It’s mostly accepted that what a central bank does is no more inconsistent with capitalism than what you and I do on a regular basis. There are various reasons for this self-inclusion which should be disqualified based on common sense alone, but monetary theory is, by intent, impenetrable beyond the few indoctrinated in its ritual mathematics. This isn’t to say that its practitioners are performing a prevarication as they see it; far from it. In fact, in the minds of the monetary economists at the policymaking level all over the world they are following in the footsteps of the great capitalists.
That is always struck me as a New Age synthesis as capitalists used to be identified with the businesses they built not the “money” that served as just a tool in the endeavor. Somewhere along the way we lost the definition of capital itself as it has become synonymous with paper; and thus theoretically interchangeable between finance and real. Enter the modern central bank and its activism.
In his inaugural blog post, Ben Bernanke asserts this as unequivocal doctrine immersed fully in the grand capitalist tradition. He performs more than a few fallacies to justify this view, and how he could have been so wrong as I noted in the first part, but most of all the sacred notion of central banks inseparable from markets is at the core of these beliefs.
The Fed’s actions determine the money supply and thus short-term interest rates; it has no choice but to set the short-term interest rate somewhere.
Following that logic, such that it is, the Federal Reserve is intertwined within the money supply so its actions are axiomatically part of all market information. The trick of the post-1980’s version was to update only methodology since targeting the money supply was found identical to targeting an interest rate. And so the failure of this broad “market” arrangement in the 21st century has opened the door to the Marxists and others that despise capitalism but have been unable, until now, to disprove its robust tendencies to enrich all the societies into which it has been largely left unfettered.
It isn’t just the Great Recession and Panic of 2008 that is laid at the feet of capitalism, it is assumed that Karl Marx was right and that the capitalist system is finally consuming itself exactly as he foresaw. There was Occupy Wall Street and the utter infatuation with Thomas Piketty, but the longer this recovery fails the more these “alternate” ideologies will gain favor among those that believe capitalism has left them behind. The New York Times continues to pound upon that fact, as even in this “booming” economy of Yellen’s mind apparently deserves continued Marxist scorn:
Let’s resolve to build something better. In the long run we know that we’ll make the transition from capitalism to some less destructive and hopefully more just system. Why not begin that transition now? If there is going to be a global market that will further enrich capitalists, there must be guarantees that the rest of the population can at least afford housing and food.
The irony of that last sentence is thick, as it was the true practice of capitalism that made food so cheap as to be “overabundant” (from the view of the obesity “crisis”) if not at least more plentiful than at any point in human history. The further irony, and which is highly relevant here, is that if housing is unaffordable in the main it was not capitalism that made it so. That was the work of the “markets” under central bank dictum as opposed to capital. Successful deployment of capital always cheapens and expands (think computer prices and consumer electronic penetration) while central banks despise such price inevitability and always seek to inflate.
There is but a small amount of mistaken assumptions to reconcile those facts under a common (from the orthodox point of view) banner. Bernanke’s point, as well as being reiterated across mainstream economics, is that central banks have had no choice in the matter of failed economies. The “equilibrium market” interest rate has been falling, which leads central banks to have to “follow” – some even admit this is asset bubbles at work without taking in the responsibility of them. That theory relies exclusively on the idea that the “equilibrium” rate is a market construction derived from economic reality apart from money.
The entire point of monetary policy in this manner is quantification, an impulse that has been alive in economics going back deep into the 19th century. In 1885, Simon Newcomb introduced what he called the “equation of societary circulation”, the nascent form of what is now recognizable as the “equation of exchange.” Newcomb used “rapidity”, balanced by a shorn money figure that excluded borrowing and lending; the intent was to identify purely economic transactions.
It was Irving Fisher that took this equation to its first modern form, having been a great admirer of Newcomb (even dedicating his major work, The Purchasing Power of Money, published in 1911, to Simon). There were several adjustments made from Newcomb to Fisher, but among them was the realization that money, even commodity or hard money, can and will be used for financial transactions as well as real economic commerce. It tended to not be widespread at that time, but any complete theory would have to take this into account.
The initial reception to Fisher’s equation was, to give it a 21st century feel, “duh.” It was thought an uninsightful tautology because everyone knew that was what money did and how the economy was, loosely at least, arranged. For Fisher, he couldn’t maximize even that basic intuition because he found, as did Newcomb, that developing a method for quantifying all the variables was nigh impossible. It seemed as if Adam Smith’s invisible hand would not so easily be lighted by modern mathematics and technology.
After Simon Kuznets developed his GNP theory of economic accounts, economists by the 1960’s started to believe in simplified versions of “reality” as if not just “close enough” than fully consistent. While Fisher’s version was still too difficult to parse, econometrics could and did move back closer to Newcomb’s theory of limited applicability in just real economy accounts. So the modern version of the equation of exchange rests with the T replaced first by Q and now y (national income).
As with all general equilibrium theory, there is no way to get an asset bubble from this. If one does rise, it is, so the theory tells, a problem within the economy itself rather than the purely nominal intrusions of central banks and money on the left side. Indeed, the world of the 1960’s almost makes that a reasonable assumption, as there wasn’t much at that time of the purely financial world as we have come to understand it. So any discrepancy between the simplified Q or y and Fisher’s T was minor – or so it seemed.
To apply equilibrium theory in the context of understood equilibrium rate theory means ignoring the “T” part and concentrating on the “M” exclusively inside the real economy. But even that simplification had already run into trouble by the time the eurodollar market had evolved. In fact, when the gold window “closed” in 1971, eurodollars were already a major imposition not just on actual “dollar” behavior but also monetary theory itself. By the end of 1974, on the eve of creating what is now referred, mistakenly in my opinion, to the petrodollar, the FOMC was well-aware of growing complexities within “M.” From the December 1974 FOMC meeting:
In reply, Mr. Coombs said an effort could be made to develop such a measure, but he doubted that it would be successful. The volume of funds which might be shifted back and forth between the of the monetary statistics arose in connection with Euro-dollars; he suspected that at least some part of the Euro-dollar-based money supply should be included in the U.S. money supply. More generally, he thought M1 was becoming increasingly obsolete as a monetary indicator. The Committee should be focusing more on M2, and it should be moving toward some new version of M3–especially because of the participation of nonbank thrift institutions in money transfer activities.
In the context of the equation of exchange view of the interaction of money and economy, this has drastic implications. In operational constraints, the evolution into eurodollars and the advance of modern technology meant that finance wasn’t so simplified. Again, that insight was delivered to the central bank forty years ago! Under Bernanke’s recent delivery, he maintains that there is no difference between targeting money supply and targeting an interest rate when his predecessors realized quite starkly that there should even be a debate about what constitutes money itself. It’s almost (being kind) as if monetary theory devolved from that point to get to interest rate targeting; all for the sake of simplified variables to generate econometric equilibriums which wouldn’t have been possible under a more realistic and complex systems approach.
In terms of economic function vs. finance, this shifting idea of “money” left open the possibility that not only was “money” growth hidden from policy view, and thus considerations, but that such transition might not conform to prior ideas and history about how finance functions in relation to the real economy – money unto itself. We know this to be the case in the eurodollar standard that transitioned globally from gold and Bretton Woods, but at first that didn’t as much matter because eurodollar development was left to primarily supply liquidity for global trade (although it made a huge and immediate impact on those that practiced it, as debt levels, in “dollars”, exploded throughout the 1970’s).
By 1985, right around the time the Federal Reserve transitioned (or was considering it; we still don’t know exactly when it happened but all outward signs point to around the time Greenspan took over in 1987 and by 1989 for sure) to purely rate targeting, the behavior of “dollars” was again irretrievably altered by the simultaneous (a fact that should be far more appreciated) introduction of eurdollar futures and interest rate swap trading regularly in Chicago. At the same time, eurodollar “dollars” began to increasingly “leak” back inside the US as bank liabilities for suddenly domestic uses.
That created a permanent expansion in what can fairly and reasonably contain the functions of “money”, as modern wholesale banking features any number of factors and facets that act like currency (as we have found out through more error than trial since 2007). Yet, the FOMC continued on as if their targeting assumption remained valid and unaltered. Several developments at the end of the 1980’s and into the early 1990’s completed this shift, including the S&L crisis, so that the dollar had fully transformed into the “dollar”; and domestic finance became inseparable from the “petrodollar” standard that was supposed to be limited to trade liquidity.
As is well known now to all but central bank theory, debt usage and production exploded. The complexity of wholesale “dollars” was not lost upon the FOMC, though, as even they were forced to admit that they could no longer even keep track of it; M3 was shut down in 2006 by the central bank somehow still maintained that targeting an interest rate was a perfect substitute for targeting “money supply.” The implications of that acknowledgement were negligible as they considered it trivial in light of how “successful” policy seemed to be at that time (when the housing bubble was still cause for celebration and tribute).
The reason for the perpetuated equality in theory that had been so thoroughly disabused by financial function was GDP. In other words, because Greenspan’s Fed had been able, so they believed, to maintain their theories and generate what they thought was largely stable and almost invariant GDP levels that everything not only worked but was validated by empirical results – until 2007.
That is why this “equilibrium market” interest rate is conspicuously absent from the front side of monetary policy pre-crisis. They didn’t think it much mattered because they believed they nailed it. Only now in examination of “what went wrong” is there cause for alteration – but not of the dominant theory and certainly not to extricate central banks from pure capitalism and truly free markets. The idea of secular stagnation is that monetary theory is still valid only that there is “something” wrong in the real economy that leaves it increasingly immune to the genius of central planners.
Even just asserting that as a potential explanation sounds silly; that central bankers are both brilliant and powerful but otherwise mistaken and powerless in terms of what occurred. What really happened was that this evolved “money” was focused more and more purely on assets and asset prices rather than any tangible relation to real economic function. The growth of asset bubbles satisfied GDP only as a “leakage” – the housing bubble was immense, perhaps the biggest in human history (the PBOC might be begging to differ), but only created a minor boost to GDP levels while leaving behind deficiencies in labor and wages. The mid-2000’s FOMC was unconcerned because they didn’t care or see that disparity, only that “leakage” was GDP-positive. Keynes’ focus only on the short run is paramount here.
But it is the increasing inefficiency of asset bubbles that relates the “equilibrium” interest rate to reality. Economists maintain that such a rate is of the economy itself, and that is true in one sense. What their equilibrium rate defines is not so much long-term potential or the full deployment of labor and capital but rather this discrepancy between asset bubble size and the ultimate inefficiency by which it leaks into the real economy (GDP or other accounts).
In short, the orthodox notion of the equilibrium rate is not the rate at which the economy best deploys real assets but the illusory rate at which asset bubbles leak back into the economy – or, more specifically to monetary policy, the rate at which it takes to maintain stability in the asset bubbles and their inefficiencies.
The larger the asset bubble, based almost exclusively on transitioned and evolved “money” types and expressions, the more “stimulus” is required to keep it afloat to maintain even highly inefficient circulation through the real economy. Bringing that back to terms with the equation of exchange, it takes more and more “M” just to generate enough “T” in the form of huge bubbles to gain even a small amount of “y.”
The problem is not the economy itself but this ridiculously inefficient arrangement derived from financial evolution and decades of mistaken policy that did not evolve with “money.” It all starts from what is so easily disproven, in that targeting money or targeting an interest rate are the only options. The growth of bubbles and domination of financialism of this type is nothing relative of capitalism – central banks are not consistent with market function. The more “M” required to maintain a stable “T” means the less actual capital is created and can do what it had always done in the past – a fact easily discernable in the shape of collateral markets and the common shortage of created suitable collateral.
The grand irony in all of this is that current infatuation with Marxism is far closer to financialism and practiced monetarism than capitalism. The central bank operates as a statist intrusion of command, supplying not capitalism but economic inefficiency which is supposed to be closed, by those who advocate against such “inequality”, by still more command. In these purely political terms, smoothing out GDP is the socialization of economic function. The funny/tragic element of that is if you were going to introduce socialist or even Marxist transitions as the New York Times would have it, a fitting place to start is the central bank.