Back to the Future?

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Things are look­ing grim indeed for the US econ­o­my. Unem­ploy­ment is out of con­trol—espe­cial­ly if you con­sid­er the U‑6 (16.7%, up 0.2% in the last month) and Shad­ow­stats (22%, up 0.3%) mea­sures, which are far more real­is­tic than the effec­tive­ly pub­lic rela­tions U‑3 num­ber that pass­es for the “offi­cial” unem­ploy­ment rate (9.6%, up 0.1%).

The US is in a Depres­sion, and the soon­er it acknowl­edges that—rather than con­tin­u­ing to pre­tend otherwise—the bet­ter. Gov­ern­ment action has atten­u­at­ed the rate of decline, but not reversed it: a huge fis­cal and mon­e­tary stim­u­lus has put the econ­o­my in lim­bo rather than restart­ing growth, and the Fed’s con­ven­tion­al mon­e­tary pol­i­cy arse­nal is all but deplet­ed.

This prompt­ed MIT pro­fes­sor of eco­nom­ics Ricar­do Cabellero to sug­gest a more rad­i­cal approach to mon­e­tary eas­ing, in a piece re-pub­lished last Wednes­day in Busi­ness Spec­ta­tor (repro­duced from Vox). Con­ven­tion­al “Quan­ti­ta­tive Eas­ing” involves the Trea­sury sell­ing bonds to the Fed, and then using the mon­ey to fund expenditure—so pub­lic debt increas­es, and it has to be ser­viced. We thus swap a pri­vate debt prob­lem for a pub­lic one, and the boost to spend­ing is reversed when the bonds are sub­se­quent­ly retired. Instead, Caballero pro­pos­es

a fis­cal expan­sion (e.g. a tem­po­rary and large cut of sales tax­es) that does not raise pub­lic debt in equal amount. This can be done with a “heli­copter drop” tar­get­ed at the Trea­sury. That is, a mon­e­tary gift from the Fed to the Trea­sury. (Ricar­do Caballero)

The gov­ern­ment would thus spend with­out adding to debt, with the objec­tive of caus­ing infla­tion by hav­ing “more dol­lars chas­ing goods and ser­vices”. This is prefer­able to the defla­tion­ary trap that has afflict­ed Japan for two decades, and now is increas­ing­ly like­ly in the US. So on the face of it, Cabellero’s plan appears sound: infla­tion will reduce the real val­ue of finan­cial assets, shift wealth from old­er to younger gen­er­a­tions, and stim­u­late both sup­ply and demand by mak­ing it more attrac­tive to spend and invest than to leave dol­lars lan­guish­ing, and los­ing real val­ue, in the bank.

How­ev­er, though this is indeed the right time to con­sid­er rad­i­cal solu­tions, Cabellero’s pro­pos­al would do only half the required job. Focus­ing on the good bit, one rea­son we got into this predica­ment in the first place was because pri­vate sec­tor, debt-based mon­ey swamped pub­lic sec­tor, fiat mon­ey. Ulti­mate­ly we need to return to the pub­lic-pri­vate mon­ey bal­ance we had in the 1950s and ear­ly 1960s.

But if get­ting “Back to the Future” was all we need­ed to do, then our prob­lems would already be over, because Ben’s Heli­copter Drop of late 2008 has got us there already: the ratio of M0 to M2 is now almost 0.25, far high­er than the 1960 lev­el of 0.14, while the ratio to M3 is back where it was then (using Shad­ow­stats data, which I can’t pub­lish here since it’s pro­pri­etary).

So why aren’t we “Back To The Future” already? Why isn’t the econ­o­my boom­ing once more, and why is infla­tion giv­ing way to defla­tion?

Because, though the mon­ey sup­ply is back to where it was in 1960, the debt to mon­ey ratio is utter­ly dif­fer­ent. Even after Ben’s Heli­copter Drop, the debt to base mon­ey ratio is almost twice what it was in 1960, and over 3 times what it was back in the Gold­en Days of the 1950s.

This points out the blind spot in the think­ing of even pro­gres­sive Neo­clas­si­cals like Cabellero, who are will­ing to con­sid­er uncon­ven­tion­al poli­cies: they don’t under­stand how mon­ey is cre­at­ed in our cred­it-dri­ven econ­o­my. Because of that, they don’t appre­ci­ate how much of that cred­it has financed a glo­ri­fied Ponzi Scheme rather than invest­ment, nor do they com­pre­hend the impact that pri­vate sec­tor delever­ag­ing is hav­ing on aggre­gate demand.

I’ve cov­ered the first top­ic ad nau­se­am in my post “The Rov­ing Cav­a­liers of Cred­it”, so I won’t repeat myself here. Instead I’ll focus on the obvi­ous mes­sage from the above chart: if the gov­ern­ment sim­ply pumps its mon­ey into the sys­tem with­out restrain­ing the finan­cial sys­tem from financ­ing spec­u­la­tion on asset mar­kets, the best we can hope for is a repeat of this cri­sis, on an even larg­er scale, some years down the track. To see that, all we have to do is look at what hap­pened back in the 1980s.

The Debt to M0 ratio, which had risen six­fold since the 1950s, went into sud­den reverse as the econ­o­my implod­ed when the Sav­ings and Loans fias­co end­ed. The growth of debt col­lapsed, and the State tried to res­cue the finan­cial sec­tor from its fol­lies by fis­cal pol­i­cy and boost­ing the mon­ey sup­ply. That res­cue ulti­mate­ly suc­ceed­ed when the reces­sion of the 1990s final­ly end­ed, but since finance was embold­ened rather than reformed, it sim­ply financed two fur­ther fias­cos: the Dot­Com mad­ness and then the Sub­prime scam.

The rea­son why the 1990s res­cue isn’t work­ing this time stands out more clear­ly when you look at the changes in debt and M0 in raw dol­lar terms (the scale of the change in M0 is 1/5th that for the change in debt in next two graphs). In the 1990s cri­sis, the rate of growth of pri­vate debt slowed by 2/3rds, but it did­n’t actu­al­ly fall; and a qua­dru­pling of the rate of growth of M0 (start­ing half a year after debt growth slowed down) was enough, after sev­er­al years, to let the Wall Street par­ty resume.

This time, the change in debt has turned solid­ly negative—having growth at up to $4 tril­lion p.a., it is now shrink­ing at over $2 tril­lion. Ben’s far larg­er quan­ti­ta­tive eas­ing (when com­pared to Alan’s back in 1990–94) sim­ply has­n’t been enough to fight a pri­vate sec­tor that is now seri­ous­ly delever­ag­ing.

QE2 could nonethe­less work, if Cabellero’s plan was exe­cut­ed with gus­to. But if all we do is effect a mon­e­tary res­cue, and yet leave the finance sec­tor untouched, then it will reborn once again as an even big­ger Ponzi Scheme.

Do we real­ly want to go through all that again?

I’ll explain two tru­ly major finan­cial reforms that could pre­vent anoth­er cred­it and asset bub­ble in a sub­se­quent piece.

Click here for this post in a PDF doc­u­ment.