The Fed's announcement that it will buy approximately $600 billion of US Treasury securities or more in the coming months has, for the first time, provoked the ire of conservatives such as Sarah Palin. Monetary policy has not been a political concern for maybe a century, when William Jennings Bryan lost his presidential bid but made history with his "Cross of Gold" speech in 1896. It is refreshing to hear some one pick up the baton somewhere near where he left off. But now as then, neither the public nor policy makers may understand modern monetary mechanics enough to advocate a coherent solution to our economic malaise. Quantitative easing or not, we will still experience economic headwinds from the aftermath of the housing bubble, as well as from our wanton fiscal policy.1 And it will likely continue to be expressed through foreign currency volatility, sovereign credit defaults or interventions, and high unemployment.
An interesting video posted by Malekanoms on YouTube lays out the growing resistance to the Fed's quantitative easing (QE) quite cleverly. It is well worth watching, because it shines a light upon this arcane policy matter, which has a large impact on the economy.
While its observations are all valid, the video skirts three issues: 1) Housing is still deflating, 2) banks are acutely vulnerable to housing credit exposure, and 3) The sustainability of the Fed's operating a system of money that rises and falls in direct proportion to the issuance of credit is questionable. Neither stopping nor starting QE2 can fix a broken system.
Let's take a look at each of these three unaddressed items:
- Why did housing prices go up? Housing prices rose because the money supply inflated dramatically well before QE1 or QE2.
In fact, despite the first round of QE, the broad money supply has not increased.2 (The money printed by the Fed was matched by the destruction of money caused by debt default and repayment - remember the total money supply rises and falls with the creation or destruction of credit). Over 95% of all dollars in existence today were "printed" through bank lending since 1971, when Nixon reneged on gold exchangeability. QE1 and QE2 are nothing in magnitude compared to the over $13 trillion that was printed by banks leading up to the crisis. Through bank lending, we were printing $1.5 trillion annually before the 2008 meltdown. Now bank lending is falling, which shrinks the money supply.
- Why are banks acutely vulnerable to housing credit exposure? When home prices fell by 25% at the beginning of the crisis, this wiped out homeowners' equity mostly, which acted like a buffer insulating banks from impairment of the value of their loans. If real estate falls another 25%, which it would without QE (and probably with QE also), then most banks are toast.
The bulk of our money printing occurred prior to QE1 or QE2 through bank lending. Thus debt has increased hand-in-hand with the money supply, but income has not kept up anywhere near as much. Most of the debt is related to mortgages. This debt is unserviceable by many people. It's true broadly, but especially if a homeowner is unemployed; some believe unemployment may be as high as 20%.
- Why is Bernanke worried about the Fed's running a system of money that rises and falls in direct proportion to the issuance of credit? If real estate prices go lower and eat into bank capital, there will be a collapse in the bank-lending based money supply, leading to overall deflation of all prices, including those mentioned as going up presently in the video.
Banks have a very thin layer of equity. Almost all of their funding for lending comes from depositors. Contrary to general public perception, depositors' money is not held at banks, waiting to be handed back upon demand. Instead, it was lent out - mostly for "investment" in real estate. More than a few of these "investors" are hung out to dry at prices that may be a tad below the nosebleed highs set in 2007.
If housing prices fall a little bit more, say 25%, then a great number of mortgages that once held decent credit scores would no longer be backed by an asset of equal value. Depositors might sense this, and would rationally ask for their money back, triggering bank runs. The FDIC has even less capital to make good on deposits than the banks have, so this is a real risk that could only be met through an extremely aggressive program of QE. In a shrinking credit system, asset holders may be moved to unload other asset classes such as stocks or bonds in order to avoid bankruptcy.
Thus, although it may not "feel" like anything is wrong now with $2 trillion propping up the banking system, Bernanke knows this, and this is why he favors QE2. Why doesn't he just come out and explain it? He is worried about deflation. But if he explains that the deflation that concerns him is that of real estate pulling the banking system under, and not consumer prices, then he has to educate us all about the pernicious nature of operating a central bank.
Central bank policy affects inflation or deflation in two separate markets: the market for assets such as land or stocks, or the market for consumer goods. The problem with popular economic theories is that they can't explain why we could get inflation in a slack economy (the 1970s discredited Keynesianism), or inflation and deflation at the same time (the post 2008 meltdown). Like the ignominious CEOs of Lehman and Countrywide, no Fed chairman can admit that the emperor has no clothes. Because if he did, it would let the cat out of the bag and people would react by withdrawing funds from the banking system. They could place their money in a mattress (but that would be awkward - think of the physical space needed to house the cash)! Or they could buy something tangible that is not real estate.
Gold and silver are the ideal monetary candidates, since they have the characteristics of money sought for millennia: durability, divisibility, transportability, and lack of susceptibility to counterfeiting. Money should also not vary much in quantity, for if it does, its ability to be a medium of exchange lessens when prices of assets and consumer goods would rise and fall unexpectedly and in no relation to underlying production capabilities.
From time to time man has used for money his most ubiquitous commodities that possessed many of these characteristics. The problem with using them is that each has been violation of one or more of these characteristics to some degree. For example, using oil to back the dollar would require a vast physical infrastructure of storage and transportation, larger than exists today. And it would wreak havoc on the present balance of supply and demand for energy if such a switch were to occur suddenly.
Using fiat money (paper or electronic currency printed out of thin air) poses a similar violation. While it needs some infrastructure (the banking sector consumes an extraordinary percentage of employment and financial capital), its Achilles heel is that its unchecked growth flows into the economy through the creation of debt, stimulating price increases in assets that can be leveraged, particularly real estate. That creates another infrastructure and employment surge in the real estate industry, further misallocating resources.
The points raised in the Malekanoms video are all true, but what is misunderstood is how these points fit in to the larger picture. It's kind of like stepping onto an auditorium during the last act of a play, and jumping to a conclusion based upon what happened solely from the last few minutes.
We can object all we want to QE2, which would produce $600 billion that might offset some similar amount of imploding credit outstanding within a $14 trillion broad money supply. It really doesn't matter much. The forces we feel so acutely - the aftermath of a housing bubble, foreign currency instability, sovereign debt crises, high unemployment - won't go away because we blocked the Fed from buying treasuries. And they won't go away if we let them do QE2, either.
We are at the crossroads of what may be a habitual breaking point in a national credit based fiat system, which has happened several times previously in the last 200 years. What is poorly understood is that our predicament is not the exception, it is the rule. Our first two central banks lasted decades at best. The greenback system collapsed by the 1870s. The gold standard of the late nineteenth century came apart at the seams because its gold base became almost completely diluted and irrelevant. Its silver component was outlawed in a backroom deal known as the "Crime of 1873."
Bank credit compounded at 7% annually from the Civil War to 1929, overwhelming any specie that was relied upon historically. The money printed thusly caused financial earthquakes at the founding of the Fed in 1913 and again in 1934. Compounding bank credit accumulated pressure that surfaced in the 1960s, busting open the system in 1971. 2008 may have just been a warning, and it is no surprise that the hapless policy measures put in place in the last two years, while "working" temporarily, have elicited calls from nations for a new monetary order.
(1) QE stands for quantitative easing, which is the lending of money to the treasury with dollars printed out of thin air by the Fed. If this is done through a middle man and not through direct purchases from the US Treasury, then these funds enter the financial system and buoy Treasury bond prices, permitting the government to issue notes and bonds at very high prices.
(2) Broad money is best tracked by M3, which is no longer published by the Fed.
William Baker is the author of "Endless Money: The Moral Hazards of Socialism." (John Wiley, 2010) A Chinese language edition is due out soon.
Disclosures: Long and short equities. Short U.S. Treasuries. Long gold, gold derivatives, and gold equities.