Aftermath
Page 2
Why is the Fed raising rates and destroying money? Despite the absence of any empirical support, Fed governors and staff economists persist in their reliance on the Phillips Curve, which predicts that low unemployment leads to rising inflation. Unemployment in the United States at 3.7 percent in early 2019 is at fifty-year lows. The Fed, despite occasional pauses, insists that the time to tighten monetary conditions is now, before the inflation emerges.
Yet the Phillips Curve bears no correspondence to reality. The 1960s were characterized by low unemployment and rising inflation. The late 1970s were characterized by high unemployment and high inflation. The 2010s have been characterized by low unemployment and low inflation. There is no correlation between inflation and unemployment, just as there is no correlation between inflation and money supply. Inflation is always and everywhere a psychological phenomenon. When citizens lose confidence in a form of money, velocity takes off. Reliance on the Phillips Curve for Fed policymaking is false science.
The other ostensible reason for Fed tightening is official confidence that the U.S. economy is on a solid growth path. As with the Phillips Curve, there is no evidence for this belief. The U.S. savings rate plunged to 2.1 percent by late 2017, a fraction of the 6.3 percent rate that prevailed from 1970 to 2000. The combined impact of the 2017 Trump tax cuts, bipartisan congressional repeal of discretionary spending caps, and rising student loan defaults will push U.S. budget deficits well past $1 trillion per year beginning in 2019 and continuing indefinitely. This added dissaving will push the U.S. savings rate to zero. This means the United States must either reduce investment or borrow savings from abroad. Both courses hurt growth. Other headwinds to growth include Trump’s trade war, impediments to immigration, and higher real rates as the U.S. Treasury tries to attract buyers for the $10 trillion of new debt it must sell in the decade to come. These specific headwinds are of recent vintage and come on top of the preexisting secular stagnation due to demographics, de-leveraging, and declining productivity.
The hoopla about higher growth associated with the Trump tax cuts is hokum. This growth expectation is rooted in the Laffer Curve, which posits that lower tax rates produce higher growth, which leads to higher tax collections that offset the rate cuts. Prominent supporters, including the eponymous economist Art Laffer, Larry Kudlow, Steve Moore, and Steve Forbes, point to the Reagan Revolution (of which they are all veterans), during which tax cuts enacted on August 13, 1981, were followed by robust real growth beginning in the first quarter of 1983 that continued through the decade. True enough.
What the Reagan Revolution myth leaves out is that from the second quarter of 1980, late in the Carter administration, through the third quarter of 1982, well into the Reagan administration, the U.S. economy suffered six quarters of negative real growth in the form of back-to-back technical recessions, including the worst recession since the Great Depression, a record that held until 2008. By 1983, the U.S. economy was primed for a strong cyclical recovery with or without tax cuts. Compare that to the U.S. economy in early 2019, which is over nine years into an expansion, the second longest in U.S. history, with little in the way of unused capacity on a scale that existed in 1982.
The other factor left out of the Reagan-Trump tax-cut comparison is that Reagan enlarged the U.S. debt-to-GDP ratio from 35 percent to 55 percent during his administration, a near 60 percent increase in the ratio. Reagan was a closet Keynesian, as David Stockman, Reagan’s budget director, pointed out then and has reminded citizens ever since. The Trump administration came into office with a debt-to-GDP ratio of 105 percent, nothing at all like Reagan’s starting line. A 60 percent increase à la Reagan would put the U.S. debt-to-GDP ratio at 170 percent, just slightly lower than Greece at 180 percent. Of course, the United States would suffer a crisis of confidence in the dollar and a global monetary collapse long before the U.S. debt ratio got that high. Worse yet for the growth thesis, extensive and convincing research by Harvard professors Carmen Reinhart and Kenneth Rogoff shows that once a nation’s debt-to-equity ratio passes 90 percent, the stimulative impact of added debt, including debt from tax cuts, is negative.
Initial conditions of debt and the business cycle confronting Trump are unlike those that Reagan enjoyed. Reagan had a once-in-a-century chance to jump-start growth with debt, and he did it successfully, to bury the Soviet Union and win the Cold War. Trump is not so lucky. Trump’s tax cuts will bury economic growth under a mountain of debt and shake world confidence in the U.S. dollar.
The Fed understands these impediments to growth, although they cannot publicly pivot away from the rosy scenario. This begs the question, why is the Fed tightening if the economy is so weak? The answer is that the Fed is preparing for the next crisis. The evidence is clear that it takes 4 percent in rate cuts to pull the United States out of a recession. The Fed cannot cut rates even 3 percent when the Fed Funds rate is less than 2.5 percent. So, the Fed is in a desperate race to raise rates before a recession arrives, so they can cut rates to cure the recession.
How does balance sheet normalization fit in? Reducing the balance sheet is a precautionary step in case a recession arrives before rates reach 4 percent. In that case, the Fed would cut rates as far as they could, until rates hit zero, and then revert to QE. (The Fed has shown no inclination to use negative rates, and the evidence from Europe, Sweden, and Japan is that negative rates don’t work anyway). Contrary to the leanings of modern monetary theorists like Professor Stephanie Kelton, the Fed does not have an unlimited capacity to monetize debt. The constraint is not legal, but psychological. There is an invisible confidence boundary on the size of the Fed’s balance sheet. The Fed cannot cross this boundary without destroying confidence in the central bank and the dollar. Whether that boundary is $5 trillion or $6 trillion is unknowable. A central bank will find out the hard way instantaneously when they cross it. At that point, it’s too late to regain trust. Having pushed the balance sheet to $4.5 trillion in the last crisis, the Fed needs to reduce the balance sheet now so they can expand it again up to $4.5 trillion in QE4 if necessary.
In short, the Fed is tightening monetary conditions now so they can ease conditions in the next crisis without destroying confidence in the dollar. The Fed’s conundrum is whether they can tighten monetary conditions now without causing the recession they are preparing to cure. The evidence of the past ten years shows the answer to that question is no. The Fed’s odds of accomplishing their task without harm to markets are near zero. Tightening monetary policy in a weak economy is steering a course between Scylla and Charybdis. Here are the likely outcomes.
In one scenario, call it Scylla, the double dose of tightening from rate hikes and QT slows the economy, deflates asset bubbles in stocks, strengthens the dollar, and imports deflation. As these trends become evident, disinflation tips into mild deflation. Job creation dries up as employers rein in costs. A stock market correction will turn into a bear market with major indices dropping 50 percent or more from 2019 highs. All of these trends would be exacerbated by a global slowdown due to the trade war, concerns about U.S. debt levels, and reduced immigration. A technical recession will ensue. This would not be the end of the world. It would be the end of one of the longest expansions and longest bull markets in stocks ever. The Fed would respond to this recession with rate cuts back to zero, the end of QT, and a new round of QE that would take the Fed balance sheet back up over the $4 trillion mark. As was the case with Odysseus, the costs would be high, yet the economic vessel and crew would (mostly) survive.
The other scenario, call it Charybdis, is a more complex process with a far more catastrophic outcome. In this scenario, the Fed repeats two historic blunders. The first blunder occurred in 1928, when the Fed tried to deflate an asset bubble in stocks. The second blunder was in 1937, when the Fed tightened policy too early during a period of prolonged weakness.
Until December 2017, the Fed rejected the idea that it could identify and deflate asset bubbles. This policy was based on the experi
ence of 1928, when Fed efforts to deflate a stock bubble led to the stock market crash of October 1929 and the Great Depression. The Fed’s preference since then is to let bubbles pop on their own and then clean up the mess with monetary ease if needed. This policy preference was followed in the aftermath of the emerging-markets bubble of 1997, the dot-com bubble of 1999, and the mortgage bubble of 2007.
However, the popping of the mortgage bubble in 2007 was far more dangerous and the policy response far more radical than the Fed expected going into that episode. Given the continued fragility of the financial system, the Fed began to rethink its cleanup policy and chose a more nuanced stance toward deflating bubbles. This new view (really a reprise of the 1928 view) emerged in the minutes of the Federal Open Market Committee, the Fed’s rate policy arm, for October 31–November 1, 2017:
In their comments regarding financial markets, participants generally judged that financial conditions remained accommodative despite the recent increases in the exchange value of the dollar and Treasury yields.1 In light of elevated asset valuations and low financial market volatility, several participants expressed concerns about a potential buildup of financial imbalances. They worried that a sharp reversal in asset prices could have damaging effects on the economy. (Emphasis added.)
This view was echoed in the public remarks of Fed officials in the days following this FOMC meeting, and in the FOMC’s decision to raise rates at their December 13, 2017, meeting despite continued concerns about disinflation. As if to validate the concerns expressed, U.S. stock markets soon suffered a sharp 11 percent correction from February 2 to February 8, 2018—a mild preview of what happens when the Fed tries to deflate asset bubbles. Still, the Fed persisted in its rate hikes throughout 2018. Given the proliferation of passive investing strategies, algorithmic trading, and hypersynchronous reaction functions, the Fed’s attempted finesse in financial markets will ultimately result in a market crash as bad or worse than 1929.
The impact of such a market crash will not be confined to the United States. In fact, a stronger dollar resulting from tight monetary policy could precipitate a crisis in emerging markets dollar-denominated debt that morphs into a global liquidity crisis through now well-known contagion channels. Turkey is a good candidate to play patient zero in such a contagion, with over $400 billion in external debt and deteriorating relations with its NATO allies. Such a debt debacle would not be entirely the Fed’s fault. Chronic trillion-dollar deficits in the United States created by Congress will require higher interest rates to induce investors to purchase massive amounts of Treasury notes. With the Fed no longer a buyer, those purchases must come from private sources here or abroad. In turn, those sources will sell U.S. stocks or foreign debt to raise cash to buy Treasuries. That’s a dangerous dynamic that could cause compression in prices of risky assets and catalyze a crisis.
The second historic Fed blunder was an effort to normalize rate policy in 1937 after eight years of ease during the worst of the Great Depression. Today’s policy normalization is almost an exact replay. Economic performance from 2007 to 2019 is best understood as a depression, not in the sense of continual declining GDP, but as Keynes defined it, “a chronic condition of sub-normal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse.”2 In other words, a depression occurs when actual growth is depressed relative to potential growth, even without outright declines.
It is understandable that the Fed wishes to resume what it regards as normal monetary policy after the better part of a decade of abnormal ease. The difficulty is that the Fed has painted itself into a corner from which there is no easy exit. When the Fed tried to normalize policy in 1937 they triggered a second severe technical recession following the 1929–1933 recession and helped to prolong the Great Depression until 1940. Reverting to monetary ease does not allow an escape from Charybdis. More ease merely reinflates asset bubbles and increases systemic scale, insuring a crash of unprecedented magnitude.
Internally, the Fed has congratulated itself on their fine-tuning and market finesse. They shouldn’t have. All the Fed proved in recent years was that they really couldn’t exit extraordinary policy intervention without disruption. The Fed has been storing up trouble for another day. That day is here.
We Are Not Helpless
History’s a hard mistress. Her judgments are unsparing, seldom those we expect. Leaders laughed at in their day are deemed heroic by later generations. Harry S. Truman was viewed as unfit and lacking in stature while president, particularly in comparison with his predecessor, FDR. Today Truman is ranked by historians as one of the ten greatest presidents, ahead of icons such as Thomas Jefferson and Ronald Reagan.3 Ike had a like reappraisal. President Eisenhower was considered an avuncular, golf-playing figure while in office, not particularly prescient or engaged in policy. Today he ranks fifth among U.S. presidents, ahead of Truman and just behind the big four—Lincoln, Washington, FDR, and Teddy Roosevelt.
In a similar way, history will elevate Gerald R. Ford. President Ford was set apart as the only commander in chief never elected to national office. Most in the baby-boom generation never forgave Ford for his 1974 pardon of the villainous Nixon. After stumbling on the Air Force One staircase, Ford was relentlessly ridiculed as clumsy by Saturday Night Live comedian Chevy Chase. Ford served only fifty-four months in office. He lost his first and only national election contest in 1976. Today, Ford is ranked by historians at twenty-fifth among forty-four past presidents, the bottom half of the class.
The reality was that Ford was a handsome college athlete who played on two championship teams and was named a college all-star. His academic record includes Phi Beta Kappa at the University of Michigan and a law degree from Yale. Ford was the Republican leader in the House of Representatives. As president, Ford’s pardon of Nixon is widely viewed as a healing act of forgiveness, even if many will not forgive Ford. In a speech at Tulane University on April 23, 1975, Ford declared the war in Vietnam “finished as far as America is concerned.” By closing the door on Watergate and Vietnam, two of the bitterest episodes in U.S. political history, Ford allowed America to mend and move on. In 1976, he led the nation in a joyous celebration of its bicentennial.
Yet these accomplishments, all well known to historians, will not advance Ford’s place in presidential annals. Ford’s lasting legacies, ones that history will smile upon, are his twin contributions to individual freedom—the Helsinki Accords and the legalization of gold.
The Helsinki Accords were signed on August 1, 1975, by President Ford; Leonid Brezhnev, general secretary of the Communist Party of the Soviet Union; and leaders of thirty-three other Western and Eastern-bloc states. The accords were an odd mix of ostensibly pro-Soviet and pro-Western pledges.
References to “territorial integrity” and the “nonuse of force” seemed to solidify Soviet claims to control of countries behind the Iron Curtain. Brezhnev said the accords ratified post–World War II boundaries from the Baltics to Berlin. Ford was bitterly criticized by Americans of European descent and others who considered the accords a sellout of Baltic and Polish aspirations for freedom.
Yet the accords also called for respect for human rights, and freedom of thought, conscience, and religious belief. The accords insisted on equal rights, self-determination, and peaceful resolution of disputes. For the first time since the Cold War began, people behind the Iron Curtain had a legitimate standard for freedom that the Soviet Union had agreed to in writing. This led to the creation of watchdog groups and regular progress reports on adherence to the accords.
The objective criteria established by the Helsinki Accords provided a legal framework for movements such as the June 1976 protests in Poland, a precursor to the formation of the Solidarity labor union in September 1980. In time, and with support from Ronald Reagan and Pope John Paul II, Solidarity and other movements led to the breakdown of the Communist order, the destruction of the Berlin Wall in 1989, and the dissolution of the So
viet Union in 1991. This is not a marginal view. As recently as July 2018, the establishment journal Foreign Affairs wrote:
In Helsinki in 1975, the United States, the Soviet Union, and various European powers devised a security architecture for Europe that was controversial at the time but ultimately crucial to the Cold War’s peaceful end.4 Without the Helsinki Accords, which fostered agreement on Europe’s borders and enshrined a nominal commitment to human rights in the Eastern bloc, the revolutions of 1989 may never have come and almost certainly would not have been as peaceful as they were.
Ford’s courage and foresight in supporting the Helsinki Accords in the face of elite skepticism abroad and popular opposition at home was a world-historic achievement.
Ford ushered in another kind of freedom on August 14, 1974, just five days after becoming president. He signed Public Law 93-373, which legalized ownership of gold by American citizens for the first time in over forty years. FDR declared gold to be contraband by Executive Order 6102 on April 5, 1933; Ford’s signature reversed FDR’s ban. The new law went into effect on December 31, 1974. Since then, Americans have been free to own physical gold bullion or coins.
Freedom to own gold means freedom from inflation, freedom from banks, and freedom from digital surveillance and hacking. America is not on a gold standard. Still, Americans can create a personal gold standard thanks to the emancipation from fiat money afforded by Gerald Ford.
Ford’s two great liberating acts—facilitating freedom from Communism and freedom from fiat currency—are why history will favor Ford in the fullness of time.
In fact, gold is one way out of the Fed’s conundrum. The Federal Reserve and U.S. Treasury acting in concert could create a one-time inflation shock by devaluing the dollar against gold and defending the new parity with the Fed’s printing press and the Treasury’s gold hoard. The Fed could conduct open-market operations in gold as it currently does in bonds to keep the dollar price of gold in narrow bands near the parity. A reasonable nondeflationary price for gold would be required. This price is estimated at ten thousand dollars per ounce, given exiting monetary aggregates and the current gold hoard. Discretionary monetary policy would exist side-by-side with gold; the money supply could be expanded by buying private gold and adding it to the hoard. Citizens who presciently purchased gold would see their wealth preserved. Social security indexation would offset the inflationary impact for current and future retirees. The real value of the national debt would be greatly diminished, saving the United States from a crisis of confidence. The dollar would become the soundest currency in the world, making the United States a magnet for foreign capital. Growth could rebalance from consumption to investment, insuring another century of American greatness. The ship of state would sail smoothly past Scylla and sister Charybdis.