A depression’s natural state is deflation. Businesses faced with declining revenue and individuals faced with unemployment will rapidly sell assets to reduce debt, a process known as deleveraging. As asset sales continue and as spending declines, prices decline further, which is deflation’s immediate cause. Those price declines then add further economic stress, leading to additional asset sales, more unemployment, and so on in a feedback loop. In deflation, the real value of cash increases, so individuals and businesses hoard cash instead of spending it or investing in new land, plant, and equipment.
This entire process of asset sales, hoarding, and price declines is called a liquidity trap, famously described by Irving Fisher in his 1933 work The Debt-Deflation Theory of Great Depressions and by John Maynard Keynes in his most influential work, The General Theory of Employment, Interest and Money. In a liquidity trap, the response to money printing is generally weak, and from a Keynesian perspective, fiscal policy is the preferred medicine.
While the response to money printing may be weak, it is not nil. Working against potential deflation has been a massive money-printing operation by the Federal Reserve. In the six years from 2008 to 2014, the Federal Reserve has increased base money from about $800 billion to over $4 trillion, a more than 400 percent increase. While the turnover or velocity of money has been in sharp decline, the quantity of money has skyrocketed, helping to offset the slower pace of spending. The combination of massive money printing and zero interest rates has also propped up asset prices, leading to a stock market rally and a strong recovery in housing prices since 2009. But asset values are being inflated from other sources too.
■ Tuition Tally
Another reason deflation has not prevailed over inflation, despite faint economic growth, is that the U.S. Treasury has promoted a new cash injection into the economy, larger than subprime housing finance in the 2002–7 period. This injection is in the form of student loans.
Student loans are the new subprime mortgages: another government-subsidized bubble about to burst. Students have a high propensity to spend, whether on tuition itself or on books, apartments, furniture, and beer. If you give students money, they will spend it; there is little danger that they will buy gold or otherwise hoard the money as savings. Tuition payments financed by student loans are a mere conduit since the payments are passed along as union faculty salaries or university overhead. Loan proceeds remaining after tuition are spent directly by the students.
Annual borrowing in all undergraduate and graduate student loan programs surged to over $100 billion per year in 2012, up from about $65 billion per year at the start of the 2007 depression. By August 2013, total student loans backed by the U.S. government exceeded $1 trillion, an amount that has doubled since 2009. A provision contained in the 2010 Obamacare legislation provided the U.S. Treasury with a near monopoly on student loan origination and sidelined most private lenders who formerly participated in this market. This meant that the Treasury could relax lending standards to continue the flow of easy money.
The student loan market is politically untouchable because higher education historically produces citizens with added skills who repay the loans and earn higher incomes over time. No member of Congress wants to support legislation that would crimp Johnnie or Susie’s ability to afford college. But the program has morphed into direct government pump priming, in the same manner that historically productive home lending programs morphed into a housing bubble between 1994 and 2007. In the mortgage market, Fannie Mae and Freddie Mac used government subsidies to push home ownership beyond levels that buyers could afford, giving rise to subprime mortgages without documentation or down payments. The mortgage market crashed in 2007, marking the start of the depression.
Student loans now pose a similar dynamic. Most of the loans are sound and will be repaid as agreed. But many borrowers will default because the students did not acquire needed skills and cannot find jobs in a listless economy. Those defaults will make federal budget deficits worse, a development not fully reflected in official budget projections. In effect, student loans are being pumped out by the U.S. Treasury and directed to borrowers with a high propensity to spend and limited ability to repay.
These monies have helped prop up the U.S. economy, but the flow of tuition dollars isn’t sustainable. It is economically no different than the Chinese building ghost cities with borrowed money that cannot be repaid. Chinese ghost cities and U.S. diplomas are real, but productivity increases and the ability to repay the borrowings are not.
While student loans may provide a short-term lift to discretionary spending, the long-term effects of excessive debt combined with the absence of jobs are another encumbrance on the economy. A record 21 million young adults between ages eighteen and thirty-one are living with their parents. Many of these stay-at-homes are recent graduates who cannot pay rent or afford down payments on homes because of student loans. For now, student loan cash flows and spending have helped to defer the deflation threat, but the student loan bubble will burst in the years ahead, making the debt and deficit crises worse.
■ The Inflation Conundrum
Former Fed chairman Bernanke once said that the Federal Reserve could combat deflation by throwing money from helicopters. His metaphor assumed that people would gladly pick up the money and spend it. In the real world, however, picking up the money means going into debt in the form of business loans, mortgages, or credit cards. Businesses and individuals are unwilling to go into debt because of policy uncertainty and the threat of even more deflation.
Going back to 2009, Bernanke’s critics have claimed that quantitative easing would lead to unacceptably high inflation, even imminent hyperinflation. These critics focused exclusively on money printing, failing to perceive that inflation is only partially a function of money supply. The other key factor is behavior in the form of lending and spending. Underlying weakness in the economy, and extreme uncertainty about policies on taxes, health care, environmental regulation, and other business cost determinants, resulted in stagnation both in consumer spending and in business investment, two main drivers of economic growth.
A standoff in the battle between deflation and inflation does not mean that price stability prevails. The opposing forces may have neutralized each other for the time being, but neither has gone away. Collapsing growth in China and a reemergence of the sovereign debt crisis in Europe could give deflation the upper hand. Conversely, a war in the Middle East followed by a commodity price shock, surging oil prices, and panicked gold buying could cause dollar dumping and an inflationary groundswell that the Fed would be unable to contain. Either extreme is possible.
This dilemma is reflected in a difference of opinion at the Federal Open Market Committee (FOMC), the Fed’s policy-making arm, between those who favor reduced money printing and those who favor a continuation or even expansion of the money supply through Fed asset purchases. The group that favors reduced money printing, so-called tapering, led by Fed governor Jeremy Stein, contends that continued money printing is having only limited positive effects and may create asset bubbles and systemic risk. Since money is practically free because of zero-rate policy, and since leverage magnifies returns to investors, the inducement to borrow money and take a chance on rising asset prices is hard to resist. Leverage is available to stock traders in the form of margin loans and to home buyers in the form of cheap mortgages. Since rising stock and home prices are based on cheap money rather than economic fundamentals, both markets are forming new bubbles, which will eventually burst and damage confidence again.
Under certain scenarios, the outcome could be worse than a bursting bubble and might include systemic risk and outright panic. The stock market is poised for a crash worse than 2000 or 2008. Business television anchors and sell-side analysts are only too happy to announce each new “high” in the stock market indexes. In fact, these highs are mostly nominal—they are not entirely real. When the
reported index levels are adjusted for inflation, a different picture emerges. The 2008 peak was actually below the 2000 peak in real terms. The nominal peak in 1973 was followed in 1974 by one of the worst stock market crashes in U.S. history. Past is not necessarily prelude; still, the combination of extreme leverage, economic weakness, and a looming recession all put the stock market at risk of a historic crash. Any such crash would result in a blow to confidence that no amount of Fed money printing could assuage. It would trigger an extreme version of Fisher’s debt-deflation cycle. In this scenario, deflation would finally gain the upper hand over inflation, and the economic dynamics of the early 1930s would return with a vengeance.
Another factor that could contribute to a worst-case result is the hidden leverage on bank balance sheets in the form of derivatives and asset swaps. The concern here relates not to a stock market crash but to a counterparty failure that triggers a liquidity crisis in financial markets and precipitates a panic.
The pro-tapering group around Fed governor Stein understands that reduced money printing may hurt growth, but they fear that a stock market crash or a financial panic could hurt growth much more by destroying confidence. In their view, reduced money printing now is a way to let a little air out of the bubbles without deflating them entirely.
In opposition to this view are FOMC members like Fed chairwoman Janet Yellen, who see no immediate inflation risk due to excess capacity in labor markets and manufacturing, and who favor continued large asset purchases and money printing as the only hope for continued growth, especially in light of the recent tightening in fiscal policy. For Yellen, the money printing should continue until persistent inflation above 2.5 percent actually emerges and until unemployment is 6.5 percent or less. Yellen favors continued money printing even if inflation rises to 3 percent or more so long as unemployment is above 6.5 percent. She regards the risks of financial panic as remote and is confident that inflation can be controlled in due course with available tools if inflation does rise too far.
Yellen’s confidence in the remoteness of inflation and in the Fed’s ability to control inflation, if it does emerge, is based on her application of conventional general equilibrium models that do not include the most advanced theoretical work on complexity theory, interconnectedness, and the sudden emergence of systemic risk. On the other hand, her understanding that inflation was not imminent due to slack in labor and industrial capacity made her economic forecasts consistently more accurate than those of her colleagues and the Fed staff from 2011 to 2013. These forecasting successes added to her credibility inside the Federal Reserve and were important in her selection as the new Fed chairwoman. As a result, her views on the need for continued money printing carry great weight with the Fed staff and the FOMC.
It is not surprising that the FOMC members are deeply divided between the contrasting views espoused by Stein and Yellen. Stein is no doubt correct that systemic risk is building up unseen in the banking system through off-balance-sheet transactions and that new bubbles are emerging. Yellen is undoubtedly right that the economy is fundamentally weak and needs all the policy support it can get to avoid outright recession and deflation. The fact that both sides in the debate are correct means both sides are also incorrect to the extent that they fail to incorporate their opponents’ valid points in their own views. The resulting policy incoherence is the inevitable outcome of the Fed’s market manipulation. Valid price signals are suppressed or distorted, which induces banks to take risky positions that serve no business purpose except to eke out profits in a zero-rate environment. At the same time, asset values are inflated, which means that capital is not devoted to its most productive uses but instead chases evanescent mark-to-market gains in stocks and housing. Both continued money printing and the reduction of money printing pose risks, albeit different kinds.
The result is a standoff between natural deflation and policy-induced inflation. The economy is like a high-altitude climber proceeding slowly, methodically on a ridgeline at twenty-eight thousand feet without oxygen. On one side of the ridge is a vertical face that goes straight down for a mile. On the other side is a steep glacier that offers no way to secure a grip. A fall to either side means certain death. Yet moving ahead gets more difficult with every step and makes a fall more likely. Turning back is an option, but that means finally facing the pain that the economy avoided in 2009, when the money-printing journey began.
The great American novelist F. Scott Fitzgerald wrote in 1936 that “the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.” By 2014, the Federal Reserve board members were being put to Fitzgerald’s test. Inflation and deflation are opposed ideas, as are tapering and nontapering. No doubt, the Fed board members start with first-rate intelligence; they are now confronted with opposing ideas. The question is whether, as Fitzgerald phrased it, they can “still retain the ability to function.”
■ Confidence
Former Federal Reserve chairman Paul Volcker joined the Fed as a staff economist in 1952 and has witnessed or led every significant monetary and financial development since. As the Treasury undersecretary, he was at President Nixon’s side when the dollar’s convertibility into gold was ended in 1971. Appointed Fed chairman by President Carter in 1979, he raised interest rates to 19 percent in 1981 to break the back of the borderline hyperinflation that gripped America from 1977 onward. In 2009 President Obama selected him to head the Economic Recovery Advisory Board, to formulate responses to the worst economic slump since the Great Depression. From this platform, he advanced the Volcker Rule, an attempt to restore sound banking practices that were abandoned with the repeal of Glass-Steagall in 1999. The Volcker Rule finally got past the big bank lobbyists in 2013. Volcker correctly perceived the riskiest facet of the banking system and deserves much credit for working to fix it. No banker or policy maker knows more about money, and how it works, than Volcker.
When pressed about the dollar’s role in the international monetary system today, Volcker acknowledges the challenges facing the U.S. economy, and the dollar in particular, with a kind of been-there-done-that attitude. He points out that circumstances are not as dire as they were in 1971, when there was a run on Fort Knox, or in 1978, when, because international creditors had begun to reject the U.S. dollar as a store of value, the U.S. Treasury issued the infamous Carter Bonds, denominated in Swiss francs.
When pressed harder, Volcker is candid about China’s rise and acknowledges talk of the dollar being knocked off its pedestal as the world’s leading reserve currency. But he just as quickly points out that despite the talk, no currency comes close to the dollar in terms of the deep, liquid pools of investable assets needed for true reserve-currency status. Volcker is no fan of the gold standard and believes a return to gold is neither feasible nor desirable.
Finally, when presented with issues such as bonded debt, massive entitlements, continuing deficits, and legislative dysfunction that suggests the dollar dénouement has already begun, Volcker narrows his gaze, hardens his demeanor, and utters one word: “Confidence.”
He believes that, if people have confidence in it, the dollar can weather any storm. If people lose confidence in the dollar, no army of Ph.D.s can save it. On this point, Volcker is certainly right, yet no one can say whether confidence in the dollar has passed the point of no return due to Fed blunders, debt-ceiling debacles, and the precautions of the Russians and Chinese.
Unfortunately, there are growing signs that confidence in the dollar is evaporating. In October 2013 the Fed’s Price-adjusted Broad Dollar Index, the best gauge of the dollar’s standing in foreign exchange markets, stood at 84.05, an improvement on the all-time low of 80.52 of July 2011 but approximately equal to prior lows in October 1978, July 1995, and April 2008. Demand for physical gold bullion, a measure of lost confidence in the dollar, began rising sharply in mid-to-late 2013, another sign
of a weaker dollar. The foreign currency composition of global reserves shows a continuing decline in the dollar’s use as a reserve currency from about 70 percent in 2000 to about 60 percent today. No one of these readings indicates an immediate crisis, but all three show declining confidence.
Other indications are anecdotal and difficult to quantify but are no less telling. Among them are the rise of alternative currencies and of virtual or digital currencies such as bitcoin. Digital currencies exist within private peer-to-peer computer networks and are not issued by or supported by any government or central bank. The bitcoin phenomenon began in 2008 with the pseudonymous publication of a paper (by Satoshi Nakamoto) describing the protocols for the creation of a new electronic digital currency. In January 2009 the first bitcoins were created by Nakamoto’s software. He continued making technical contributions to the bitcoin project until 2010, at which point he withdrew from active participation. However, by that time a large community of developers, libertarians, and entrepreneurs had taken up the project. By late 2013, over 11.5 million bitcoins were in circulation, with the number growing steadily. The value of each bitcoin fluctuates based on supply and demand, but it had exceeded $700 per bitcoin in November 2013. Bitcoin’s long-term viability as a virtual currency remains to be seen, but its rapid and widespread adoption can already be taken as a sign that communities around the world are seeking alternatives to the dollar and traditional fiat currencies.
The Death of Money Page 29