In the Trenches: Command and Control

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Like it or not, central banks are now the most influential, global financial market participants. Sovereign rates and risk are now only rarely a function of market forces. Central banks have asserted this influence in the name of moderating business cycles and associated financial market volatility. How could such a paternalistic and noble desire for business cycle moderation be misguided? Because the road to perdition is paved with good intentions.

The Great Moderation – a term oft cited before 2008 but little referenced since – was attributed to Fed maestro, Alan Greenspan. Unfortunately, had he still been chairman, his encore would have been the catastrophic meltdown in global financial markets and real economic performance. This discordant meltdown necessitated the use of ZIRP (zero interest rate policy) and QE (quantitative easing). [1] Since then, the move off the zero-interest rate bound in late-2016 marked the end of an almost 40-year secular trend towards lower interest rates.

The end of this secular trend confronts the Fed and other developed central banks with a new challenge. With rates still so close to the zero bound and with balance sheets still so swollen, when an economic downturn comes, what tools will be effective? Central banks have slowly begun to run out of assets to credibly buy. This is leading to a new, creeping narrative: MMT (Modern Monetary Theory), a theory that Larry Fink labeled last week as ‘garbage.’ I agree.

Because there’s so little central banks can do, they are anxious to prevent another downturn before it starts.

As a result, we’ve witnessed the Fed’s most recent dovish pivot, the ECB’s less hawkish tone, and the BoJ’s seeming admission to a QE addiction it has no intention of kicking. For short periods and when used prudently, QE is a useful tool, especially when used to purchase risk-assets that have suffered a liquidity dislocation – such as mortgage-backed securities (MBS) in 2008. It can alleviate this kind of credit crunch by directly targeting and suppressing risk premia. When applied more broadly to suppress risk-free term premia, it may pull forward demand in the real economy. In turn, that ought to help create a virtuous, reinforcing growth cycle.

So, why has growth been so modest in this economic cycle and why has inflation globally, even in economies like Brazil, been somewhat absent (at least for now)? It’s simple. Prolonged monetary policy accommodation (and especially QE) has led to the inefficient allocation of resources, especially in developing economies. They have benefited from lower internal rates as capital flowed from low-rate developed economies to higher rate developing ones. This fueled an investment boom that led to overcapacity, especially in basic industries. China, in particular, is suffering from this hangover right now as it attempts to eliminate overcapacity and associated debt. It’s not an easy task, and it has managed to do it only in fits and starts. In turn, global inflation has been largely absent this cycle as overcapacity persists.[2]

Resurrect the Austrians. Austrian theory, popularized by Nobel prizewinner Friedrich Hayek, generally suggested that market prices reflect a totality of information unknowable to any single policy actor. This information, when available to market participants and economic actors collectively, determines the allocation of resources in an economy. Moreover, the Austrian theory of the business cycle suggests that bank credit issuance is generally the cause of economic cycles. Ludwig von Mises first articulated this idea, and it was later amplified by Hayek. Mises believed that when banks extend credit at artificially low interest rates, business engage in “malinvestment.” According to Mises, “[t]here is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

Ben Bernanke got a big laugh from economists in Atlanta on January 4th. A few minutes after Janet Yellen said, “I don’t think expansions just die of old age,” he replied, “I like to say they get murdered.” Strategists cite this idea ad nauseam to support their bullish views. On its face, it appears that Bernanke believes the business cycle rests firmly in the hands of life-preserving central bankers. If this interpretation is correct, it drips of potentially tragic hubris. Finally, even if he’s correct, what’s the role of market forces in a central bank controlled environment?

Let’s consider an extreme scenario: MMT. Consider a world in which all central banks are implementing aggressive QE policies ad infinitum. MMT suggests that as long as a country (and by implication its corporations) issues debt in its own currency, the country should be able to indefinitely fund debt issuance vis-à-vis creation of new reserves. Those reserves are used to purchase the treasury’s issuance. But something just doesn’t feel right about this. What does such a scenario imply for global capital flows and sovereign risk pricing? In such a world, it’s likely that economies would become isolated. What would be the incentive for countries to remain open to foreign capital flows? Rather than a deficit nation relying upon savers in surplus nations to fund deficits, the country’s central bank would simply fund the shortfall with printed currency. Thus, cross border capital flows would atrophy. In fact, global capital flows would be an unwelcome influence on capital costs that central banks would instead want to control. Indeed, the emergence of populist governments globally is also an apparent symptom of globalization’s infringement on sovereignty and the ability of monetary and fiscal policy to control economic outcomes. In an MMT world, a country’s printing press might replace its nuclear weapons as its enemies’ next existential threat. To what lengths would countries go to sabotage each other’s financial systems in an MMT world?

As the Fed attempts to normalize, most other developed or large developing central banks continue to stimulate. Indeed, I have argued that the Fed will act slowly to cut interest rates – precisely because it does not want to resemble Europe and Japan. Thus, it will first start by stopping the balance sheet runoff, but ultimately, economic conditions will force it to cut again – most likely in early to mid-2020. Another likely eventuality is that balance sheet engorgement will resume sometime later. The world has become dependent on low interest rates and central bank intervention. The issuance of debt facilitated by fiat rates has pulled forward future demand – perhaps to its ultimate limit – and a misappropriation of capital has ballooned global goods supply.

How does a QE all-the-time and all-over-the-world exist in seeming perpetuity? How does risk ‘price’ in capital markets when the cost of capital is constantly set too low?

It’s a difficult concept with which to wrestle. In essence, markets are no longer pricing risk; rather, a central command and control mechanism – global central banks – is pricing risk for the markets. I would argue this condition is neither durable nor stable.


[1] As I wrote in my previous In the Trenches, were central banks to articulate policy by explicitly saying they were going to set prices (in the form of capital costs) rather than use monetary policy tools, would not public perception of Fed action be different?… Consider that the Fed funds rates had historically been generally managed into a corridor using what the Fed calls temporary open market operations or OMOs. While QE is simply an extension of this idea to ‘permanent’ OMOs, QE’s suppression of term-premia – over which market forces normally dominate – is a powerful tool. Suppression of term premia enables corporations and individuals to term out maturing obligations and prevent defaults. QE simply allows central banks to fix capital costs lower over longer periods of time. I

[2] Even outside developing economies, firms and individuals have an incentive to overinvest in low ROA projects because capital costs are artificially lower than hurdle rates. Overinvestment tends to suppress inflation – in turn, this keeps term premia low. Importantly, companies adjust their expectations and behavior. They become reliant on low rates, which makes it difficult for the Fed (and other central banks) to move off the zero bound. Market participants adjust their behavior to a low rate environment make marginal investments that depend on low capital costs for prolonged periods of time. This makes normalization without default a difficult task.

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Nicholas Allen
Member
Nicholas Allen

“From what I’ve tasted of desire
I hold with those who favor fire.”

This matches up pretty closely, obviously, with Ben’s “fourth horseman”. Is there any path forward you see for this confluence of MMT, global QE, populism, etc., that doesn’t involve globally synchronized hyperinflation? It seems like all the trends are pushing inflation, and it’s notoriously hard to stamp brakes once inflation has begun.

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Victor K
Member
Victor K

I have the honor of never having read any economics until recently. I was also a (bad) math major at Princeton. Just as the Disruptor-in-chief has propagated much new learning about our government and media, Disruptor MMT seems to be doing the same for economics, at least for me. Judging from my initial readings of Wray, Mosler, and ‘comrades’, I am sure of just a few things so far. The narrative machine is working overtime against MMT. Meanwhile, some ‘socialists’ have latched on (Mother’s Milk Theory) for political gains. My take is that terms like ‘keystroke’, ‘helicopter’, and ‘print’ money are clues to against MMT, and ‘sectors’, ‘stock-flow’, and ‘private vs government (net financial) surplus’ are the contrary. Rather than take either the Pessimistic Weimar or Optimistic Socialist point of view, please consider reading some primary source material if not already done.

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Nicholas Allen
Member
Nicholas Allen

Primary source material… on MMT? Do you have any specific recommendations? I’m always happy to read more history, particlarly economic history.

I’ve done a decent amount of related reading: “Fiat money inflation in France”, “Navigating Big Debt Crises”, a few others. I’m sympathetic to the Pessimistic Weimar view, since the Optimistic Socialist can point to 0 historical cases where unbridled printing was sustainable, but I’ve also noticed that most of the pessimists have no ability to explain the non-barking dogs, and are actually proven right about as often as the proverbial broken clock. They generally predict about 1000 out of every 2 significant inflationary periods.

But that still beats the Optimistic Socialist track record…

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Victor K
Member
Victor K

neweconomicperspectives.org/modern-monetary-theory-primer.html
This is Randall Wray’s compilation of 52 MMT blogs. Each blog has comments, Wray’s answers to comments, and then comments to Wray’s answers. (A few of the links are 404s.) I found it very helpful.
On a side note, there is so much talk about ‘printing’. My understanding of the UST and FED is that the FED generally is not allowed to buy directly from the UST and instead buys ‘Treasuries’ on the open market (banks). The banks paid the UST for these ‘Treasuries’ and the FED holds the account of the UST. BUT when the FED buys ‘Treasuries’ on the open market (from banks), those same banks’ FED accounts are credited (here is where ‘keystroke’ comes in). So now both the UST account and the bank’s account at the FED holds the amount paid for the ‘Treasurie’, and new ‘money’ is created in the private sector when the FED pays private sector bills from the UST’s account. I could have it all wrong so please correct as needed!!!

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Peter Perez
Member
Peter Perez

What keeps banging around in my head as the answer to the lack of inflation conundrum…debt is deflationary. Debt, especially excess indebtedness, has two pernicious effects. Firstly, debt brings forward into the present future consumption that needs to be paid with future earnings, dampening future consumption. Secondly, debt demands repayment…at the expense of current consumption. When mal-investment/over-consumption indebtedness gets large enough and reaches a tipping point you get systemic debt deflation (Irving Fisher) by way of liquidation of assets to pay debt (yes, the Fed short-circuited this in 2008…at the expense of creating a still larger debt pile and bigger problem later on). If memory serves, every hyper-inflation has been preceded by collapse via systemic debt deflation. My point is that we should not be surprised to see a deflationary bust first before we get a highly/hyper-inflationary bust after. Soooo…Crack-up boom (now), deflationary bust (later), hyper-inflation thereafter. Wash, rinse, repeat.

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Mark Kahn
Member
Mark Kahn

You’re saying it (and understanding the economics and history of it) better than I do, but it’s clear the establishment looked into the abyss of a debt-deflation spiral in ’08 (literally when it revoted to pass TARP) and has, as Ben has noted, decided to NEVER let that happen again.

Hence, everything the political establishment does is to generate inflation (despite an official stance of, and the occasional publicity feign toward, preventing inflation), but my guess, the massive debt buildup is too deflationary for even the government marshaling* all its forces to overcome – delay, yes, but not overcome.

So, the next stop – when is anyone’s guess – is a deflationary bust and, as you note, an inflationary phoenix to follow – when no one is left who owns a single inflation-oriented investment anymore. All that said and believed, based on Japan, we could be in this low-rate, low-growth, massive-debt-overhang environment for years to come.

* Why isn’t “marshaling” spelled with two “Ls?”

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Peter Perez
Member
Peter Perez

Of course…inflation is the ally of the debtor, enemy of the lender. The Bernank short-circuited the Fisher debt deflation thesis/process. I’m not advocating that they should have allowed “full market price clearance/liquidation” of a 70 year debt super-cycle a la Great Depression. Instead, I’m arguing that they should have let there be more pain and liquidation…instead of encouraging still more debt, mal-investment, etc…with a much bigger price to be paid later. The economy and markets are complex, dynamic, self-organizing systems. You try to “manage” them at your peril, creating all manner of unintended consequences…often in greater proportion to your input/effort to distort in the first place. Riddle me this. What happens when market forces win, forcing rates higher…not bc of Fed policy or economic growth prospects but bc of credit quality concerns in say…a slowing/recessionary economy? Game, set, match.

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Mark Kahn
Member
Mark Kahn

Not a perfect analogy, but the way the government handled the S&L crisis of the late ’80s – it managed the crisis (bad banks, good banks, mergers, etc.) while letting there be “pain and liquidation,” as you said – worked. And, I hear ya, a global-economy-wide Minsky moment could be the endgame.

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Peter Perez
Member
Peter Perez

My use of Crack-up Boom may not have been precise. I mean that the fix for 2008 resulted in what I suspect will be judged ex post to be a crack-up boom. https://www.investopedia.com/terms/c/crackup-boom.asp

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