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Is there a “policy”?

from Peter Radford

I read this morning that the Federal Reserve had bought, at the peak of the recent crisis, about 40% of all US government bonds being issued.

This may, to some of you, be something of no concern.

Think again

The illusion that there are separate spaces for monetary and fiscal policy is belied by this fact.  Which one was it?  Was it the Fed flooding the economy with money?  Or was it the government issuing debt to finance economic support? I suppose it was both.  But it wasn’t fiscal policy.  The effect of all that money was simply to support asset prices.  Whether that was the intention is irrelevant.  The flood found its way into the financial system and relatively little found its way into the economy in the form of an expansion of productive activity.  We could go further: a great deal of what expansion of capacity actually occurred went abroad to build fragile supply chains and take advantage of low wages in distant parts.

What also happened was that households sat on the portion of the flood that they received as a hedge against further economic mayhem.  And when, as now, they began to feel more confident they started to spend the money on goods rather than services.  Remember that the economy is heavily skewed towards consumption, and within that, towards services.  The problem with services is that they tend to be in-person.  And being in-person is something a lot of people are avoiding right now.  So they decided to switch and buy goods instead.

This, being the twenty-first century, those goods usually contain some sort of a computer chip.  Quite why we need our refrigerators to talk to each other is beyond me, but someone decided it has great value to us.  So everything nowadays is packed with the ability to communicate.  Which puts pressure on the chip manufacturers.

It also, coincidentally, puts enormous pressure on the people who move the chips around the globe because, this also being the twenty-first century, chip production is concentrated in far corners of the globe rather than near to where they might be incorporated into the final product.  This is the way of efficient supply chains.  Which, as we now know, is something of an oxymoron.

With the supply side of the economy so battered by both unexpected money-induced demand and the corporate delusion of efficient supply chains, we are now being bombarded by price increases.  This has given rise to the specter of inflation.

I hope you have noticed that inflation is always a specter.  It is a ghost that haunts the minds of serious people who, once they see workers demanding more wages, seek to damp such demands as being insidious.

But insidious to whom?

Asset holders of course!

The long term value of assets is eroded by inflation.  Those pesky workers demanding higher wages works to undermine that value by inducing a cycle of “inflationary expectations”.  That wages have been suppressed for eons in order to boost the profits earned by asset holders is left out of the discussion.  We must, at all costs, preserve those asset values.

So, in the face of a collapsed economy in, say, 2008, we pump in trillions of dollars of money.  This has the primary effect of ensuring asset holders don’t get taken completely to the cleaners.  Job well done.  The problem then becomes how to wean ourselves off the flood of money.  That’s easy: we wait for the economy to return to its long term trajectory and then ease off.  The presumed recovery in earnings prospects will offset any downside implied by removing the monetary life support.  Rising interest rates will prevent the specter of inflation undermining asset prices.  Wages will be contained within sensible bounds.  Profits will recover.  Asset values will flourish.

Phew.

Except.

What happens if the economy doesn’t return to its long term trajectory?  What happens if it wallows along sub-optimally, starved of investment, with low productivity and perpetually on the brink of a renewed downturn?

Well, in that case you keep flooding it with money.  Just like we did between the Great Crash and the Pandemic Crisis which provide bookends for a period of pretty awful economic policy.  Too little reliance of fiscal policy at one end and relentless floods of money throughout.  It was called quantitative easing.  In fact it was an addiction.

In the absence of an economic policy that put government expenditure of real activity at its heart, think of the bridges that could have been built with all that money, we monetized the debt instead.  We flooded the financial system with cheap money.  Indeed we ended up making money so cheap it has become incredibly difficult to increase its price.  It has made credit so widely available that even the most perverse investment opportunity is grasped as a possibility worth thinking about.  The search for returns has overwhelmed any sense of risk aversion.  Everything goes.  And like all addictions this will end badly.

We have produced an economy awash with debt and with asset prices higher than the underlying cash flows justify.  This is what happens when you ignore history and imagine that you don’t need proper fiscal policy.  Or, at the very least, that you distinguish between monetary and fiscal policies.

So now the central banks are stuck.  Having created an addiction they need to offset the inevitable withdrawal symptoms.  If they raise interest rates they might deflate asset values from their addiction riddled levels.  If they don’t raise interest rates they might abet the onset of an inflationary cycle that might deflate asset values from their addiction riddled values.

Whoops.

Meanwhile the bond market, in its current addicted state, prefers to believe that the central banks will continue to drip feed it sufficiently to prevent a decline in values.  How else can we interpret the contradiction between the constant refrain of the inflation specter being raised by bankers and their concurrent willingness not to bid up long term interest rates?

Interesting times.

So the Fed’s avowed intention to taper its asset purchases down to zero by mid 2022 looks like an exercise in hope and belief that something will turn up.  Which doesn’t sound much like “policy” to me.

But it will have to do.

______________________

Modern monetary theorists will chortle at the above.  The constraint they prefer to rely on with respect to the flood of money is inflation.  Great.  Question: is the exchange of Fed-created money for Treasury-issued debt not a form of MMT?  After all it ends up as money.  And the debt becomes an issue only for those who talk about debt ceilings and “affordability”.  We talk flippantly about low interest environments being comfortable for the issuance of debt to finance government spending.  So we ought not concern ourselves about etc debt per se, only the cost of carrying it?  But who made interest rates so low?  Did we not manufacture the exact conditions within which debt is so cheap?  It sounds so circular.  Meanwhile why don’t we simply dispense with the illusion of debt to begin with?  Why don’t we recognize it as money at the source?  Why don’t we simply fund government with money?  If Fed-created money and Treasury-issued debt are so fungible why bother with the distinction?  In whose interest is it to maintain the difference?  Asset holders.  Now we know who policy is maintained for.  Surprise.

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