Currency Wars: The Making of the Next Global Crisis

by James Rickards

  But what if velocity is not constant?

  It turns out that money velocity is the great joker in the deck, the factor that no one can control, the variable that cannot be fine-tuned. Velocity is psychological: it all depends on how an individual feels about her economic prospects or about how all consumers in the aggregate feel. Velocity cannot be controlled by the Fed’s printing press or advancements in productivity. It is a behavioral phenomenon, and a powerful one.

  Think of the economy as a ten-speed bicycle with money supply as the gears, velocity as the brakes and the bicycle rider as the consumer. By shifting gears up or down, the Fed can help the rider accelerate or climb hills. Yet if the rider puts on the brakes hard enough, the bike slows down no matter what gear the bike is in. If the bike is going too fast and the rider puts on the brakes hard, the bike can skid or crash.

  In a nutshell, this is the exact dynamic that has characterized the U.S. economy for over ten years. After peaking at 2.12 in 1997, velocity has been declining precipitously ever since. The drop in velocity accelerated as a result of the Panic of 2008, falling from 1.80 in 2008 to 1.67 in 2009—a 7 percent drop in one year. This is an example of the consumer slamming on the brakes. More recently, in 2010 velocity has leveled off at 1.71. When consumers pay down debt and increase savings instead of spending, velocity drops as does GDP, unless the Fed increases the money supply. So the Fed has been furiously printing money just to maintain nominal GDP in the face of declining velocity.

  The Fed has another problem in addition to the behavioral and not easily controlled nature of velocity. The money supply that the Fed controls by printing, called the monetary base, is only a small part of the total money supply, about 20 percent, according to recent data. The other 80 percent is created by banks when they make loans or support other forms of asset creation such as money market funds and commercial paper. While the monetary base increased 242 percent from January 2008 to January 2011, the broader money supply increased only 34 percent. This is because banks are reluctant to make new loans and are struggling with the toxic loans still on their books. Furthermore, consumers and businesses are afraid to borrow from the banks either because they are overleveraged to begin with or because of uncertainties about the economy and doubts about their ability to repay. The transmission mechanism from base money to total money supply has broken down.

  The MV = Py equation is critical to an understanding of the dynamic forces at play in the economy. If the money (M) expansion mechanism is broken because banks will not lend and velocity (V) is flat or declining because of consumer fears, then it is difficult to see how the economy (Py) can expand.

  This brings us to the crux. The factors that the Fed can control, such as base money, are not working fast enough to revive the economy and decrease unemployment. The factors that the Fed needs to accelerate are bank lending and velocity, which result in more spending and investment. Spending, however, is driven by the psychology of lenders, borrowers and consumers, essentially a behavioral phenomenon. Therefore, to revive the economy, the Fed needs to change mass behavior, which inevitably involves the arts of deception, manipulation and propaganda.

  To increase velocity, the Fed must instill in the public either euphoria from the wealth effect or fear of inflation. The idea of the wealth effect is that consumers will spend more freely if they feel more prosperous. The favored route to a wealth effect is an increase in asset values. For this purpose, the Fed’s preferred asset classes are stock prices and home prices, because they are widely known and closely watched. After falling sharply from a peak in mid-2006, home prices stabilized during late 2009 and rose slightly in early 2010 due to the policy intervention of the first-time home buyer’s tax credit. By late 2010, that program was discontinued and home prices began to decline again. By early 2011, home prices nationwide had returned to the levels of mid-2003 and seemed headed for further declines. It appeared there would be no wealth effect from housing this time around.

  The Fed did have greater success in propping up the stock market. The Dow Jones Industrial Average increased almost 90 percent from March 2009 through April 2011. The Fed’s zero interest rate policy left investors with few places to go if they wanted returns above zero. Yet the stock rally also failed to produce the desired wealth effects. Some investors made money, but many more stayed away from stocks because they had lost confidence in the market after 2008.

  Faced with its inability to generate a wealth effect, the Fed turned to its only other behavioral tool—instilling fear of inflation in consumers. To do this in a way that increased borrowing and velocity, the Fed had to manipulate three things at once: nominal rates, real rates and inflation expectations. The idea was to keep nominal rates low and inflation expectations high. The object was to create negative real rates—the difference between nominal rates minus the expected rate of inflation. For example, if inflation expectations are 4 percent and nominal interest rates are 2 percent, then real interest rates are negative 2 percent. When real rates are negative, borrowing becomes attractive and both spending and investment grow. According to the monetarists’ formula, this potent combination of more borrowing, which expands the money supply, and more spending, which increases velocity, would grow the economy. This policy of negative real rates and fear of inflation was the Fed’s last, best hope to generate a self-sustaining recovery.

  Negative interest rates create a situation in which dollars can be borrowed and paid back in cheaper dollars due to inflation. It is like renting a car with a full tank of gas and returning the car with the tank half empty at no charge to the user. Consumers and businesses find this difficult to pass up.

  The Fed’s plan was to encourage borrowing through negative interest rates and encourage spending through fear of inflation. The resulting combination of leverage and inflation expectations might increase money supply and velocity and therefore increase GDP. This could work—but what would it take to increase expectations?

  Extensive theoretical work on this had been done by Ben Bernanke and Paul Krugman in the late 1990s as a result of studying a similar episode in Japan during its “lost decade.” A definitive summary of this research was written by economist Lars Svensson in 2003. Svensson was a colleague of Bernanke’s and Krugman’s at Princeton and later became a central banker himself in Sweden. Svensson’s paper is the Rosetta stone of the currency wars because it reveals the linkage between currency depreciation and negative real interest rates as a way to stimulate an economy at the expense of other countries.

  Svensson discusses the benefits of currency war: Even if the ... interest rate is zero, a depreciation of the currency provides a powerful way to stimulate the economy.... A currency depreciation will stimulate an economy directly by giving a boost to export . . . sectors. More importantly . . . a currency depreciation and a peg of the currency rate at a depreciated rate serves as a conspicuous commitment to a higher price level in the future.

  Svensson also describes the difficulties of manipulating the public in the course of pursuing these policies:If the central bank could manipulate private-sector beliefs, it would make the private sector believe in future inflation, the real interest rate would fall, and the economy would soon emerge from recession.... The problem is that private-sector beliefs are not easy to affect.

  Here was Bernanke’s entire playbook—keep interest rates at zero, devalue the dollar by quantitative easing and manipulate opinion to create fear of inflation. Bernanke’s policies of zero interest rates and quantitative easing provided the fuel for inflation. Ironically, Bernanke’s fiercest critics were helping his plan by incessantly sounding the inflation alarm; they were stoking inflation fears with language no Fed chairman could ever use himself.

  This was central banking with the mask off. It was not the cool, rational, scientific pursuit of disinterested economists sitting in the Fed’s marble temple in Washington. Instead it was an exercise in deception and hoping for the best. When prices of oil, silver, gold and other commoditie
s began to rise steeply in 2011, Bernanke was publicly unperturbed and made it clear that actual interest rates would remain low. In fact, increasing inflation anxiety reported from around the world combined with continued low rates was exactly what the theories of Bernanke, Krugman and Svensson advocated. America had become a nation of guinea pigs in a grand monetary experiment, cooked up in the petri dish of the Princeton economics department.

  The Bernanke-Krugman-Svensson theory makes it clear that the Fed’s public efforts to separate monetary policy from currency wars are disingenuous. Easy money and dollar devaluation are two sides of the same coin, and currency wars are part of the plan. Easy money and dollar devaluation are designed to work together to cause actual inflation and to raise inflation expectations while holding interest rates low to get the lending and spending machine back in gear. This is clear to the Chinese, the Arabs and other emerging markets in Asia and Latin America that have complained vociferously about the Fed’s stewardship of the dollar. The question is whether the collapse of the dollar is obvious to the American people.

  Fundamentally, monetarism is insufficient as a policy tool not because it gets the variables wrong but because the variables are too hard to control. Velocity is a mirror of the consumer’s confidence or fear and can be highly volatile. The money supply transmission mechanism from base money to bank loans can break down because of the lack of certainty and confidence on the part of lenders and borrowers. The danger is that the Fed does not accept these behavioral limitations and tries to control them anyway through communication tinged with deception and propaganda. Worse yet, when the public realizes that it is being deceived, a feedback loop is created in which trust is broken and even the truth, if it can be found, is no longer believed. The United States is dangerously close to that point.

  Keynesianism

  John Maynard Keynes died in 1946 and so never lived to see the errors committed in his name. His death came just one year before the publication of Samuelson’s Foundations of Economic Analysis, which laid the intellectual base for what became known as neo-Keynesian economics. Keynes himself used few equations in his writings, but did provide extensive analysis in clear prose. It was only in the late 1940s and 1950s that many of the models and graphs associated today with Keynesian economics came into existence. This is where the conceptual errors espoused under the name “Keynesian” are embedded; what Keynes would have thought of those errors had he lived is open to speculation.

  Near the end of his life, Keynes supported a new currency, which he called the bancor, with a value anchored to a commodity basket including gold. He was, of course, a fierce critic of the gold exchange standard of the 1920s, but he was practical enough to realize that currencies must be anchored to something and, for this reason, preferred a global commodity standard to the dollar-and-gold standard that emerged from Bretton Woods in 1944.

  Our purpose here is not to review the field of Keynesian economics at large, but rather to zero in on the flaw most relevant to the currency wars. In the case of monetarism, the flaw was the volatility of velocity as expressed in consumer choice. In Keynesianism, the flaw is the famous “multiplier.”

  The Keynesian multiplier theory rests on the assumption that a dollar of government deficit spending can produce more than a dollar of total economic output after all secondary effects are taken into account. The multiplier is the Bigfoot of economics—something that many assume exists but is rarely, if ever, seen. The foundation of Keynesian public policy is called aggregate demand, or the total of all spending and investment in the domestic economy, excluding inventories. For example, if a worker is fired, he not only loses his income, but he also then stops spending in ways that cause others to lose income as well. The lost income and lost spending cause a drop in aggregate demand, which can feed on itself, leading more businesses to fire more employees, who then spend less, and so on in a vicious circle. Keynesian theory says that government can step in and spend money that individuals cannot or will not spend, thereby increasing aggregate demand. The government spending can reverse the slide and contribute to renewed economic growth.

  The problem with this theory of government spending to boost aggregate demand is that governments have no money of their own in the first instance. Governments have to print the money, take the money in the form of taxes or borrow the money from their citizens or from abroad. Printing money can cause nominal growth, but it can also cause inflation, so that real growth is unchanged over time. Taxing and borrowing may enable the government to spend more, but it means there is less for the private sector to spend or invest, so it is not clear how aggregate demand increases. This is where the multiplier claims to play a role. The idea of the multiplier is that one dollar of government spending will stimulate more spending by others and result in more than one dollar of increased output, and this is the justification for taking the dollar from the private sector.

  How much more output is yielded by one dollar of government spending? Put differently, what is the size of the multiplier? In a famous study written just before the start of President Obama’s administration, two of Obama’s advisers, Christina Romer and Jared Bernstein, looked at the multiplier in connection with the proposed 2009 stimulus program. Romer and Bernstein estimated the multiplier at about 1.54 once the new spending was up and running. This means that for every $100 billion in the Obama spending program, Romer and Bernstein expected output to increase by $154 billion. Since the entire Obama program ended up at $787 billion, the “extra” output just from doing the stimulus program would amount to $425 billion—the largest free lunch in history. The purpose of this stimulus was to offset the effects of the depression that had begun in late 2007 and to save jobs.

  The Obama administration ran U.S. fiscal year deficits of over $1.4 trillion in 2009 and $1.2 trillion in 2010. The administration projected further deficits of $1.6 trillion in 2011 and $1.1 trillion in 2012—an astounding total of over $5.4 trillion in just four years. In order to justify the $787 billion program of extra stimulus in 2009 with deficits of this magnitude, it was critical to show that America would be worse off without the spending. The evidence for the Keynesian multiplier had to be rock solid.

  It did not take long for the evidence to arrive. One month after the Romer and Bernstein study, another far more rigorous study of the same spending program was produced by John B. Taylor and John F. Cogan of Stanford University and their colleagues. Central to the results shown by Taylor and Cogan is that all of the multipliers are less than one, meaning that for every dollar of “stimulus” spending, the amount of goods and services produced by the private sector declines. Taylor and Cogan employed a more up-to-date multiplier model that has attracted wider support among economists and uses more realistic assumptions about the projected path of interest rates and expectations of consumers in the face of higher tax burdens in the future. The Taylor and Cogan study put the multiplier effect of the Obama stimulus program at 0.96 in the early stages but showed it falling rapidly to 0.67 by the end of 2009 and to 0.48 by the end of 2010. Their study showed that, by 2011, for each stimulus dollar spent, private sector output would fall by almost sixty cents. The Obama stimulus program was hurting the private sector and therefore handicapping the private sector’s ability to create jobs.

  The Taylor and Cogan study was not the only study to reach the conclusion that Keynesian multipliers are less than one and that stimulus programs destroy private sector output. John Taylor had reached similar conclusions in a separate 1993 study. Empirical support for Keynesian multipliers of less than one, in certain conditions, was reported in separate studies by Michael Woodford of Columbia University, Robert Barro of Harvard and Michael Kumhof of Stanford, among others. A review of the economic literature shows that the methods used by Romer and Bernstein to support the Obama stimulus program were outside the mainstream of economic thought and difficult to support except for ideological reasons.

  Keynes’s theory that government spending could stimulate aggre
gate demand turns out to be one that works in limited conditions only, making it more of a special theory than the general theory he had claimed. Stimulus programs work better in the short run than the long run. Stimulus works better in a liquidity crisis than a solvency crisis, and better in a mild recession than a severe one. Stimulus also works better for economies that have entered recessions with relatively low debt levels at the outset. The seminal yet still underappreciated econometric work of Professor Carl F. Christ from the 1960s theorized that both Keynesian and monetarist tools work most powerfully for economies that have started with a balanced budget. Christ was the first to identify what he called the “government budget restraint,” a concept that seems to have been forgotten in the meantime. Christ wrote, “Results suggest forcefully that both the extreme fiscal advocates and the extreme monetary advocates are wrong: Fiscal variables strongly influence the effect of a given change in the . . . money stock, and open market operations strongly influence the effects of given changes in government expenditures and taxation.” Christ was saying that the impact of Keynesian stimulus could not be gauged independently of the deficit starting line.

  None of the favorable conditions for Keynesian stimulus was present in the United States in early 2009. The country was heavily burdened with debt, was running huge deficits and was suffering from a severe solvency crisis that promised to continue for many years—exactly the wrong environment for Keynesian stimulus. The stimulus spending would increase the deficit and waste valuable resources, but not do much else.

  Two years after the Romer and Bernstein study, the economic results were in, and they were devastating to their thesis. Romer and Bernstein had estimated total employment at over 137 million by the end of 2010. The actual number was only about 130 million. They had estimated GDP would increase 3.7 percent by late 2010; however, it had barely increased at all. They had also estimated that recession unemployment would peak at 8 percent; unfortunately, it peaked at 10.1 percent in October 2009. By every measure the economy performed markedly worse than Romer and Bernstein had anticipated using their version of the Keynesian multiplier. From the start, the Obama stimulus was little more than an ideological wish list of favored programs and constituencies dressed up in the academic robes of John Maynard Keynes.