Wednesday, March 18, 2009

The Maestro has no clothes

Interesting guest post on The Big Picture. It is long but a good read.

Basically it is a lot of name calling towards Greenspan who gave a WSJ interview where he basically said that the FED was not to blame because "it had lost control of the monetary supply a long time ago" and what was to blame was "large excess pools of savings".

The blame game is going on in earnest and this attempts hits the nail on many issues but goes overboard on some others, let me see if I can put some order. The gist of my argument is that while the FED is to blame for many things, the core of the argument, that the FED lost control of the money supply, is imho solid.

There was (and remains) no limit to the repo lines the Fed and Wall Street may create (other than the amount of eligible assets that may be offered as collateral), meaning the Fed largely controls the amount of US dollar-based credit provided to the markets. In short, through the repo market the Fed controls/supplies funding for the largest Wall Street banks and, secondarily, the shadow banking system (the securitization process and levered buyers of those securities that borrow from Wall Street).

This is the main argument, that the FED controls monetary levels and I find this belief to be lacking.
1/ See Keen's/Graziani/Minsky research on the endogenous creation of money in positive contexts. Credit money is wanted because a "ponzi" spread exists while prices go up in a self fulfilling fashion. DEMAND is strong. So wall street markets these loans and securities and in turn 'demands' credit. Yes in theory the FED could turn the spigot, in practice as long as there is demand who is the FED to call a bubble? no one complained on the way up as ponzi investments in real estate drove demand. Greenspan is not responsible for creating a bubble, our own greed as home buyers, our own greed as bankers is to blame. The neo-classical school of thought wanted less intervention, not more. Can you imagine the outrage if the FED was to intervene in markets this way. Yet, I agree, it probably is the only way if impractical.

2/ Securitization. Securitization enabled wall street to create un-precedented levels of credit money by recycling its own debt via CDO's. See my previous posts on the topic that credit money levels got out of control via this mechanism which was really created to bypass the ratio limits on bank balance sheets. The velocity of money was greatly increased with a constant base and the velocity of that money enabled the creation of paper that cleared the balance sheets of banks. That was clearly out of the control of the FED. It was called "Innovation".

Through Fed repos, Wall Street was able to grow its collective balance sheet dramatically and then use it to
distribute — through the shadow banking system — credit to homeowners and consumers. Wall Street provided vendor financing to leveraged debt investors through their profitable prime brokerage units. Yet, ultimately, the credit came from the Fed. (The Fed and commercial banks “create, distribute and sometimes even extinguish” credit while Wall Street “intermediates and demands” it. Wall Street does not create it but does “market” and “redistributes” it.)

See above why this statement is false imho. Wall Street CREATES credit. Securitization has enabled the banks to create infinite leverage. That leverage was eaten up by un-regulated and regulated pools alike. Credit money, bank money is what has flooded the system. Private debt to GDP ratios have gone through the roof.
Private debt does not track M0 growth with the usual "money multiplier". Greenspan is imho, correct in his assertion that the FED does not control debt money creation anymore, years of deregulation saw to that. Innovation knew better than our forefathers and I believe the motto was "let the invisible hand set the money levels, not that filthy government". We are able to reap the rewards of the invisible hand dealing the coke-money supply. Repeat after me: creation of debt money is something that must never be entirely left to the invisible hand.

Ironically, Mr. Greenspan seems to be pointing his finger at banks and borrowers for taking the Fed’s credit. (Even more ironic is that, as the Fed Chairman, he was the chief bank regulator and could have stepped in to prevent bank, and ergo, leveraged-investor balance sheet growth by demanding and enforcing more traditionally- stringent lending standards.)

Yeah, of course he does point his finger at banks and borrowers, who else? this statement is a little disturbing in its "bad governement good people" bias. Ideology can kill a good argument.

We assert that without this Fed-induced financing, the credit, housing and derivative bubbles would not have developed to anywhere near the magnitude they ultimately did. The nexus of these bubbles was a currency bubble initiated and exacerbated by the Greenspan Fed.

And I assert this is bollocks. Without the greed and securitization there would have been a bubble of this magnitude. The FED can take the full blame here.

It appears the Maestro sacrificed the future for the present, which is a sure way to make people on Wall Street, Main Street and in Washington happy…temporarily.

Here I completely agree. Politics in general cannot be entirely trusted with the money supply EITHER because you want to keep main street and wall street happy and the easier way is to open the credit money valves as it will provide a jolt that last the length of your mandate, and almost guarantees re-election.

I have a follow up blog on this theme, monetary good behavior of governments is, I am increasingly convinced, an impossible task. See Carter and the blame he took when he committed political suicide by tightening monetary policy to kill inflation. He succeeded and politically died (see Greenspan's book). By contrast see the praise that someone like Reagan got when he opened the monetary valves and created a budget deficit without precedent. He was a hero. Politics due to its time horizon linked to elections and the time lag money has in impacting the economy will most certainly take the WRONG path on monetary policy. Take the EASY road.

We must ask ourselves why banks and investors would keep buying homeowner and consumer debt even as
interest rates began rising in 2004. The answer is simple: as long as banks could maintain a profitable spread between the rate at which they borrowed overnight from the Fed (the repo rate) and either the rate at which they could lend directly or the rate of return implicit in the fees they generated by effectively re-structuring and distributing their repurchase agreements (and, as long as debt buyers could maintain a positive arbitrage), then the actual level of interest rates – benchmark, mortgage or consumer rates – didn’t matter. It was, as all things financial usually are, the “spread” that mattered.

Yeah, and that spread came from a ponzi like expectation that "prices always go up". A better argument (which is made later in the article) is that prices going up, asset prices that is, is in fact a reflection of monetary increase.

We argue that Mr. Greenspan would have had to restrict Fed credit far more than he did if he wanted to close the arbitrage spread giving bond investors incentive to keep adding credit to their balance sheets. He should have shifted the funds rate higher and more forcefully. The move in the fed funds rate from 1% to 5.25% from 2004 to 2006 was woefully inadequate and should have been MUCH more aggressive if spurious credit demand were to be discouraged. Put slightly differently, we assert that the ENTIRE fed funds move from 1% to 5.25% was driven by increased credit DEMAND (levered credit buyers had incentive to put as much on their balance sheets at a positive spread between funding costs and bond yields). Mr. Greenspan didn’t seem to get this.

Had the Fed wanted to restrict the clearing quantity of credit, it would have had to target a fed funds rate well in excess of 5.25% and/or acted much quicker than it did. The Fed would have needed to restrict SUPPLY and thus target less growth in overall credit. This, no doubt, would have endeared him to no one (but former Chairman Volcker perhaps?). More forceful credit restriction would have clearly retarded any growth in demand from the shadow banking
system and the credit bubble would have been stopped in its tracks well before it burst. We don’t believe that Econ-101 supply/demand curve analysis is beyond Mr. Greenspan’s reach as he seems to protest, nor was it so when he was Chairman of the Fed.

I agree with the fact that DEMAND drove the un-precedented growth in credit. It seems fair to argue that the FED could have done something to restrict the SUPPLY. It also points to this insatiable demand for credit in a run-away system. The FED DID LOSE CONTROL. Which is Greenspan's main point. In a monetary system gone wild, the FED could not apply the brakes on securitization and the credit money dog was wagging the fiat money tail. Can you imagine the outcry if the FED was to apply the brakes on the housing bubble? Is the role of the FED to prick bubbles or control damage once they burst?

We were ALL GUILTY of running a massive ponzi scheme (housing) based on monetary jubilation and the expectations of prices going up that come with it. Growth of credit spurs price increases, spurs positive spreads, spurs growth of credit in a positive feedback loop that quickly turns negative. The point is well taken however.

For example, the Consumer Price Index (CPI) and other price baskets generally used as “inflation” indicators had not risen to reflect gross monetary inflation produced by the Fed from 1996 to 2006. This is not proof that money growth does not equal inflation; rather it is proof that the CPI does not accurately reflect the diminution of a dollar’s purchasing power. (If an indicator like the M3 growth rate had been a generally-accepted inflation metric — not perfect but closer than highly subjective price baskets — then there would not have been buyers of credit at negative real yields.)

I completely agree here and it is one of my pet peeves: INFLATION SHOULD INCLUDE ASSET INCREASES NOT JUST CONSUMPTION. Consumption prices have been kept low due to China. But asset prices, stocks, bonds, houses have shot through the roof following debt growth. My favorite chart is DOW 1980-now in LINEAR which clearly shows a linear tendency of growth (which would be normal for a mature economy, you can't grow like a pup forever) and clearly display two HUMPS corresponding to monetary bubbles. IN other words most of the growth we have seen across asset classes was MOSTLY monetary growth, not "real" growth.

“As I noted on this page in December 2007, the presumptive cause of the world-wide decline in long-term rates was the tectonic shift in the early 1990s by much of the developing world from heavy emphasis on central planning to increasingly dynamic, export-led market competition. The result was a surge in growth in China and a large number of other emerging market economies that led to an excess of global intended savings relative to intended capital investment. That ex ante excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005.”

Mr. Greenspan surely knows that there cannot be “an excess pool of savings” because, by definition, the pool of savings equals the pool of investment. (Mr. Bernanke seems guilty of this lapse too, we’re afraid.) However, there is an excess pool of “currency” in today’s world. Again, as the simple laws of supply and demand suggest, an increase in the supply of currency which is not coincident with an increased supply of assets will drive asset prices higher. A prudent central banker acting in the interests of economic stability would have absorbed that excess pool of currency (and would not now dub it as “savings”).

But he is correct in pointing this out. There was a glut of savings from China, they were getting the money from us buying all their stuff. That money came from credit, that credit came from banks. Banks did not need the FED to create credit, they were completely unregulated and created vasts amounts of credit money, WHO WOULDN'T???. Way beyond what the money multiplier model said was safe to do. The savings, meaning savings and pools of money available for investment, did depress long term rates. Too much credit money was flooding the system and the FED was not entirely to blame.

In an honest or “hard” money system, the “tectonic shift” Mr. Greenspan discusses would have led to CPI
deflation as the newly accessible pool of cheap Asian labor would have been deployed in the productive process. This would have implied lower consumer prices and higher interest rates. There would have been better margins helping asset prices on the one hand, and higher interest rates hurting them on the other. The net effect on productive asset prices would thus be ambiguous.

I completely agree with the first part, namely that CPI should have gone down instead of remaining stable and that monetary increase probably kept CPI afloat. However it seems pretty clear that hard money would not have allowed this vast increase in bubbles. If by hard money they understand 100% reserve banking (no fractional banking) then agree, but it seems also very impractical. Glass Steagal set the money multiplier at 12x, Securitization bypassed it and needs to be recaptured (again Debt to GDP isn't a bad measure) and that gave us years of stability.

Clearly, Mr. Greenspan allowed the various measures of the monetary aggregates to inflate and his reputation did not suffer for it during his tenure. The organic forces of price deflation provided him a shield. Why did he do this? To keep asset prices up? To keep US tax receipts up? The effect of his actions hurt dollar-based savers, fixed-wage workers and people living on a fixed-income. All would have been better off if the purchasing power of the dollar were to have been maintained or even, via the “tectonic shift”, enhanced.

Completely agreed, money levels got out of hand. Why? because we are all pigs? because indeed tax receipts need to be kept? because CPI deflation did provide a shield and finally because we just do not know how to run an economy in a deflationary environment, period. All the animal spirits go in reverse and the positive feedback loops turn negative. Debt deflation economics in the minsky/fisher sense are the economics of depression. Who wants that... politically, economically, socially...

Blame the dog for not wanting to learn a new trick. Afterall the FED mandate is PRICE STABILITY. And an inflationary monetary policy counteracted the deflationary influences of asia and productivity increases. This seems quite trivial in retrospect and the most likely path to take.

Mr Greenspan was put on a pedestal when he was there and keeping the inflation machine going and is torn to pieces now that it has all gone to hell. I do not contest that there is something they could have done (prick bubbles) how practical it is I do not know. However the core of Greenspan's defense, that the FED had LOST CONTROL OF THE CREDIT MONEY SUPPLIES seems like an obvious statement. Everyone is to blame.


tom said...

so what's your take on the Bernanke solution of buying trillions of $ of treasuries?

am I correct in thinking this is like using more doses of the problem to address, but not "solve", the problem?

If so, I'm thinking this will be popular because everybody likes to play "the inflation game" because they know how to do that - and it's a feel good and fun past time - whereas playing "the deflation game" is unpopular because nobody knows how to play it and it's not fun...

but in the longer term we'll end up back where we are again - out of control.

Marcf said...


I believe it is a numbers game to some extent and a head game to another level.

If the banks are losing 3T then a 1T injection will *help* but not reverse the main which is deflationary in numbers.

However inflation and deflation are as much about expectations as anything else so if people expect inflation then they start buying assets that float with inflation (stocks, commodities, TIPS, real estate) and those prices go up by virtue of the buying and the feedback loop kicks positive. Can that outweight a 3-to-1 monetary mass that is going negative, I frankly have no idea.