These machinations work as long as markets stay calm and there is no panic to repossess collateral. But in a liquidity crisis of the kind experienced in 2008, these densely constructed webs of interlocking obligations quickly freeze up as the demand for “good” collateral instantaneously exceeds the supply and parties scramble to dump all collateral at fire-sale prices to raise cash. As a result of the scramble to seize good collateral, another liquidity-driven panic soon begins, producing tremors in the market.
Asset swaps are just one of many ways financial institutions increase risk in the search for higher yields in low-interest-rate environments. A definitive study conducted by the IMF covering the period 1997–2011 showed that Federal Reserve low-interest-rate policy is consistently associated with greater risk taking by banks. The IMF study also demonstrated that the longer rates are held low, the greater the amount of risk taking by the banks. The study concludes that extended periods of exceptionally low interest rates of the kind the Fed has engineered since 2008 are a recipe for increased systemic risk. By manipulating interest rates to zero, the Fed encourages this search for yield and all the off-balance-sheet tricks and asset swaps that go with it. In the course of putting out the fire from the last panic, the Fed has supplied kindling for an even greater conflagration.
■ The Clouded Crystal Ball
The most alarming consequence of Fed manipulation is the prospect of a stock market crash playing out over a period of a few months or less. This could result from Fed policy based on forecasts that are materially wrong. In fact, the accuracy of Fed forecasts has long been abysmal.
If the Fed underestimates potential growth, then interest rates will be too low, with inflation and negative real interest rates a likely result. Such conditions hurt capital formation and, historically, have produced the worst returns for stocks. Conversely, if the Fed overestimates potential growth, then policy will be too tight, and the economy will go into recession, which hurts corporate profits and causes stocks to decline. In other words, forecasting errors in either direction produce policy errors that will result in a declining stock market. The only condition that is not eventually bad for stocks is if the Fed’s forecast is highly accurate and its policy is correct—which unfortunately is the least likely scenario.
Given high expectations for equities, bank interconnectedness, and hidden leverage, any weakness in stock markets can easily cascade into a market crash. This is not certain to happen but is likely based on current conditions and past forecasting errors by the Federal Reserve.
As these illustrations show, the consequences of Federal Reserve market manipulation extend far beyond policy interest rates. Fed policy punishes savings, investment, and small business. The resulting unemployment is deflationary, although the Fed is desperately trying to promote inflation. This nascent deflation strengthens the dollar, which then weakens the dollar price of gold and other commodities, making the deflation worse.
Conversely, Fed policies intended to promote inflation in the United States, partly through exchange rates, make deflation worse in the economies of U.S. trading partners such as Japan. These trading partners fight back by cheapening their own currencies. Japan is currently the most prominent example. The Japanese yen crashed 33 percent against the U.S. dollar in an eight-month stretch from mid-September 2012 to mid-May 2013. The cheap yen was intended to increase inflation in Japan through higher import prices for energy. But it also hurt Korean exports from companies such as Samsung and Hyundai that compete with Japanese exports from Sony and Toyota. This caused Korea to cut interest rates to cheapen its currency, and so on around the world, in a blur of rate cuts, money printing, imported inflation, and knock-on effects triggered by Fed manipulation of the world’s reserve currency. The result is not effective policy; the result is global confusion.
The Federal Reserve defends its market interventions as necessary to overcome market dysfunctions such as those witnessed in 2008 when liquidity evaporated and confidence in money market-funds collapsed. Of course, it is also true that the 2008 liquidity crisis was itself the product of earlier Fed policy blunders starting in 2002. While the Fed is focused on the intended effects of its policies, it seems to have little regard for the unintended ones.
■ The Asymmetric Market
In the Fed’s view, the most important part of its program to mitigate fear in markets is communications policy, also called “forward guidance,” through which the Fed seeks to amplify easing’s impact by promising it will continue for sustained periods of time, or until certain unemployment and inflation targets are reached. The policy debate over forward guidance as an adjunct to market manipulation is a continuation of one of the most long-standing areas of intellectual inquiry in modern economics. This inquiry involves imperfect information or information asymmetry: a situation in which one party has superior information to another that induces suboptimal behavior by both parties.
This field took flight with a 1970 paper by George Akerlof, “The Market for ‘Lemons,’” that chose used car sales as an example to make its point. Akerlof was awarded the Nobel Prize in Economics in 2001 in part for this work. The seller of a used car, he states, knows perfectly well whether the car runs smoothly or is of poor quality, a “lemon.” The buyer does not know; hence an information asymmetry arises between buyer and seller. The unequal information then conditions behavior in adverse ways. Buyers might assume that all used cars are lemons, otherwise the sellers would hang on to them. This belief causes buyers to lower the prices they are willing to pay. Sellers of high-quality used cars might reject the extra-low prices offered by buyers and refuse to sell. In an extreme case, there might be no market at all for used cars because buyers and sellers are too far apart on price, even though there would theoretically be a market-clearing price if both sides to the transaction knew all the facts.
Used cars are just one illustration of the asymmetric information problem, which can apply to a vast array of goods and services, including financial transactions. Interestingly, gold does not suffer this problem because it has a uniform grade. Absent fraud, there are no “lemons” when it comes to gold bars.
A touchstone for economists since 1970, Akerlof’s work has been applied to numerous problems. The implications of his analysis are profound. If communication can be improved, and information asymmetries reduced, markets become more efficient and perform their price discovery functions more smoothly, reducing costs to consumers.
In 1980 the challenge of analyzing information’s role in efficient markets was picked up by a twenty-six-year-old economist named Ben S. Bernanke. In a paper called “Irreversibility, Uncertainty, and Cyclical Investment,” Bernanke addressed the decision-making process behind an investment, asking how uncertainty regarding future policy and business conditions impedes such investment. This was a momentous question. Investment is one of the four fundamental components of GDP, along with consumption, government spending, and net exports. Of these components, investment may be the most important because it drives GDP not only when the investment is made, but in future years through a payoff of improved productivity. Investment in new enterprises can also be a catalyst for hiring, which can then boost consumption through wage payments from investment profits. Any impediments to investment will have a deleterious effect on the growth of the overall economy.
Lack of investment was a large contributor to the duration of the Great Depression. Scholars from Milton Friedman and Anna Schwartz to Ben Bernanke have identified monetary policy as a leading cause of the Depression. But far less work has been done on why the Great Depression lasted so long compared to the relatively brief depression of 1920. Charles Kindleberger correctly identified the cause of the protracted nature of the Great Depression as regime uncertainty. This theory holds that even when market prices have declined sufficiently to attract investors back into the economy, investors may still refrain because unsteady public policy makes it impossibl
e to calculate returns with any degree of accuracy. Regime uncertainty refers to more than just the usual uncertainty of any business caused by changing consumer preferences, or the more-or-less efficient execution of a business plan. It refers to the added uncertainty caused by activist government policy ostensibly designed to improve conditions that typically makes matters worse.
The publication date of Bernanke’s paper, 1980, is poised in the midst of the three great periods of regime uncertainty in the past one hundred years: the 1930s, the 1970s, and the 2010s.
In the 1930s this uncertainty was caused by the erratic on-again-off-again nature of the Hoover-Roosevelt interventionist policies of price controls, price subsidies, labor laws, gold confiscation, and more, exacerbated by Supreme Court decisions that supported certain programs and voided others. Even with huge pools of unused labor and rock-bottom prices, capitalists sat on the sidelines in the 1930s until the policy uncertainty cloud was lifted by duress during the Second World War and finally by tax cuts in 1946. It was only when government got out of the way that the U.S. economy finally escaped the Great Depression.
In the 1970s the U.S. economy was experiencing another episode of extreme regime uncertainty. This episode lasted ten years, beginning with Nixon’s 1971 wage and price controls and abandonment of the gold standard, and continuing through Jimmy Carter’s 1980 crude oil windfall profit tax.
The same malaise afflicts the U.S. economy today due to regime uncertainty caused by budget battles, health care regulation, tax policy, and environmental regulation. The issue is not whether each policy choice is intrinsically good or bad. Most investors can roll with the punches when it comes to bad policy. The core issue is that investors do not know which policy will be favored and therefore cannot calculate returns with sufficient clarity to risk capital.
In his 1980 paper, Bernanke began his analysis by recapitulating the classic distinction between risk and uncertainty first made by Frank H. Knight in 1921. In Knight’s parlance, risk applies to random outcomes that investors can model with known probabilities, while uncertainty applies to random outcomes with unknown probabilities. An investor is typically willing to confront risk but may be paralyzed in the face of extreme uncertainty. Bernanke’s contribution was to construct the problem as one of opportunity cost. Investors may indeed fear uncertainty, but they may also have a fear of inaction, and the costs of inaction may exceed the costs of plunging into the unknown. Conversely, the costs of inaction may be reduced by the benefits of awaiting new information. In Bernanke’s formulation, “It will pay to invest . . . when the cost of waiting . . . exceeds the expected gains from waiting. The expected gain from waiting is the probability that [new] information . . . will make the investor regret his decision to invest. . . . The motive for waiting is . . . concern over the possible arrival of unfavorable news.”
This passage is the Rosetta stone for interpreting all of Bernanke’s policies relating to monetary policy during his time as chairman of the Federal Reserve. After 2008, Bernanke’s Fed would increase the cost of waiting by offering investors zero return on cash, and it would reduce the cost of moving ahead by offering forward guidance on policy. By increasing the costs of waiting and reducing the costs of moving ahead, Bernanke would tip the scales in favor of immediate investment and help the economy grow through the jobs and incomes that go with such investment. Bernanke would be the master planner who pushes capitalists back into the investment game. He showed his hand when he wrote, “It would not be difficult to recast our example of the . . . economy in an equilibrium business cycle mold. As given, the economy . . . is best thought of as being run by a central planner.”
Bernanke’s logic is deeply flawed because it supposes that the agency that reduces uncertainty does not also add to uncertainty by its conduct. When the Fed offers forward guidance on interest rates, how certain can investors be that it will not change its mind? When the Fed says it will raise interest rates upon the occurrence of certain conditions, how certain can investors be that those conditions will ever be satisfied? In trying to remove one type of uncertainty, the Fed merely substitutes a new uncertainty related to its ability to perform the first task. Uncertainty about future policy has been replaced with uncertainty about the reliability of forward guidance. This may be the second derivative of uncertainty, but it is uncertainty nonetheless, made worse by dependence on planners’ whims rather than the market’s operation.
An important paper by Robert Hall of Stanford University, delivered at the Fed’s Jackson Hole gathering in August 2013, demonstrates the counterproductive nature of Bernanke’s reasoning. Hall’s paper makes the point that the decision to hire a new worker implicitly involves a calculation by the employer of the present value of the worker’s future output. Present value calculations depend on the discount rates used to convert future returns into current dollars. But uncertainty caused by the Fed’s policy flip-flops makes the discount rate difficult to ascertain and causes employers to reduce or delay hiring. In effect, the Fed’s efforts to stimulate the economy are actually retarding it.
Free markets matter not because of ideology but because of efficiency; they are imperfect, yet they are better than the next best thing. Akerlof illustrates the costs of information asymmetry at one point in time, while Bernanke shows the costs of information uncertainty over time. Both are correct about these theoretical costs, but both ignore the full costs of trying to fix the problem with government intervention. Akerlof was at least humble about these limitations, while Bernanke exhibited a central planner’s hubris throughout his career.
Adam Smith and Friedrich Hayek warned of the impossibility of the Fed’s task and the dangers of attempting it, but Charles Goodhart points to a greater danger. Even the central planner requires market signals to implement a plan. A Soviet-style clothing commissar who orders that all wool socks be the color green might be interested to know that green is deeply unpopular and the socks will sit on the shelves. The Fed relies on price signals too, particularly those related to inflation, commodity prices, stock prices, unemployment, housing, and many other variables. What happens when you manipulate markets using price signals that are the output of manipulated markets? This is the question posed by Goodhart’s Law.
The central planner must suspend belief in one’s own intervention to gather information about the intervention’s effects. But that information is a false signal because it is not the result of free-market activity. This is a recursive function. In plain English, the central planner has no option but to drink his own Kool-Aid. This is the great dilemma for the Federal Reserve and all central banks that seek to direct their economies out of the new depression. The more these institutions intervene in markets, the less they know about real economic conditions, and the greater the need to intervene. One form of Knightian uncertainty is replaced by another. Regime uncertainty becomes pervasive as capital waits for the return of real markets.
Unlike Shakespeare’s Salanio, we can no longer trust what the markets tell us. That’s because those who control them do not trust the markets themselves; Yellen and the rest have come to think their academic hand is more powerful than Adam Smith’s invisible one. The result has been the slow demise of market utility that, in turn, presages the slow demise of the real economy—and of the dollar.
CHAPTER 4
CHINA’S NEW FINANCIAL WARLORDS
Most countries fail in the reform and adjustment process precisely because the sectors of the economy that have benefitted from . . . distortions are powerful enough to block any attempt to eliminate those distortions.
Michael Pettis
Peking University
December 2012
China’s shadow banking sector has become a potential source of systemic financial risk. . . . To some extent, this is fundamentally a Ponzi scheme.
Xiao Gang
Chairman, Bank of China
October 2012
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■ History’s Burden
To contemporary Western eyes, China appears like a monolithic juggernaut poised to dominate East Asia and surpass the West in wealth and output in a matter of years. In fact, China is a fragile construct that could easily descend into chaos, as it has many times before. No one is more aware of this than the Chinese themselves, who understand that China’s future is highly uncertain.
China’s is the longest continuous civilization in world history, encompassing twelve major dynasties, scores of minor ones, and hundreds of rulers and regimes. Far from being homogeneous, however, China is composed of countless cultures and ethnicities, comprising a dense, complex network of regions, cities, towns, and villages linked by trade and infrastructure, that has avoided the terminal discontinuities of other great civilizations, from the Aztec to the Zimbabwe.
A main contributor to the longevity of Chinese civilization is the in-and-out nature of governance consisting of periods of centralization, followed by periods of decentralization, then recentralization, and so on across the millennia. This history is like the action of an accordion that expands and contracts while playing a single song. The tendency to decentralize politically has given Chinese civilization the robustness needed to avoid a complete collapse at the center, characteristic of Rome and the Inca. Conversely, an ability to centralize politically has prevented thousands of local nodes from devolving into an agrarian mosaic, disparate and disconnected. China ebbs and flows but never disappears.
Recognizing the Chinese history of centralization, disintegration, and reemerging order is indispensible to understanding China today. Western financial analysts often approach China with an exaggerated confidence in market data and not enough historical perspective to understand its cultural dynamics. The Zhou Dynasty philosopher Lao Tzu expressed the Chinese sense of history in the Tao Te Ching—“Things grow and grow, but each goes back to its root.” Appreciating that view is no less important today.
The Death of Money Page 10
