to stimulate them further. The "Greenspan put" protected investors on the downside, encouraging them to buy more stocks and push up their prices. This policy was justified by the belief that boosting the markets would create a wealth effect that would stimulate consumption and growth, but it also encouraged the speculative "greater fool" mentality to take hold, in which people would knowingly buy overvalued assets in the belief that some greater fool would buy them at higher prices. But market fundamentals eventually reassert themselves, and the market crashes.

The markets then boomed before crashing in 2001, only for Greenspan and (later) Bernanke to repeat the process to produce both another stock market boom and a housing boom, both of which crashed in 2007-08. Bernanke then stoked up the biggest booms in asset markets generally, including commodities, stocks, housing, and junk and government bonds.

As Dan Thornton (2016) has pointed out, repeatedly doing the same thing and expecting a different result the next time is literally insane. The "everything bubble" is the biggest monetary experiment ever, so why wouldn't it also lead to the biggest ever collapse? It appears that the Fed has set up the market for a fall.

Zero Interest Rate Policy (ZIRP)

One of the Fed's main responses to the Global Financial Crisis was to push interest rates to almost zero. The federal funds rate was lowered from 5.25 percent in August 2007 to near zero by December 2008 and has not changed much since. ZIRP has a number of adverse effects, however.

First, it encourages investors to take more risks to boost yields (see, e.g., Thornton 2016). Investors are pushed out of safe fixed-income positions into riskier positions such as stocks, real estate, commodities, and structured products, which are often not appropriate for them and whose true risks are not apparent because risk spreads are suppressed as well.

Second, it encourages more borrowing and higher leverage. Many companies have used low interest rates to load up on debt they don't need to reinvest in equity markets via M&A or share buybacks in attempts to push up share prices further. As Soc Gen's Andrew Lapthome recently noted, "The effect on U.S. nonfinancial balance sheets is now starting to look devastating." (2) Low interest rates also delay restructuring, by allowing zombies that would otherwise fail to continue in operation, and encourage greater fiscal profligacy.

Third, low interest rates reduce financial returns, which puts pressure on savers by making it more difficult to reach their savings targets. To illustrate, if ZIRP were implemented for a decade and succeeded in pulling down returns on saving from 3 percent to zero over that period, then the value of the fund would be 26 percent lower by the end of that decade than it would have been. To indicate the scale of losses involved, OECD data suggest U.S. pension fund assets in 2009 were about $14.42 trillion, so a decade of ZIRP would imply $2.54 trillion in accumulated lost returns--and this figure ignores the losses on assets acquired in the interim, which could be another trillion. (3) These numbers also ignore losses to other fonns of saving, which might easily be another one and a half trillion. (4) The law of compound interest implies that sustained ultra-low interest rates have a devastating impact on savers and pension funds.

The conventional wisdom is that the lower the interest rate the greater the stimulus to credit. The level of interest rates is a key profit driver for all banks, however, and the lower the interest rate the...