Monday, September 24, 2007

For My Next Trick, I Will Fall Into This Here Trap...

I noticed that recently there has been a "surge" in the readership of this blog and some readers were even kind enough to provide encouragement and valuable criticism in the comments section. Thank you.

Please note that in the interest of brevity I may sometimes quickly pass over whole sections of knowledge in the presumption that readers are familiar with the subject. I recognize that this is not always so, but it would be cumbersome for most to constantly repeat material, particularly if I have already dealt with them in previous posts. I encourage new readers, if they have the time and inclination, to read some older posts. Alternatively, if some financial terms are unfamiliar there are tremendous encyclopedic resources in the Internet these days, e.g. Investopedia is a fine tool for basic information.

Back to our regularly scheduled program..

Apart from combating inflation, the Fed's mandate includes maintaining economic stability, which is officialese for "avoid recessions - but if you can't, make damn sure we get out of 'em ASAP". The main instrument at its disposal is setting the cost of short-term money via targeting the Fed Funds rate, i.e. what banks charge each other for overnight money. It is a weapon with one critical built-in defect, as the Bank of Japan can readily testify: Once interest rates go to zero the central bank is out of conventional ammunition for stimulating the economy. This is known as the "liquidity trap": once you are in it... good luck getting out. You can't set nominal interest rates below zero because no one will pay interest to have his/her fiat money on deposit with a bank - not for very long, anyway*.

(If you want to experience first hand the thrills and chills of running your own central bank, visit the Swiss National Bank's site, where they have an excellent monetary policy simulation program - a sort of internet game for money geeks. All I can tell you without spoiling the fun is that you will walk away with a much greater appreciation for the challenges of a central banker's job. Lots and lots of humble pie for us backseat monetary policy amateurs.)

Because of the trap, a careful central banker tries to stay as far away from the "hole" as he/she possibly can. Mr. Bernanke's now infamous speech about raining money from a helicopter, a joke originated by his mentor Milton Friedman, refers to just such a "liquidity trap" and how to get out of it - at least theoretically.

How is the Fed doing on this "stay as far away from the hole as possible" front? Not too well, I'm afraid. As you can see in the chart below, during the past 35 years, before every recession (indicated in grey) Fed Fund rates were anywhere from a low of ~7% to a high of ~18%, i.e. there was plenty of room to cut substantially in order to stimulate the economy.

Where are we now? Because in this cycle the Fed started raising rates from such a record-low level, it only managed to get to a high of 5.25% - the lowest post-recession peak since 1960 - before stimulation in the form of rate cuts was necessary once again (indicating, also, how shallow the recovery really was). The Fed is starting with significantly less ammunition in its monetary policy gun than ever before, while at the same time faced with runaway debt, a massive current account deficit and a tumbling dollar.

There is another very powerful monetary policy tool: the statutory ratio of bank reserves to deposits. It sets how much of the depositors' money can be lent out and is the way to control credit growth directly. For example, a 10% reserve ratio can ultimately create $1000 credit out of $100 of deposits, as the money lent out is re-deposited from one bank to the next. The Fed's ratio for non-transaction deposits (e.g. savings accts. that limit the number of withdrawals, CD's, time deposits, etc.) is now 0% - can't get any lower than that. For checking and other such transaction deposits the ratio is 10%.

From the above it is obvious that the Fed doesn't have much wiggle room before hitting the bottom of the trap at 0% interest rates, implying that very soon policy makers must look elsewhere for economic stimulation: financial/asset bubbles are exhausted as levers for growth.

Where should they/we look? Call me a romantic, but I believe widespread economic prosperity is not a matter of finance, but of industry. In the past several years we have put the cart (finance, assets, consumption) before the horse (R&D, innovation, production) and we are now caught in a bind. In my opinion it is time to correct this and have finance once again follow and serve the interests of industry. Our world is faced with immense challenges from resource depletion to climate change that cannot be dealt with by finance alone - or the consumerist technology of games and cell phones. We need to reclaim our global technical and political leadership position in "harder" industries, from alternative energy to environmental protection.

We now, sadly, lag - and that's is no place for America.


(*) There has been a notable exception: Switzerland in the late '70s had negative rates for a short period because foreigners kept piling into the Swiss franc, expecting FX gains.


  1. Hi again hellasious,
    many thanks for reminding people the Swiss experience in th 70's. How young investors could understand that ? but that was a reality ! By opposition we could easily imagine rates going higher in the US...
    On your last point (room to manoeuvre rates is too small today compared to previous recessions) I think we have to lool at real rates and not nominal rates. If CB's cut nominal rates for example to 2 % and inflation is 3 % the real rate should stimulate the economy. So today at 4.75 % and 2 % inflation the Fed has a medium size room...In Japan the problem was more complicated as we were in a deflation (negative inflation). in that case the BOJ should have brought rates in the negative territory...
    best regards

  2. If the real rate of inflation is 10% right not, then the Fed has to raise by 525 basis points just to maintain the USD. It is ironic that Euro companies are making major investments in the U.S. for geothermal development.

  3. That's what I mean... EUROPEAN companies are making investments in the US, JAPANESE companies have taken over the car industry, CHINESE companies have taken over manufacturing of just about everything...

    What are *US* companies making? CDOs and LBOs.

    Oh, but I forget.. we also have Exxon, Boeing and Microsoft (GE is a finance company in industrial clothing)... plus *$'s and Hollywood.

    Good luck to us all.

  4. I want to say that I read you commentary religiously every day and have learned a lot from you wisdom. You are one of the smartest people on the Web.

    You keep revealing new aspects of this epic debt bubble.

  5. ...(indicating, also, how shallow the recovery really was).

    As soon as I read this, and before getting to the rest of your post, my thought was 'If so, how much of that has to do with the continued gutting of American manufacturing?'. I mean, look at many of the major business headlines, and note how much of it has to do with relatively trivial things like selling music (a recent AMZN venture), or advertising (GOOG) on the internet (just two examples, maybe not the best). Can such economic activity really create wealth and sustain a middle class? Compare to (what seems like to me, along with BA) the one remaining bastion of US manufacturing, automobiles, which is in serious trouble (UAW strike or not).

    In Praise of Hard Industries

    And to add to the chorus: You have an excellent blog -- always thought-provoking and well written. Regarding lack of knowledge among your (growing) readership, I have often wanted to ask for a further elaboration/explanation of some things you mention in your posts, but was reluctant. Perhaps occasionally you will have the time.


  6. re: gutting of mfg. in the US

    I have charts on that... see post from Aug. 25th "The Inflated Asset Economy".

    Regards...and thanks for the kind words.

  7. Asia hasn't robbed us of jobs as much as it's robbed us of income through currency manipulation.

    A highly productive US worker is replaced by several workers in India or China. Total world productivity goes down and so does real income.

    The resulting drag on consumption is offset by Asian financing of US debts. By keeping interest rates low, US consumers are encouraged to accelerate consumption through borrowing.

    The end game is when incomes are no longer able to service those debts. In other words, every willing consumer is leveraged to the hilt.

    The US isn't investing in geo-thermal or alternative energy sources at this point because we know that US households simply can't afford it. Or, to put it another way, switching to more environmentally friendly but higher cost energy sources is an additional drag on productivity and real wages.

  8. great blog!

    'All I can tell you without spoiling the fun is that you will walk away with a much greater appreciation for the challenges of a central banker's job. Lots and lots of humble pie for us backseat monetary policy amateurs.'

    that is a funny is kind of like a serial killer stuck between no space in the back yard for dead bodies and having to eat all the victims. the fed creates their own problems!

    henry ford had to spend massive amounts of money to create profits. the fed and the banks create a raw resource(money/credit) out of thin air. they also dont have to worry about pension benefits!

    it is easy money (for the rich) while it last. what is sad is that poorer groups of people have tried to borrow their way to wealth not realizing the banks 'own' the presses (so the banks have no 'debt') and the gov will bail the banks out. the sheeple are just going to suffer.............

  9. Asia hasn't robbed us of anything - we are robbing ourselves. Imagine what any Asian leader thought when he heard GWB say "go shopping more" in the middle of two wars.

    Why am I thinking of Nero all of a sudden?

  10. What the US creates is still pretty high-margin, high-return on capital stuff. I really wouldn't mind being in a country that ran persistent trade deficits because it 1) imported low-margin stuff (computer hardware), 2) exported high-margin stuff (iPods, search, movies, music, software), and 3) financed the creation of 2) partly with overseas investment -- which we continue to get because the aforementioned activities get a higher rate of return than what's available in the home country.

  11. And if Andrew Keen got it right in "The cult of the amateur", Web 2.0-technologies will gut Hollywood and music industry worldwide.

    But of course, Facebook is worth more than all train manufacturers together, I am afraid.

  12. re: high margin stuff

    I would agree with you if the high margin manufacturing produced goods other than mostly mass-consumerist gizmos whose demand may go "poof" in a persistent recession.

    We are grossly mis-allocating our debt-financed spending. If we went into debt to build solar farms and wind farms or perhaps to massively finance a Manhattan R&D project, I would have no quibble. But then the Chinese would never lend us the money, would they?


  13. Great site Hellasious,

    I came across your site after a visit over at I must say you have some of the most lucid and sublime insight on the web. And I don't say that lightly. I will definitely be linking back to you regularly.

  14. Hellasious, who said Greenspan and Bernanke is not very much responsible for the credit and housing mess??

    It is the duty of FED to regulate the banking industry, and they were on Bush's agenda to BLESS the housing bubble by ignoring Repeated warning about lax lending standards for years.

    Didn't you notice right after Sept 11, Bush met very frequently with Greenspan, and every subsequent speech by Bush STRONGLY advocates Housing as American Dream, and Greenspan lowered the interest rate to way below inflation, and encourage ARM and also put a blind to lax lending standards.

    Coincident??? I said many times before: Bush + Greenspan/Bernanke + Paulson = Financial Axis of Evil

  15. Asia hasn't robbed us of anything - we are robbing ourselves.

    I agree, we've been shooting ourselves in the foot since the original Bretton Woods agreement.

    But, the impact of Asian currency pegs has been to import US inflation. If the Federal Reserve was completely rational, they would have looked at inflation rates across the entire "dollar hegemony" and fixed rates accordingly. But, what they did was only look at US inflation data and kept interest rates too low.

    That is what started the decade's long boom in US asset prices. It only took Americans a couple decades to switch from income based savings (passbook savings account) to asset based savings (401Ks, etc). It only took a couple more decades after that to switch from asset based savings to arbitrage (real-estate, CDOs, LBOs, etc). It's not uncommon today to hear financial planners encouraging households to increase debt levels as a way of maximizing wealth.

    But, what would you suggest the Federal Reserve do? Holding interest rates at "natural" levels would have resulted in full employment in Asia at the expense of under-employment in the US.

    What should the government have done? Reverse decades of trade agreements by imposing tariffs on Asian goods?

    What should have US consumers have done? Save their nickles while the value of the assets they eventually wanted to buy grew at 2-3 times the rate of their pass book savings accounts?

  16. A simpler way of saying it is that the US and Asia constitute a sub-optimal Nash equilibrium.

    Eventually, the game will terminate but until then there is no "more rational" strategy for either party.

  17. My local newspaper (St. Petersburg Times) ran a story today about oil production decline rates in Mexico. Within the article, not only were the heretofore unmentionable words "peak oil" used, but the author posited that we may be there. That's mainstream recognition of a problem previously confined to internet backwaters inhabited by foil hatters living in their mom's basement such as yours truly.

    I would submit that the time to prepare for the coming calamity was ideally in 1976, when Jimmy Carter first suggested driving slower and turning down out thermostats. Having gipperized that opportunity, our next chance came in the 1998-2000 time frame, with WTIC @ around 12 bucks, and the dollar index @ 120.

    Alas, it was not to be. Two oil men, a $70 per barrel bloating, and a 50% slide in Uncle Buck's stature later, here we go. Buckle up, it's gonna suck. Period.

  18. A friend introduced me to your blog, and (not to brag or anything but my professional site really has high traffic) I included your headlines on my home page. That might have generated a few visitors. ;-)

  19. Would it be a surprise to find that, from moreless 1963 until 1983, the rate of profit (not earnings) for nonfinancial U.S. corporate sector was higher than that of the financial sector whereas from 1987-2000 the contrary?

    If so, please see: Figure 9 in THE REAL AND FINANCIAL COMPONENTS OF PROFITABILITY (USA 1948-2000), Gerard DUMENIL and Dominique LEVY, MODEM-CNRS and CEPREMAP-CNRS, 2005

    IMO, the change in each of the two rates may help explain why investment has not moved towards such sectors as alternative energy but has tended towards more strictly financial activities.
    Might also be part of an explanation for the transnationalizing of nominally U.S. production capital as it has sought to maximize profit rate through standard of living and labor arbitrage.

    (For 'some' reason, neoclassic economics became overly fixated on the demand side and the micro, so misses what more hetrodox economists 'see' ...but that's a really long story)

  20. The leverage associated with the reduced bank reserve requirement may be significantly greater than you have described. Beginning some time in the mid-90's, banks are allowed to partition each night, transparent to the account holder, demand deposits (checking accounts) by sweeping those funds into two accounts, one a savings account and one a checking account. This accounting is internal to the bank. The account holder never sees any of this. By this method, banks can effectively further reduce their overnight reserve requirement. Banks can adjust the partition as desired every night. To offset the possibility that the bank sweeps so much into the savings side that checking accounts cannot satisfy withdrawal demands, the bank can require checking account holders to give one week notice before making a withdrawal from the checking account. Read the fine print in the terms of your checking account.

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