The latest unemployment data reveal the hope and tragedy of the American economic plight. Cheers went up for a modest increase in hiring, one that:
- barely keeps up with population;
- features mostly temp workers;
- leaves out prime-age males and all young workers;
- and keeps labor participation rate at a low level from 1979.
This is good news? Hmmm…
But the central bank will save us, right? So say economic journalists. They love metaphors. Actually, professional economists love them too. The latest phrase being tossed around is that world central banks are “stepping on the gas” to get the economy to move.
The European Central Bank dropped rates again after noting that economies are stagnant or shrinking. The Federal Reserve too says it will not let up in its asset-buying program, all in an attempt to make economic growth happen.
Let’s look at the car analogy. I took my car into the shop the other day. It had developed two problems. The gas pedal was sticky. I mashed and mashed the pedal, but the car was unresponsive. At the same time, the brakes weren’t working right. I had to push the brake all the way to the floorboard to stop the car.
Let say the mechanics had said, “The fix is to do more of what you are doing. Just sit there and keep pushing the gas and the brake. Do this as long as necessary to get it going again.”
As a customer, I would have immediately seen that this was stupid advice. The point isn’t to keep doing the same thing, but to look for a deeper solution. One that actually fixes the problem. It turns out that a cable that made the accelerator work was slipping, and the brakes needed more fluid. The mechanics fixed both, and I was on my way.
But with the central bank, it never occurs to them to look under the hood or check the underlying mechanics. They just keep doing the same thing over and over again: lowering rates and buying bad assets with newly created money.
How’s that worked out?
Well, the results are in: five years of continued stagnation. The central bankers are sitting in the car and really want to make it move, but they keep using the tools they have in front of them. It’s almost as if they can’t discern the incredibly obvious fact that they need to get out and look under the hood.
One of the symptoms of the problem is right in front of their eyes. The money they are creating isn’t becoming part of the real economic lives of spenders. Instead, it keeps piling up in bank vaults, fixing the balance sheets of banks, but not achieving the end of bringing about economic growth.
On the one hand, there are the reserve balances of banks carried by the Federal Reserve. They have never been higher. The money to create the appearance of recovery and even create crazy hyperinflation is certainly there:
Banks Suddenly Turned into Hoarders After 2008 and the Introduction of Easy Money
On the other hand, there is the money velocity statistic. This measures the average frequency with which money is being spent. It is a crucial indicator, because consumers and borrowers are the ones who determine velocity. It is an extension of human choice that the Fed with all its power cannot control.
Now look at what’s happened. Velocity was at its highest point during the inflation of the late 1970s, because people couldn’t wait to get rid of their money. But as the inflation rate has fallen over the last 30-plus years, so too has velocity fallen. You can see that it rose slightly during the 2000s bubble, but then crashed again after the beginning of the 2008 recession:
Consumers, Not the Fed, Controls How Fast We Spend Dollars
Again, there is absolutely nothing that the Fed’s stimulative activities can do to change this. Yet in order for the Fed’s policies to actually inspire economic growth, this will have to change. Not that the Fed hasn’t been trying. It has knocked interest rates down to zero in order to discourage saving and punish people for failing to employ cash balances. But it hasn’t done the trick. It is just like the 1930s, when the Fed tried to inflate, but couldn’t manage to get the public to go along with its plan.
For anyone who believes in markets as opposed to central planning, these results are actually encouraging. They show that even the much-vaunted power of central bankers can be severely limited by human choice. If we don’t go along, they are circumscribed in their power. They can buy and buy and print and print, but it changes nothing about how you and I respond. Yet you and I are the keys to making their plans come to fruition.
What mistake have the central bankers made? To beat an already dead analogy, they failed to look under the hood and see that the economic problem cannot be cured through the exercise of the printing power alone.
What was revealed in 2008 is known as a bubble. Bubbles follow predictable courses. They appear and expand due to increases in the money supply. They are exacerbated by policies like “too big to fail” and federally guaranteed institutions like Fannie Mae and Freddie Mac. This money expansion gives rise to irrational exuberance that shows up in various sectors, and this is followed by the realization that such exuberance is unsustainable.
This pattern is not new. Doug French demonstrates this in his wonderful book Early Speculative Bubbles, available now to all members of the Spy Briefing Club.
Tulip mania, the Mississippi bubble, and the South Sea bubble were all due to this same thing. They were blown up by increases in the money supply. They were cured by deleveraging and starting over again.
Here, you can easily see the relationship between recession (in the gray bars) and the expansion and contraction of the rate of increase in the money supply:
How an economy responds to delusional, know-it-all central bankers
The most recent period of recession is particularly interesting. The people who calculate whether we are in a recession or not called its end in 2009. Yet has expansion really been the result? Not really. We had the deepest collapse in economic activity in the postwar period, followed by the slowest sustained rates of economic growth in living memory. Meanwhile, incomes continue to fall, small-business creation is pathetic, and the falling rate of unemployment is due almost entirely to labor-force dropouts.
This is not a pretty picture, yet the central banks just keep doing the same thing over and over. This is not scientific public policy. This is pure witchcraft. And it is dangerous. Moreover, it all traces to one fundamental error. The Fed was unwilling to let the economy hit bottom so that it could enter a sustainable growth path. Its role as savior after the bubble collapse has gone nearly unquestioned. It’s as if the whole world just suddenly decided that dealing with economic pain should be against the law. Ironically, this decision has only prolonged the pain.
Back to the original metaphor. If the time of honesty ever arrives and someone in a position to fix the problem finally lifts up the hood of this stalled engine, there will be an ugly sight to behold. That person will find a bank sector sustained by fake money, a housing sector sustained by a fake market, a savings sector gutted by mandatorily low returns, and a whole new series of new bubbles that will prove themselves unsustainable.
The managers of the central banks can look at these charts same as you or I. They just choose to ignore the obvious lessons they impart.
It kind of makes you long for the days of Tulip mania. The episode in Holland was nuts, but at least no one tried to repair the damage by doing more of what caused it in the first place.