This week we would like to have a closer look at the challenges the central banks are facing and the fundamental problem of a central bank in general. We look at their workings from an alternative angle and even go back to the industrial revolution to compare them with the mechanics of a steam engine. Furthermore in tackling the current crisis we wonder whether the Keynesian approach will bear fruits.
But we won’t be too strict on the current generation of government officials as some of them are showing leadership in trying to divert the crisis. As even the IMF is starting to acknowledge under Mr. Strauss-Kahn, the developed economies are on the brink of tumbling into a depression and there are not a lot of text books out there how we have to cope with the current situation. Apart from the Great Depression there is not a lot of literature available what we can do, so probably this era will go down in history as the Great Experiment.
Apart from bailing out the banks the only remedy they are using is a good old fashioned Keynesian tool and hope that with massive government expenditures one can kick start the economy. One of the questions we will raise is whether this is going to be effective?
But let us take a step back and dig into the literature that is available of the Great Depression. Probably the most important guidance available is Milton Friedman’s classic “A Monetary History of the United States, 1867 – 1960”
The greatest mistake made during the Great Depression was the Fed relaxing the money supply not enough and too late. As a matter of fact they even reversed their quantitative easing mid July 1932 which gave the final neck shot to the economy.
Fed Chairman B. Bernanke, realises this very well as he studied the Great Depression from close by during his academic career at Princeton University. As he learned from Friedman, it is key to increase the liquidity in the system and stabilize the velocity of money, which is the frequency with which a unit of money is spent during a specific period of time.
We don’t want to scare you away but this can be expressed as:
VT = nT/M
VT : Velocity of money
nT : nominal value of aggregate transactions
M : amount of money in the economy ( M1; M2; M3)
The Fed or any central bank in general is doing this by injecting cash directly into the system by purchasing US Treasuries. In this case there will come more money M into the system.
The Fed’s ability to create money by purchasing assets is only limited by its balance sheet. Its balance sheet liabilities consist of bank reserves held on deposit and deposits from the Treasury. Recently the Treasury sold a substantial amount of debt for the purpose of depositing the proceeds at the Fed. This allowed the Fed to double its balance sheet to about $2T. The Fed is using this extra leverage to buy assets or loan on collateral with risks much higher than treasuries. Even though Chairman Bernanke says the Fed is taking an appropriate haircut and the Fed can sit on assets until they mature, these toxic and semi-toxic assets will be far more difficult to sell when the Fed needs to unwind its liabilities.
But there is another problem. As you have noticed in the formula velocity is also a measure for the turnover of money supply. If banks are not lending the velocity of money will keep dropping. And even worse, as people start to realise that they have to save more and spend less, because this is what got us into trouble initially, it will not solve the problem either.
This is the paradox that central bankers are facing now with the risk of lifting the system one more time over the edge. As we saw in Japan, people adjusted their behaviour and took more then a decade before there were signs they started spending again. Neither government spending could trigger economic growth (see more later). We are only 1.5 years in this crisis and what central bankers are saying to us is start spending again and go back to your old behaviour.
And the last challenge they will face is once the economy starts recovering again, and let’s all hope we will see this sooner rather than later (although we doubt very much) the Fed and other central bankers will have to be extremely fast to remove the excess liquidity they provided at the beginning. Otherwise the velocity of money will explode, read inflation will be back with a vengeance.
This was the mistake Greenspan made at the beginning of this decade. After the dotcom bubble exploded and 9/11 pushed the economy into a recession there was a short scare of deflation as well. What we know now is that the Fed was much too late in starting to take part of that money back in 2004, with the ultimate consequences we are in right now.
The only difference with 2001-2004 is the Fed and other central banks in the world are providing liquidity at a multiple of the period then. The saying “We are walking on thin ice here” is an understatement. We even think the central bankers believe that they are Jesus…
Ben Bernanke knows the dangers and even publicly admitted they aren’t gifted with an invisible hand. In a speech given in honour of Friedman’s 90th birthday in 2002 he said: “I would like to say to Milton and Anna: Regarding the Great Depression, you’re right. We did it. We’re very sorry.”
The problem however is that central banks have a great hand in the boom and bust cycles and are accelerating economic events. Friedman is reported to have said, just before he died : “It is preferable to abolish the Fed entirely and just have the government stick to a monetary growth rule. Unfortunately there is no chance at all of it happening”(1)
There is an interesting reading on the role of central banks by George Cooper where he compares the central banks with the working of a steam engine during the industrial revolution.(2)
More specifically the way a central bank operates is similar to the workings of mechanical devices which were developed to stabilize the rotation of steam engines in the 1860’s. For example a sawmill powered by steam engines at the time faced the danger to run out of control once it got into contact with a chunk of wood that needed to be sawn. For that reason they placed governors on the machine which kept the steam engine going at a constant speed under conditions of variable load. Soon one discovered that rather than bringing the rotation speed of the machine to a constant level, there were disturbances in the machines speed which could create heavy vibrations and even shake the machine apart.
The mathematician J.C. Maxwell did some research on the mechanics of these governors and his conclusion on the cause of these disturbances can be closely compared with the short comings of central banks. The problem was that the governors would hit the breaks quite abruptly when they noticed the rotator was spinning to fast, causing the machine to slow down suddenly. Afterwards it would release the breaks abruptly and causing a sudden re-acceleration. As a result the machine showed very heavy vibrations.
Does this already look familiar with a central bank?
Further findings of Maxwell showed that one did not need more powerful governors but calibrate the device to a lighter touch. In doing so the engine linked to the sawmill would rotate within a tolerable range and converge the control process over several sawing cycles.
That’s what central banks also need to do. Since 2001 central banks have been swinging the pendulum of interest rates violently from one side to another with severe disturbances in the economy as a consequence.
In the meantime the governments around the globe are taking Keynesian measures to get the economy going again. However the added value of this tax money spend is highly inefficient. As Keynes argues higher government spending increases GDP and the consumers respond to the extra income they earn by spending more themselves. Unfortunately the contribution of a dollar spent to GDP turns out to be very low. An interesting paper was written on this subject by Valeri A. Ramey, from the University of California. Both quantitively as empirically she came to the conclusion that for every USD the government injected to the system, GDP expanded only by a third of a dollar.(3) It is very important whether the spending is on things which are necessary or valuable. If it is on repairing bridges that lead to nowhere or putting an asphalt layer on an existing road this multiplier will be even zero.
To put it ironically, if you hire your neighbour for $100 to dig a hole in your backyard and then fill it up, and he hires you to do the same in his yard, the government statisticians report that things are improving. The economy has created two jobs, and the G.D.P. rises by $200. But it is unlikely that, having wasted all that time digging and filling, either of you is better off.
No matter how you turn it, government spending will always be at the expense of the private economy. To fund your debt you either have to raise taxes which will push down the private economy or go to the capital markets to issue new debt and taking funds away which could be used by the private sector. If you look at Japan since the late 1980’s they ran huge budget deficits but still their economy did not take off.
The only result one achieves is a distortion of the free economy. Luckily there are still politicians who are aware of this and are still willing to fight for this. The battle between those who would like to throw the system overboard and go to a state intervened model like France has known for decades or those who want to safeguard the system which has brought the most prosperous 25 years since mankind but with some adjustments and cutting off the sharp edges of capitalism is gigantic.
Apparently this battle is even going on within President Obama’s own Administration and can explain to a certain extent why the TALF, or call it TARP II, is lacking details. Based upon findings of analyst James Barnes at Gavekal Dragonomics, and conversations with well-informed people in Washington there are two camps within the US government at the moment.
On one side there is Geithner and Summers, who want to focus on the financial issues of how to free banks from toxic loans. On the other side we have Rahm Emanuel, David Axelrod and most Congressional leaders, who think it is more important to announce punishments for senior bankers and, more importantly that any measures to support banks should be clearly punitive of bank shareholders.
However, you can not punish the banks and restructure the banks at the same time. You have to choose.
Geithner and Summers won the argument by pointing out that the Paulson approach was very punitive to shareholders and where did that get us?
But the internal bickering over pay curbs etc - plus the effort of pushing the stimulus bill through Congress - makes it difficult to finalize controversial issues like the amount of effective taxpayer support in pricing of toxic assets which could only in the end be decided at the very top, being President Obama.
This is, of course, all pretty depressing and makes one wonder whether the Obama administration will descend into Carter-style impotence.
(1)Interview in Reason magazine “Can we Bank on the Federal Reserve” November 2006
(2)George Cooper “The Origin of Financial Crises. Central banks, credit bubbles
and the efficient market fallacy.” 2008, Harriman House Ltd.
(3)Valerie A. Ramey “Identifying Government Spending Shocks : Its all in the Timing”
2006, University of California
