The Good and the Bad

Bloomberg, which is a major purveyor not only of useful economic and financial data, but also a major proponent of economic central planning as practiced by modern central banks, informs us that Fed chair Janet Yellen has actually found the holy grail. Finally, central planning will work! At last, the promise of the “scientific monetary policy” is about to be fulfilled. Nirvana has practically arrived.

In a once again slightly confusing Bloomberg headline we are told: “Yellen Takes the Good Greenspan, Leaves the Bad”. If that’s so, obviously nothing can go wrong. It does make us wonder though what she’ll do about the ugly Greenspan.

In a way, this is an almost prophetic poster, with its references to risk taking and someone “doing the cutting”…

So what is the promising secret sauce discovered by Ms. Yellen? After a string of abysmal failures over the past century, how is central economic planning by the Fed finally going to lead us to salvation? As the headline already indicates, tweaking Alan Greenspan’s playbook is believed to do the trick:

“Janet Yellen looks to be taking one page out of Alan Greenspan’s playbook while tearing up another as she plots monetary strategy for 2015 and beyond.

The Federal Reserve chair and her colleagues signaled this month they would be willing to push unemployment below its so-called natural rate — a feat Greenspan as chairman managed in the late 1990s without fanning much inflation. Yellen showed less desire to pursue her predecessor’s “measured” approach to raising interest rates in the mid-2000s, suggesting his strategy may have fostered complacency that made a small contribution to the financial crisis.

The late 1990s “was a very good period for the U.S. economy, and Greenspan made the correct call on monetary policy,” said Michael Gapen, a former Fed official who is now senior U.S. economist for Barclays Capital Inc. in New York. On the other hand, “there is a general consensus the way they did policy wasn’t right” in the run-up to the housing bust that preceded the 2007-2009 recession.”

There was in fact little practical difference between the late 1990s policy, the Fed’s reaction to the bursting of the asset bubble this policy fostered, and its reaction to the bursting of the next bubble its policies then caused. In fact, the demise of the late 1990s bubble was what motivated Greenspan’s early to mid- 2000ds policy. And the end of this echo boom in turn has motivated current policies. Apart from technicalities, it is very difficult to discern any differences. Dangerous credit and asset bubbles have formed every time, and the central bank then proceeded to provide the fuel for even bigger credit and asset bubbles. We do not need to “guess” about this, or consider trivial details, we only need to ponder a chart of the money supply.

US broad true money supply (TMS-2) since 1988 (via St. Louis Federal Reserve Research): the three bubble eras can be easily recognized. It ain’t rocket science, as they say – click to enlarge.

Professional Bubble Spotters At Work

Fed members are evidently aware that the institution has rightly been charged by critics with fomenting numerous asset bubbles and these days feel compelled to make statements that indicate that A) this time they “have a plan”, and B) no bubbles are in sight anywhere, so there’s no need to worry anyway. Right.

So what’s the plan?

“Yellen stressed to reporters on Sept. 17 that the Fed’s actions would depend on how the economy evolves. “There is no mechanical” approach to carrying out policy, she said, adding that “many people” think the Fed relied too much on a lock-step strategy in the mid-2000s.

James Bullard, St. Louis Fed president, is among those who argue that approach led to complacency about the Fed’s intentions and too much risk-taking by investors and home buyers.

“The 2004 to 2006 tightening cycle was way too mechanical,” he said Sept. 23. “There was so much predictability there that I think it did foster asset-price bubbles.”

Apart from the fact that the monetary tightening of 2004-2006 was what actually unmasked the capital malinvestment of the bubble and led to its eventual demise (which was inevitable anyway), one wonders in what way the current situation is supposed to be different, apart from the fact that monetary policy is even looser than it was then, and has already created another set of bubbles that actually dwarf the previous ones in several respects.

Do these people really believe what they are saying? Making their policy “less mechanical” cannot avoid creating a bubble that is already in full swing, or avert its eventual collapse.

Let us also not forget that the Fed has never – not once in its entire history – actually recognized a bubble that was staring into its face. Today is no different. Readers are encouraged to read the middle portion of the Bloomberg article as well, which discusses the potential dangers of “inflation” breaking loose (i.e., strong rises in CPI) and Mr. Dudley’s notion that the Fed should “let the economy run a little hot” (meaning, allow its inflation target to be exceeded), which documents the sheer hubris of these people. We are going to focus here on what is said further about asset bubbles, including Mr. Greenspan’s disingenuous comments on the Fed’s responsibility for the housing boom.

“Dudley said there has been a “sea change” in the way the Fed thinks about asset bubbles since Greenspan’s tenure. Under Greenspan, policy makers thought bubbles were “very hard” to spot beforehand. So they decided to wait until they burst and “clean up after the fact,” he said.

“That didn’t work out so well in the financial crisis,” he said. Now officials “try to identify asset bubbles in real time” and “see what tools you have” to address them.

In what JPMorgan Chase & Co. economist Michael Feroli said was probably a nod to such concerns, Yellen suggested to reporters on Sept. 17 that she wouldn’t emulate Greenspan’s methodical approach to raising interest rates.

The Greenspan-led Fed began tightening credit in June 2004, bumping up the federal funds rate by a quarter percentage point while saying it expected further increases to be “measured.” The central bank then raised rates in 25-basis-point increments for 16 straight meetings.

Greenspan has conceded that he was wrong in opposing more oversight of the financial markets in the run-up to the crisis. He has, though, rejected arguments that an overly loose monetary policy helped fuel the housing bubble that eventually burst.

“There is no evidence that the actual price levels of homes was significantly affected by the action which we took,” Greenspan said on CNBC last December.

First a few words on Greenspan reiterating Ben Bernanke’s assertion that rising asset prices, specifically the housing bubble, were independent of the Fed’s policy. He is in fact rejecting the notion that boom-bust cycles have monetary causes. Pray tell, what is causing them then? Mysterious forces from another dimension? Magic? It should be obvious even to a layman that unless the supply of money and credit is increased, no asset bubbles can possibly form. In “The Theory of Money and Credit” Ludwig von Mises has proposed and explained the monetary theory of the business cycle more than 100 years ago already (at least in its first outline). It was subsequently refined further by Mises, Hayek and their followers. One would think that no serious economist can possibly doubt that business cycles have monetary causes. So Greenspan is either fibbing, or he’s in urgent need to brush up on his economic knowledge.

As to Mr. Dudley’s assertion that the Fed is now “trying to spot bubbles in real time”, that sounds almost as though he were practicing for a stand-up comedy routine. Say what? As one observer remarked:

“They are going to be trying to thread a needle,” he said. “They’re going to want a gradual pace of rate hikes but don’t want people to get too relaxed, like they did with measured pace. Good luck with that.”

Good luck with that indeed. Given Mr. Dudley’s assertions above, what “tools” then does the central bank possess? And why aren’t they being deployed yet, given the massive bubble in financial assets (chiefly stocks and corporate debt, especially junk debt)? We can infer that Dudley is referring to so-called “macro-prudential measures”, but if one takes steps to blunt a bubble caused by loose monetary policy in one area (e.g. by sharply increasing margin requirements so as to blunt the stock market bubble, to name an example), then those who dispose over the flood of money provided by the Fed will simply seek out other alternatives, and dangerous bubbles will be set into motion elsewhere. The only way to avoid bubbles is not to pump up the supply of money and credit in the first place. In that sense, the best thing to do would be to abolish the central bank, as nothing would hamper the financial system’s bubble-blowing capacity more.

We can explain though why all this talk has not resulted in any action yet – once again, Fed members are simply unable to see that they have helped produce another boom in asset prices. As Zerohedge recently reported, new Cleveland Fed president Loretta Mester told an audience that “stability risks in the US are well contained right now”. That’s right, even the “well contained” phrase is back.

We already know that Ms. Yellen has so far been unable to spot any bubbles (see: “Janet Yellen Chimes in on the Bubble Question” for details), and yesterday she has been joined in this assessment by über-dove Charles Evans, president of the Chicago Fed. According to Marketwatch:

“While a rate hike next June is a “certainly a possibility,” Evans said he thinks a little longer than the summer would be appropriate. The Fed wants to make sure that inflation gets to its 2% annual target, he said. Getting interest rates off of zero is a “really difficult proposition,” Evans said, pointing to the example of Japan over the last 20 years. “We need to make sure we have got the fundamentals right in order to have strong growth – get inflation up to 2% – so that we can exit the zero lower bound dilemmas that we have,” he said. The Chicago Fed president said he saw no evidence of asset bubbles in the economy. Evans is one of the leading doves on the Fed policy committee. He will be a voting member in 2015.”

Note here that it would probably make little difference if they actually did somehow develop the ability to “spot bubbles in real time”. We sometimes wonder how difficult that can be, given that money supply data and financial asset prices are readily available, but as noted above, the inability of Fed members to recognize bubbles staring them into the face is legendary by now.

Still, what if they did notice that another asset bubble is underway? Then they would be faced with the choice of taking action to deflate it either sooner or later. Does anyone seriously believe that they would voluntarily opt for ‘sooner’?

Stocks and junk bonds: As far as the Fed is concerned, these are “invisible” bubbles. They don’t exist because they say so. Of course, this is precisely what Bernanke said when he was asked in 2006 whether he realized that there was a housing bubble – via StockCharts – click to enlarge.

Conclusion:

All this talk about “making central economic planning better” by tweaking the odd detail is really nothing but hot air. Central economic planning is literally impossible and modern central banks are essentially demonstrating “the impracticability of socialist economic calculation in the financial sphere”, as J.H. De Soto has put it.

Nevertheless, occasionally somewhat more conservative central bankers have been in charge here or there, who at least tried to minimize the damage they were doing. The current crop of monetary bureaucrats is however wedded to especially misguided economic theories, which evidently include a firm but utterly misguided belief that the economy can be improved by printing money. The are also vastly overestimating their ability to “fix” whatever ails the economy – and have thus far proved completely unable to recognize or acknowledge their own role in producing these ailments.

One thing that always jumps out at us in interviews and speeches by Fed members are the frequent references to the economy as a mere set of numbers or equations, that are assumed to be perfectly controllable by well-meaning bureaucrats pulling this or that lever. But the “economy” is not just some abstract thing – people are acting in it, and it is their individual actions, goals and plans that give rise to what we call the economy. Central bank policy is effectively interfering with this actions and plans and leading them astray – under the widely accepted notion that a bunch of bureaucrats “knows better”. In short, ultimately the entire conceptual foundation on which central banking rests is utterly absurd.