Uneasy Money

Just to follow up my earlier post about the difference between central banking  and central planning, I would just like to post the following quotation from Hayek’s The Road to Serfdom pp.121-22.

There is, finally, the supremely important problem of combating general fluctuations of economic activity and the recurrent waves of large-scale unemployment which accompany them.  This is, of course, one of the gravest and most pressing problems of our time.  But, though its solution will require much planning (my emphasis) in the good sense, it does not — or at least need not — require that special kind of planning which according to its advocates is to replace the market (my emphasis).  Many economists hope, indeed, that the ultimate remedy may be found in the field of monetary policy, which would involve nothing incompatible even with nineteenth-century liberalism (my emphasis).  Others, it is true, believe that real success can be expected only from the skillful timing of public works undertaken on a very large scale.  This might (my emphasis) lead to much more serious restrictions of the competitive sphere, and, in experimenting in this direction, we shall have to carefully watch our step if we are to avoid making all economic activity progressively more dependent on the direction and volume of government expenditure.  But his is neither the only nor, in my opinion, the most promising way of meeting the gravest threat to economic security.  In any case, the very necessary effort to secure protection against these fluctuations do not lead to the kind of planning which constitutes such a threat to our freedom (my emphasis).

For good measure, here is Hayek in The Constitution of Liberty (pp. 324-25)

The experience of the last fifty years has taught most people the importance of a stable monetary system.  Compared with the preceding century, this period has been one of great monetary disturbances.  Governments have assumed a much more active part in controlling money, and this has been as much a cause as a consequence of instability.  It is only natural, therefore, that some people should feel it would be better if governments were deprived of their control over monetary policy.  Why, it is sometimes asked, should we not rely on the spontaneous forces of the market to supply whatever is needed for a satisfactory medium of exchange as we do in most other respects?

It is important to be clear at the outset that this is not only politically impracticable today but would probably be undesirable if it were possible.  Perhaps, if governments had never interfered, a kind of monetary arrangement might have evolved which would not have required deliberate control; in particular, if men had not come extensively to use credit instruments as money or close substitutes for money, we might have been able to rely on a self-regulating mechanism.   This choice, however, is now closed to us.  We know of no substantially different alternatives to the credit institutions on which the organization of modern business has come largely to rely; and historical developments have created conditions in which the existence of these institut9ions makes necessary some degree of deliberate control of the interacting money and credit systems (my emphasis).  Moreover, other circumstances which we certainly could not hope to change by merely altering our monetary arrangements make it, for the time being, inevitable that this control should be largely exercised by governments.

Treasury prices are rising across the board (except for maturities six months or less) suggesting that the S&P downgrade is having little or no effect on the markets.  What is affecting the markets is the overall economic outlook which is bad and getting worse.  Now it may be that the sense that economic policy in the US is out of control, which, at least in part, was the basis for the downgrade, is affecting contributing to pessimism about the future, but in that case the downgrade is merely reflecting what the market already was sensing.  But it is not quality of US Treasuries that is the issue.

From today’s New York Times story:

The decision late Friday by the ratings agency Standard & Poor’s to downgrade the United States’s debt rating one level to AA+ from AAA has global implications, said Alessandro Giansanti, a credit market strategist at ING in Amsterdam.

“We can see that this may force the U.S. to move more aggressively to cut spending,” he said, something that could drive the already weak economy into recession and weigh on the economies of all of its trading partners. “That’s the main driver” of the stock market declines, he said.

So the markets are taking fright because they are expecting more draconian cuts in government spending and perhaps increased taxes as part of an upcoming budget deal.  You don’t have to be a Keynesian to understand that slashing government spending and raising taxes precisely when the economy is starting to weaken is not good counter-cyclical policy.  But that is the program that almost everyone in Washington, gripped by a deficit-cutting frenzy, has signed on to.  The idea that we must — MUST — reduce the budget deficit is now wreaking havoc.  With the Fed apparently as paralyzed now as it was in September 2008, we are not in a good place.

Since I started blogging exactly a month ago, I have been arguing that what our weak and faltering recovery needs is a good strong dose of inflation announced in advance by the Fed/Treasury.  The reasoning behind that prescription is that inflation and the expectation of inflation would induce businesses sitting on hoards of cash and households trying to shore up their balance sheets to start spending some of their cash on investments and consumer durables rather than watch the cash depreciate.  Additionally, rising prices, and the expectation of rising prices, would encourage businesses, afraid to expand output and employment because of insufficient demand, to do just that in the expectation that prices would rise sufficiently to allow them to sell the added output at a profit.  Because increased output and employment would, by virtue of Say’s Law, simultaneously create the increased demand to purchase the increased output, there is a very good chance that the leap of entrepreneurial faith encouraged by expected inflation would be self-fulfilling and self-sustaining.

There is another argument for inflation, which I may have already mentioned in passing, but it deserves some further attention, especially after the events of this week.  When the financial crisis turned into a panic in September 2008, it did not take long for Secretary of the Treasury Henry Paulson to propose a scheme whereby the government would buy the so-called toxic assets, largely mortgage backed securities and derivatives of those securities, held by the banks.  Suspecting each other of holding large quantities of toxic assets and therefore of being potentially insolvent, banks stopped lending to each other in the overnight market, causing the entire payment and credit system to break down.  Paulson decided that the only way to loosen up credit was to clear away the toxic assets from the banking system by having the government buy the assets, so that banks would no longer have to worry about lending to potentially insolvent banks in the overnight market.

In the end, the program could not be implemented as planned, because no mechanism could be found to price the toxic assets that the government would purchase from the banks.  Banks, after all, could have sold off those assets at a loss, cleansing their balance sheets, except that doing so would have either precipitated insolvency or made it plain to shareholders how much of their wealth had been dissipated by management error or malfeasance.  Banks insisted that the markets were grossly undervaluing the toxic assets, whose “true” worth was far more than the banks could realize if forced to unload them in a distress sale.  Pleading their case to the sympathetic ears of Secretary Paulson and then Secretary Geithner, the banks succeeded in avoiding being forced to unload the toxic assets on their balance sheets to the government for anywhere near to their market value.  The government, however, was unwilling to pay the banks what they were asking for the toxic assets, so most of the TARP money wound up being used to purchase preferred stock or warrants in banks judged to be at risk of insolvency.  Banks received substantial infusions of government funds with which to recapitalize themselves, thereby avoiding having to book losses on the toxic assets still on their balance sheets.  All in all not a bad outcome from the point of view of the banks.  With a few exceptions like WAMU that were clearly and irretrievably insolvent, banks were not forced into receivership and were not forced to sell any assets at drastic write-downs.

That was not the only largesse directed towards the banks.  In November 2008, the Fed began paying banks interest on their reserves, just as the Fed was reducing its target for the Federal Funds rate to 0.25%.  The interest rate that banks have been receiving on reserves has actually exceeded the rate on 6-months and 1-year Treasury bills almost continuously since December 2008.  Never before in history was holding reserves, which used to be the equivalent of a tax on banks, so attractive.  The resulting expansion of the Fed balance sheet has not monetized the debt; it has merely exchanged Treasury debt previously held by the banking system for generally higher-yielding reserves, providing banks with increased interest income and increased liquidity.

Nevertheless, despite all the goodies showered on them, banks are still burdened with toxic assets on their balance sheets.  Those assets are tied to the real estate market which remains severely depressed, and it now seems even more likely that their prices will fall even further.  There is a good chance that the toxic assets will sooner or later be revealed to be worth close to what markets were offering for them in the darkest days of 2008.  Instead of getting rid of the albatross, banks have held onto them in the hopes of a real-estate recovery that never came.

Why not?  Because the real estate bubble was predicated on expectations of an economic boom with high employment that were not realized.  That was not the only unfounded expectation responsible for the bubble, but it certainly was an important part of the story.  Given that the assumptions on which borrowers and lenders entered into mortgage agreements, it would be reasonable for them to revise the original contracts to allow home owners capable of making reduced payments, perhaps over an extended period of time, to remain in their homes as an alternative to foreclosure.  Mortgage renegotiation has been encouraged, but generally hasn’t worked, because too many separate parties would have to sign off on a renegotiation agreement.

Since renegotiation has not turned out to be practical, the only other method of accomplishing the goal of reducing the unsustainable burden of mortgage debt would be for an outside party to impose a reduction in the value of the debt and monthly payments obviating any agreement by the parties.  One way to do that would be by legislation.  That option has gone nowhere, and is no longer even discussed.  An even simpler and more direct option is inflation.  Increasing prices would increase cash flows and would reduce the burden of outstanding mortgage debt.  Banks would be unhappy, but better off, because fewer foreclosures would mean fewer losses and less expense.  Even if, as I suspect, prices initially rise faster than wages, mortgage payments are fixed, so homeowners would almost certainly come out ahead despite lagging wages.

People often assume that inflation is good for debtors and bad for creditors, while deflation is bad for debtors and good for creditors.  But that holds only if there are no feedback effects from inflation and deflation.  But when deflation increases the burden of real debt and reduces the cash flows available to service that debt, it harms creditors by making too much of  debt they hold uncollectable.  Similarly, inflation can make creditors better off by reducing the debt burden and increasing the cash flows available for debt service.  At this moment, we may well be at a point where creditors, especially banks, have more to gain more from inflation than they would lose.  Similarly, the European Union in general, and even Germany in particular, would likely gain far more from an inflation allowing Greece, Portugal, Ireland, Spain and Italy to pay off their bonds in somewhat depreciated euros than from insisting on ruinous austerity measures that can only lead to the self-destruction of the common currency and perhaps the European Union itself.  Perhaps that is a topic for a future post.

I actually feel uncomfortable doing a day-by-day analysis of how the markets are moving, as I have done for three days in a row.  If I had wanted to be a trader or a market commentator, I would have become one.  And various commenters have correctly pointed out that price movements have more than one possible interpretation.  So it should be understood that all I am doing is adding my own, possibly eccentric, perspective to the mix for whatever it is worth.

With that disclaimer, I will observe that yesterday, the inflation expectations implicit in the TIPS spread on the 2-, and 5-year Treasuries both dropped by more than 10 percentage points, which are pretty significant daily changes, while the implicit expectations on 10-year Treasuries dropped by 9 points.  Interestingly, although the S&P 500 was down for most of the day, it rallied in the afternoon and closed up by almost half a percent.  But the yield on the 5- year conventional Treasuries actually rose by 2 percentage points, so that the implied real return rose a little more than expected inflation dropped.  Even though the market loves inflation, it also likes higher real interest rates, so the real-interest-rate effect, I could argue, offset the effect of declining inflation expectations.  But today the market is again dropping, with rates on the 5-, 10-, and 30-year Treasuries dropping by about 4, 5, and 6 percentage points.  So it seems likely that both real interest rates and inflation expectations are again dropping.  It doesn’t look good to me.

So let me now reply to Lars Christensen (and I hope that he will respond with some cogent observations of his own) who has been arguing that declining inflation expectations are not so ominous, because the Fed has managed to stabilize expectations in the 2 to 2.5 percent range, after having dropped to dangerously low levels last summer before Bernanke,   supported by some key members of the FOMC, decided to initiate QE2.  My concern is that the level of inflation expectations that you need to prevent an asset price crash such as we experienced in September 2008 is not necessarily fixed at a particular level, say 2.5 percent.  In my view, discussed in more detail in my paper on the Fisher Effect, asset prices crash when the expected yield from holding real assets (which one can think of as being represented by the real rate of interest, though this is a huge simplification) is less than the yield from holding money which is the negative of the rate of inflation.  Thus, when asset holders expect deflation, but very little return on real assets, they shift out of holding real assets into money, triggering a decline in asset prices until the expected rate of return on real assets rises enough to make holding real assets preferable to holding money.

This I believe is what was going on, along with a bunch of other bad stuff, in the fall of 2008.  Investors were anticipating falling asset prices concluded that holding money was preferable to holding real assets and there was a crash in asset prices.  The FOMC, instead of counteracting the fall in asset prices by cutting interest rates immediately and flooding the markets with liquidity, sat back and watched happily as the dollar soared in the foreign exchange markets, believing that they had finally broken the back of rising inflationary expectations over which they had been obsessing since commodity prices spiked in the spring.  Job well done.

What I am afraid is happening now is that the expected yield from holding real assets has fallen sharply over the past few months.  Six months ago in early February the yield on a 10-year TIPS bond was 1.39%, so in the last six months the expected real interest rate has fallen by more than 1%.  Just since July 1, the yield has fallen by almost half a percent. There were a number of reasons for this.  Oil prices spiked in February (not because of QE2 as so many now disingenuously allege, but because of the revolt in Libya and other fallout from the Arab Spring) followed by the earthquake and Tsunami in Japan, renewed debt problems in Europe, the farcical soap opera over the debt ceiling that has been playing out in the US, and downward revisions in US GDP, all of which have clouded prospects for future GDP growth to which real interest rates are closely connected.

Now last August when the economy was teetering on the verge of falling into a recession, the stock market declined by about 8 percent before QE2 was announced, the real interest rate on the 10-year bond was just over 1% and inflation expectations were barely over 1.5%.  So if real interest rates have fallen by nearly 1 percent since last August, and expected inflation as measured by the 10-year TIPS spread is 2.28% as of yesterday, I think that we may again be in a danger zone.  I hope that I am wrong.  Lars?

UPDATE:  Well I just saw Lars’s comment on the previous post.  I guess I can’t look for any solace from that source?  Anyone else care to offer some words of encouragement?  Please.

UPDATE II @ 1:12PM EDST:  On Bloomberg, I just saw that gold is now down $15 from its opening today (it was up earlier this morning).  Does that mean that people are trying to get more liquid now?  Query for Ron Paul, when people want to be more liquid, do they prefer holding gold or holding dollars?

After I posted this yesterday at about 3PM EDST, the S&P 500 fell another 10 points in the last hour of trading and the yield on the 10-year Treasury fell another several basis points.  Lars Christensen, in his comment, tried to put a better face on things by suggesting that implied inflation expectations as measured by the TIPS spread had not really moved very much.  That was true on Friday and Monday, but yesterday they dropped sharply.  I use the TIPS spread on the 10-year constant maturity Treasury Bond, which I can only get from the St. Louis Fed with a one-day lag.  However Bloomberg reports the TIPS spread on two and five year Treasuries.  And they both dropped steeply yesterday.  So, despite Lars’s attempt to cheer me up, I am still worried.

This isn’t the first time, and I doubt the last, that I have used a post by Scott Sumner as the basis for one of my own.  But a blogger’s gotta do what a blogger’s gotta do.  Scott is properly worried by the falling yield on the 5-year Treasury.  The entire yield-curve is shifting down rapidly.  The yield on the 10-year constant maturity Treasury, which I follow closely, because I use it in my empirical model correlating movements in the S&P 500 with inflation expectations, has fallen to 2.68%, 30 basis points less than it was last Thursday and 54 basis points less than it was on July 1.  In the meantime the S&P 500 at this moment is down about 40 points since Thursday and 70 points since July 1.

The sharp decline in Treasuries seems to have been triggered by the downward revision real GDP released by BEA on Friday.  As a result, the decline in Treasuries was reflected almost entirely in a decline in the inflation adjusted yield of TIPS-bonds.  Today, however, if I am reading Bloomberg’s quotations correctly, the yields on conventional Treasuries are dropping faster than the yields on TIPS bonds, as they did yesterday, suggesting that inflation expectations are also declining, perhaps explaining why the stock market decline is accelerating today.  Remember the stock market loves inflation.

All of this is starting to get really scary.  The markets obviously believe that the real economy is deteriorating.  They presumably interpret the recent budget deal as a sign of increasing fiscal tightness, but the news story quoted by Scott suggests that the Fed is not at all inclined to provide any new monetary stimulus to compensate for the loss of federal spending.  The dollar is appreciating against the Euro, providing further evidence that inflation expectations are falling.

I really don’t like what I am seeing out there.  HELP!