Thursday, April 2, 2015

Yes, the debt matters...

Central Banking Refuted In One Blog—–Thanks Ben!

By David Stockman

Blogger Ben’s work is already done. In his very first substantive post as a civilian he gave away all the secrets of the monetary temple. The Bernank actually refuted the case for modern central banking in one blog.

In fact, he did it in one paragraph. This one.

A similarly confused criticism often heard is that the Fed is somehow distorting financial markets and investment decisions by keeping interest rates “artificially low.” Contrary to what sometimes seems to be alleged, the Fed cannot somehow withdraw and leave interest rates to be determined by “the markets.” The Fed’s actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere.

Not true, Ben. Why not ask the author of the 1913 Federal Reserve Act and legendary financial statesman of the first third of the 20th century—–Carter Glass.

The then Chairman of the House Banking and Currency Committee did not refer to the new reserve system as a “banker’s bank” because he was old-fashioned or unschooled in finance. The term evoked the essence of the Fed’s original mission. Namely, to passively rediscount good commercial collateral (receivables and inventory loans) brought to its window by member banks—priced at a penalty spread floating above the market rate of interest.

Notwithstanding Bernanke’s spurious claim that the Fed has to “set the short-term rate somewhere”, the reserve system designed by Congressman Glass was authorized to do no such thing. It had no target for the Federal funds rate; no remit to engage in open market buying and selling of securities; and, indeed, no authority to own or discount government bonds and bills at all.

Instead, its job was to passively respond to the ebb and flow of trade and industry on main street as mediated through the commercial banking system. If business conditions were robust, interest rates would rise on the free market in order to balance the demand for working capital loans and long-term debt financing with the available supply of private savings.

In that environment, commercial banks wishing to expand their loan books beyond what could be supported by their deposits and reserves ( the latter generally amounted to between 9% and 15% of deposits), could “rediscount” their loans for cash at a penalty rate. Likewise, solvent banks holding good commercial collateral which faced unexpected or untimely deposit redemptions could borrow cash in the same manner in lieu of liquidating their loan books. The entire purpose of the original Fed’s rediscounting tool was to augment liquidity in the banking system at market determined rates of interest.

This modus operandi was the opposite of today’s monetary central planning model. Back then, the rediscount window at each of the twelve Reserve Banks had no remit except the humble business of examining collateral.

The green eyeshades who toiled in the Richmond, St. Louis and Dallas reserve banks thus did not know from the macros. That is, they were on the look-out for “slow” paper, not slow GDP growth or slow progress in lifting housing starts, retail sales and business inventories—–or even “slowflation” on the CPI less food and energy index. And that’s not only because most of such “incoming data” measures did yet exist—- or even because the Fed had no proactive tools to guide the macro-economy in any event.

In fact, the Fed was created on the earlier side of the Keynesian divide. When Woodrow Wilson signed the act on Christmas eve of 1913, the notion that the state must manage the business cycle and turbocharge capitalist prosperity did not exist.

And well it didn’t. During the prior 40 years, the US economy had grown at a 4% compound rate—the highest four-decade long growth rate before or since—- without any net change in the price level; and despite the lack of a central bank and the presence of periodic but short-lived financial panics largely caused by the civil war-era national banking act.

So in 1913 there was no conceit that a relative handful of policy makers at the White House, or serving on Congressional fiscal committees or at a central bank could improve upon the work of millions of producers, consumers, workers, savers, investors, entrepreneurs and even speculators. Society’s economic output, living standards and permanent wealth were a function of what the efforts of its people added up to after the fact—-not what the state exogenously and proactively targeted and pretended to deliver.

And most importantly, the cosmic economic error of the 20th century had not yet settled in. That is, the false belief that market capitalism has a suicidal impulse and chronically veers towards underperformance, breakdown and depressionary spirals absent the deft interventions and ministrations of the state and its central banking branch. Indeed, that is the utterly false lesson of the Great Depression——a Big Lie regarding which Bernanke himself is a principal propagandist (see below).

In short and contrary to Bernanke, the Fed’s actions under its original charter did not “determine the money supply and thus short-term interest rates”. It was exactly the opposite. Short-term interest rates (and the whole yield curve, too) were determined by supply and demand on the free market.

Likewise, the “money supply” was a product of the banking system, not the writ of the Federal Reserve. That is, the supply of checkable demand deposits and the “elastic” Federal Reserve notes enabled by the 1913 Act were essentially determined by private savers and augmented by lenders when their advances generated new checkable deposits. Indeed, even the rediscount loans issued by the “banker’s bank” did not represent new money; they only liquefied working capital savings or collateral which had already been created in the process of production and commerce.

It is therefore more than a bit rich that the Bernank even talks about the Fed’s supposedly indispensable role in creating the “money supply”. That’s because during his entire tenure at the Fed he paid no heed to it whatsoever.

He virtually never even uttered the word! His entire focus was on pegging interest rates low for long in order to promote incessant and monumental credit expansion. And the more the better on the theory that debt is the elixir of economic growth and prosperity.

But here’s the thing. There is absolutely no need for a central bank to create honest credit. The latter comes from savers who are willing to forgo current consumption (or reinvestment of business profits) at a price that rewards them for their thrift and deferral of the current use of their incomes.

What the Bernanke-style Fed does is foster the creation of dishonest credit. That is, mortgage loans, credit card loans, auto loans, and government bonds that bear subsidized below-market interest rates.

This form of dishonest credit arises when the central bank buys government bonds and bills with credits made out of thin air rather than funded from savings out of current income that must earn a market clearing price or rate of interest. Bad credit also arises when banks make auto loans funded by deposits that earn the Fed’s pegged money market rate of interest rather than the market clearing price. And dishonest credit is generated when brokers hypothecate collateral for repo or margin loans at short-term rates fixed by the writ of the central bank, not the law of supply and demand.

So rather than performing the necessary function of money creation, the modern Keynesian era central bank performs the unnecessary and harmful function of generating mis-priced credit—–or, for the want of a better term, fraudulent excess finance.

The latter, in turn, fosters a plethora of ills including penalties for savings and the crushing of thrift; cheap funds for speculation and carry trades in the financial markets which eventually transforms them into dangerous houses of leveraged gambling; and false, low prices on government debt which turn democratic politicians into agents of chronic fiscal profligacy and destructive free lunches for organized and financially advantaged lobby groups.

To be sure, all of these adverse consequences of cheap dishonest credit might be at least vaguely plausible if it could be shown the economic benefits and gains outweigh the disadvantages. But no such showing is possible, nor is it really even attempted any more by our Keynesian economic rulers.

They just postulate it. And after decades upon decades of repetition—ritual incantation, almost—-the attentive public does not question it; the Wall Street casino finds in convenient; and the politicians are tickled pink.

Aside from the special case of capitalism’s alleged depression- seeking tendency, just exactly how does dishonest credit cause more growth, prosperity and societal wealth and welfare than does honest credit reflecting market-priced bargains between savers and borrowers?

Surely, it can’t be that under a free market regime there would be too little savings to fund the growth of working capital and the long-term debt needed to finance the fixed production assets of growing businesses. Indeed, scratch a Keynesian during almost any phase of the last eighty years of economic history and you will hear the opposite. Namely, that economic output and growth is always being impaired by too much savings and too little demand—-by which they mean consumer spending.

Likewise, there is no empirical argument whatsoever that the massively higher leverage ratios to income that have prevailed since the early 1970’s have led to a step-wise and sustainable improvement in economic growth or in real median household incomes(as a proxy for gains in living standards). As a matter of fact, both measures have been heading south since the nation’s credit market debt to national income ratio came off its historical average of 150% in the late 1970’s—- and then kept climbing until it reached the 350% zone during the Greenspan-Bernanke-Yellen era of Keynesian central banking.

Needless to say, when it comes to a $17.8 trillion GDP two extra turns of debt against national income amount to a lot more than chump change. Total credit market debt outstanding today is $58 trillion and nearly 3.5X GDP; it would be $33 trillion lower or about $25 trillion under the ratio that prevailed during the 1950-1975 era shown in the graph...

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