November 4 (Washington Post) — Two years have passed since the worst financial crisis since the 1930s dealt a body blow to the world economy.

Only because policy makers failed to respond with an appropriate fiscal adjustment.

And, worse, they continue to fail to recognize this policy blunder.

Working with policymakers at home and abroad, the Federal Reserve responded with strong and creative measures to help stabilize the financial system and the economy. Among the Fed’s responses was a dramatic easing of monetary policy – reducing short-term interest rates nearly to zero. The Fed also purchased more than a trillion dollars’ worth of Treasury securities and U.S.-backed mortgage-related securities, which helped reduce longer-term interest rates, such as those for mortgages and corporate bonds. These steps helped end the economic free fall and set the stage for a resumption of economic growth in mid-2009.

In Q3 08 the Fed failed to provide sufficient routine bank liquidity for several critical months while it experimented with a variety of poorly thought out open market operations that progressively accepted more and more bank collateral until they eventually did what they should have all along- lend to member banks at their target rate on a continuous, as needed basis. Yet even now they fail to do this to the smaller community banks, whose cost of funds remains at least 1% over the fed funds rate.

They also continue to fail to recognize that their role is setting the term structure of risk free rates, which can be done directly. By simply offering to buy tsy securities at their target rates in unlimited quantities.

However, they have yet to fully appreciate that it’s the resulting interest rates and not the quantities they purchase that are of further economic consequence. And if they wish to specifically target mortgage rates, this is readily done by lending to their member banks specifically for this purpose at the Fed’s desired target for mortgage rates, with the Fed assuming the ‘convexity’ risk.

Additionally, while the Fed did address the ‘market functioning’ issues that were caused by the Fed’s own initial lack of liquidity provision, they failed to recognize that monetary policy was not going to restore aggregate demand. In fact, they were all but certain it would, as evidenced by their concern their policies carried the risk of generating ‘inflation, etc.’ this led other policy makers to take a ‘wait and see’ attitude which has been monumentally costly with regards to lost real output and all the real costs of unemployment.

Notwithstanding the progress that has been made.

After more than two years the output gap in general remains at near record levels.

when the Fed’s monetary policymaking committee – the Federal Open Market Committee (FOMC) – met this week to review the economic situation, we could hardly be satisfied. The Federal Reserve’s objectives – its dual mandate, set by Congress – are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.

The fed’s responsibility for this is largely that of its failure to do its job of providing continuous and unlimited liquidity to its member banks and to not recognize that monetary policy was not capable of restoring the aggregate demand necessary to support full employment.

Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. Although low inflation is generally good, inflation that is too low can pose risks to the economy – especially when the economy is struggling. In the most extreme case, very low inflation can morph into deflation (falling prices and wages), which can contribute to long periods of economic stagnation.

Morph? Inflation deteriorates to unwelcome deflation with a lack of aggregate demand. There is no mystery here.

Even absent such risks, low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating.

Note the continued failure to recognize monetary policy has no tools to support demand at desired levels.

The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion..

These are all very weak channels at best.

What is hoped for is that lower interest rates encourage private credit expansion, where consumers return to borrowing to spend. And while this can happen, and may already be happening to a small degree, there is no reason to believe that QE will promote this outcome.

What the chairman knows and fails to discuss are the interest income channels, which he wrote about in a published paper in 2004. Lower rates cause the treasury to pay less interest on its treasury securities, and the interest the Fed earns on its newly purchased securities is interest no longer earned by the economy which previously held those securities. This reduced interest income paid by govt to the non govt sectors is much like a tax increase that to some degree neutralizes the modest positive effects the Fed is hoping for.

Also ignored is the fact that Japan has had near 0 rates and much lower long rates than the US, also helped by massive QE, and has also had very large net exports helping to support GDP, something the Fed and the US administration aspires to as well, yet has failed to restore desired aggregate demand, growth, and employment.

While they have been used successfully in the United States and elsewhere, purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason the FOMC has been cautious, balancing the costs and benefits before acting.

Costs?

As monopoly provider of net clearing balances (reserves) for the payments system, the Fed is necessarily ‘price setter’ of the term structure of risk free rates. Their notion of ‘cost’ is inapplicable. And all QE does is alter the duration of total govt liabilities. It doesn’t change the quantity of non govt net financial assets.

We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change.

Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.

Agreed! Yet their expressed motivation all along is to prevent deflation, which is the same as ‘causing inflation.’

A problem here is they believe that inflation is caused by rising inflation expectations, and not aggregate demand per se. That is, rising demand per se doesn’t cause inflation until that demand starts to drive inflation expectations.

Until this confused theory of inflation is discarded policy will continue to be confused as well.

Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation.

Correct, which also means the policy failed to generate the desired results.

We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time.

Agreed.

The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.

The Federal Reserve cannot solve all the economy’s problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation..

How about an obligation to support a sufficient fiscal adjustment to eliminate the output gap rather than supporting deficit reduction?

With floating fx, it’s necessarily about price (interest rate) and not quantity.

That includes China’s ‘dirty float’, a currency not convertible on demand at the CB, but with periodic CB market intervention.

Loans necessarily create deposits at lending institutions, and they also create any required reserves as a reserve requirement is functionally, in the first instance, an overdraft at the CB, which *is* a loan from the CB.

So from inception the assets and liabilities are necessarily ‘there’ for the CB to price.

Liquidity is needed to shift liabilities from one agent to another.

For example, if a depositor wants to shift his funds to another bank, the first bank must somehow ‘replace’ that liability by borrowing from some other agent, even as total liabilities in the system remain unchanged.

That ‘shifting around’ of liabilities is called ‘liquidity’.

But in any case at any point in time assets and liabilities are ‘in balance.’

It’s when an agent can’t honor the demand of a liability holder to shift his liability to another agent that liquidity matters.

And if a bank fails to honor a depositor’s request to shift his deposit to another institution, the deposit remains where it is. Yes, the bank may be in violation of its agreements, but it is ‘fully funded.’

The problem is that to honor its agreements to allow depositors to shift their deposits to other banks, the bank will attempt to replace the liability by borrowing elsewhere, which may entail driving up rates.

Likewise, banks will attempt to borrow elsewhere, which can drive up rates, to avoid overdrafts at the CB when the CB makes it clear they don’t want the banks to sustain overdrafts.

The problem is that only the CB can alter the total reserve balances in the banking system, as those are merely balances on the CB’s own spread sheet. Banks can shift balances from one to another, but not change the total.

So when the total quantity of reserve balances on a CB’s spreadsheet increases via overdraft, that overdraft can only shift from bank to bank, unless the CB acts to add the ‘needed’ reserves.

Or when one bank has excess reserves which forces another into overdraft, and the surplus bank won’t lend to the deficit bank.

This is all routinely addressed by the CB purchasing securities either outright or via repurchase agreements. It’s called ‘offsetting operating factors’, which also include other ‘adds and leakages’ including changes in tsy balances at the fed, float, cash demands, etc.

And when the CB does this they also, directly or indirectly, set the interest rate as they do, directly or indirectly, what I call ‘pricing the overdraft.’

So to restate, one way or another the CB sets the interest rate, while quantity remains as it is.

And those spikes you are seeing in China are from the CB setting rates indirectly.

The evidence from China is telling me that the western educated new kids on the block flat out don’t get it, probably because they were never told the fixed fx ‘monetarism’ they learned in school isn’t applicable to non convertible currency???

In any case the CB is the monopoly supplier of net reserves to its banking system and therefore ‘price setter’ and not ‘price taker’, and surely they learned about monopoly in school, but apparently/unfortunately have yet to recognize their currency itself is a simple public monopoly?

Thinking back, this is exactly the blunder of tall Paul back some 33 years ago. He made the same rookie mistake, for which he got credit for saving the US, and the world, from the great inflation of his day.

However, the fact that he made it worse, vs curing anything is of no consequence.

What matters is how the western elite institutions of higher learning spin it all…

:(

Crude pricing

The Saudis are the ‘supplier of last resort’/swing producer. Every day the world buys all the crude the other producers sell to the highest bidder and then go to the Saudis for the last 9-10 million barrels that are getting consumed. They either pay the Saudis price or shut the lights off, rendering the Saudis price setter/swing producer.

Specifically, the Saudis don’t sell at spot price in the market place, but instead simply post prices for their customers/refiners and let them buy all they want at those prices.

And most recently the prices they have posted have been fixed spreads from various benchmarks, like Brent.

Saudi spread pricing works like this:

Assume, for purposes of illustration, Saudi crude would sell at a discount of $1 vs Brent (due to higher refining costs etc.) if they let ‘the market’ decide the spread by selling a specific quantity at ‘market prices’/to the highest bidder. Instead, however, they announce they will sell at a $2 discount to Brent and let the refiners buy all they want.

So what happens?

The answer first- this sets a downward price spiral in motion. Refiners see the lower price available from the Saudis and lower the price they are willing to pay everyone else. And everyone else is a ‘price taker’ selling to the highest bidder, which is now $1 lower than ‘indifference levels’. When the other suppliers sell $1 lower than before the Saudi price cut/larger discount of $1, the Brent price drops by $1. Saudi crude is then available for $1 less than before, as the $2 discount remains in place. Etc. etc. with no end until either:

1) The Saudis change the discount/raise their price.

2) Physical demand goes up beyond the Saudis capacity to increase production.

And setting the spread north of ‘neutral’ causes prices to rise, etc.

Bottom line is the Saudis set price, and have engineered the latest decline. There was no shift in net global supply/demand as evidenced by Saudi output remaining relatively stable throughout.

The Global Economy

If all the crude had simply been sold to the highest bidder/market prices, in a non monetary relative value world the amount consumed would have been ‘supply limited’ based on the real marginal cost, etc. And if prices were falling do to an increased supply offered for sale, the relative price of crude would be falling as the supply purchased and consumed rose. This would represent an increase in real output and real consumption/real GDP(yes, real emissions, etc.)

However, that’s not the case with the Saudis as price setter. The world was not operating on a ‘quantity constrained’ basis as the Saudis were continuously willing to sell more than the world wanted to purchase from them at their price. If there was any increase in non Saudi supply, total crude sales/consumption remained as before, but with the Saudis selling that much less.

Therefore, with the drop in prices, at least in the near term, output/consumption/GDP doesn’t per se go up.

Nor, in theory, in a market economy/flexible prices, does the relative value of crude change. Instead, all other prices simply adjust downward in line with the drop in crude prices.

Let me elaborate.

In a market economy (not to say that we actually have one) only one price need be set and with all others gravitating towards ‘indifference levels’. In fact, one price must be set or it’s all a ‘non starter’. So which price is set today? Mainstream economists ponder over this, and, as they’ve overlooked the fact that the currency is a public monopoly, have concluded that the price level exists today for whatever ‘historic’ reasons, and the important question is not how it got here, but what might make it change from today’s level. That is, what might cause ‘inflation’. That’s where inflation expectations theory comes in. For lack of a better reason, the ‘residual’ is that it’s inflation expectations that cause changes in the price level. And not anything else, which are relative value stories. And they operate through two channels- workers demanding higher wages and people accelerating purchases. Hence the fixation on wages as the cause of inflation, and using ‘monetary policy’ to accelerate purchases, etc.

Regardless of the ‘internal merits’ of this conclusion, it’s all obviated by the fact that the currency itself is a simple public monopoly, rendering govt price setter. Note the introduction of monetary taxation, the basis of the currency, is coercive, and obviously not a ‘market expense’ for the taxpayer, and therefore the idea of ‘neutrality’ of the currency in entirely inapplicable. In fact, since the $ to pay taxes and buy govt secs, assuming no counterfeiting, ultimately come only from the govt of issue, (as they say in the Fed, you can’t have a reserve drain without a prior reserve add), the price level is entirely a function of prices paid by the govt when it spends and/or collateral demanded when it lends. Said another way, since we need the govt’s $ to pay taxes, the govt is, whether it knows it or not, setting ‘terms of exchange’ when it buys our goods and service.

Note too that monopolists set two prices, the value of their product/price level as just described above, and what’s called the ‘own rate’/how it exchanges for itself, which for the currency is the interest rate, which is set by a vote at the CB.

The govt/mainstream, of course, has no concept of all this, as inflation expectations theory remains ‘well anchored.’ ;)

In fact, when confronted, argues aggressively that I’m wrong (story of my life- remember, they laughed at the Yugo…)

What they have done is set up a reasonably deflationary purchasing program, of buying from the lowest bidder in competition, and managed to keep federal wages/compensation a bit ‘behind the curve’ as well, partially indexed to their consumer price index, etc.

And consequently, govt has defacto advocated pricing power to the active monopolist, the Saudis, which explains why changes in crude prices and ‘inflation’ track as closely as they do.

Therefore, the way I see it is the latest Saudi price cuts are revaluing the dollar (along with other currencies with similar policies, which is most all of them) higher. A dollar now buys more oil and, to the extend we have a market economy that reflects relative value, more of most everything else. That is, it’s a powerful ‘deflationary bias’ (consequently rewarding ‘savers’ at the expense of ‘borrowers’) without necessarily increasing real output.

In fact, real output could go lower due to an induced credit contraction, next up.

Banking

Deflation is highly problematic for banks. Here’s what happened at my bank to illustrate the principle:

We had a $6.5 million loan on the books with $11 million of collateral backing it. Then, in 2009 the properties were appraised at only $8 million. This caused the regulators to ‘classify’ the loan and give it only $4 million in value for purposes of calculating our assets and capital. So our stated capital was reduced by $2.5 million, even though the borrower was still paying and there was more than enough market value left to cover us.

So the point is, even with conservative loan to value ratios of the collateral, a drop in collateral values nonetheless reduces a banks reported capital. In theory, that means if the banking system needs an 8% capital ratio, and is comfortably ahead at 10%, with conservative loan to value ratios, a 10% across the board drop in assets prices introduces the next ‘financial crisis’. It’s only a crisis because the regulators make it one, of course, but that’s today’s reality.

Additionally, making new loans in a deflationary environment is highly problematic in general for similar reasons. And the reduction in ‘borrowing to spend’ on energy and related capital goods and services is also a strong contractionary bias.

In the week following the bankruptcy of Lehman Brothers on September 15, 2008 – global financial markets actually broke down and by the end of the week they had to be put on artificial life support. The life support consisted of substituting sovereign credit for the credit of financial institutions which ceased to be acceptable to counter parties.

As Mervyn King of the Bank of England brilliantly explained, the authorities had to do in the short-term the exact opposite of what was needed in the long-term: they had to pump in a lot of credit to make up for the credit that disappeared and thereby reinforce the excess credit and leverage that had caused the crisis in the first place. Only in the longer term, when the crisis had subsided, could they drain the credit and reestablish macro-economic balance.

Not bad, but he doesn’t seem to understand there is no ‘macro balance’ per se in that regard. He should recognize that what he means by ‘macro balance’ should be the desired level of aggregate demand, which is altered by the public sector’s fiscal balance. So in the longer term, the public sector should tighten fiscal policy (what he calls ‘drain the credit’) only if aggregate demand is deemed to be ‘too high’ and not to pay for anything per se.

This required a delicate two phase maneuver just as when a car is skidding, first you have to turn the car into the direction of the skid and only when you have regained control can you correct course.

It’s more like when you come to an up hill stretch you need to press harder on the gas to maintain a steady speed and if you get going too fast on a down hill section you need to apply the brakes to maintain a steady speed. And for me, the ‘right’ speed is ‘full employment’ with desired price stability.

The first phase of the maneuver has been successfully accomplished – a collapse has been averted.

But full employment has not been restored. I agree this is not the time to hit the fiscal brakes. In fact, I’d cut VAT until output and employment is restored, and offer a govt funded minimum wage transition job to anyone willing and able to work.

In retrospect, the temporary breakdown of the financial system seems like a bad dream. There are people in the financial institutions that survived who would like nothing better than to forget it and carry on with business as usual. This was evident in their massive lobbying effort to protect their interests in the Financial Reform Act that just came out of Congress. But the collapse of the financial system as we know it is real and the crisis is far from over.

Indeed, we have just entered Act II of the drama, when financial markets started losing confidence in the credibility of sovereign debt. Greece and the euro have taken center stage but the effects are liable to be felt worldwide. Doubts about sovereign credit are forcing reductions in budget deficits at a time when the banks and the economy may not be strong enough to permit the pursuit of fiscal rectitude. We find ourselves in a situation eerily reminiscent of the 1930’s. Keynes has taught us that budget deficits are essential for counter cyclical policies yet many governments have to reduce them under pressure from financial markets. This is liable to push the global economy into a double dip.

Yes, and this is an issue specific to govts that are not the issuers of their currency- the US States, the euro zone members, and govts with fixed exchange rates.

It is important to realize that the crisis in which we find ourselves is not just a market failure but also a regulatory failure and even more importantly a failure of the prevailing dogma about financial markets. I have in mind the Efficient Market Hypothesis and Rational Expectation Theory. These economic theories guided, or more exactly misguided, both the regulators and the financial engineers who designed the derivatives and other synthetic financial instruments and quantitative risk management systems which have played such an important part in the collapse. To gain a proper understanding of the current situation and how we got to where we are, we need to go back to basics and reexamine the foundation of economic theory.

I agree, see my proposals at moslereconomics.com.

I have developed an alternative theory about financial markets which asserts that financial markets do not necessarily tend towards equilibrium; they can just as easily produce asset bubbles. Nor are markets capable of correcting their own excesses. Keeping asset bubbles within bounds have to be an objective of public policy. I propounded this theory in my first book, The Alchemy of Finance, in 1987. It was generally dismissed at the time but the current financial crisis has proven, not necessarily its validity, but certainly its superiority to the prevailing dogma.

First we can always act to sustain aggregate demand and employment at desired levels across any asset price cycle with fiscal policy. No one would have cared much about the financial crisis if we’d kept employment and output high in the real sectors. Note that because output and employment remained high (for whatever reason) through the crash of 1987, the crash of 1998, and the Enron event, they were of less concern than the most recent crisis where unemployment jumped to over 10%..

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality I speak of far from equilibrium conditions. That is where we are now.

I’d say ‘equilibrium’ conditions are necessarily transitory at best under current institutional arrangements, including how policy is determined in Washington and around the world, and continually changing fundamentals of supply and demand.

Second, financial markets do not play a purely passive role; they can also affect the so called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function the fundamentals are supposed to determine market prices. In the active or manipulative function market prices find ways of influencing the fundamentals. When both functions operate at the same time they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other so that neither function has a truly independent variable. As a result neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.

Goes without saying.

I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921 but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever and if the underlying reality remains unchanged it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals. By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity but they are the most spectacular.

Ok, also seems obvious? Now he need to add that the currency itself is a public monopoly, as the introduction of taxation, a coercive force, introduces ‘imperfect competition’ with ‘supply’ of that needed to pay taxes under govt. control. This puts govt in the position of ‘price setter’ when it spends (and/or demands collateral when it lends). And a prime ‘pass through’ channel he needs to add is indexation of public sector wages and benefits.

In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting case where negative feedback is carried to its ultimate limit. Positive feedback has been largely assumed away by the prevailing dogma and it deserves a lot more attention.

Even his positive feedback will ‘run its course’ (not to say there aren’t consequences) for the most part if it wasn’t for the fact that the currency itself is a case of monopoly and the govt. paying more for the same thing, for example, is redefining the currency downward.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.

Make sense.

Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved.

I’d say it’s more like the price gets high enough for the funding to run dry at that price for any reason? Unless funding is coming from/supported by govt (and/or it’s designated agents, etc), the issuer of the currency, that funding will always be limited.

A twilight period ensues during which doubts grow and more and more people lose faith but the prevailing trend is sustained by inertia.

‘Inertia’? It’s available spending power that’s needed to sustain prices of anything. The price of housing sales won’t go up without someone paying the higher price.

As Chuck Prince former head of Citigroup said, “As long as the music is playing you’ve got to get up and dance. We are still dancing.”