Submitted by David Stockman – The Contra Corner Blog
The world of Bubble Finance economies created by the Fed and other central banks is fundamentally different than that prevailing under the “Lite Touch” monetary policies which preceded the Greenspan era.
Those essentially reactive and minimally invasive central bank intrusions into the money and capital markets prevailed from the time of the Fed’s 1951 liberation from the US Treasury by the great William McChesney Martin through September 1985. That’s when the US Treasury/White House once again seized control of the Fed’s printing presses and ordered Volcker to trash the dollar via the Plaza Accord. In due course, the White House trashed him, too.
The problem today is that the PhDs running the Fed have an economic model which is a relic of the Lite Touch era. It is not only utterly irrelevant in today’s casino driven system, but is actually tantamount to a blindfold. It causes them to look at a dashboard full of lagging indicators like jobs and GDP components, while ignoring the explosive leading indicators starring them in the face on CNBC.
In a word, the rate of stock buybacks and M&A deals is 100X more important than the monthly jobs print, housing starts or retail sales.
The clueless inhabitants of the Eccles Building do not recognize that they have created a world in which Wall Street supersedes main street; and in which the monetary inflation that eventually brings the business cycle to a halt is soaring financial asset prices, not wage rates and new car prices.
During the Light Touch era recessions were triggered by sharp monetary tightening that caused interest rates to surge. This soon garroted business and household borrowing because credit became too expensive. And this interruption in the credit expansion cycle, in turn, caused spending on business fixed assets and household durables to tumble (e.g. auto and appliances), setting in motion a cascade of recessionary adjustments.
But always and everywhere the pre-recession inflection point was marked by a so-called wage and price spiral resulting from an overheated main street economy. Yellen’s Keynesian professors in the 1960s called this “excess demand”, and they should have known.
Professor James Tobin in particular, Yellen’s PhD advisor, had been the architect of a virulent outbreak of this condition during his tenure in the Kennedy-Johnson White House. He had been a pushy advocate of massive fiscal deficits under the guise of full employment accounting, and then had encouraged Johnson to unmercifully browbeat William McChesney Martin until he relented and monetized LBJ’s massive flow of “guns and butter” red ink.
Indeed, according to some historians Tobin and the White House Keynesians worked LBJ into a fiery rage about Martin’s reluctance to run the printing press, and had him summoned to the President’s Texas ranch for the “treatment”. As one journalist described it,
And in 1965, President Lyndon B. Johnson, who wanted cheap credit to finance the Vietnam War and his Great Society, summoned Fed chairman William McChesney Martin to his Texas ranch. There, after asking other officials to leave the room, Johnson reportedly shoved Martin against the wall as he demanded that the Fed once again hold down interest rates. Martin caved, the Fed printed money, and inflation kept climbing until the early 1980s.
This is to say, free market economies really don’t “overheat” on their own motion. The old fashioned kind of wage and price spirals happened because even Lite Touch central banks did not allow financial markets to fully and continuously clear.
Instead, they tended to sit on the front end of the yield curve too heavily and for too long. This tendency prevented the market from rationing excess demands for loanable funds through a flexible free market interest rate. A rising price for credit, of course, would curtail borrowing and induce additional savings and less spending, thereby preventing the general economy from getting out of balance.
In the era of Light Touch monetary policy, therefore, the Fed caused every recession, including when it accommodated artificial economic booms generated by war spending during Korea and Vietnam. That’s why it was perennially criticized by sound money advocates for being “behind the curve”.
Nevertheless, in attempting to belatedly catch-up the Fed invariably was forced to throw on the monetary brakes, as is was usually described. In due course, the rise of idle labor and industrial capacity would cause product price inflation to cool and union pressure for excessive wage hikes to abate.
At length, the wage-price spiral would settle back to a point low enough relative to the recent past to satisfy the FOMC that it was safe to supply new reserves to the banking system, and thereby restart the process of credit expansion.
The big difference between the relative success of Lite Touch monetary policy during the Martin era prior to LBJ’s 1965 ukase and the disaster of the 1970s under Arthur Burns and William Miller was a matter of degree.
William McChesney Martin had experienced first hand the Fed induced financial boom of the 1920s and the thundering bust of the Great Depression. He was therefore extremely reticent to use the monetary accelerator during expansions and was quick to tap the brakes after the recovery got started.
He did this within months of the 1958 rebound and famously described his moves to raise interest rates and increase stock market margin loan requirements as “taking away the punch bowl just when the party is getting started.”
By contrast, Arthur Burns was a pipe-smoking economist who had pioneered business cycle studies at Columbia University during the 1930s and 1940s, and as fate had would have it, was also Milton Friedman’s PhD advisor.
Unlike Martin, Burns was an arrogant prig who thought he could read the business cycle tea leaves better than Mr. Market. He was also a coward who craved political power, publicity and praise.
An historical ill-wind was blowing, therefore, the day he hitched his star to the power-mad Richard Nixon in the Eisenhower White House, and then rode to power after the 1968 election. But soon after being appointed Fed Chairman in January 1970, he was hauled into the oval office by Tricky Dick’s praetorian guard and told in no uncertain terms that his sole mission at his new berth in the Eccles Building was to generate a rip-roaring economic boom by the time of the 1972 election.
Burns complied with supine enthusiasm. Soon a virulent domestic wage and price spiral was underway compounded by a global commodities boom, including the then shocking surge of oil prices in late 1973. This was all blamed on nefarious political maneuvering by the Saudis and the newly ascendant OPEC cartel, but it was nothing of the kind.
As I documented in detail in The Great Deformation, the Nixon-Burns monetary explosion caused such a huge surge in US imports that it literally absorbed all available capacity to produce oil, copper, soybeans, iron ore, polyethylene, rubber, industrial tallow etc. and manufactured goods throughout the global economy.
It was a massive worldwide demand shock emanating from the Eccles Building on the Potomac. The historical data clearly show how it was transmitted through a booming expansion of US bank credit which, in turn, financed massive artificial demand for capital goods and consumer goods alike.
At length, even the craven Burns had to end the party, throwing on the monetary brakes hard and thereby triggering the deepest recession of the post-war period as of that time. Undoubtedly, his courage quotient had risen sharply after Nixon was Watergated out of office.
Nevertheless, the “stop and go” business cycle pattern of the Lite Touch era of monetary policy was now well established. However, rather than being taken as a warning sign that central bank management of the business cycle was an inherently dubious proposition, the expanding colony of economists on Wall Street and in Washington took the Nixon-Burns disaster as a challenge to do more, not less.
Soon they had equipped themselves with computer based econometric models that aspired to capture and connect all of the moving parts and the entirety of the short-run ebb and flow of the then trillion dollar US economy. Henceforth, Fed policy would avoid the extremes of Burnsian stop and go by equipping the FOMC to forecast the future direction of the macroeconomy and deftly calibrate its policies accordingly.
This was Lite Touch on a mainframe. It was destined to fail but Milton Friedman and his disciples launched an historic detour that eventually led to the Greenspan/Bernanke/Yellen era of Bubble Finance and the resulting crisis of growth, democracy and capitalism which now weighs heavily upon us.
The Friedmanesque detour, in a word, was the massive, continuous and egregious export of US dollar liabilities to the rest of the world after Nixon closed the gold window at Camp David in August 1971. It was that disastrous act—–advocated and vouchsafed to Nixon by Professor Friedman—–of unshackling the Eccles Building from its need to husband the nation’s gold reserves that had unleashed the Nixon/Burns re-election party in 1972.
Had the US honored its Bretton Woods obligations to redeem for gold the huge overhang of unwanted dollars that had built-up abroad owing to the Keynesian policies of the 1960s, and especially due to the dollar trashing policies of Professor Tobin, there would have been a hair-curling Nixon Recession in 1972, and the world would have been spared his reelection and the monetary mayhem which followed.
Indeed, within a few years even Arthur Burns recognized the immense mistake that had been made a Camp David and advocated a return to some version of a fixed exchange rate and gold convertibility anchor on the FOMC. But it wasn’t to be.
By then the Nixon-Ford White House was crawling with Professor Friedman’s disciples, most especially an insufferably pedantic professor of labor relations from the Chicago Business School, George Shultz, who shared Friedman’s naïve view that the Fed could be trusted with an unfettered printing press. That is, that an organ of the state should be put in charge of the most important pricing mechanism in all of capitalism——price discovery in the money and capital markets—-in order to foster capitalist prosperity.
What it actually fostered, however, was the greatest binge of monetary profligacy known to history, and there is a simple indicator that measures it precisely. Namely, the gigantic and continuous current account deficits that emerged after the 1970s—–and which have now cumulated to $8 trillion and counting.
In an anchored system of sound money the above graph could have never happened. The outflow of gold or other reserve assets in response to this borrowing hemorrhage would have stopped the money printers at the Fed short decades ago. And Alan Greenspan would have never discovered the figurative printing press in the basement of the Eccles Building at the time of the October 1987 stock market crash because the latter never would have happened under a regime of sound money and an shackled central bank.
Nor is this merely a historical curiosity. The flip side of the massive US current account deficits has been a reciprocal explosion of central bank balance sheets on a worldwide basis. That’s because foreign central banks—especially those of mercantilist oriented Asian state driven economies and the Persian Gulf oil exports—–were under unrelenting pressure to peg their currencies by purchasing excess dollars and expanding their own money supplies.
Not incidentally, that is exactly what Professor Tobin prescribed to the rest of the world during the 1960s. To wit, if you are accumulating too many unwanted dollars there is a simple solution: Man-up and run your own printing press, thereby sequestering unwanted dollar liabilities on your own balance sheet.
That is exactly what has happened since the mid-1990s and is the reason why the James Tobin version of Keynesian bathtub economics has become such a destructive force.
What it did was obliterate the economic borders on which the entire apparatus of central bank demand management policies are based and made irrelevant the dashboard of lagging economic indicators that our Keynesian school marm so blindly tracks.
Next comes Part 2: The Recession Signs In Plain Sight.