Friday, November 11, 2011

When It Makes Sense to Print Money

This post may seem incompatible with previous items but there are times when the data is just so startling that it changes the math.  Recently I learned that M4, a broad measure of the country's money supply which is no longer published by the Federal Reserve but is still tabulated by private sources, may have fallen by as much as 4% during the latest 12 months.  Such a number implies that not only is the American economy not on the verge of recovery but it is actually most certain to double-dip into recession next year.

That being the case, I will suggest the following:  one of the few times that printing money makes sense is when the overall money supply is actually declining.  In such an instance, the inflationary effect of printing would simply offset the deflationary effects of the decline.

Years ago, believe it or not, I used to correspond with Milton Friedman.  What I enjoyed most about Dr. Friedman was his openness to discussion with a non-academic like myself.  One of the major topics we discussed was which measure of the money supply was appropriate to follow insofar as monetary policy is concerned.  He felt that M2, which is the broadest measure the government now discloses and is directly influenced by government policy, was appropriate.  I felt that M3 or M4, which the government disclosed until 2005 and includes monetary measures that are less influenced by the government--primarily credit related--should be used.  He liked to use M2 as a shorthand way to look at monetary policy because the relationship between M2 and broader measures like M4 had always been fairly stable.  

While that may have been true, the relationship has clearly been broken.  Recent M2 growth figures show a nearly 10% year-over-year increase and M4. as stated earlier, may have fallen by 4% in the same period.  To have such a dislocation implies that the components that make up the difference between the two measures--primarily credit--must have fallen precipitously.  Since housing demand--the major source of credit expansion--has collapsed, this makes perfect sense.

The Fed has tried to increase the money supply through "quantitative easing" but the so-called "multiplier" that would be expected to result in expanded credit has failed to function.  The Fed has literally been pushing on a string because credit is contracting faster than money has been printed!  This is the recipe for deflation, i.e., prices actually falling, which we may not have seen at the gas pump, but we sure as well have seen in the prices of our homes.

Which gets us back to the point of this post.  Home prices are in a death spiral that needs to be reversed if people are to regain confidence in their future.  And the way to do that now is to increase M2 by an amount large enough to offset the decline in M4.  How does the Fed actually do this?  Deficit funded stimulus--taking money from one person and giving it to another--won't work because it yields no net increase.  That leaves more--significantly more--of the dreaded quantitative easing, which in the current situation would act to stabilize M4 rather than expand it.  And until the money supply--the broad M4 money supply--stabilizes, the economy can't restart.  Expanding M2 is easily accomplished--the Fed buys and buys and buys U.S. government treasury bills until M4 stops declining and begins to expand.  [This would yield a secondary benefit of reducing  the country's total debt, helping to reduce the annual deficit as well.]

The problem with addressing the M4 decline in this manner, however, is that the Fed has never shown an ability to do so without going too far in the other direction, i.e., increasing past the point of stability into the realm of inflation.  It's likely that long bond yields will begin to rise once M4 has stabilized and that credit will expand as well.  At that point, to counteract increasing inflationary forces, the Fed would have to act quickly in the other direction.  That is when its independence would truly be tested.

Alan Greenspan kept the punch bowl on the table far too long and helped contribute to our current economic and fiscal malaise.  Ben Bernanke needs to put an even bigger bowl on the table--and then pull it away just as the party gets started.  Whether he can do that will be the real test.      



 

Friday, November 4, 2011

Government Support Leads to Dangerous Economic Distortions

By now one consistent theme should have become clear to readers of this blog:  if you want to increase something like employment, you make it less costly.  The country is struggling because the President doesn't understand that simple concept.

But this post is not once again about the negative effects of increasing the cost of doing business above those imposed by the market--it is about the perils of reducing them.  For while many industries, like manufacturing and energy, have been hamstrung by government imposed (or sanctioned) costs others, like banking, healthcare and education, have grown much too large because the government has removed costs that would otherwise have been imposed on them in a true market-based economy.  

Let's look at banking.  From 1933 to 1991 commercial banks were restricted from investment banking activities by the Glass-Steagall Act.  The rationale for this was that since banks were insured by the FDIC it was appropriate that the federal government restrict their activities.  In 1999, the Republican-controlled Congress and President Bill Clinton repealed Glass-Steagall, having been convinced by the banking industry's arguments (and campaign contributions) that it would otherwise be unable to compete against investment banks and foreign banks.  The banks were supposed to keep their new activities separate from their older, stodgier commercial banking businesses so that depositors' funds remained safe.  What happened instead nearly blew up the world.

What happened was the banks took more risk than they could or would have otherwise in their new businesses because the depositors' funds in their traditional businesses were insured by the federal government!  Insurance essentially eliminated the banks' risk so they took much more of it!  Heads I win, tails you lose.  Who wouldn't play that game?  So bankers, with little to lose and much to gain, rolled the dice.  And when they finally--and quite predictably--lost, Uncle Sam had no choice but to bail them out; they had bet so much that not only would they have killed themselves, but quite possible the world's financial system, as well.  

Glass-Steagall kept the banks under control by prohibiting them from jeopardizing insured deposits on high-risk activities.  It was only after its repeal that the banking industry's share of our economy became so large.  Permitting commercial banks to undertake investment banking activities essentially extended deposit insurance to those activities as well.  Investment banks, at that point themselves not able to compete with the commercial banks--since they weren't insured!--took on far too much risk.  Lehman, Bear Stearns and Merrill Lynch blew up.  Goldman Sachs and Morgan Stanley are still stumbling along.  But the big banks, JPMorgan, Citibank and Bank of America are too big to fail?  They're the ones that caused the crisis in the first place!

Insurance helps decision makers limit risk when they undertake an activity.  However, insurance does not function unless there are restrictions on the activities of the insured.  By repealing Glass-Steagall, a Republican Congress and a Democratic President did just the opposite--and in so doing encouraged an increase in risky activity that would never have occurred otherwise.  Health insurance that doesn't restrict health choices has the same effect and so do below market student loans.  Each of these increases the demand for the underlying service by reducing the cost to the individual of using them.  Of course, the costs don't disappear--they're just transferred to society.  

Trying to pick winners, the government never fails to do the opposite.  In doing so it has distorted our economy to the point where certain industries--like banking--have become so large that they are either too big to fail or--in the case of education and healthcare--too expensive too succeed.  Without government actions favoring them, this would never have been the case.