The "New" Liquidity

This is the age of the “New” liquidity.  This new liquidity is driven by two things: first, information technology; and second, by the free flow of capital throughout the world. 

Finance is nothing more than information.  A dollar bill can be exchanged for another dollar bill.  A demand deposit can be exchanged for dollars and is nothing more than 0s and 1s on some bank’s computer.  A bond provides you with a series of cash flows, which are nothing more than electronic blips, 0s and 1s.  Mortgage-backed securities are nothing more than different cash flows cut into streams that suit the needs of whoever buys them…0s and 1s.

Information can be “sliced and diced” any way that you want it and can be stored and transmitted instantaneously almost anywhere in the world.   This latter point is where the free flow of capital throughout the world enters the picture.

This free flow of capital throughout the world is where the “new” liquidity comes in.  Financial assets, in today’s world, are extremely liquid.

 That is, these assets are liquid…until they aren’t liquid!  They remain liquid until something changes, like the price of the real estate behind certain assets ceases to rise continuously. 

And, this is the new world that the Federal Reserve has to operate within. 

The financial innovation of the last fifty years has been truly exceptional.  Information technology has aided this advance.  There are derivative instruments everywhere.  International capital markets have meant that financial assets can be placed all over the world.  The finance industry has become a huge part of the global economy, both in terms of wealth produced and in terms of employment.  Even manufacturing firms like General Motors and General Electric have gotten into the game and in recent years their finance wings have produced a majority of their profits.

The volume of financial assets that have been produced in this environment has relied on the liquidity of international capital markets to facilitate and expand the flow of these assets into every corner of the world.  The ease of the flow has been truly remarkable.

But, it is the very ease of the flow that has created problems here and there.  The problems I am alluding to are called “bubbles.”  Because capital can flow so freely from market to market and this flow can take place almost immediately, capital can move rapidly from various segments of the capital markets into other segments as sentiment or information changes.  And, as long as the markets remain “liquid” the movements can continue until the situation is played out.

This is a different environment from the one that the current model of monetary policy is based upon.  That model, originally created through the Bretton Woods agreement in the 1940s, assumed that there would not be a free flow of capital internationally.  Thus, with a gold standard and fixed exchange rates, the economic policy of a government could be focused on maintaining high levels of employment, low levels of unemployment. 

Of course, the credit inflation of the 1960s destroyed the underlying assumptions of this international monetary agreement and this was institutionalized on August 15, 1971 as President Richard Nixon took the United States off the gold standard and floated the value of the dollar.

The subsequent period of credit inflation and the consequent explosion of financial innovation has taken us into another realm.  And, it is this new environment we are dealing with now.

Money can now flow almost anywhere at extremely rapid speeds.  Money can flow almost instantenously into different sectors of the financial market.  Thus a change in investor sentiment or the introduction of new information or a change in the stance of monetary policy can create “bubbles” in different sectors of the economy. 

We saw a growing occurrence of bubbles over the past 20 years.  We saw the dot,com bubble in the 1990s followed by its collapse in the early 2000s.  We saw the housing bubble in the early 2000s, followed by the collapse in the housing market in the latter part of the decade.  We seemed to have had stock market bubbles in both decades. 

Recently we seem to have had a bubble in international commodity markets due to the quantitative easing of the Federal Reserve system along with bubbles in certain emerging nation stock markets.  One can also make the argument that the recent behavior of the Treasury bond market represents a bubble.  How else can you explain the fact that the yield on Treasury Inflation Protected Securities (TIPS) has been negative.  Participants in the financial markets were not interested in TIPS for their yield but as a price play connected with the “rush to quality” in international financial markets.  (See Jeremy Siegal and Jeremy Schwartz, “The Bond Bubble and the Case for Stocks,” http://professional.wsj.com/article/SB10001424053111903639404576516862106441044.html?KEYWORDS=jeremy+siegel&mg=reno-wsj.)

Former Fed Chairman Alan Greenspan continues to claim that a bubble cannot be perceived before-the-fact, that is, before the bubble has burst.  Hence, the Federal Reserve could not fight off bubbles in financial (or commodity) markets because they could not be identified.  This seems to be the reigning philosophy of the current leadership at the Fed.   It is the old model of monetary policy.

Yet, the liquidity of international financial markets is a reality and the existence of bubbles is a fact of life.  I believe that these facts are being accepted by the people running our governments and central banks.   Yet, their thinking still has a ways to go and their model of how central banking should be conducted has not been completely formed. 

For one, these “leaders” seem to think that every problem they are facing is a liquidity problem.  I have addressed this earlier. (See http://seekingalpha.com/article/288610-the-debt-crisis-it-ain-t-over-until-it-s-over.) Thus, their solutions are systematically based on the maintenance of liquidity in international capital markets.

The fact that the market for an asset may be illiquid because it is related to cash flow problems, say as in real estate investment, and that no amount of liquidity will bring the value of the asset back to previous levels seems to escape these “leaders.”  That is, an asset is liquid, until it is no longer liquid.

Second, the model being used by these “leaders”, a model that places high economic growth to achieve low levels of unemployment, leads these “leaders” to adopt policies, like QE2, that are totally inappropriate for the current economic situation.  Providing liquidity in these cases may create further bubbles, as presented above, but may have little or no effect on economic growth or employment.

Fed Chairman Ben Bernanke is a very creative person.  He has been improvising monetary policy for the last three years.  The old model does not seem to fit any more.  Yet, a new model has not been created.  But, any new monetary policy must be based on the reality of today, a reality dominated by instantaneous flows of money to almost any where in the world.   

Keynes knew that you could not focus a nation’s economic policy on its own employment situation when capital flowed freely throughout the world.  That is why he created his macroeconomic model.  His followers, especially the fundamentalists Keynesians, don’t seem to understand this reality.   It is time to move on.  It is time to accept the reality of the “New” liquidity.

The Bubbles Are Real

On Thursday, three-month forward contracts put the yield spread between Brazilian and United States rates at 8.75 percentage points. And, you have questions about the existence of the carry trade, the borrowing at excessively low interest rates in one country to invest at much higher rates in another country.

Well, these yield spreads are not quite as attractive as they once were because Brazil has placed a tax on foreign investment in sovereign bonds. This tax was initiated in 2009 and after two increases is now 6 percent. Several fund managers told the Financial Times outlet that “the appeal of the carry trade had diminished considerably as a result.” (http://www.ft.com/cms/s/0/ec755d4a-1f40-11e0-8c1c-00144feab49a.html#axzz1B0wmwdeP)

Two points on this: first, there is no doubt in my mind that the quantitative easing (QE2) on the part of the Federal Reserve System has created bubbles in other parts of the world: and second, countries around the world have reacted to these bubbles by selectively trying various policy tools to try and contain the capital flows into their financial markets confirming, to me, that the bubbles are real.



Yesterday, the Brazilian central bank introduced a new effort to slow down the rise in the Real “by offering to buy as much as $1 billion in the currency futures market. (“Brazil Central Bank Intervenes,” http://professional.wsj.com/article/SB20001424052748703583404576079511405101244.html.)

But, governments all over the world are trying to clamp down on “hot money flows”. Gillian Tett writes about “New Ways to Control Hot Money Bubbles,” in the Financial Times this morning. (http://www.ft.com/cms/s/0/8bfc81e2-1f30-11e0-8c1c-00144feab49a.html#axzz1B0wmwdeP)

South Korea, in particular, is “launching” experiments aimed at stemming rising currency prices or frothy stock markets or other cross-border flows of funds. The effort is to find ways to apply more activist and “macro-prudential” policies to banks or the banking system.

Even the International Monetary Fund, this week, recognized the legitimacy of and the need for


countries to control capital flows when other countries are following independent economic policies aimed at resolving domestic economic problems that have impacts on others.

The problem is “what constitutes a bubble?”

A bubble seems to be like pornography, it depends upon who is looking at it. Former Federal Reserve Board Chairman Alan Greenspan never saw a bubble, at least while it was taking place. Apparently, the current chairman Ben Bernanke can’t see one either.

Now, it seems, that there are other economic phenomenon that are maybe not so easy to identify. United States Treasury Secretary Tim Geithner has stated that it is hard to identify financial institutions that are “systemically important” in advance of a crisis. “It depends too much on the state of the world at the time. You won’t be able to make a judgment about what’s systemic and what’s not until you know the nature of the shock.” Well, so much for “too big to fail.” (http://www.ft.com/cms/s/0/1122ed96-1f7e-11e0-87ca-00144feab49a.html#axzz1B0wmwdeP)



Still, there are flows of funds that seem very “bubble-like” Take a look at the following chart. Notice the flows of funds into emerging markets in 2009 and 2010. It was December 2008 that the Federal Reserve forced the effective Federal Funds rate into the range of 15 basis points to 25 basis points. Fund flows into emerging markets took off to new highs once this policy was in place. Who says the international flow of funds is restricted.


The next point, however, is the movement in the exchange rates in these emerging countries relative to the dollar. Note, the figures presented are the percent change over the past two years.

One definition of a bubble is when fund flows into a nation or a sector exceed the ability of real economic activity in that nation or sector to grow. In the case of funds flowing into these emerging nations it certainly appears as if the funds flowing into the countries exceed the ability these countries have to grow.

Raghuram Rajan and Luigi Zingales, in their book “Saving Capitalism from the Capitalists” argue that bubbles occur when you get people investing in markets that are not familiar with the markets, people who don’t really understand the fundamental characteristics of the new market they are investing in. As a consequence, people make money as prices continue to rise and this fact draws more and more people into the market place. In this respect, bubbles can possibly be observed by paying attention to who is being drawn into the market. This can be another piece of evidence in attempting to discern “bubbles.”

Thus, the carry trade has proven to be very attractive, has produced a lot of profitable positions, and has gained a lot of publicity in the popular press and in the investment community. One could argue that investments in the bonds and equities in emerging nations have drawn a lot of new investors over the past two years. More are coming into the markets every day.

One can also make a similar case for the flurry of activity in world commodity markets.

In fact, one could argue that in many of these situations policy makers are setting up attractive “one-way bets” for investors and these are drawing new money into these areas from investors not familiar with the markets. (http://seekingalpha.com/article/237076-interventionists-are-setting-up-one-way-bets-for-traders)

It seems to me that in present circumstances it is harder to argue that bubbles ARE NOT real than that they really exist.

Bubble, Bubble, Everywhere!

The Federal Reserve just doesn’t seem to get it!

Monetary ease can cause bubbles and not just in the United States. Bubble Ben at the Fed still denies that the Federal Reserve had anything to do with the bubbles in asset prices in the early 2000s in housing and the stock market. Bubble Ben, in 2005, placed blame on the Chinese and other countries for the “Global Savings Glut” that helped to finance the budget deficits of the United States government thereby allowing the interest rates in the America and other countries to be excessively low, causing substantial concern about world inflation and international resource misallocation.

Bubble Ben continues to see price moderation as a problem, just as in 2006 and 2007 he saw inflation as a problem far beyond the period when inflation was a problem. When it comes to price movements and asset bubbles, Ben Bernanke is a lagging indicator!

What is happening in the real world, Ben?

We see the headlines, “Investors Pile into Commodities”, (http://professional.wsj.com/article/SB10001424052748703963704576005933072423242.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.) “Investors are holding their biggest positions on record in the commodities markets as prices surge…Hedge funds, pension funds and mutual funds dramatically ramped up their holdings in everything from oil and natural gas to silver, corn and wheat this year. In many cases, the number of contracts held for individual commodities now far exceeds the amount outstanding in mid-2008, the last time commodity markets were soaring to records and debate raged about whether excessive speculation was driving up prices.”

We read in the Financial Times, “Crude Oil Tipped to Bubble over $100 a Barrel,” (http://www.ft.com/cms/s/0/cfb5cd58-022f-11e0-aa40-00144feabdc0.html#). “For the first time in two years, oil bulls are starting to outnumber bears.” Have you noticed that the price of gas has jumped $0.30 or so over the past month or two. And, the price of gasoline at the pump is going to continue to rise.

And the same picture arises for worldwide commodity prices, “Material Difference,” (http://www.ft.com/cms/s/0/d1e31d98-023d-11e0-aa40-00144feabdc0.html#axzz17WmrNvT3). “World prices for cotton have risen by 73 percent since the start of June.” This is just one item; one can go to other commodities and see substantial increases. This is sure going to help the economic recovery?

“In other words, a generation that has grown up with food and clothing deflation must now get used to paying more for the shirts on their backs and the bread on their table. The options: less breakfast cereal in the carton and hair-raisingly static-inducing nylon shirts, or pummeled profit margins for the global food and clothing industry.” That is, world commodity inflation is causing cost pressures that must surface somewhere. And, this is going to help the recovery?

And, we are seeing China, Brazil, and India, among other countries, raising interest rates and restricting bank lending so as to combat increasing levels of inflation. Governments are very concerned.

Last week, the Federal Reserve released information about the financial and non-financial institutions that it assisted throughout the world during the recent financial crisis.

Commentators responded by referring to the Federal Reserve System as the “world’s central banker.”

The Federal Reserve System has become the “world’s inflator”!

International financial markets have become so interlinked and flows of funds have become so fluid that pumping up the world’s reserve currency can affect almost every corner of that world. If the Federal Reserve creates an environment in which investors can borrow at 25 to 50 basis points and lend elsewhere at much higher rates, money is going to flow from the United States into these other opportunities.

And, bubbles result...worldwide!

What the Federal Reserve fails to understand is that industry and finance in the United States is in need of a massive re-structuring. Efforts to pump funds into the U. S. economy in a short-run attempt to put people back to work is just resulting in the money going “off-shore”. These efforts are not helping people and businesses de-leverage and modernize; it is not helping them re-structure.

And, these efforts are not helping America compete in the 21st century when its educational system is just producing students that are average or just above average in science, math, and reading when compared with other children throughout the world.

Also, the Federal Reserve does not understand the role it has played in exacerbating the increasing gap in incomes between the highest earners and the rest of the income spectrum.

As a consequence, the Federal Reserve is just producing bubbles everywhere and it is hard to see how this is really going to help us.

Why Future Bubbles Can Be Expected

We have been told for at least two years now that the problems in the banking sector are liquidity problems. But, liquidity problems are of short-term nature and need to be resolved within a relatively short period of time. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

The policies that are used to combat a liquidity crisis are also of a short-term nature. These policies are based upon the need to supply the market with liquidity so that asset prices will stop dropping.

Given this interpretation, the Federal Reserve, under Chairman Bernanke’s leadership, has supplied liquidity…and more liquidity…and more liquidity to resolve the issue.

This is a sign that the model being used by Bubble Ben and the Fed is inappropriate for the particular situation that they face.

But, this was the policy prescription for the Federal Reserve in the early 2000s when interest rates were kept around one percent for about 18 months. And, what did we get…a pair of asset bubbles.

In terms of fiscal policy, the situation is similar. The “experts” in the Obama administration, led by Treasury Secretary Tim Geithner, have called for more spending…and more spending…and more spending.

In both cases, the reason given why the policy prescription is not working is that the particular stimulus package tried has not been large enough. The solution Ben and Tim have given is to make the policy package larger. More spending…and more liquidity!

This is a sign that something is wrong!

The model and the analysis being used are not appropriate. The model being used to develop economic policy must be changed.

In the financial markets, the problems that exist are solvency problems. Households are declaring bankruptcy in record numbers and foreclosures on homes continue to run at very high rates. Small businesses are also declaring bankruptcy and loan demand coming from small businesses is dropping as of the last Federal Reserve survey. Thousands of small banks are on the verge of insolvency. (See http://seekingalpha.com/article/235712-it-s-a-solvency-problem-not-a-liquidity-problem.)

And, guess what? The monetary policy that the Federal Reserve is following has successfully resulted in the accumulation of massive amounts of cash in the hands of large banks and large corporations. I am just waiting for the acquisition binge to begin once the economy stabilizes a little more. So much for "Main Street"!

In the economy, the “consensus” economic model that has been used over the past fifty years is still contributing to the “more-of-the-same” policies that are being followed by the Federal Reserve and the Treasury Department.

Yet, over these past fifty years the application of this model has produced the following results: the United States has moved from an “under”-employment rate of around 8% of the working population to about 25% in the current environment; these policies have also resulted in the capacity utilization in industry moving from about 93% in the 1960s to about 75% at the present time, constantly eroding throughout the whole time period; and, the distribution of income in the United States over this fifty years has moved dramatically toward the end of the most wealthy.

The foreign exchange markets have signaled to the United States that something is wrong! Over the past fifty years, the value of the dollar has declined by more than 40% in foreign exchange markets. After a recovery in the latter part of the 1990s, the value of the dollar once again tanked until we hit the financial crisis of 2008 and there was a “stampede to quality.” Once this “stampede” was over and markets and economies stabilized, the value of the dollar declined once again. And, after Ben made his remarks in Jackson Hole concerning the forthcoming quantitative easing, the value of the dollar plunged 7% in a matter of weeks.

Paul Volker has written that the most important price in a country is the price of its currency in terms of other currencies. If the value of your currency declines, this is a sign of weakness…weakness in your economy and in your economic policies.

And, here we are. Thursday November 11, 2010, the President of the United States was lectured to by Hu Jintao, the Chinese President, over the United States currency. Other world leaders, from Germany, Great Britain, and Brazil, have also reprimanded the President over the United States currency situation. (http://seekingalpha.com/article/236430-release-from-the-g20-what-more-needs-to-be-said)

Furthermore, given the election results in the mid-term elections held last week, the American people seem to have a problem with United States economic policies.

The policy direction in Washington needs to be changed and changed soon.

However, I don’t expect a change to be made in the near future. President Obama seems to be adamant that this policy must be effectively enforced.

Therefore, like the early 2000s I expect bubbles to occur here and there.

The problem is, as we well know…that, sooner or later, bubbles burst!

Bubble, Bubble...Where's the Bubble?

In Bloomberg Businessweek, Nouriel Roubini is quoted as saying “Zero interest rates are leading to an asset bubble globally…”

What is an “asset bubble” and how can one identify it?

Is an asset bubble like pornography? “I can’t define an asset bubble, but I know one when I see one!” Thank you Supreme Court Justice Potter Stewart.

Such a renowned economic prognosticator as former Fed Chairman Alan Greenspan couldn’t identify a bubble. He argued that you cannot identify an asset bubble before the fact. One has to wait until an asset bubble is over before you can identify it as an asset bubble. That sure builds confidence!

In Wikipedia, an asset bubble…or economic bubble…or whatever…is defined in the following way: An economic bubble (sometimes referred to as a speculative bubble, a market bubble, a price bubble, a financial bubble, a speculative mania or a balloon) is “trade in high volumes at prices that are considerably at variance with intrinsic values”. (Another way to describe it is: trade in products or assets with inflated values.)

Others have spoken of a credit bubble. A credit bubble is a situation where the rate at which credit is flowing into the economy, financial markets or sub-segments of the economy or financial markets exceeds the growth rate of other parts of the financial markets or the economy causing the prices of assets in the economy, financial markets or a sub-segment of the economy or financial markets to rise much faster than elsewhere.

The example that quickly comes to mind is that of the housing markets in the 2000s where credit was flowing into this sub-segment of the economy at a much faster rate than elsewhere causing housing prices to rise much faster than prices were rising in the rest of the economy. Although, before the fact, as Alan Greenspan stated, he could not identify this as a credit bubble.

But, Roubini has stated that current Federal Reserve policy (“zero interest rates”) is “leading” to an asset bubble. The bubble is not here yet, but it is on-the-way.

What might be behind this argument?

Well, since December 16, 2008, the lower bound of the Fed’s target Federal Funds rate has been zero. Since that date the daily average of the effective Federal Funds rate has been between 8 basis points and 22 basis points: effectively zero.

Getting into this position of “zero interest rates” and “quantitative easing” the Federal Reserve, through the financial crisis in the fall of 2008, moved to increase the Reserve Bank Credit it injected into the system from $892 billion on August 27, 2008 to $2,245 billion on December 11, 2008, just before the “zero” interest rate target was approved by the Fed’s Open Market Committee.

Commercial bank held balances with Federal Reserve banks of $12 billion on August 27; on December 11 the total was $773 billion. In the month of August 2008, excess reserves held by commercial banks was less than $2 billion; in the month of December 2008 this total rose to $767 billion, an increase of more than 38,000%!

In the first six months of 2010, reserve balances with Federal Reserve banks and excess reserves in the commercial banking system both hovered around $1.1 trillion!

Federal Reserve releases have implied that the target interest rate will stay at such low levels for “an extended period” because of the weak economy. In recent weeks, analysts have argued that such low levels will be maintained into 2011. Now, a new study by Glenn Rudebusch of the Federal Reserve Bank of San Francisco (see “The Fed’s Exit Strategy for Monetary Policy”, http://www.frbsf.org/publications/economics/letter/2010/el2010-18.html, and as reported in the New York Times, http://www.nytimes.com/2010/06/15/business/economy/15fed.html?ref=todayspaper) argues that target interest rates may stay low into 2012!

“If the rate were raised too soon, it would be hard to reverse course, whereas if tightening is started too late, the Fed could catch up by raising rates at a rapid pace.”

But, interest rates are not asset prices! Asset bubbles or credit bubbles occur when credit (funds) flow into the economy or the financial markets or sub-segments of the economy or financial markets at a pace that exceeds the speed at which things are growing.

In the 2000s, we had excessively low interest rates and things were felt to be OK because the economy did not seem to be growing excessively and consumer price inflation appeared to be under control. Yet, we got the boom in housing prices…and, in stock prices. (Note, that neither of these prices is included in the Consumer Price Index. Housing costs are included through an imputed rental value which has very little to do with the price of a house itself.)

Much of the liquidity the Fed has pumped into the economy is, so far, just setting on the balance sheets of financial institutions…and, non-financial institutions. The commercial banks are not the only ones “piling up cash reserves. See “U. S. Firms Build Up Record Cash Piles,” http://online.wsj.com/article/SB10001424052748704312104575298652567988246.html?KEYWORDS=justin+lahart.

“The Federal Reserve reported Thursday that nonfinancial companies had socked away $1.84 trillion in cash and other liquid assets as of the end of March, up 26% from a year earlier and the largest-ever increase in records going back to 1952. Cash made up about 7% of all company assets, including factories and financial investments, the highest level since 1963.”

At some time, these cash balances, at financial institutions and non-financial institutions, are going to be used. The totals are so huge, I can’t imagine that “the Fed could catch up by raising rates at a rapid pace,” as Rudebusch suggests in his paper. When these cash balances are used, the impact will be on asset prices and not on consumer prices. This represents the potential for the “asset bubble” Roubini is talking about. And, remember, bubbles “break”!

Just one other point on this: I believe that what is happening in European financial markets is a part of this “bubble” activity. International investors are not acting like they are scared and strapped for funds. Their aggressiveness, to me, indicates that they are flush with money and hence have the confidence to be aggressive in attacking the financial condition of euro-zone countries on the sell-side. Investors “in dire straits” do not take on sovereign nations. This indicates, to me, that there are plenty of “well off” investors in the world that can move money around and “make things happen.” The European situation is a result of the U. S. “quantitative easing”. Further “quantitative easing” just exacerbates the problem!

Economic Recovery?

The front page of the New York Times reads, “Why So Glum? Numbers Point to a Recovery.” (http://www.nytimes.com/2010/04/09/business/09norris.html?hp) The economic recovery is at hand, yet, to many, even to many economists, something seems to be missing.

Unemployment remains high, but it is a lagging indicator. Consumer debt remains high and home foreclosures and personal bankruptcies continue to stay near record levels, but these tend to be lagging indicators. State and Local governments are on the edge, apparently faced with becoming the “next Greece.” (For example, this morning see “Los Angeles Faces Threat of Insolvency”, http://online.wsj.com/article/SB20001424052702304830104575172250422355156.html#mod=todays_us_page_one, and “Next ‘Big Crisis’ Is Unfolding in Muni-Bond Market”, http://www.bloomberg.com/apps/news?pid=20601039&sid=aKj_LXH6zUrw.) But, these problems are related to the condition of the consumer and hence will not recover until the consumer recovers. Commercial banks are not lending, small businesses are not getting bank loans, and there are still concerns about the value of bank assets and the impending loan problems.

Floyd Norris, in his New York Times article, speaks about slow economic recoveries and attempts to put the current situation within the context of other post-World War II recessions. Within this context, he argues, the prospects for the current recovery are not that bad. When the economy is turning around, current data tend to be revised as more information becomes available and the recoveries, historically, appear to be “less slow” than they were during the time they were actually being experienced.

I believe that Norris is correct in his interpretation of where the United States economy is at the present time and how the data we are now receiving compares with the data relating to previous
recoveries.

What this misses, as I have tried to present over the past six-to-nine months, is that there are other factors at play in the economic developments of the past fifty years and this has created a situation that is not favorable to a strong economic performance in upcoming years…unless some things change.

One of those changes that are necessary relates to the inflationary bias of our government’s monetary and fiscal policies. As I have mentioned many, many times before, inflation is not helpful over the longer run and, in fact, over the longer run tend to hurt the very people the inflationary bias is aimed to help. The fact that the purchasing power of a dollar has declined by over 80% in the last fifty years has left the American economy is a very weak position. Long-term inflation has had an impact on the economy.

For one, inflation is supposed to help existing manufacturing industries. Yet, we have seen that over the past fifty years, the capacity utilization of United States industry has continuously declined with each peak reached in a subsequent period of economic recovery lying below the level of the previous peak. (See my post “The Trouble with Recovery,” http://seekingalpha.com/article/192713-the-trouble-with-recovery.)

Inflation is supposed to help labor, yet the level of the under-employed has risen almost constantly during the last fifty years. As capacity utilization has declined, the “mainstream” laborer has found him- or her-self less and less trained to do something outside “mainstream” industry. Hence, the growing number of those that don’t “fit” into the twenty-first century industrial structure. It will be very difficult to put these people back-to-work on a full time basis.

The economy of the past fifty years has also relied on the strength of construction, especially the construction of houses. This area has received special attention in that the government has created many, many financially innovative ways to support this industry which has led to an inflation in real estate prices that has out-stripped those in other areas of the economy.

A consequence of this has been that most personal saving over the past fifty years was tied up in the value of a person’s home. People saved by investing in a home and then watching the value of the house continue to appreciate. This appreciation of home prices also allowed their owners the opportunity to borrow against the increased value of the house to maintain higher and higher living standards. Now much of this “wealth” has been destroyed.

And, the inflationary bias has led to a hurricane of financial innovation. The creation of debt and financial innovation thrive in an inflationary environment. The last fifty years has been a treasure-trove for those in the financial industry and the financial innovation that has resulted exceeds that of any period in the history of human-kind. The economy may seem unbalanced with the growth of the finance industries relative to the manufacturing industries, but that is what you get when you have fifty years of consumer and asset price inflation.

The theoretical underpinnings of the policies that have resulted in the inflationary bias of the last fifty years were built on two primary assumptions. The first is that the labor force must be kept employed in order to avoid revolutionary unrest. The second assumption is that foreign exchange rates would be fixed in value. (See my book review: http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.)

The model derived from these assumptions is “short-run” in nature. (Remember Keynes is quoted as saying “In the long run we are all dead.”) Policy making within this paradigm, therefore, focuses upon achieving short-run goals even if the long run consequences, as presented above, are detrimental to the people that are, hopefully being helped. Since the world is a series of short-runs, the problems resulting from previous “short-run solutions” will be offset at a later date. As we have seen, this does not happen.

In addition, since 1971 most of the world has been operating within a regime of floating foreign exchange rates. A country cannot isolate itself from other countries, in terms of the fiscal and monetary policies it follows, without repercussions. In the case of the United States, we have seen during this period of inflationary bias the value of the United States dollar has declined. The two periods in which this was not the case were those of the late 1970s-early 1980s, when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve System, and the 1990s, when Robert Rubin was an influential member of the Clinton Administration. Overall, however, the value of the United States dollar has declined during this period and is currently substantially lower, relative to other major currencies, than it was in the 1970s.

The policy focus of the United States government must change. To me, Paul Volcker had it right when he argued that “a nation’s exchange rate is the single most important price in its economy.” Consequently, he argued that a government cannot ignore large swings in its exchange rate. A country’s exchange rate reflects how international markets interpret the inflationary stance of the monetary and fiscal policy of a government. In the future, more emphasis must be placed upon this price in making policy decisions for the United States no longer dominates the world the way it did in the past.

Second, the policy focus of the United States government must move away from employment in legacy industries. A recent research paper by Dane Stangler and Robert Litan, “Where Will the Jobs Come From?”, published by the Kauffman Foundation, emphasizes that “nearly all” of the jobs created in the United States from 1980-2005 were created in firms less than five years old. By focusing on legacy industries in determining its economic policy, the federal government is just fostering an environment in which under-employment is going to continue to grow. This is not healthy for the future of the American economy, especially as emerging nations around the world are focusing on the future and not the past.

Inflation is in the News

There were quite a few articles in the newspapers this morning concerning inflation and how governments should set their policy targets with respect to inflation. This discussion was set off by a paper written by Oliver Blanchard, the top economist at the International Monetary Fund, and examined in this post on February 12, “Doesn’t Anyone Understand Inflation,” http://seekingalpha.com/article/188351-doesn-t-anyone-understand-inflation. The proposal of Mr. Blanchard’s that caught everyone’s eye was the proposal that central banks set their target rate of inflation at 4% rather than 2%.

This morning we see an opinion piece by Wolfgang Münchau in the Financial Times, http://www.ft.com/cms/s/0/9776aeb0-1ef2-11df-9584-00144feab49a.html; an article by Sewell Chan in The New York Times, http://www.nytimes.com/2010/02/22/business/22imf.html?ref=business; and another article by Jon Hilsenrath in the Wall Street Journal, http://online.wsj.com/article/SB20001424052748704511304575075902205876696.html#mod=todays_us_page_one. All discuss changing ideas about inflation and how government policy, particularly monetary policy, might be adjusted to reflect what has been “learned” from the recent financial crisis.

The underlying concern in these discussions is what changes need to be made to macroeconomic models that will allow us to be better prepared for the next financial disruption. Münchau concludes that in a globalised world with large financial markets, “Unless and until macroeconomists find a way to integrate concepts such as default and bubbles into their frameworks, it is hard to see them making a useful contribution to the policy debate.”

In other words, unless the models include situations that account for rising debt levels and credit inflation (inflations that can lead to excessively rising prices in subsectors of the economy, like in housing markets) we cannot expect economic policy advice that is of much value in combating the problems of the global economy. Sounds like we need to go back to Irving Fisher rather than Maynard Keynes.

The point is that in the United States, the purchasing power of a dollar bill has declined more than 80% since early 1961. In some sub-sectors we saw greater amounts of inflation up until 2007. During this time, global markets developed to a degree never seen before and inflation could be more easily passed from one country to another so that “sectoral” inflations could take place in different nations throughout the world. Living in an inflationary environment changes things!

It is interesting to see in some of these articles that the control of international capital flows is a rising issue. The concern is with the possibility that a debtor nation could export inflation to other countries. In particular, this exporting of credit inflation is being discussed in the Euro-zone in the talks surrounding the ‘bail out’ of Greece. Capital controls are seen as a possible solution to the problem of free-flowing capital.

The ironic thing is that the last period of world-wide discussion of capital flows began at the Paris Peace Conference in 1919 and ended up as a part of the Bretton Woods agreement that followed World War II. The restraint on capital flows following this period lasted until there was a final breakdown of the Bretton Woods system in August 1971 as President Nixon took the United States off the gold-exchange standard.

Maynard Keynes was very much in favor of restricted international capital flows because this allowed countries to operate economic policies independently of other countries and thereby promote “full employment” strategies. Free international capital flows, of course, eventually exert pressure on governments to operate their budgets on a more disciplined basis.

The real problem of inflation, as Münchau argues, “is that macroeconomists treat inflation as a variable, while most of us do not.” He continues: “Price stability is a critical component of the social contract we call money. We accept money as a means of payment, as a unit of account and, most importantly in this context, as a store of value. We trust that the central bank does not debase it. The problem here is not that a particular rate of inflation would be breached; it is the simple fact that inflation is considered a variable to be messed with in the first place.”

The reason that inflation becomes a variable in macroeconomic models is that unemployment becomes a fixed target. That is, in the late 1910s and early 1920s, economists, like Maynard Keynes, became so fearful of a Bolshevik revolution, that they built their models to focus on achieving high levels of employment. In the United States this got built into law: first in the Full Employment Act of 1946, and then in the Humphrey-Hawkins Full Employment Act of 1978. Of course, the definition of “full employment” is a man-made policy objective.

The problem is that once the “social contract” is violated by political consent, inflation becomes a variable that can be sacrificed at the altar of “full employment.” Even “inflation targeting” on the part of central banks’ assumes that there is a tradeoff between higher levels of employment and inflation.

Once the environment incorporates inflationary expectations, debt becomes the currency of record and more and more the expansion of credit comes to rule the economy. Once credit inflation takes over, manufacturing firms focus less on production and more on financial engineering, higher and higher levels of leverage are accepted, and financial innovation becomes crucial to survival.

Three things then happen: first, financial markets become more efficient in that more and more firms, financial and non-financial, can buy or sell ALL the funds they want at the going market rate. Second, this means that there is no limit on the size that firms, financial and non-financial, can become. Third, the financial sector becomes a larger proportion of the economy and hire relatively more people than before.

The conclusion from this is that debt and debt creation is a major part of economic activity. If this fact is not considered in macroeconomic models, then the models will be blatantly deficient. The decline in the purchasing power of the dollar has resulted from putting almost all the emphasis of economic policy on the level of unemployment. The focus on “full employment” has resulted in almost 50 years of credit inflation, financial innovation, and a decline in financial discipline.

I am not saying that high levels of employment are not important. However, one thing I have seen over the past 50 years is a government full employment policy that “forces” people back into jobs they had lost in the economic downturn and that are declining in importance or menial in nature. As a consequence, underemployment has been increasing over the last 50 years or so. But, education and re-training and such are more important over the longer run than putting people back into all of the jobs they lost.

The one thing that is becoming more and more obvious, however, is that once a person, a family, a business, or a nation, loses their financial discipline that all of the resulting policy options are undesirable. As an alcoholic finds out, the early stages of drinking can be very enjoyable and returned to regularly in pleasure and companionship. However, as the discipline of the alcoholic deteriorates, the drinking becomes less and less enjoyable, becomes more and more solitary, and ends up with no happy choices. As many people, businesses, and governments are finding out, having issued large amounts of debt in the past leave very little room to maneuver when the times get tough.

This is something that must be remembered in the future. But, accepting higher levels of inflation is not the answer. Businesses are criticized for focusing too much on the short run: governments should be as well.

Blame the Central Bankers more than the Private Bankers

“I cannot help thinking that the central bankers are escaping very lightly in the post-crisis dust-up. For while incentive structures in banking exacerbated the credit bubble, they were a much less potent cause of trouble than central bank behavior across the world.”

So writes John Plender in the Financial Times this morning (See “Blame the Central Bankers more than the Private Bankers”: http://www.ft.com/cms/s/0/58aa12a8-0575-11df-a85e-00144feabdc0.html.)

This article should be read!

One point that Plender makes is that maybe we need fewer academic central bankers and “more private sector bankers with a practical understanding of markets.” You mean heading up the Economics Department at Princeton is not enough to be the head of a central bank?

“The academics who dominate modern central banking were ideologically committed to the notion of efficient markets and to exclusive reliance on inflation targeting regardless of imbalances arising from easy credit and soaring asset prices.”

The consequence? An asymmetrical approach to monetary policy: “Interest rates were reduced when asset prices fell, but were not raised in response to wildly overheating markets.”

This focus gave us the ridiculously low interest rates in the United States from 2002 through to 2004 and the subsequent asset (housing) bubble which accompanied them. This conclusion comes even after and “In spite of the bizarre recent assertion by Ben Bernanke…that the Fed was largely innocent in the matter of bubble creation.”

This mindset, Plender argues, is still around and is present in some of the approaches to fight systemic risk and to provide “macro-prudential” regulation and supervision. The mix of policy that these “academic” officials are proposing “suffers from the single disadvantage that it will not work.”

What Mr. Plender really asks for is central bankers that have less experience with the academic study of banking and financial markets and that have more practical experience in these markets.

The particular approach followed by central bankers, Plender continues, led to the rise in bank leverage which was “a far more important factor” in the crisis than was financial innovation.

How could this be?

Well, the incentive structures in banking placed emphasis on current bank earnings. And, the surest way to increase performance during the 1990s and 2000s was to leverage up the portfolio so as to earn a few more basis points. This behavior had to continue because competitors kept doing it. As “Chuck” Prince, the Chairman and CEO of Citigroup, so eloquently put it, if the music is still playing you must continue to dance. Competition demanded more basis points to keep in the dance for investor’s money.

And, the continued increases in leverage were underwritten by the monetary authorities who followed the philosophy of central banking described above. When the bubble burst, the leverage, of course, worked in the opposite direction.

I would highly recommend reading Plender’s article.

More Talk About Credit Bubbles

Bloomberg put up a headline this morning that I found eye-catching: “Stock Market ‘Bubble’ to End, Morgan Stanley Says”, http://www.bloomberg.com/apps/news?pid=20601110&sid=a.YErMIwMYKA. Ruchir Sharma, who oversees $25 billion in emerging-market stocks at Morgan Stanley, is quoted as saying “the (global stock market) rally will end as the effects of the (government) stimulus begins to fade and the credit bubble caused by easy money disappears.”

We are still learning about asset bubbles and credit bubbles so it is interesting to examine what market participants are seeing and what they are saying about the existence of bubbles and the subsequent collapse of bubbles. In this reported interview we get some insight as to how one person sees the current situation in the stock market.

“Some markets may be hurt by the diversion of government stimulus away from the economy and into stocks and other investments,” Sharma states. “Central banks globally were hoping the funds would result in an increase in credit growth, driving the economy. That remains weak in most countries.”

“Liquidity has found its way to the wrong assets,” he said. “You can take a horse to water but can’t force it to drink.”

According to Sharma, what many have been talking about with respect to the United States economy is being seen around the world. Governments have spent large amounts of money attempting to stimulate their economies and the central banks in those countries have poured liquidity into their country’s financial system in order to get credit flowing again.

Rather than the funds going directly into the spending flow, increasing economic activity, the funds have circuitously found their way into “stocks and other investments.” The diversion of these funds into “stocks and other investments” have resulted in a substantial rise in asset prices in these areas, stock markets and commodities markets, and have left productive outlets wanting for resources.

How could this situation have evolved having just gone through three recent experiences of asset or credit bubbles, the stock market bubble of the 1990s, the “bull run,” according to Sharma, “between 2003 and 2007” and the housing bubble? Don’t the policymakers have any idea of the damage they can do to a financial system and economy?

In this respect, another person, Arthur Smithers, with a “deep understanding of economics and a lifetime’s experience of financial markets” (See Martin Wolf”s “How Mistaken Ideas Helped to Bring the Economy Down” in the Financial Times: http://www.ft.com/cms/s/0/38164e12-c330-11de-8eca-00144feab49a.html.) has also questioned current values in stock markets.

Smithers has used “two fundamental measures of value” to determine the “fair value” of markets. These two measures are the “Q” valuation ratio that was developed by the economist James Tobin and the CAPE measure, the Cyclically Adjusted Price Earnings” ratio developed by the economist Robert Shiller. (The “Q” data are available from Smithers own company, Smithers & Co, http://www.smithers.co.uk/, and the CAPE data are available through Shiller’s web site relating to his book “Irrational Exuberance”, http://www.irrationalexuberance.com/index.htm.)

Both measures relating to the stock market give off very similar signals. Each measure is indicating that, currently, the stock market in the United States is 30% to 35% overvalued.

According to Smithers, and as discussed by Wolf, being overvalued, even by this amount, does not mean that the market will immediately revert back to a more reasonable price. The market may not revert back to its more fundamental value for a year or more. But, it does return to more “justified” levels. Sharma also indicates that the markets he is talking about may not return to more reasonable levels for some time.

A reason why the value of the stock market may deviate from its fair value for an extended period of time? Government policy, especially monetary policy, may “inflate credit growth and asset prices.” And, errors in monetary policy can extend on for several years. (For more on this see the book “Wall Street Revalued” just published by Smithers. Also, you can read my review of this book on Seeking Alpha: http://seekingalpha.com/article/163499-imperfect-markets-inept-central-bankers-wall-street-revalued-by-andrew-smithers.)

Wolf summarizes the work produced by Smithers: “Imperfectly efficient markets rotate around fair value. Bandwagon effects may push them a long way away from fair value. But, in the end, powerful forces will bring them back.” In other words, bubbles always burst and the balloon always comes back to earth.

Another problem associated with bubbles like this is that resources are pushed back into the same old economic sectors that had been the focus of investors in the past. That is, physical resources are going back into industries that are less productive and less robust than what they should be going into. As Sharma is quoted as saying, “A new rally globally needs to be driven by new industry groups,” not the same sectors that led “the bull market that ended in 2007.”

This is exactly the problem that I presented in my posts of October 26, http://seekingalpha.com/article/168852-the-state-of-the-economy-the-good-news-and-the-not-so-good-news, and October 27, http://seekingalpha.com/article/169130-is-it-time-for-more-economic-stimulus. The trouble with trying to “force” the economy to grow and to achieve certain objectives that are important to the politicians, the economy does not grow and develop organically.

Thus, the sluggishness of old industries is re-enforced while the opportunities connected to new, more dynamic industries are retarded. The consequences are only seen later in slower economic growth and reduced increases in productivity. But, these problems are for another time, and the politicians don’t have to focus on yet.

The Stock Market: A Bubble or Not?

Questions are now being asked about the nature of the rise in the stock market. These questions have to do with the reality of the rise, how high the market will go, and when will the economy produce results that are consistent with the optimism captured in the stock market rise.

There is another way to look at the rise in the stock market since March 2009: the rise could be just another asset bubble.

Asset bubbles are a form of inflation. As we have learned over the past fifty years, excessive monetary or credit ease can come out in one of three ways. First, there can be outright inflation. In this case, popular price indices, like the Consumer Price Index, can rise by inflated amounts. Second, prices of assets in one or more sectors of the economy can rise at a pace that exceeds the rate justified by the underlying fundamentals of the sector. Third, when the economy is facing supply side adjustments that constrain the healthy growth of the economy, excessive monetary or credit ease can force economic growth in areas that have declined in productivity. That is, the excessive monetary growth can force resources back into declining industries rather than allow them to adjust into the more productive areas of the economy that are in the process of expanding. In these cases nominal growth of the economy is higher than it would be otherwise and inflation is muted by the re-kindling of industries that needs to change or modernize. This results in a form of “stagflation” where we get the worst of both slow growth and masked inflation.

There is little doubt that the monetary authorities have pumped plenty of liquidity into the banking system. The year-over-year increase in the monetary base (currency in circulation plus bank reserves) has been increasing at a rate of around 100% for the past year. As yet, little of this liquidity has found its way into bank lending.

Still, the two basic measures of the money stock have shown year-over-year rates of increase that, historically, can be considered to be substantial. The M1 measure of the money stock has been rising for months in the range of 15% year-over-year, while the M2 measure of the money stock has been rising in the 8% range over the same span of months. Some of this growth can be attributed to a re-arranging of asset portfolios into more liquid assets. Still, all of this money is not sitting idle even though interest rate levels are historically low.

How might this expansion of the monetary variables be used? In the past, rates of growth like this would be considered to be inflationary. Yet, there is no evidence that spending on final goods has increased appreciably and, hence, the rate of increase of consumer prices has remained just above zero, year-over-year. There has been some growth of the economy and some of this growth can be attributed to areas where resources had been leaving (autos) to move to more productive operations. The government stimulus spending has produced a spike in output here and there but does not seem to have produced any sustained increases in economic growth. The possibility of stagflation seems to lie in the future. Therefore, it seems as if two of the three outlets for monetary ease can be excluded from the present analysis.

That leaves us looking for the existence of an asset bubble. Certainly the movement in the stock market since March is a good place to look for a possible asset bubble.

We certainly have some experience in stock market bubbles having just gone through the stock market bubble of the 1990s. Could we be having a repeat performance?

In terms of assessing this possibility I am going to turn to two measures of stock market valuation that were discussed in a book I recently reviewed. The book is titled “Wall Street Revalued” and was written by Arthur Smithers. The review can be found at http://seekingalpha.com/article/163499-imperfect-markets-inept-central-bankers-wall-street-revalued-by-andrew-smithers. The two measures are Tobin’s Q ratio and the Cyclically Adjusted Price/Earnings (CAPE) ratio developed by Robert Shiller. In mid-September, these ratios were already showing that the U. S. stock markets were 35% to 40% overvalued, and that was before the run-up that took the Dow above 10,000. (For a report on these numbers see http://www.ft.com/cms/s/0/b82d2b96-bc02-11de-9426-00144feab49a.html.)

Is the rise in U. S. stock markets a bubble?

Bubbles, of course, are easier to define after-the-fact than when they are occurring. But, the “Q” ratio and the CAPE have done a pretty good job historically of indentifying times when the stock market is overvalued.

If the stock market is overvalued right now because the Federal Reserve has created another asset bubble--it’s third in about 15 years—then the economic and financial situation in the United States is quite tenuous. The economy sucks, the banking system is still faced with major credit problems, and the dollar has fallen close to 15% since January 20, 2009. What kind of a policy can the government throw at this dilemma?

Any tightening to brake the expansion of the bubble and/or combat the decline in the value of the dollar threatens the solvency of the banking system and the fragility of the economic recovery. But, as we have seen over the past 15 years, bubbles eventually collapse on their own. Are there any “good” ways out of this situation?

This is not a pretty sight, but it is one we must take into consideration. As we continue to learn, though, once we lose our discipline, all the good choices in policy seem to disappear!