Bubble. Burst. Liquidity. Repeat

Increasing both

In March 2000 the dot com bubble burst. From a peak of 5,048.62 on March 10th, 24 percent up on late 1999, the NASDAQ Composite index had fallen to half that by late 2000. GDP growth slumped and unemployment steadily climbed from under 4 percent in late 2000 to a peak of 6.25 percent in mid-2003.

On January 3rd, 2001, Alan Greenspan acted and cut the Fed funds rate to 6 percent. By June 2003 it was down to 1 percent where it stayed until June 2004. The effects are well known. This wave of liquidity was directed by government action like the Community Reinvestment Act, government bodies like Fannie Mae and Freddie Mac, and a minefield of moral hazard in a financial sector which knew it would be bailed out of any trouble, into a housing bubble.

That bubble burst too. With inflation on its way up from 2 percent in mid-2003 to 4.7 percent in October 2005, Greenspan gradually raised the Fed funds rate, reaching 5.25 percent in June 2006. But this crippled many people who had borrowed at lower rates to buy property. The number of new foreclosure starts in the US increased by more than 50 percent to 1.1 million between 2006 and 2007.

Assets backed with these non-performing loans crashed in value. Banks holding them saw their balance sheets ravaged. Seeing counterparty risk everywhere, banks stopped lending to each other and the LIBOR, usually about 0.15 percent above where the market thinks the bank rate will be in three months’ time, shot up to over 6.5 percent in August 2007. The credit crunch had arrived.

And Greenspan, his academic successor Ben Bernanke, and central bankers around the world reacted as they had to the bursting of the dot com bubble. The Fed funds rate went back down from 5.25 percent in September 2007 to 0.25 percent in December 2008. Likewise, between July 2007 and March 2009 the Bank of England slashed its Base Rate from 5.75 percent to 0.5 percent. Even the supposedly cautious European Central Bank reduced its key rate from 4.25 percent in summer 2008 to 1 percent by the spring of 2009.

When this failed to have the desired stimulative effect central bankers began trying to pull down the long end of the yield curve. Under Quantitative Easing the Bank of England spent £375 billion of newly printed money on British government debt. The Federal Reserve is spending $85 billion dollars a month on bonds.

There is a pattern here. A bubble in assets (dot com stocks) bursts and central banks react by hosing liquidity into the system. But this liquidity inflates another bubble (property) and when that bursts central banks react by hosing liquidity into the system…

In the high Keynesian noon of the post-war period it was widely thought that monetary policy was ineffective for macroeconomic management (it is debatable how much this is actually owed to Keynes). All that could be hoped for from monetary authorities was support for the fiscal policies which really had the clout to equilibrate the economy.

But this Keynesian paradigm fell apart with the stagflation of the 1970s. Money mattered was the lesson and it became the primary tool of macroeconomic management, replacing fiscal action, at least until the ‘Return of the Master’ following the credit crunch.

But what has this meant in practice? As interest rates are lowered in response to an adverse shock investment, calculations change, especially when, like Alan Greenspan, those behind the policy publicly promise its continuance. To the extent that this fosters a wealth effect, consumption, as well as investment, may be stimulated. And this, in fact, is exactly the way the policy is supposed to work.

But the rates cannot stay that low indefinitely, nor, despite the jawboning by monetary policymakers, are they intended to. At some point they will rise. Again, this actually is the way the policy is supposed to work.

And when those rates do rise what happens to those marginal investors who made their decision when rates were at their lowest? What happened to the NINJAs who bought condos in Michigan when interest rates were 1 percent when the rates went up in 2006? They were scuppered. And what will happen to all the enterprises which are currently dependent on interest rates remaining at their historic lows when those rates start to rise? It is because more people are now asking that question that markets have turned skittish recently, since Ben Bernanke even began to discuss a possible future ‘tapering’ of Quantitative Easing.

Those rates will have to rise at some point. But, when they do, whichever bubble we have now will burst. Our monetary authorities have printed themselves into a corner.

This is what passes for macroeconomic management. As one of the high priests of this bubble-onomics, Paul Krugman, advised in 2002 in the wake of the dot com bust “To fight this recession the Fed needs…soaring household spending to offset moribund business investment…Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble”. And no, that’s not taken out of context.

One of the great myths in economics is that of some sort of stable equilibrium. It is apparent that active monetary policy is little better at producing that than fiscal policy proved. Instead the economy is characterised by crises of increasing frequency and amplitude and the only solutions policymakers appear to have to deal with them will buy ever shorter-lived respite at the cost of increasing both the frequency and amplitude of crises.

We are in an equilibrium of sorts, but it is an equilibrium of crises.

This article originally appeared at The Commentator

Obama’s economic failure


For a man famed for his rhetoric the tweet was simplicity itself: “Four more years”. Indeed, I thought, four more years of high unemployment and economic stagnation.

For the second time Barack Obama had beaten an opponent who understood more about economics than he did. In 2008 John McCain admitted he didn’t “really understand economics” yet in June that year he said,

“We are borrowing from foreign lenders to buy oil from foreign producers. In the world’s capital markets, often we are even borrowing Saudi money for Saudi oil. For them, the happy result is that they are both supplier and creditor to the most productive economy on earth. For us, the result is both dependency and debt. Over time, in interest payments, we lose trillions of dollars that could have been better invested in American enterprises. And we lose value in the dollar itself, as our debt portfolio undermines confidence in the American economy”

Intuitively, McCain had grasped that America could not keep swapping devalued dollars for foreign goods and services.

Obama, meanwhile, gave a speech saying

“I’m not talking about a budget deficit. I’m not talking about a trade deficit. I’m not talking about a deficit of good ideas or new plans. I’m talking about a moral deficit. I’m talking about an empathy deficit”

So Obama had named five deficits, only three of which were real, and he was going to talk about the two that weren’t. This was typical of the sort of overripe guff soaring rhetoric which enraptures Obama’s supporters. It makes you feel good as long as you don’t try to figure out what it means.

And again, this year, Mitt Romney gave a speech saying

“I met with (former head of Goldman Sachs and the New York Federal Reserve John Whitehead), and he said as soon as the Fed stops buying all the debt that we’re issuing—which they’ve been doing, the Fed’s buying like three-quarters of the debt that America issues. He said, once that’s over, he said we’re going to have a failed Treasury auction, interest rates are going to have to go up. We’re living in this borrowed fantasy world, where the government keeps on borrowing money. You know, we borrow this extra trillion a year, we wonder who’s loaning us the trillion? The Chinese aren’t loaning us anymore. The Russians aren’t loaning it to us anymore. So who’s giving us the trillion? And the answer is we’re just making it up. The Federal Reserve is just taking it and saying, “Here, we’re giving it.” It’s just made up money, and this does not augur well for our economic future.”

Romney was dead right about the parlous state of US finances but, in the same speech, he made his remark about ‘the 47 percent’ and this was drowned out.

Obama, meanwhile, released an ad saying

“Now Governor Romney believes that with even bigger tax cuts for the wealthy, and fewer regulations on Wall Street, all of us will prosper. In other words, he’d double down on the same trickle-down policies that led to the crisis in the first place

Obama thinks this despite the fact that Bush’s deficits were driven by spending increases and not tax rises. There is no mention of loose Federal Reserve monetary policy. There is no mention of political action which pushed banks to lend to marginal borrowers.

Obama’s faulty prognosis follows from his faulty diagnosis. America, he believes, can tax and spend its way back to prosperity.

Well, he tried the spending. In February 2009 the $831 billion American Recovery and Reinvestment Act came before Congress. If the ARRA was passed, President Obama promised, unemployment would peak at 8 percent in late 2009 and would fall to a little over 5.1 percent by October 2012. He painted a doomsday scenario if the ARRA wasn’t passed; unemployment would peak at 9 percent in 2009 and by October 2012 would still be at 5.5 percent.

The act was passed. Unemployment peaked at 10 percent in October 2009 and in October 2012 was 7.9 percent. In other words, even with Obama’s $831 billion package, unemployment peaked later, peaked higher, and remains higher than in the doomsday scenario he said would befall America if the ARRA wasn’t passed. Unemployment was wedged above 8 percent for 43 consecutive months, the longest period since the Great Depression. The American economy underperformed even Obama’s own worst case scenario.

But even these dreadful figures might not tell us the whole story. America’s unemployment figures are notorious for their unreliability. Those who just stop looking for work are not counted as unemployed. So many Americans lost hope of finding a job in Obama’s America that in September 2012 the Labor Force Participation Rate fell to its lowest since 1981. If the LFPR was the same as when Obama took office unemployment would be a staggering 10.6 percent.

And even this might understate matters. If unemployment was measured now the same way it was in the 1930s, today’s level would be higher than in any single year of the Great Depression. That is why Obama didn’t run on his record; it’s awful. Instead his pitch was ‘Give a guy a second chance’ like some desperate ex-boyfriend.

And now he’s going to try taxing. But here’s the problem: last year the Federal government’s unfunded liabilities, which includes Social Security, Medicare, and Medicaid, all programs Obama has no plans to reform, increased by $11 trillion to $222 trillion. To put this in context, the entire American economy is just $15 trillion. If you expropriated the entire wealth of the richest 400 Americans and left them on food stamps you would take $1.7 trillion – it wouldn’t make a dent. All Americans will face huge tax rises.

F. Scott Fitzgerald said that there are no second acts in American lives. Obama must hope he was wrong. As Jay Leno put it, “Economists say we’re heading for a fiscal cliff and we elected a guy whose campaign slogan is ‘Forward!’” Barack Obama: the Thelma and Louise President.

This article originally appeared at The Commentator

A profligate president

“C’mon, let me drop you home”

Bearing epithets such as “prudence”, “capability”, and “the Iron Chancellor”, there was once a time when Gordon Brown was taken very seriously indeed. Now, an economic collapse later, his reputation is shot and his book about the global economy after the credit crunch can be found at the bottom of bookshop bargain bins for a distinctly deflationary £2.99.

George W. Bush, by contrast, was rarely taken seriously. Bush himself was aware of his limitations (and to preempt the obvious jokes, that’s something more politicians could do with) and gave a longer leash to subordinates like Dick Cheney and Donald Rumsfeld than either his predecessor or successor.

The same applies in The 4 per cent Solution: Unleashing the Economic Growth America Needs. Bush has not written a book about the global economy after the credit crunch; instead, ever the CEO, he has assembled a collection of leading economists and got them to write one. So we have Nobel Prize-winning economist Robert Lucas on economic growth past and present, fellow Nobel laureate Gary Becker on immigration (and Standpoint contributors Amity Shlaes and Michael Novak on, respectively, Calvin Coolidge and the moral superiority of free markets).

The puzzling thing is why Bush ignored all this when he was in office. There is a chapter on sound money when, with White House encouragement, base money in the United States grew by more than 33 per cent between 2001 and 2005, fueling the housing boom. There is a chapter on sound government finances when Bush turned Clinton’s budget surpluses into deficits with the largest expansion in Federal entitlement spending since Lyndon Johnson’s Great Society.

The irony is that Brown, a man once taken so seriously, produced such a squib of a book, while Bush, a man widely seen as a nincompoop, has produced something much more substantial. If only he’d acted on this wisdom before the event.

This article originally appeared in Standpoint

It’s anything but the economy, stupid

Wrigley Field, Chicago, 2040 AD

Walking around the ruins of the old Roman town of St Albans can make you feel like Shelley’s “traveller from an antique land”. As you look down into the remains of the Roman amphitheatre, where the town’s inhabitants flocked in the second and third centuries AD, you wonder what those people thought and talked about as Roman Britain approached its collapse.

You’d like to think they talked about that looming collapse. Perhaps they did. It was, after all, the existential issue of the day. But looking at behaviour in another, contemporary, troubled great power, you do wonder.

The United States government hasn’t balanced its budget since 2001. In the past ten years, starting in 2002 when Republicans controlled the Congress and the White House, Federal government debt has more than doubled from $6.5 trillion to over $15 trillion, or nearly $51,000 for every US citizen. Since September 2007 that debt has been increasing by nearly $3.9 billion a day. The Congressional Budget Office reported last week that in 2012 the Federal government’s debt increased by over a trillion dollars for the fourth year running.

Over the same ten year period the dollar has lost about 25 percent of its value. The rampant credit creation of the Federal Reserve which fuelled the housing bubble has created $1.4 trillion of new base money since 2000. At the moment most of this is sitting on banks’ balance sheets but if it emerges into the wider economy the US will have an inflation crisis.

Likewise, if the foreigners who hold nearly a third of America’s debt decide to dump these depreciating assets, the dollar will collapse.

These are the existential issues for the United States as November’s presidential election nears. But to look at the media you’d never know it.

Instead the American media has lately been preoccupied with a fast food chicken chain. More precisely, it has been preoccupied with what the president of that chain thinks of gay marriage.

“Who cares?” might have been the appropriate response. If you’re a Chick-fil-A shareholder and you don’t agree with him, sell up and invest somewhere else. If you’re a customer, go and buy your artery clogging food down the street. Capitalism, more so than any other system, gives you scope to exercise your morality.

Instead the views of one guy became a minutely discussed national news event. Democrats in a number of cities called for local branches of Chick-fil-A to be shut down, a curious course of action in the face of high unemployment. Supporters of Dan Cathy’s views had a Chick-fil-A Appreciation Day where they filled their faces to show solidarity. They should have called it Cholesterol for Christ.

Then, last week, media attention fixed upon the previously little known Republican Representative from Missouri, Todd Akin. In an interview with a local TV station Akin aired the unusual view that women couldn’t become pregnant through “legitimate rape”.

Worryingly Akin sits on the House Science Committee. This provides yet another argument for leaving more to free markets and less to government. Under free markets science ends up in the hands of people like Bill Gates and Steve Jobs. Only government could put someone like Akin in charge of science.

Neither gay marriage nor rape should be belittled as issues. Laurie Penny, not someone I’m given to quoting approvingly, noted in a moving blogpost that between ten and twenty percent of women in America have experienced rape, 90,000 in 2008 alone. This is awful and ought to be tackled.

But neither should silly remarks from a silly man like Todd Akin drown out the great existential issue in American politics: the economy.

And America’s solvency ought to matter to everybody. It ought to matter to Democrats who care about redistribution of wealth: watch your economy disappear over a cliff and then try and redistribute nothing; see how far that gets you.

It ought to matter to neo-conservatives: America’s economic wellbeing is a sine qua non of American strength. The United States did not become rich because it had powerful armed forces; it got powerful armed forces because it was rich. If the wealth goes so does the power.

And, most importantly, it ought to matter to every ordinary American citizen who will suffer if the economy continues on its current, Hellenic path.

But instead of this discussion we have the ongoing row about Mitt Romney’s taxes. With unemployment stuck above 8 percent and poverty at record levels, Obama’s supporters are trying to turn an election that should be about how much money Americans have in their pockets into one about how much money Mitt Romney has in his.

President Obama’s economic track record has been dismal so you can’t blame him for running away from it. Bill Clinton’s strategist James Carville famously said it was “The economy, stupid” but Obama and his supporters are desperately trying to shift the focus of this election to anything but. And the Republicans have been lead-footed enough to let them.

Ultimately, Americans have a decision to make. What matters most: Tax returns or job reports?

This article originally appeared at The Commentator

Is the bond bubble the biggest yet?

Forever blowing bubbles

In March 2000 the NASDAQ Composite index broke. From a peak of 5,048.62 on March 10th, 24 percent up on late 1999, the NASDAQ Composite had slumped to half that by the end of the year.

The bursting of the dot com bubble sent unemployment shooting up from less than 4 percent in late 2000 to 5.75 percent in late 2001. And it stayed there. Indeed, American unemployment didn’t peak until mid 2003 when it hit 6.25 percent.

As unemployment refused to budge and inflation slowed in early 2001 Alan Greenspan acted. Between January 2001 and June 2003 Greenspan slashed the Fed funds rate from 6.5 percent to 1 percent where it stayed until June 2004.

The effects are well known. With the economic foundations in place for an asset boom, institutional factors took over to decide which asset would do the booming. In this case government action like the Community Reinvestment Act, government bodies like Fannie Mae and Freddie Mac, and a minefield of moral hazard in a financial sector which knew it would be bailed out of any trouble, combined to direct the flood of credit into housing.

All booms and busts follow this pattern. An expansion of credit unsupported by real savings provides an economic base for a boom bust cycle and the institutional superstructure dictates which asset or assets will be the locus.

Since the credit crunch of 2007, and especially since the collapse of Lehman Brothers in 2008, central banks around the world have indulged in a massive expansion of credit not backed by savings. This looks very much like the foundation for another boom bust cycle. Where will it originate?

The trick is to follow the money and this means examining the institutional factors. Central banks have pumped their money into banks, who have sat on it, and, via Operation Twist, the EFSF, Quantitative Easing, or whatever, into government bonds. Is this where we will see the next bubble?

Let’s take a moment to explain how bonds work. If I want to borrow £100 I can issue a £100 bond with a maturity of one year, meaning that a year from now I will have to pay the buyer of the bond £100.

But I am unlikely to be loaned the full £100 by the person who buys the bond. If they did they would be giving me £100 now in return for £100 365 days from now. But to a buyer these two things, £100 now and £100 next year, are not the same.

The reason for this is time preference which is the basis of interest. If you are offered £100 which you can have today or £100 which you can have next year (the situation our lender is in) time preference dictates that you will prefer to get the £100 today. In other words, even though £100 is £100, time has a value so that the same thing offered at different points in time will be valued differently.

Put simply, something today is valued higher than the same thing at some future point. A bird in the hand is worth two in the bush, as they say.

To offset your preference for the £100 today over the £100 next year I would need to change the offer so that you give me £100 now and I repay £105 next year. An interest rate of 5 percent has emerged.

So if you issue a £100 bond you might only get £95 for it, this being the bond price. But you will still have to hand over £100 on maturity; the £5 difference is the interest, or the yield in bond market parlance. (The yield would be given as 5.26 percent as it would be a percentage of the bond price not its face value)

From this it should be obvious that bond prices and yields move in opposite directions. If the price rose to £96 the yield would fall to £4 (4.16 percent) and if the price fell to £94 the yield would rise to £6 (6.38 percent). In some cases bond prices can rise above face value giving a negative yield, meaning that lenders are paying for the privilege of lending.

Bonds prices are subject to the same supply and demand pressures as any other. So when demand rises/supply falls we will see higher prices and lower yields, and when supply rises/demand falls we will see lower prices and higher yields.

Let’s step back into the real world. Greek bond yields are high because few believe they will get the face value on maturity which, given Greece’s hideous debt problems, is a reasonable assessment. There is little appetite for Greek bonds and, with budget deficits of 8 percent of GDP, there is plenty of debt for sale. Germany, meanwhile, has a relatively sounder economic outlook and low (even negative) yields.

But Britain has Greek levels of debt and German interest rates, a new bond market conundrum. One reason is that of the vast expansion of credit undertaken by the Bank of England since at least 2008 much has flowed into British government bonds. Currently the Bank holds about 25 to 30 percent of British government debt.

A bubble is where asset valuations become divorced from the fundamentals of that asset’s ability to produce a return. A government with sound finances backed by a robust economy should enjoy low bond yields. But does this sound like Britain’s government or economy?

By pumping bond prices up and yields down this monetary action has helped inflate a bubble in bonds just as surely as previous credit expansions have inflated other bubbles.

Is the bond bubble the biggest yet?

This article originally appeared at The Commentator

Overrated: Paul Krugman

“Snake oil, £14.99!”

When Friedrich von Hayek became a Nobel Laureate in economics in 1974 he said: “The Nobel Prize confers on an individual an authority which in economics no man ought to possess.” The truth of this is demonstrated daily by the case of Paul Krugman.

Krugman and his supporters whip out his Nobel Memorial Prize in Economic Sciences like a Top Trump of Diego Maradona. It is awarded annually — so why the special fuss about a prize Krugman won four years ago? His Nobel is being used to intimidate opponents. Any opposition to Krugman with his Nobel Prize is opposition to science itself.

Why Krugman generates so much opposition isn’t hard to fathom. From his perch in the New York Times he says one ridiculous thing after another. In the British context Krugman’s risible thesis is that the economy is struggling because the government isn’t spending enough money, that austerity is driving us back into recession, and that the solution to our debt crisis is to borrow and spend even more money.

But there is no austerity. British government spending has fallen from record highs by only about 1 per cent since the coalition took office. This has tipped us back into recession? Most private sector companies could save that by switching to cheaper copier paper.

Krugman argues that we need vast government spending to get us out of the recession. But Britain is running a budget deficit of more than 8 per cent of GDP, one of the highest in the developed world. The government is spending more than 400 million borrowed pounds every day; the national debt is increasing by more than £5,000 every second.

And yet, with all this extra borrowing and all this spending Britain’s economy is still tanking. Perhaps this suggests that massive deficit spending isn’t the answer. That’s one interpretation. Not for Krugman. To him the problem is that even the record levels of borrowing which will see Britain’s national debt increase by 60 per cent, from £1 trillion to £1.6 trillion, by the next election, are not enough. We need to borrow more. That, he claims, would solve our debt crisis.

Krugman’s new book (its recommended retail price an aggregate demand boosting £14.99) is called End This Depression Now! (Norton) as though that hadn’t previously occurred to anyone else. Indeed, it’s possible that if George Osborne decided to increase borrowing to 10 or 12 per cent of GDP we might have a quarter or two of growth. Labour managed to boost GDP growth to 1 per cent by dumping £160 billion of borrowed money into the economy.

But after that? Don’t ask Krugman. He follows John Maynard Keynes who, accurately but none too helpfully, observed: “In the long run we are all dead.” Actually, if you did ask Krugman, you might get a response like the one he gave when the dot com bubble burst: “To fight this recession the Fed needs . . . soaring household spending to offset moribund business investment . . . Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.”

That worked out fine, didn’t it? Well yes, in Krugman’s terms it did. Sure, we are now living with the effects of the bursting of that bubble but we did get a few good years of rocketing property prices which made us all feel as though we were getting richer just by sitting in our homes. And now that bubble has burst we just inflate a new one somewhere else. And when that bursts we inflate a new one. And when that bursts . . .

This is where the Keynesian ignorance of the long run demonstrated by Krugman leads you: lurching from one catastrophe to the next with a series of increasingly expensive quick fixes of ever shorter duration which do nothing to address the underlying problems.

The economic problems of Greece, Spain, and Britain are not that the deficits of 7 per cent, 7 per cent and 8 per cent their governments are respectively running are not high enough. Greek labour costs are higher than elsewhere and Greece doesn’t export very much. Spain has unemployment of 24 per cent thanks to a labour market which makes job creation almost impossible. Britain is  already one of the most indebted nations on the planet.

These fundamental problems are ignored by Krugman and his followers. In his 1994 book Peddling Prosperity Krugman accused the supply-side economists of the 1980s of being “cranks” selling “snake oil” because, he said, they offered politically expedient economic non-remedies with no   basis in fact. Hypocrisy, thy name is Krugman.

As for that Nobel Prize, Paul Krugman won it for his work on international trade patterns, not his crackpot Keynesianism. Sir Paul McCartney won an Ivor Novello award for writing “Yesterday”. That doesn’t mean sentimental schlock like “Mull of Kintyre” is worth listening to.

This article originally appeared in Standpoint

The Fed giveth and the Fed taketh

The Maestro

Alan Greenspan’s pronouncements used to be described as ‘Delphic’ because of their rarity and mystery of meaning. So his blunt attack on the monetary policies of his successor, Ben Bernanke, last week on CNBC was quite striking.

“I am ill-aware of anything that really worked. Not only QE2 but QE1” Greenspan said, elaborating “There is no evidence that huge inflow of money into the system basically worked”. No doubt it will come as a shock to hear the man who gave his name to the use of huge inflows of money into the system to combat any downturn – the ‘Greenspan put’ – turning his back on the method. It will likewise surprise some, perhaps, to see the man who presided over a dollar which lost about a quarter of its value against the euro expressing concern about policies which might “continue erosion of the dollar”. That would be the erosion he played a large part in.

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The causes and consequences of a falling dollar


QE3 remains in dry dock for now but the dollar is still shipping water. Last week the dollar tumbled to its lowest level since July 2008 against a basket of five major currencies on speculation that Ben Bernanke, Chairman of the Federal Reserve, plans to hold interest rates to the historic lows of 0-0.25%, where they have been since 2008.

Bernanke’s dollar printing is based on the thinking that “price stability should be a key objective of monetary policy”. If the price level falls, deflation, debtors see the real value of their debts increase and have to devote a greater portion of their wealth to paying them off. Likewise, it is believed, consumers seeing falling prices may hold off on purchases in expectation of even lower prices in the future. Both forces will act to decrease spending and kick the economy into a downward spiral. Following Milton Friedman and Anna Schwartz’ prescription for the Depression, Bernanke sees the Fed as having to pump as much money as it takes into a failing economy to keep prices stable.

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The causes and consequences of a falling dollar

On July 15th both sterling and the euro gained on the dollar, the latter hitting a two month high. Why is the dollar losing its value and what will be the consequences if it continues?

The exchange rate is simply the price of one currency stated in another currency. So an exchange rate of £1 = $1.54 means it takes one pound coin to buy a dollar note and fifty-four cents or vice versa. Put this way its easy to see why currencies rise or fall in value. Price, like an exchange rate, reflects relative supply and demand pressures. If supply rises relative to demand or if demand falls relative to supply then the price will fall. If, on the other hand, supply falls relative to demand or demand rises relative to supply the price will rise.

Yesterdays fall was, apparently, caused by a fall in demand relative to supply. The Federal Reserve issued a fairly gloomy prediction for the prospects of the US economy over the next few years, notably forecasting that “the unemployment rate was generally expected to remain noticeably above its long-run sustainable level for several years”. But this demand side issue is only half of the story. The other half is the supply side.

The supply of dollars has exploded in recent years. Alan Greenspan, who became chairman of the Fed in 1987, inherited a reasonably tight monetary policy from his predecessor Paul Volcker who had raised the Fed funds rate to choke off the double digit inflation of the 1970’s. Almost immediately Greenspan was faced with stock market crash of October 1987 and responded by slashing interest rates to boost the economy and keep it from recession.

It is important to bear in mind how this works. Interest rates are just the price of money and are as bound by supply and demand pressures as is any other price including the exchange rate. To push this price, the interest rate, down, the Fed increases the supply of dollars. It worked in 1987 and recession was avoided but Greenspan pulled the same trick in 1998 when the Asian financial crisis struck and again in 2000 when the dotcom bobble burst. This technique of using floods of dollars to cushion downturns became known as the ‘Greenspan put’ and his successor, Ben Bernanke, has tried it again in the face of the bursting of the housing bubble and the resultant credit crunch.

But each of these injections of liquidity have piled upon one another. According to the Federal Reserve Board of Governors between 1987 and 2006 the amount of dollars in circulation, on the M3 measure, increased from about $3.5 trillion to over $10 trillion. One analyst, Adrian Van Eck, estimated that $3 trillion dollars were created between 2003 and 2006 alone. In early 2006 the Fed stopped counting M3.

So, coupled with the short term ‘demand shock’ of the Fed’s report yesterday we also have the longer term pressure of rapidly increasing supply on the value of the dollar.

What are the potential consequences of all this? To answer this we must first answer another question; why hasn’t this tidal wave of dollars created rampaging inflation as almost every school of economic thought suggests it should?

The answer lies on the demand side. As fast as the Federal Reserve has been able to pump dollars out America’s trading partners have been sucking them in. From the late 1980’s onwards large swathes of the planet embraced economic liberalization, most notably China, and began to trade. China sent cheap goods to the United States and the United States sent dollars to China. China accumulated over $1 trillion and the dollar holdings of Abu Dhabi, Saudi Arabia, Kuwait and Qatar were estimated at $2.1 trillion.

Inflation is caused by the growth of the money supply relative to the amount of goods and services in an economy. The entrance of emerging markets into the global economy increased the amount of goods and services available and offset the growth of the supply of dollars. Instead of staying at home and pushing up inflation the dollars printed in the US went abroad.

This brings us to the consequences of a falling dollar. As the Fed pumps out more and more dollars to revive the American economy the dollars value falls. This pushes down the value of these foreign dollar holdings. At a certain point the sheiks or politburo members will wonder just how long they want to hold onto a depreciating asset. And when they decide they no longer want to an awful lot of dollars will head back to the one place they can be redeemed; the United States.

With demand for dollars falling its exchange value will collapse. The dollars flooding back into the US will cause inflation as the holders of foreign dollars repatriate them and try to cash their depreciating dollars in for other American assets. Anything not nailed down between Cape Cod and Honolulu will be bought and shipped abroad. There are 8.9 million mobile homes in the US so perhaps shipping these off to Beijing and Bahrain could ease the housing glut.

How likely is this doomsday scenario? As we’ve seen, like all else in economics, it depends on supply and demand. On the demand side if foreign holders of US debt are content to keep hoovering up dollars its value will be maintained. There are reasons to think they might. A collapse in the value of the dollar, beyond the creaking seen yesterday, would see the value of dollar holdings decimated. Also, China might find the leverage it now has over the US useful in any future dispute over, say, Taiwan. The threat of currency mayhem could castrate a United States response.

Other factors work the other way. The continuing weakness of the US economy, as highlighted by the Fed, will give foreign dollar holders pause for thought as will the Fed’s policy of creating dollars if continued beyond some point. Then the dollar will fall and inflation will follow.

On the supply side it is clear that the more dollars the Fed creates the greater a tumble in its value prompting an exchange rate dive and inflation. The Fed can only influence the demand side indirectly. The supply side is in its own hands.


When economic crises hit people eventually turn to ask two questions; 1) How did it happen? 2) How do we stop it happening again? The current crisis has been no exception.

The popular reason put forward is “greed”, usually bankers lending to people unlikely to pay it back to achieve their bonuses. Such a simple minded explanation leaves many questions unanswered such as where did the bankers get all this money to lend out in the first place?

On a more scholarly level the old Keynesian theory of recessions has been dusted off which, essentially, puts everything down to a decline in business confidence. But this begs the question of what caused the decline in business confidence. It treats the symptom, the recession, without addressing underlying illness.

At times like this the search for explanations covers ground usually left alone. Marxists have been happily claiming that Marx has, after 160 years of waiting, been proved right. But another usually obscure theory offers answers to the two questions posed at the top.

Austrian Business Cycle Theory sounds like a tedious nightmare. In fact it is a school of economic thought which proudly renounces long winded, irrelevant, and often self defeating mathematical equations, relying, instead, on logical deduction. It is probably this accessibility to the general reader that accounts for its being largely ignored by mainstream economists eager to give their art the appearance of science by dressing it up in algebra.

Austrian Theory starts with the idea that the interest rate is a price like any other, matching the supply of something to the demand for it. In this case the supply is savings and the demand is funds for investment. So, if the public decide that they want to increase the amount of money they are saving they put it in a bank. A business, on the other hand, which wants to borrow cash to invest in a new factory, must go to the bank and borrow this money.

The interest rate matches the two sides of this transaction. When people save they are, essentially, postponing spending today for spending tomorrow. The banks offer interest to savers so they can encourage them to deposit their money with them and, thus, give the banks money to loan out to businesses for investment. When people decide to save the banks don’t need to offer such a high incentive to deposit so can afford to offer lower interest rates. These lower interest rates are passed on to the businesses. They see that the cost of borrowing from a bank has fallen so they borrow to fund investment projects, such as new factories, which will not produce a return in the short run but will in the future. The signal has passed, via the interest rate, from the savers who wish to postpone their spending, to businesses who will now borrow this money to cater for the future spending.

So far so good. Savings equal investment. And when people decide they want to spend rather than save they pull their money out of the banks which forces them to offer higher interest rates to attract loanable funds. These higher rates are, as before, passed onto business which sees the signal that people are spending their money now so investment spending on future projects is stopped.

But then the monetary authority steps in. In the UK it is the Bank of England, in the US the Federal Reserve, in the EU the European Central Bank, and there are as many around the world as there are currencies to be issued. Say, for example, that the Federal Reserve decides that it wants low interest rates to spur investment and economic growth, exactly, in fact, what it is doing now. It does this through what are called ‘Open Market Operations’. The Fed offers to buy securities from banks and buys them with money created out of thin air. It’s that simple.

But this intervention destroys the interest rates ability to balance saving and investment and the two things rapidly tumble out of kilter. This is where it hits the fan.

The banks are now awash with cash and can go merrily lending out to anyone they like whether they can pay it back or not (especially if, as in the US, they are under Congressional pressure to lend to poor families). Indeed, interest rates are so low that to make a profit they may be forced to lend to just the sorts of marginal borrowers least likely to be able to pay it back.

Business, meanwhile, sees these low interest rates and begins borrowing to invest assuming that people are saving to spend in future. They may decide to build units in places like Michigan assuming that they will be bought in a few years when people have decided to start spending again.

But people are already spending. The lower interest rates mean there is no incentive for them to save as they will see no reward for it. So they go out and spend and, encouraged by the low interest rates, they borrow and run up massive credit card bills and take out mortgages at 6 times their salary.

The economy is, by now, being constantly pumped up by continuing injections of new money. But eventually the penny drops. The central bank raises interest rates. Business can no longer borrow to fund investment. People begin saving thanks to these higher interest rates and, coupled with a fall in consumer borrowing, another source of income for business dries up. We now have a recession.

That, in a nutshell, is the theory. How does it stack up in practice?

A recent book by Thomas E Woods, ‘Meltdown’, applies the theory to the US and shows how the property bubble (like the dot com bubble before it) was inflated then popped by the loose monetary policy of Alan Greenspan’s Federal Reserve.

But the theory doesn’t just hold for the US. In Britain too we’ve had a long period of historically low interest rates. Between 1993 and 2001, interest rates averaged 6%. From 2002 to 2008 they averaged 4.5%. This prompted corporate borrowing in the UK to balloon from £99 billion in 2003 to £269 billion in 2008. Consumer debt also rocketed to more than £1.4 trillion. Then interest rates rose from 4.5% in July 2006 to 5.75% in July 2007; right when the crisis began.

Much has been left out here, notably the role of the inevitable inflation which follows the credit expansion in prompting central banks to raise interest rates. In the UK the RPI index rose from 2.6% in April 2006 to 4.8% in March 2007 prompting the Bank of England’s to raise interest rates from 4.5% to 5.75% in July 2007. Similar inflationary pressures in the US saw the inflation rate rise from 2.6% in spring 2005 to 4.75% in the autumn. This prompted the Fed to edge the Fed Funds Rate up from 1% in mid 2004 to 5.25% in early 2006 where it stayed until late 2007. These central bank rate increases were a direct cause of the bursting of the property boom the same authorities had created.

We’ve also not looked at how the credit expansion especially effects the capital goods industries, such as manufacturing or building which thrive on cheap borrowing but suffer disproportionately in the credit contraction. In June this year LDV Vans went bust in the UK after failing to secure a government bailout. In the US Chrysler had no such trouble getting its hands on taxpayer cash. In the UK the housing construction market declined by 13% in 2008. In the US McGraw-Hill Construction calculated a 12% decrease in construction starts in the same year.

So we have, perhaps, an answer to our first question. We can also answer another question of why Austrian Theory is paid little attention by monetary managers; Shifting the blame from greedy bankers, mysterious declines in business confidence or inherent flaws in capitalism and placing responsibility squarely with the mangers of the national currency is a sure way to earn the opposition of those very same managers. For an answer to the second question, how stop this happening again, Ill return next week.

Heres a link to the book ‘Meltdown’ http://blog.mises.org/archives/009387.asp