How Quantitative Easing really works: Occupy Wall Street Edition (2)
As a contribution to Occupy Wall Street’s efforts against debt, I am continuing my reading of William White’s “Ultra Easy Monetary Policy and the Law of Unintended Consequences” (PDF). I have covered sections A and B. In this last section I am looking at to section C of White’s paper and his conclusion.
Back to the Future
It is interesting how White sets all of his predictions about the consequences of the present monetary policies in the future tense as if he is speaking of events that have not, as yet, occurred. For instance, White argues,
“Researchers at the Bank for International Settlements have suggested that a much broader spectrum of credit driven “imbalances”, financial as well as real, could potentially lead to boom/bust processes that might threaten both price stability and financial stability. This BIS way of thinking about economic and financial crises, treating them as systemic breakdowns that could be triggered anywhere in an overstretched system, also has much in common with insights provided by interdisciplinary work on complex adaptive systems. This work indicates that such systems, built up as a result of cumulative processes, can have highly unpredictable dynamics and can demonstrate significant non linearities.”
It is as though White never got the memo about the catastrophic financial meltdown that happened in 2008. If his focus is on the “medium run” consequences of easy money that has been practiced since the 1980s, isn’t this crisis the “medium run” result of those policies? Why does White insist on redirecting our attention to an event in the future, when this crisis clearly is the event produced by his analysis.
We need to provide the proper perspective in order to set White’s argument in the proper historical context. So far as I can figure, White is roughly covering the period from 1980 or so to 2012 — about 32 years since the Volcker shock and recovery. So, what did the economy look like during this period? Well, it depends on what measure you use to judge “economic growth”. If you use dollars to measure the increase in GDP between 1980-2010, you get one view of how the economy performed:
As you can see in this chart, annual GDP rose almost uninterrupted from 1980 until 2008, when the financial crisis hit — not bad, huh?. However, if you measure GDP in a commodity money like gold, the results are far less sunny.
In this view GDP rose from 1980 until 2001, and then began plunging. Dollars say this crisis began in 2008, while gold insists it began in 2001 — but which is right? I used to argue gold was right, but Moishe Postone’s argument convinces me now that, in fact, both are right for different reasons. Gold is telling us what is happening in the “real economy” — i.e., it is showing us when the total social capital began to contract in a depression. Dollars, on the other hand, are telling us when this real contraction began to be expressed in the breakdown of fascist state economic policy.
Now, the background to the events White describes are all important: the period of 1980-2008 is the period when monetarism and neoliberalism were all the rage. Washington swore the state’s fiscal intervention in the economy was no longer necessary and policy aims could be accomplished by manipulating and debasing the currency. That argument met its first big test when the “real economy” — the total social capital — began to contract in 2001.
Could the contraction of the total social capital be offset by monetary policy alone? This was the question raised by the real contraction that occurred in 2001, as White himself posed it:
“First, will ultra easy monetary conditions be effectively transmitted to the real economy? Second, assuming the answer to the first question is yes, will private sector spending respond in such a way as to stimulate the real economy and reduce unemployment?”
Although White answers his two questions with a negative, in fact the empirical data suggests monetary policy continued to be effective for another 6 years after the start of the depression, as measured in terms of a definite physical quantity of gold. In one sense he was right: the effectiveness of monetary policy in no way stopped the collapse of the “real economy”, i.e., the real contraction of the total social capital. But Washington effectively covered up this collapse with a phony credit expansion and rising debt servitude by the mass of society.
People went deeply into debt, and the saving rate fell into negative territory, wiping out the savings of the working class. When that “false prosperity” — to use Eisenhower’s term — finally collapsed, monetary policy collapsed as well and the Fed encountered the dreaded zero lower bound of monetary policy. Which is to say, even at a 0% policy rate, there were no more marks in the working class to remortgage their homes.
“Re-temporalizing” White’s argument
It can be quite confusing to read White’s paper as he tries to describe “future” events that have already happened. To properly situate his argument, the events described in White’s paper as the “medium run” results of “easy money policies” should be understood as having already occurred. White can’t quite bring himself to state this truth, but it is evident in his discussion in section C.
For instance when he talks of the potential for what the Austrian school calls “malinvestment” (a term meant to describe misallocation of resources) during upswings and downswings, his examples are all drawn from events leading to this crisis during the last period of expansion and in the following period of contraction (both measured in terms of physical gold, rather than dollars): the housing boom; projects like Boston’s ‘Big Dig’; a rapid increase in capital investment in export oriented less developed countries; and a collapse in the savings rates of working families in this country. And he also refers to that period when discussing the use of monetary policy to mask one financial crash after another from 1987 until now — arguing that these efforts have prevented the reallocation of capital from less productive to more productive uses.
“By mitigating the purging of malinvestments in successive cycles, monetary easing thus raised the likelihood of an eventual downturn that would be much more severe than a normal one. Moreover, the bursting of each of these successive bubbles led to an ever more aggressive monetary policy response. From a Keynesian perspective, this response seemed required to offset the effects of the ever growing “headwinds” associated with all the malinvestments noted above. In short, monetary policy has itself, over time, generated the set of circumstances in which aggressive monetary easing would be both more needed and also less effective.”
White speaks as if these are the potential future results of quantitative easing, when it is clear quantitative easing itself results from the failure of the monetary policy that was expressed in these forms. Which is to say, quantitative easing became necessary only because these policies were no longer sufficient to stem the collapse of capitalism. In fact, he argues easy money policies has the “medium term” effect of creating a credit crunch in a downturn that sounds a lot like the financial crisis that occurred in 2008:
“The first of these would be that lenders suffer losses severe enough to cause an eventual and marked tightening of credit conditions. This could occur spontaneously, helping precipitate an economic slowdown, or could follow upon an economic slowdown (led from the demand side) that significantly raised loan losses. Tighter credit conditions would feed back on the real economy, aggravating the downturn. There seems clear evidence of such phenomena today, and also in the historical record.”
This pattern in White’s paper recurs over and over again. White makes the argument, that we are looking at a financial disaster if the Fed continues with quantitative easing, as if the the Fed is not already responding to this disaster by embarking on open ended quantitative easing. In fact, all the potential events listed by White as possible outcomes of quantitative easing have already happened as a result of the monetary policy pursued prior to quantitative easing.
Quantitative easing itself is nothing more than the product of these events.
How White engages in BUttKiSSN the Fed
At this point, I want to comment on a pathology present in White’s argument in the form of a bias or fallacy he wants to draw us into:
To do this for the sake of my argument, I want to coin a term, the “Bush-Kept-Us-Safe-Since-911 fallacy”, or, more briefly the “BUttKiSSN fallacy”. This fallacy, which has been remarked upon several times, consists in arguing the absence of repetition of a catastrophic event means the catastrophic event has not happened yet. So, for instance, as the name implies, the absence of a second 9-11, proves Bush kept us safe from “terrorism”. Of course, the fallacy ignores the fact that Bush did not prevent 9-11 itself and may have even had a hand in it, but we always begin marking the fallacy from the day after such an event, which appears as day 0.
This bias is actually much more common in Washington than it seems and in William White’s paper the BUttKiSSN fallacy is a fundamental premise of the writer’s argument that ultra-easy money policies will someday lead to a financial crisis. But, of course, we have already had the financial crisis he predicts in his paper following on a period of monetary policies that by all estimations were remarkable for being loose. QE is the result of that financial crisis — it did not cause it.
I think there is a BUttKiSSN fallacy in arguments like White’s because the catastrophic event itself calls into question the institution commonly held to be the one with responsibility for preventing its occurrence in the first place. Since it is commonly held that the president’s national security team was responsible for “preventing a 9-11 type event”, the argument for continuing with this responsibility can’t very well rest on “Bush prevented 9-11″. Instead we get “Bush prevented another 9-11″.
Likewise White never makes the argument the Federal Reserve and monetary policy produced the financial meltdown, since this would call into question the very existence of both the Fed and monetary policy itself — and monetary policy is White’s bread and butter, it is how he reproduces himself as an economist. Instead he predicts that at some point in the “medium term” future Fed policies will lead to a catastrophic financial meltdown like the one we just saw in 2008.
It is a bias rooted in the nature of institutions that they can never admit direct responsibility for the catastrophes they in fact create. The fascist state was responsible for two catastrophes in an eight year period, but despite this, Washington cannot admit responsibility for these events; instead, what it does is slap itself on the back for having prevented their repetition, or vows such an outcome “will never happen on our watch”.
The coming backlash against fascist state policy
The fear of a backlash against fascist state policies that cause catastrophes is embedded in White’s argument, and explains why he must project into the future the consequences of policy that have already occurred. These fears are two-fold — a loss of independence by central banks like the Fed, as these banks must be bailed out themselves; and a growing understanding on the part of citizens that monetary policy is itself responsible for the growing income inequality we have been witnessing for the last forty years.
Thus we find this warning in White’s paper:
“…the actions undertaken by AME central banks pose a clear threat to their ‘independence’ in the pursuit of price stability. First, as central banks have purchased (or accepted as collateral) assets of lower quality, they have exposed themselves to losses. If it were felt necessary to recapitalize the central bank, this would be both embarrassing and another potential source of influence of the government over the central bank’s activities. Second, the actions of central banks have palpably been motivated by concerns about financial stability. Going forward, it will no longer be possible to suggest that monetary policy can be uniquely focused on near term price stability. Third, by purchasing government paper on a large scale, central banks open themselves to the criticism that they are cooperating in the process of fiscal dominance.”
To understand what White is talking about in the last sentence it is necessary to understand “monetary dominance”, which, in the paper, he contrasts with “fiscal dominance”. I had never heard these terms before, so I went looking for a definition and found this paper from the research department of the Bank of Israel. According to the paper a regime of fiscal dominance,
“states that any arbitrary fiscal policy has to be supported by monetary policy. By this we mean that monetary policy has to ensure the solvency of the public sector for any fiscal policy.”
Monetary dominance, by contrast states,
“that the fiscal policy has to accommodate any monetary policy. By this we mean that the fiscal policy has to ensure that the solvency of the public sector is maintained for any monetary policy.”
To understand the difference, consider that in monetary dominance, Greece has to get its debts in order so that it can accommodate the monetary policy of the European Central Bank. While, in fiscal dominance the ECB has to bail out Greece and accommodate its ongoing deficits. The struggle, therefore, is which of these two policy regimes will dominate the world market: the central bank or the nation state?
But simply identifying this struggle does not explain the parameters of the whole debate. The background to this struggle is that fiscal dominance has already failed in the prior depression. That depression, which no one seems to notice, occurred in the 1970s, and is generally called stagflation. Basically, in the 1970s, fiscal policy ruled and presidents would phone up the Fed to order them to get on board with the policy. How this worked in practice, can be seen in this funny anecdote posted to Wikipedia on the relation between President Richard Nixon and Federal Reserve Chairman Burns in the 1970s:
“Nixon named Burns to the Fed Chairmanship in 1970 with instructions to ensure easy access to credit when Nixon was running for reelection in 1972.
“Later, when Burns resisted, negative press about him was planted in newspapers and, under the threat of legislation to dilute the Fed’s influence, Burns and other Governors succumbed. Burns’ relationship with Nixon was often rocky. Reflecting in his diary about a 1971 meeting attended by himself, Nixon, Treasury Secretary John Connally, the Chairman of the Council of Economic Advisors, and the Director of the Bureau of the Budget, Burns wrote:
“The President looked wild; talked like a desperate man; fulminated with hatred against the press; took some of us to task — apparently meaning me or [chairman of the Council of Economic Advisors, Paul] McCraken or both — for not putting a gay and optimistic face on every piece of economic news, however discouraging; propounded the theory that confidence can be best generated by appearing confident and coloring, if need be, the news.”
Nixon definitely subscribed to the idea of fiscal dominance, but his commitment led directly to the collapse of fiscal dominance. The result in the 1970s depression was massive inflation combined with massive unemployment. Very quickly inflation rose from an already unheard of 6% to nearly 14% per year. Somewhere between 1980 and 1984 the idea took hold that the Fed and central banks generally, should be “independent”. For this to happen, the political branches had to accommodate their spending to a monetary policy aimed at maintaining stable low inflation. So far as I understand, this was given legal form in the Humphrey–Hawkins Full Employment Act. So, in fact, fiscal dominance failed in the 1970s and monetary dominance (monetarism) replaced it. When, therefore, White writes:
“…by purchasing government paper on a large scale, central banks open themselves to the criticism that they are cooperating in the process of fiscal dominance.”
He is actually misstating the actual problem, which is far more serious than a mere conflict between two branches of policy makers. It is not fiscal dominance here that is lurking in the wings, but the complete collapse of fascist state economic policy — both fiscal and monetary. The problem can be understood by following White’s argument of a hypothetical situation where a central bank requires a bailout itself. What happens if a central bank, having reached its limits by bailing out a nation state, now has to be recapitalized?
This may be less of a problem with the Federal Reserve, since the Treasury can do it; but not so with the European Central Bank — who bails it out? Last year it was reported the Federal Reserve bailed out the European Central Bank as well as the central banks of Mexico, Sweden, Australia, Switzerland, Japan, Norway, Bavaria, Libya, Korea among others since the financial crisis in 2008.
In fact, when we step back from the problem and look at the central banks that have been bailed out, it is clear national governments are no longer able to do this — the central banks themselves are too big to fail. In practice, the loss of monetary dominance by central banks has meant, not a reversion to fiscal dominance, but Federal Reserve bailouts. The reason the Fed ends up bailing them out has nothing to do with the Fed itself, but with the dollar and its unique role as world money.
Impoverishing society through monetary policy
Since there is in fact, no longer a possibility that the failure of any central bank can be prevented by national government intervention, and, therefore, lead to the dominance of the national government over the central bank, the question of a failure of monetary policy must hinge on another tendency White’s notes: that monetary policy will become increasingly understood by society as the mechanism for growing inequality within society.
“… after many years when distributional issues were largely ignored, these trends are now receiving increased attention. While arguments can easily be made for some degree of inequality to foster growth , there is a sense almost everywhere that recent trends have gone too far. Wilkinson and Picket (2009) suggest that greater inequality has many undesirable social effects. It has also been suggested that greater inequality can leads to a concentration of political power in the hands of those who wish to use it for their own purposes.”
So, in the end, why does White feel it necessary to pose his medium run consequences as the potential result of quantitative easing, rather than the other way around? One obvious reason can be found simply by stating directly what White only hints at: Handing control of society over to a handful of banksters has led to inequality, economic waste, financial speculation, and demonstrated the complete failure of monetary policy to counteract a depression.
The policies of the Federal Reserve have always been aimed at impoverishing the mass of society. Stated this way however, White’s career as a bankster technocrat would likely be over, and folks with otherwise widely divergent views ranging from Ron Paul to the Occupy movement would be vindicated.
Moreover the privileged position of the financial sector in Washington’s Ponzi scheme would be threatened by a rising sense that indeed most of the social ills we have experienced can be traced to monetary policy in particular and fascist state economic policy in general. White’s paper suggests there is clear evidence implicating the Federal Reserve’s monetary policies themselves in the catastrophic meltdown of the financial system in 2008 and the accumulation of social ills like debt, poverty, and social inequality that directly led to that crisis.
The sooner we bring an end to the Federal Reserve and the cabal of banksters on Wall Street, the better off society will be.