The Death of Money (11 page)

Federal Reserve policy has also damaged lending to small and
medium-size enterprises (SMEs). This does not trouble the Fed, because it favors the
interests of large banks. Johns Hopkins professor Steve Hanke has recently pointed
out
the reason for this damage to SME lending. SME loans, he argues, are funded by banks
through interbank lending. In effect, Bank A lends money to Bank B in the interbank
market, so that Bank B can fund a loan to a small business. But such lending is unattractive
to banks today because the interbank lending rate is zero due to Fed intervention.
Since banks cannot earn a market return on such interbank lending, they don’t participate
in that market. As a result, liquidity in the interbank lending market is low, and
banks can no longer be confident that they can obtain funds when needed. Banks are
therefore reluctant to expand their SME loan portfolios because of uncertain funding.

The resulting credit crunch for SMEs is one reason unemployment remains stubbornly
high. Big businesses such as Apple and IBM do not need banks to fund growth; they
have no problem funding activities from internal cash resources or the bond markets.
But big business does not create new jobs; the job creation comes largely from small
business. So when the Fed distorts the interbank lending market by keeping rates too
low, it deprives small business of working capital loans and hurts their ability to
fund job creation.

Other unintended consequences of Fed policy are more opaque and insidious. One such
consequence is perilous behavior by banks in search of yield. With interest rates
near zero, financial institutions have a difficult time making sufficient returns
on equity, and they resort to leverage, the use of debt or derivatives, to increase
their returns. Leverage from debt expands a bank’s balance sheet and simultaneously
increases its capital requirements. Therefore financial institutions prefer derivatives
strategies using swaps and options to achieve the targeted returns, since derivatives
are recorded off balance sheet and do not require as much capital as borrowings.

Counterparties to derivatives trades require high-quality collateral such as Treasury
notes to guarantee contractual performance. Often the quality of assets available
for these bank collateral pledges is poor. In these circumstances, the bank that wants
to do the off-balance-sheet transaction will engage in an “asset swap” with an institutional
investor, whereby the bank gives the investor low-rated securities in exchange for
highly rated securities
such as Treasury notes. The bank promises to reverse the transaction at a later date
so the institutional investor can get its Treasury notes back. Once the bank has the
Treasury notes, it can pledge them to the derivatives counterparty as “good collateral”
and enter into the trade, thus earning high returns off balance sheet with scant capital
required. As a result of the asset swap, a two-party trade turns into a three-party
trade, with more promises involved, and a more complex web of reciprocal obligations
involving banks and nonbank investors.

These machinations work as long as markets stay calm and there is no panic to repossess
collateral. But in a liquidity crisis of the kind experienced in 2008, these densely
constructed webs of interlocking obligations quickly freeze up as the demand for “good”
collateral instantaneously exceeds the supply and parties scramble to dump all collateral
at fire-sale prices to raise cash. As a result of the scramble to seize good collateral,
another liquidity-driven panic soon begins, producing tremors in the market.

Asset swaps are just one of many ways financial institutions increase risk in the
search for higher yields in low-interest-rate environments. A definitive study conducted
by the IMF covering the period 1997–2011 showed that
Federal Reserve low-interest-rate policy is consistently associated with greater risk
taking by banks. The IMF study also demonstrated that the longer rates are held low,
the greater the amount of risk taking by the banks. The study concludes that extended
periods of exceptionally low interest rates of the kind the Fed has engineered since
2008 are a recipe for increased systemic risk. By manipulating interest rates to zero,
the Fed encourages this search for yield and all the off-balance-sheet tricks and
asset swaps that go with it. In the course of putting out the fire from the last panic,
the Fed has supplied kindling for an even greater conflagration.

■
The Clouded Crystal Ball

The most alarming consequence of Fed manipulation is the prospect of a stock market
crash playing out over a period of a few months or less. This
could result from Fed policy based on forecasts that are materially wrong. In fact,
the accuracy of Fed forecasts has long been abysmal.

If the Fed underestimates potential growth, then interest rates will be too low, with
inflation and negative real interest rates a likely result. Such conditions hurt capital
formation and, historically, have produced the worst returns for stocks. Conversely,
if the Fed overestimates potential growth, then policy will be too tight, and the
economy will go into recession, which hurts corporate profits and causes stocks to
decline. In other words, forecasting errors in either direction produce policy errors
that will result in a declining stock market. The only condition that is not eventually
bad for stocks is if the Fed’s forecast is highly accurate and its policy is correct—which
unfortunately is the least likely scenario.

Given high expectations for equities, bank interconnectedness, and hidden leverage,
any weakness in stock markets can easily cascade into a market crash.
This is not certain to happen but is likely based on current conditions and past forecasting
errors by the Federal Reserve.

As these illustrations show, the consequences of Federal Reserve market manipulation
extend far beyond policy interest rates. Fed policy punishes savings, investment,
and small business. The resulting unemployment is deflationary, although the Fed is
desperately trying to promote inflation. This nascent deflation strengthens the dollar,
which then weakens the dollar price of gold and other commodities, making the deflation
worse.

Conversely, Fed policies intended to promote inflation in the United States, partly
through exchange rates, make deflation worse in the economies of U.S. trading partners
such as Japan. These trading partners fight back by cheapening their own currencies.
Japan is currently the most prominent example. The Japanese yen crashed 33 percent
against the U.S. dollar in an eight-month stretch from mid-September 2012 to mid-May
2013. The cheap yen was intended to increase inflation in Japan through higher import
prices for energy. But it also hurt Korean exports from companies such as Samsung
and Hyundai that compete with Japanese exports from Sony and Toyota. This caused Korea
to cut interest rates to cheapen its currency, and so on around the world, in a blur
of rate cuts, money printing, imported inflation, and knock-on effects triggered by
Fed manipulation of the world’s reserve currency. The result is not effective policy;
the result is global confusion.

The Federal Reserve defends its market interventions as necessary to overcome market
dysfunctions such as those witnessed in 2008 when liquidity evaporated and confidence
in money market-funds collapsed. Of course, it is also true that the 2008 liquidity
crisis was itself the product of earlier Fed policy blunders starting in 2002. While
the Fed is focused on the intended effects of its policies, it seems to have little
regard for the unintended ones.

■
The Asymmetric Market

In the Fed’s view, the most important part of its program to mitigate fear in markets
is communications policy, also called “forward guidance,” through which the Fed seeks
to amplify easing’s impact by promising it will continue for sustained periods of
time, or until certain unemployment and inflation targets are reached. The policy
debate over forward guidance as an adjunct to market manipulation is a continuation
of one of the most long-standing areas of intellectual inquiry in modern economics.
This inquiry involves imperfect information or information asymmetry: a situation
in which one party has superior information to another that induces suboptimal behavior
by both parties.

This field took flight with a 1970 paper by George Akerlof, “
The Market for ‘Lemons,’” that chose used car sales as an example to make its point.
Akerlof was awarded the Nobel Prize in Economics in 2001 in part for this work. The
seller of a used car, he states, knows perfectly well whether the car runs smoothly
or is of poor quality, a “lemon.” The buyer does not know; hence an information asymmetry
arises between buyer and seller. The unequal information then conditions behavior
in adverse ways. Buyers might assume that all used cars are lemons, otherwise the
sellers would hang on to them. This belief causes buyers to lower the prices they
are willing to pay. Sellers of high-quality used cars might reject the extra-low prices
offered by buyers and refuse to sell. In an extreme case, there might be no market
at all for used cars because buyers and sellers are too far apart on price, even though
there would theoretically be a market-clearing price if both sides to the transaction
knew all the facts.

Used cars are just one illustration of the asymmetric information problem, which can
apply to a vast array of goods and services, including financial transactions. Interestingly,
gold does not suffer this problem because it has a uniform grade. Absent fraud, there
are no “lemons” when it comes to gold bars.

A touchstone for economists since 1970, Akerlof’s work has been applied to numerous
problems. The implications of his analysis are profound. If communication can be improved,
and information asymmetries reduced, markets become more efficient and perform their
price discovery functions more smoothly, reducing costs to consumers.

In 1980 the challenge of analyzing information’s role in efficient markets was picked
up by a twenty-six-year-old economist named Ben S. Bernanke. In a paper called “
Irreversibility, Uncertainty, and Cyclical Investment,” Bernanke addressed the decision-making
process behind an investment, asking how uncertainty regarding future policy and business
conditions impedes such investment. This was a momentous question. Investment is one
of the four fundamental components of GDP, along with consumption, government spending,
and net exports. Of these components, investment may be the most important because
it drives GDP not only when the investment is made, but in future years through a
payoff of improved productivity. Investment in new enterprises can also be a catalyst
for hiring, which can then boost consumption through wage payments from investment
profits. Any impediments to investment will have a deleterious effect on the growth
of the overall economy.

Lack of investment was a large contributor to the duration of the Great Depression.
Scholars from Milton Friedman and Anna Schwartz to Ben Bernanke have identified monetary
policy as a leading cause of the Depression. But far less work has been done on why
the Great Depression lasted so long compared to the relatively brief depression of
1920. Charles Kindleberger correctly identified the cause of the protracted nature
of the Great Depression as
regime uncertainty
. This theory holds that even when market prices have declined sufficiently to attract
investors back into the economy, investors may still refrain because unsteady public
policy makes it impossible to calculate returns with any degree of accuracy. Regime
uncertainty refers to more than just the usual uncertainty of any business caused
by changing consumer preferences, or the
more-or-less efficient execution of a business plan. It refers to the added uncertainty
caused by activist government policy ostensibly designed to improve conditions that
typically makes matters worse.

The publication date of Bernanke’s paper, 1980, is poised in the midst of the three
great periods of regime uncertainty in the past one hundred years: the 1930s, the
1970s, and the 2010s.

In the 1930s this uncertainty was caused by the erratic on-again-off-again nature
of the Hoover-Roosevelt interventionist policies of price controls, price subsidies,
labor laws, gold confiscation, and more, exacerbated by Supreme Court decisions that
supported certain programs and voided others.
Even with huge pools of unused labor and rock-bottom prices, capitalists sat on the
sidelines in the 1930s until the policy uncertainty cloud was lifted by duress during
the Second World War and finally by tax cuts in 1946. It was only when government
got out of the way that the U.S. economy finally escaped the Great Depression.

In the 1970s the U.S. economy was experiencing another episode of extreme regime uncertainty.
This episode lasted ten years, beginning with Nixon’s 1971 wage and price controls
and abandonment of the gold standard, and continuing through Jimmy Carter’s 1980 crude
oil windfall profit tax.

The same malaise afflicts the U.S. economy today due to regime uncertainty caused
by budget battles, health care regulation, tax policy, and environmental regulation.
The issue is not whether each policy choice is intrinsically good or bad. Most investors
can roll with the punches when it comes to bad policy. The core issue is that investors
do not know
which policy will be favored and therefore cannot calculate returns with sufficient
clarity to risk capital.

In his 1980 paper, Bernanke began his analysis by recapitulating
the classic distinction between risk and uncertainty first made by Frank H. Knight
in 1921. In Knight’s parlance,
risk
applies to random outcomes that investors can model with known probabilities, while
uncertainty
applies to random outcomes with unknown probabilities. An investor is typically willing
to confront risk but may be paralyzed in the face of extreme uncertainty. Bernanke’s
contribution was to construct the problem as one of opportunity cost. Investors may
indeed fear uncertainty, but they may also have a fear of inaction, and the costs
of inaction may
exceed the costs of plunging into the unknown. Conversely, the costs of inaction may
be reduced by the benefits of awaiting new information. In Bernanke’s formulation,
“
It will pay to invest . . . when the cost of waiting . . . exceeds the expected gains
from waiting. The expected gain from waiting is the probability that [new] information . . .
will make the investor regret his decision to invest. . . . The motive for waiting
is . . . concern over the possible arrival of unfavorable news.”