by Gary North
In yesterday's 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.
Let's follow 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.)
When the 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!")
When the Treasury spends any money, it issues a check. The recipient of this check deposits it in his commercial bank.
I assure 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.
The banker 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.
This means 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.
So, when 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 do.
Then how 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?
A Magician's Incantations
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. Lewis writes:
Money: What is it? Base money? M2? M2+CDs? M3? M13? MZM?
Velocity: A totally unmeasurable unknowable residual mystery variable
Prices: What is it? A price index? Whose price index?
Transactions: What is it? GDP? GNP? Measured by whom?
In other words, MV=PT is an uncertainty multiplied by a mystery equivalent to the product of two academic abstractions.
Notions 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 El Salvador?
Does GDP take into account dollar-denominated trades in the Russian black market?
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.
This raises 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.
Congressman 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?
Greenspan 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..."
Congressman Paul asked "Well, if you can't define Money, how can you control the Monetary System?"
Greenspan replied "That's the problem..."
The dirty 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 explain.
Sorry about that.
Paying Off Debt: Is This Deflationary?
When businessmen 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.
When they 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).
The total 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!"
Unless the 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 1930's.
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 yet.
The stock 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 points.
The profits 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 to them.
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.
There has 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.
The FED's 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.
With the 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 expansion.
The reason 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."
When you 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. . . .
A Paine 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.
Buffett 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.
Corporate 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).
But the 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 earnings do."
All optimistic 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.
Interest 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.
Recently, 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%.
Mr. Greenspan, 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. . . .
In addition, 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.
All of 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 the world.
The problem 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.
The Fed 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 market.
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.
Today's low 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.
There is 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.
The optimist 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.
Traditionally, 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.
The case 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.
December 27, 2001
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