column, I ended with a reference to “pushing on a string.”
“Pushing on a string” is a phrase that has been around for over
half a century. It refers to the ineffectiveness of Federal Reserve
monetary policy: specifically, the FED’s expansion of monetary
reserves. It is said that the FED can add to its own reserves
by purchasing assets — usually, government debt — but
commercial banks will not take advantage of these reserves by
lending out money. So, the FED’s policy will not jump-start the
economy. The FED can make reserves available, but it cannot force
banks into converting these reserves into loans. Like a string
— unfrozen, anyway — the FED’s pushing on one end does
not produce forward movement on the other end.
I have serious
doubts about this thesis. For this reason, I have been a steady
predictor of long-term price inflation. I think the FED always
pushes on a stick, to which is attached a carrot: below-cost money.
the chain of events. The FED (or any central bank) purchases government
debt with newly created money. These debt certificates serve as
the assets that justify the increase of fiat money. Assets and
liabilities match in the FED’s accounts. The government’s debt
certificate is a FED asset that pays interest to the FED. The
money issued by the FED to buy the asset is legally a FED liability,
but the FED doesn’t pay interest on this money. Nice work if you
can get it! (The FED does pay the government for this unique privilege.
After deducting all expenses in any fiscal year, the FED returns
any excess income to the Treasury. But the FED doesn’t have much
incentive to cut expenses.)
FED buys a government bond, it issues a check to one of the FED’s
authorized bond brokerage firms. The firm takes its commission
and then transmits a credit to the U.S. Treasury, which immediately
spends the money. (If you don’t think the U.S. government spends
every nickel it pulls in, you don’t understand the government.
Members of Congress buy votes in their districts with this money.
“Keep that money flowing!”)
Treasury spends any money, it issues a check. The recipient of
this check deposits it in his commercial bank.
you, bankers do not let checks sit around on someone’s desk collecting
no interest. The bank now has a liability sitting in the depositor’s
account. This is the depositor’s asset, but it is the bank’s liability.
Legally, the depositor can withdraw his money, so it’s the bank’s
liability. The bank may be paying interest on this deposit.
wants to convert that bank liability into a bank asset. He goes
looking for a borrower. The banker does have to keep a very small
deposit with the FED as a legal reserve. This reserve earns no
interest. This is why the system is called fractional reserve
banking. With all the money left over — at least 98% of the
original deposit — he goes looking for a borrower who will
pay his bank more interest than he is paying to the depositor.
The banker may lend the money overnight to another bank that needs
legal reserves for its deposits. This is the famous federal funds
market. Or he may lend it to the government by purchasing a government
bond or T-bill. Or he may lend it to a business. Or he may lend
it to a consumer. The point is, he is going to lend it, immediately:
the same day that the entry goes into the depositor’s account.
The money will not sit, unused, in the bank’s computer as a non-interest-bearing
liability. The flow of funds keeps flowing, like Old Man River.
that, one way or another, all of the fiat money created by the
FED or any other central bank will be converted into commercial
banks’ loans of one kind or another. The commercial banking system
operates profitably only when every last penny on deposit in the
bank gets loaned out to interest-paying debtors. The fiat money
created by the FED to buy government bonds does not wind up in
some bank’s cookie jar. Banks don’t have cookie jars.
the FED increases its purchase of assets, it is not pushing on
a string. Consumers may decide to spend the money more slowly,
but if the money isn’t in the form of currency, it is in the flow
of funds. Someone is using it because someone is paying interest
on it. Currency does not draw interest; all other forms of money
does the velocity of money change? If money is always in use —
in some depositor’s bank account, earning interest, and also in
some debtor’s account, paying even more interest — then why
isn’t the velocity of money a constant, except for the relatively
small currency component of money?
We now get
to one of many unsolved mysteries in economics. Economists are
part-time verbal magicians, kind of like Harry Potter, except
that they don’t have any power. They are master illusionists.
Once in a while — very rarely — someone in the audience
calls their bluff. Financial columnist Nathan Lewis did this on
Jude Wanniski’s Polyconomics Website on August 2, 2001. He pointed
out that economists for 250 years have clung to a concept of the
velocity of money. (Actually, it goes back over 300 years: the
economist William Petty.) This relationship was made famous in
1911 by a Yale University economist, Irving Fisher. He expressed
it as an equation, MV = PT. This equation symbolizes a supposedly
measurable real-world relationship: the relationship between the
quantity of money and prices. MV = PT means the quantity of money
times the velocity of money equals the price level times the number
of transactions. It looks very scientific, but it’s mostly abracadabra.
Money: What is it? Base money? M2? M2+CDs? M3? M13? MZM?
A totally unmeasurable unknowable residual mystery variable
What is it? A price index? Whose price index?
What is it? GDP? GNP? Measured by whom?
words, MV=PT is an uncertainty multiplied by a mystery equivalent
to the product of two academic abstractions.
of “Prices” and “Transactions” become even more vague in a situation
where the dollar is used all over the world. In fact, most dollar
bills are apparently being used overseas, in dollarized countries,
in black markets, as a secondary currency, in the international
drug trade, by commodities producers, by tourists, and by foreign
banks and central banks. These are all dollar transactions.
Do the Ms take account of eurodollars, or deposits in Japanese
banks? Do price indexes include prices of Middle East arms shipments,
or Cambodian heroin or Columbian cocaine, or groceries in dollarized
take into account dollar-denominated trades in the Russian black
I have never
read a cogent study of exactly how the velocity of money can rise
or fall in a fractional reserve banking system, when all banks
are fully loaned out 100% of the time, which they always are.
This may be because I have not read enough. But the statistic
exists, and when it is falling, prices are not rising as fast
as the increase in the money supply.
the question of what constitutes money. Greenspan has admitted
repeatedly that nobody really knows which monetary statistic is
the “true” money. Consider the answer that Greenspan gave to Congressman
Ron Paul of the House Banking Committee on November 17, 2000.
Ron Paul asked him why the Money measure-M3 — has been growing
for the past several years. WHY, If Inflation, which Greenspan
claims to be trying to control, is caused by growth in the Money
Supply, why has the FED allowed M3 to grow unchecked since 1992?
replied, “… We have a problem trying to define exactly what
MONEY is…the current definition of MONEY is not sufficient
to give us a good means for controlling the Money Supply…”
Paul asked “Well, if you can’t define Money, how can you control
the Monetary System?”
replied “That’s the problem…”
little secret of the MV = PT equation is that economists cannot
easily explain changes in the velocity of money in an economy
in which currency is not the main component of money. They invoke
a change in velocity when increases in the money supply have not
produced corresponding increases in the price level. They say
that the velocity of money has fallen. They say this because they
can’t explain why prices in general haven’t risen in response
to an increase in the money supply. Federal Reserve Bank statisticians
don’t survey a randomly sampled group of 1,500 people to find
out if they have made fewer transactions. The velocity of money
is an inference drawn from statistics that economists cannot easily
Off Debt: Is This Deflationary?
plan on selling their wares to consumers who are ready and able
to buy, they increase production. When they encounter tight-fisted
consumers who refuse to buy what they have produced, they suffer
losses. They start selling off inventories. They don’t re-order
from their suppliers. The economy slows. They may use their revenues
to pay off debt.
pay off debt, the repaid credit goes looking for a new debtor.
A banker can always find at least one debtor: the government.
But when other debtors are not eager to borrow, the banker will
face a debt market with lower interest rates: more supply of loans
than demand for loans at yesterday’s price (interest rate).
supply of credit/debt is set by the FED: the commercial banks’
reserve requirements and the monetary base. Interest rates fluctuate,
and the allocation of who gets what fluctuates, but the total
supply of credit stays constant. Banks are fully loaned out at
all times. “If you got it, lend it!”
FED starts selling some of the assets in its portfolio, the repayment
of debt does not deflate the money supply. Debt repayment changes
the names on a bank’s list of debtors. It may change the rate
of interest. But it does not shrink the money supply. Only the
FED’s shrinking of the monetary base does that, unless commercial
banks are actually failing and defaulting on their liabilities.
This happened during the Great Depression, 1930-33, but that was
an aberration. Today, there are Federal loan guarantees and other
regulatory tools for maintaining bank solvency. If the banking
system is solvent, then the central bank’s portfolio of assets,
coupled with reserve requirements that seldom are changed by the
FED, determines the money supply.
This is not
to say that an international, systemic banking crisis cannot happen.
It can happen. The level of the world’s interconnected debt is
so huge that there is no way for any system to ensure solvency.
But such a systemic breakdown has not taken place since the early
What no central
bank can guarantee is where the money it creates will be spent.
It cannot ensure the stability of prices. It can try, but the
level of prices of many assets, such as housing, by means of creditors’
assumptions that a particular stream of income will be maintained.
A recession can destroy these assumptions when millions of people
find that their streams of income have been cut short. They start
defaulting on debt. This destroys bank assets. The liabilities
— depositors’ money — are no longer offset by a bank
asset. That’s when things get dicey for the banking system. This
is what Japan is facing today. Japan’s central bank is expanding
the money supply, but prices are falling in Japan. Bankruptcies
and unemployment are increasing. Banks are going bankrupt.
So, the debate
over string-pushing is really a debate over commercial bank solvency.
If there is a widespread break in the banking payments system
— the debt-repayment system — fiat money may not be
sufficient to reverse a falling economy. This is not the situation
in the United States today. It may be next year, but it isn’t
market has been bid up to price/earnings multiples that are unlikely
to be sustained: about 39 to one for the S&P 500. But profits
are dismal. Accounting standards have fallen, making profits appear
larger than they really are. Enron’s $63 billion crash has made
Arthur Anderson look bad. The decision by Arthur Anderson to sue
a bankrupt Enron for $2 billion is a symbol of what may at long
last be a realization among the accounting profession that all
is not as it seems in the corporate world’s dance of the decimal
boom of 1991-95 was generated mainly by falling interest rates.
Businesses could operate more profitably than in the 1980′s. But
the recent rise in the T-bond rate indicates that the experts
whose profits depend on accurately predicting long-term rates
have decided that the FED’s expansion of the money supply will
produce inflation, which will reduce the value of the dollar.
This will persuade creditors to demand higher interest rates.
The interest rate on bonds, far more than the short-term CD rate,
is what determines the long-term profitability of business.
A mild price
deflation will continue in those areas of the economy that face
foreign imports. I don’t see anything like a collapse of prices.
What I see is continuing pressure on profit margins of manufacturers.
But never forget: one man’s nightmare is another man’s bonanza.
When American firms that buy the output of American manufacturing
see stable or falling prices for what they buy, it’s a benefit
What I don’t
see is a stock market that soars upward because “the recession
is over.” First, the profits recession is likely to continue.
This is bad news for stocks. Second, unemployment is still low
for a recession. There is more unemployment ahead. This causes
other workers to cut back on spending, to become more cautious.
The decline in the velocity of money should continue in 2002 —
if there really is such a measure.
I see no
rush to invest in capital equipment. The hope of future profits
is today’s capital investments. Some economists say that this
is a lagging indicator, that investment won’t increase until the
economy has recovered. But those who we pay to forecast the future
— businessmen — ought to know before the rest of us
do what the state of consumer demand will be in a year. They are
saying that discretion is the better part of valor.
been no significant pain in the recession so far. The stock market
did not fall appreciably. Unless this turns out to be the mildest
recession on record, there is more bad news to come.
policy of 8% monetary inflation indicates that Greenspan is doing
whatever he can to keep a hard landing from occurring. But in
Asia, a hard landing has only just begun. The FED’s fiat money
will get spent, but the only thing keeping long-term rates low
is the threat of price competition from abroad.
economic recovery will come stagflation: economic stagnation
and price inflation. I don’t mean price inflation in the manufacturing
sector, which accounts for one-third of the U.S. economy. I mean
price inflation in the service sector. The more optimistic a forecaster
is regarding the imminence and magnitude of the economic recovery,
the more attention he should pay to today’s high rate of monetary
why I don’t take seriously the almost universal forecast that
the recovery is just around the corner is that none of these forecasts
is accompanied by a discussion of stagflation. Another reason:
these rosy-scenario forecasters did not forecast this recession
last year, nor did they announce it last March when it hit. They
admitted its existence only when they added that it’s old news
anyway, and just about over. They are insistent that recessions
don’t happen very often, and by the time we hear about them, they’re
just about over. Every recession is supposedly a V-curve with
a fast rebound. Their message is always the same: it’s time to
buy stocks. It is never, ever time to sell stocks. When you think
of well-known forecasters, think “Enron.”
see a report by a “time to buy” stock analyst, see when he issued
a “time to sell” warning, or a “time to buy puts” hedge warning.
See when he warned of the recession to come before you take him
too seriously about the recession to go away.
Here is the
inescapable fact: with an economic recovery, interest rates will
go back up. But falling interest rates, 1982-98, were the primary
reason for the rise in corporate profits. In the February, 2000
issue of Remnant Review, I warned my readers about the
scariness of the NASDAQ. This was four weeks before the NASDAQ
peaked at 5040. I wrote:
[Warren] Buffett sees the great boom in terms of the downward
move in interest rates and the upward move of corporate profits
from 3.5% (1981) to the 6% range. By late 1998, long-term rates
on U.S. bonds were in the 5% range. The boost from these two factors
established the underlying basis of the more than 10-fold increase
in the Dow, he says. (It was 13-fold by late 1999). Meanwhile,
the economy grew less than it had, 1964-81. . . .
Webber/Gallup survey last July revealed that investors with
less than five years experience in the stock market expected
a return of 22.6% over the next decade. As I figure this, that
would mean a Dow of over 88,000. (72 divided by 22.6 = 3.19,
i.e., the Dow will double every 3.19 years.) Those with more
than 20 years experience expected 12.9% compound growth.
says this is not going to happen. Why not? Because interest
rates are not going to fall that much, and corporate profitability
in relation to GDP will not rise sufficiently.
profits are now at the high end of the scale by historic standards.
Politics will not allow them to get much higher, nor will competition.
Interest rates are low compared to 1981.
In my free
e-mail newsletter, on August 9 of this year (Issue 74), I
quoted the Boston Globe (Aug. 5).
most interesting numbers may have been a more obscure set of
figures that measure profit margins or the share of the economy’s
output that winds up as profits. Warren Buffett, a pretty fair
investor, attaches great importance to the profit margin numbers.
Buffett believes that the rise in those margins from the early
1980s to the late 1990s was a key driver of the great bull market
of the last 20 years. As Buffett put it in a 1999 Fortune article,
“The value of an asset cannot over time grow faster than its
talk about the coming economic recovery should be accompanied
by a detailed consideration of the likely effect of any such recovery
on long-term interest rates. This is closely related to the crucial
issue of corporate profitability. If the FED’s monetary inflation
is the key factor in forecasting the recovery — which most
analysts seem to believe it is — then why should anyone believe
that the recovery will bring back a booming stock market? We see
low interest rates at the bottom of a recession. If this is the
bottom of the recession, yet T-bond rates are still above 5%,
then where will the stock market boom come from? We are being
told that the recovery is imminent because we are seeing a rise
in long-term rates. But a rise in long-term rates is detrimental
to corporate profitability.
Rates and the FED
I, for one,
am not convinced that FED policy is what forced down short-term
rates. As I said in the yesterday’s report, there has been a recession-driven
fall in demand for loans from business. The FED’s expansion of
money has increased the supply of fiat money to be loaned by banks,
but the more significant factor has been falling demand.
Bill Bonner sent me a copy of a March 22 article in the Wall
Street Journal by Arthur Laffer: “So
You Thought the Fed Set Interest Rates?” He sees it pretty much
the same way I do. He commented on the downward move of the Federal
Funds rate from 5% to 4.5%.
in my opinion, did just what he had to do. What astounds me,
however, is why anyone cares or why anyone was surprised. The
Fed is enormously important for the U.S. and world economies,
but not because it changes the discount rate or the targeted
federal funds rate. All this hoopla over the Fed’s rate changes
is misplaced. . . .
the so-called federal-funds target rate set by the Fed couldn’t
be more vacuous. Just what does it mean when the Fed says it’s
going to target a rate that is determined in a market-interbank
loans-in which the Fed is not a participant? If that isn’t jawboning,
I don’t know what is. And a jawbone without teeth isn’t much
of a threat.
the interest rate hoopla surrounding the Fed’s Open Market Committee
meetings is nothing but a sideshow. I too wish the Fed could
just wave a wand and change interest rates, but it can’t. In
the near term, the Fed has very little power to do much of anything.
In the long run, however, the Fed is the single most powerful
force in our economic universe. It can and does move planets
and change the world. But it doesn’t change the world by directly
changing interest rates. The key to the Fed’s power is its total
control over the monetary base-the sum of currency in circulation,
vault cash and member-bank deposits at the Fed. . . . In dynamic
terms, the rate of growth of the monetary base ultimately determines
inflation, interest rates, the price of gold, exchange rates,
etc. By controlling the monetary base, the Fed really does control
our nation’s destiny and probably the economic well-being of
is, when the FED adopts a policy of high growth in the monetary
base — 8% seems high to me — the threat of price inflation
reappears. Laffer was writing last spring. He saw no problem then.
is now doing everything correctly. If it were to once again
grow the monetary base too rapidly our short-term euphoria would
come back, at the risk of long-term inflation and economic stagnation
like that of the 1970s. By maintaining stable, modest growth
in the monetary base, the Fed will help the economy start to
recover and secure our longer-term prosperity.
I see a problem
today. Short-term interest rates are as low as they has been in
over three decades. The unemployment rate keeps climbing. The
FED is pumping in new money. I do not regard 8% per annum as “stable,
modest growth in the monetary base.” Long-term rates have started
moving back up. There are few signs of economic recovery, but
the core rate of price inflation — the median CPI-rose in
November at 3.5% on an annual basis. This is down from 3.9%, November
to November, but not by much.
What I see
is a FED that is very concerned about the worldwide economic recession.
The FED is trying not to get blamed for having done too little,
too late. The FED will have to tighten money as soon as the recovery
is visible. It always does. If it refuses, long-term rates will
soar, and business profitability will plummet. So will the stock
We are now
watching the FED race against the cascading effects of falling
demand for business loans, falling business investment, falling
profits, and spreading effects of worldwide recession. The optimists
are now saying that the economic recovery will come in the second
half of 2002. Six months ago, they were saying the same thing
about the second half of 2001. But when it comes, the cost of
servicing business debt will increase.
short-term rates are a combination of FED monetary inflation and
falling demand for loans. Fiat money is going into the hands of
consumers and government, not businesses. Will this additional
money produce the economic recovery? Keynesian economists say
yes. They see the problem as one of consumer tight-fistedness.
some truth to this. The velocity of money has fallen for four
years, sharply since mid-2000 (it says here). Consumers are not
actively spending as wildly as they did, 1995-97. But it is not
as though falling velocity appeared only this year. What did appear
late last year and throughout this year was the disappearance
of corporate profits.
should make a strong case for a change in the economy that will
restore profitability. Rising long-term interest rates are on
the bears’ side of the debate. A tightening of FED credit is,
too: rising short-term rates. Yet the FED always tightens once
a recession is past.
long-term investments in plant and equipment have been the source
of profits. Today’s investments in high-tech capital depreciates
very fast. You know the rule: “The day that you take delivery
of your new PC, it’s obsolete.” Moore’s Law is still operating.
“Computer capacity doubles every year.” The pace is speeding up.
It used to be 18 months. Now, it’s 12 months. So, investments
in high tech must be made again, soon. What nobody is saying is
this: consumers reap most of the rewards of high-tech investing.
The companies don’t. Profit margins cannot be sustained for long.
New competition keeps appearing.
This is as
it should be. Consumers should reap the lion’s share of the rewards.
The free market is a social system that rests on consumer sovereignty,
not producer sovereignty (mercantilism). But the reality of the
“new economy” only began to penetrate the thinking of investors
in March, 2000. It has not really re-shaped the investing world.
Here is the
new rule: “High tech means short-term profitability.” It means
rapid depreciation schedules and a new round of investment two
or three years from now. It means competitors who respond fast
by adopting new technology. The rate of profit on capital invested
is falling like a stone.
for a stock market boom must rest on the case for the restoration
of long-term profits, which in turn will call forth high rates
of investment. That case is becoming very hard to make. Certainly,
American businessmen today are staying on the sidelines.
The FED is
pumping in new reserves. Short-term rates have fallen. I think
they have fallen mainly because of reduced corporate demand for
loans. I think the recession is why they have fallen, not the
FED’s actions. Be that as it may, long-term rates have risen.
Rising bond rates mean rising costs to businesses. The profitability
of business is not guaranteed by the FED’s expansion of money.
This is why the FED’s lowering of short-term rates is no guarantee
of a stock market boom.
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