Monetary Fables and Sand Traps

It is said so many times now it is almost a mantra – Then Fed engineered a recovery for Wall Street, leaving Main Street and most of us to suffer or at least languish. The intuition is easy. Think of Ms. Yellen in a helicopter spewing hundred dollar bills over banks that collect them in giant bins and then hide them in big vaults away from public view. What money does leak out of the banks goes to purchase bonds and stocks and sustains a financial bubble or at least a rally. Fed behavior also keeps interest rates limbo low and cause reallocations of portfolios away from money and into more risky bonds and stocks with higher promised returns. Firms are not allowed to borrow and expand and therefore employment does not increase and both consumer and business spending remain in the doldrums.

I would be surprised if this story has not already made its way into Dr. Seuss or other children’s books.   It has appealing though contradictory themes. The big bad Fed is a lackey of the right wing helping to keep the upper 1% as rich as possible while regular folks suffer. Alternatively the Fed is a willing compatriot of the liberal left, but alas needs to do even more to complete the task. The Fed pumps money into the economy willy nilly praying each evening to Paul Krugman that money will work wonders for Main Street. Surely if the Fed continues on this course and pumps in ENOUGH money, the economy will be saved. Imagine Paul Krugman in tights with a large S on his chest.

Neither of these stories is correct. 

Let’s take the first one. The first one is based on the idea that when the Fed injects money into the system it somehow prefers the filthy lucre to end up in risky financial markets instead of supporting loans that expand the economy.  This one is pretty silly. I don’t know of one money and banking book that suggests any reasons why the Fed would want the rich to get richer at the expense of the rest of us. Historically it is hard to find times when the intention of a loose monetary policy was to avoid real loans and pump up stock markets.

As for the second story, it is true that there is a lot of hope and faith when it comes to money’s magical impacts on employment and output. But this current episode goes beyond hope and even Paul Krugman seems to have lost his tights. Historical amounts of money have been pumped into the US economy and rates have been kept at zero levels for a long time. Yet, the economy stalls. John M Keynes, the great one, recognized the limits of money when he cleverly invented the so-called liquidity trap. Modern Keynesians agreed a long time ago that once a country enters the trap it is like a monetary Bermuda Triangle in which everything gets sucked onto a giant hole never to be seen again. Money can approach savior status but not when expectations are tender. It makes no sense to keep pouring money into this economy and it makes no sense for money to pull us out of slow growth. This is what Keynes and his band of merry Keynesians said to Maid Marian and Friar Tuck.

Most textbooks and Fed statements suggest some very clear avenues about money. The money mechanism is simple but it is full of traps. Here is the usual story.

·        The Fed sends a check to a bondholder in exchange for his bond. Bond interest rates fall.

·        The check is deposited in his bank.

·        Banks have more money and do not need to borrow to raise funds and the Federal Funds Rate (FFR) falls.

·        Since the FFR is a cost of funds, this causes other interest rates to fall.  

·        Households and firms hop on the first bus to their banks to borrow money.

·        With these low-priced loans consumers buy durable goods and firms buy capital goods.

·        All this spending causes firms to hire more workers and expand output.

·        Christmas comes early.

If the above sounds like a fairy tale to you it is because you have learned about the traps – all the things that could go wrong so that none of the above actually happens on your planet. So here is a brief list of these traps:

·        Liquidity Trap: Bondholders are more than happy to sell their bonds to the Fed so bond returns do not fall much.

·        Deposit Trap: Worried about banks, investors do not deposit checks in the banks. Money might leak out directly to shadow banks or financial investments.

·        Loan Trap: either banks do not trust borrowers or borrowers are too indebted to even ask, so loans do not increase.

·        Spending Trap: No loans, no spending.

·        Employment Trap: even if households and firms do begin to want more goods and services, firms may be pessimistic about the future and not want to make permanent increases in employment or output.

·        Uncertainty Trap: so long as policymakers keep trying to make things better – and they don’t get better – firms and households become even more uncertain and conservative in their decisions.

·        Left tackle Trap: when the left tackle feigns a missed block and the defender comes rushing in for glory and finds that the left guard is there to smash him to the ground.

My first point is that the Fed need not be a lackey of the left or the right if it somehow misread a golf course full of traps. Why do so many golfers end up in sand traps? Because they know they need to take risks to come from behind. They need a low score and at the moment they are way behind the leaders. With unemployment at 10% and a mandate to reduce it, the Fed chose a risky path that ended up with us in a lot of traps. Because the recession was not your run-of-the-mill downturn, the Fed did not anticipate a lot of the traps. Once in the traps we lose. You would think that recognition of such mistakes would be influential but this risky behavior carries on even today. The Fed remains unwilling to reverse its risky policy.

Which brings us to my last point before I sit down to a large bowl of JD. Yes, I know I forgot to mention JD in my last post and I got several angry letters from JD Distilleries worldwide. My last point is all this concern on the part of the Fed that without their continued hose full of money pouring on the economy, interest rates are going to rise to the stratosphere and the economy will come crumbling down. What gall. Does the Fed really have all that control over the economy? No and for several reasons.

First, all those traps listed above suggest the Fed often has little control. Second, there are huge money and financial markets out there that determine asset prices and rates in the USA and globally. If participants in those markets think rates are going to rise in the future, then they will make trades that push the rates up today. There is little to nothing the Fed can do to offset a major change in market psychology. Think of the little Dutch kid with his finger in the dyke. His T-shirt reads "I am the Fed."  In Dutch, of course. 

Finally why would the psychology change to make participants more certain that rates are going to rise? For one thing, the US economy is gathering steam. Among the many positive indicators was the recent announcement that labor costs are rising. All that money outstanding will eventually have to go somewhere. Some of the above traps will disappear – banks will make more loans, firms will replace decaying equipment, and households will buy more cars and JD. Firms will hire more workers. Prices might be under control, but there is no way for them to go except up. The best guess is for higher inflation and that too will drive up interest rates. This is not magic. This is what usually happens during an economic expansion. Rates return to normal with or without the Fed's love or encouragement. 

The Fed knows rates are going to rise and it can’t do a thing about it. It should give up this silly game of hubris and just back away. Pull that money out before it causes a fire! The longer the Fed waits, the more the negative backwash. Get on with it. The markets are ready for a return to normalcy. And I am ready for that JD.