Farther Down The Rabbit Hole: The Long Dark Twilight Of America's Banking Collapse

In his August 15, 2020, press conference, President Trump delivered a glowing assessment of the current state of the United States economy,  spending considerable time crowing about the speed of the current economic "recovery". 

There is just one problem with his economic analysis: it is completely wrong.

In his zeal to both defend his policies and maintain a spirit of optimism for the future, President Trump is relying on certain top-level benchmark indicators while ignoring the far less favorable dynamics taking place underneath. The top level numbers do suggest expansion is occurring, but they overlook the distorting impact of the massive government injections of money into household incomes as well as the ongoing injections of liquidity by the Federal Reserve into financial markets. 

To accurately assess the true state of the economy, we must first unwind these distortions.

Not Only A Lost Decade, But A False Decade

The Nobel Prize-winning economist Milton Friedman once observed that “Underlying most arguments against the free market is a lack of belief in freedom itself.” A great many notable economists from Ludwig von Mises and Friederich Hayak to the progressive (and frequently pandering) Paul Krugman have commented at length on the intersection of economics and politics, and of the correlation between a free society and a free marketplace, culminating in the Friedman quote just cited.

If we are to have a free society, we must have free markets. If we are to have free markets, we must have a free society.

Thus it is when the Federal Reserve's policy statements and forward guidances on interest rates are treated with scorn by financial markets, we should pay attention. When central banks around the world pursue interest rate policies that are demonstrably harmful to the world's banking systems, we should pay attention. When the Federal Reserve appears to talk out of both sides of its institutional mouth, we should pay attention.

We should ask questions. We should seek answers.

What we should not do is trust the media. As has become all too apparent, the media is less interested in informing than it is in entertaining. Narrative has displaced even a biased presentation of facts, and many of the media narratives have been shown to be demonstrably false.

Thus, when I witness the nonsensical statements that have been made by officials of the Federal Reserve, such as Fed Chairman Jay Powell's disingenuous statement recently that the economy "is in a good place" even as the Fed mounted emergency "repo" operations to inject liquidity into financial markets--emergency actions are not my notion of a "good place"--or Atlanta Federal Reserve Bank President Raphael Bostic proclamation the US economy is not headed into a recession, glossing over the aforementioned "emergency" actions by the Fed, the desire to research and answer the question "what the heck is going on here?" becomes overpowering.

In an essay I posted on LinkedIn last year, I argued that the essential question in any analytical framework is "does this make sense?" Any explanation for anything has to make sense or it is of no value. The logic has to be consistent, it has to be complete, and it has to be comprehensible; when it is neither consistent, nor complete, nor comprehensible, the one conclusion we must draw is that more research is needed.

Accordingly, after reading on ZeroHedge and other sites various criticisms of Federal Reserve monetary policy--all of which had compelling arguments behind them--it had become clear that a greater familiarity with the actual data underpinning reports of that policy was needed. While I am no professional economist, I do believe in doing my own research on important matters, and so I set out to perform a bit of research and analysis on my own, using only raw data, independent of any other analysis or report.  This post is the results of that research.

The data sets I used were the historical M1 money supply data downloaded from the Federal Reserve, going back to January 1 1997, the historical monthly CPI numbers from the Bureau of Labor Statistics going back to the same date, and the historical Dow Jones Industrial Average and S&P 500 stock indices, reported monthly and also going back to January 1, 1997.

Those wishing to review my source data may download a file with the data sets gathered together in either Excel format or in CSV format.

The questions in my mind were as follows:

• How did the Federal Reserve find itself confronted with a crisis of liquidity during the month of September, 2019?
• How is it that, after more than a decade of near zero interest rates and "quantitative easing" by the Federal Reserve, inflation has not ever materialized in the US economy (or anywhere else in the world, for that matter)?

I began by focusing on the reported size of the money supply from the Fed, looking at both the M1 and M2 numbers. The M1 money stock figure is that amount of money readily available for spending--physical currency and deposits in various on-demand bank accounts--whereas the M2 figure includes "near money" accounts such as various money market accounts and time deposit instruments. There had been a third figure, the M3, which included an even broader array of money equivalents, but reporting of that figure was discontinued by the Federal Reserve in 2006.

The M1 and M2 charts are fairly mundane and even predictable.

One point that is fascinating about the M2 curve was that there was no dramatic spike up beginning in 2008/2009, when the Federal Reserve instituted quantitative easing policies in response to the 2008 financial crisis. "Quantitative Easing" is broadly defined as an expansion of a central bank's open market operations, which are specifically intended to increase the money supply. There is an upward trend in the the M1 figure, but in moving from the M1 measure to the M2, the increase in money effectively disappears.

In part, this is almost certainly due to more rapid expansion of the M2 money stock vs the M1. Going back to at least 1997, the differential between the two figures is steadily increasing.

If we look at just the M1 in isolation, we do see a significant upward trend beginning in 2009, which is exactly what quantitative easing would produce.

But here is also the first surprise. The official Fed pronouncements on quantitative easing declared the quantitative easing programs to be fully ended on October 29, 2014. Yet the pace of money creation did not show any signs of diminishing until 2017. There is at most a brief pause in 2014-2015, after which the pace of money creation resumed.  This presumably was during a time of gradual tightening by the Federal Reserve. Either the Federal Reserve is greatly misinformed about the impacts of its various operations, or it was greatly deceptive in describing the same.

The initial rationale for quantitative easing was easy enough to understand: with stock markets plummeting and financial markets seizing up, the Federal Reserve wanted to avoid a repeat of the mistakes in an earlier era, when the Federal Reserve allowed the money supply to shrink dramatically following the 1929 stock market crash, producing the deflationary downward spiral known as the Great Depression. Based on that rationale, and based on the behavior of the stock market indices in the wake of the Fed QE policy, quantitative easing certainly appears to have been a success, in that it prevented complete stock market collapse. This, at least is what the performance of the S&P 500 stock index shows.

After giving up all of the gains made between 1997 and 2008, the S&P began climbing steadily starting in 2008, and has largely kept on climbing.

Another curious aspect of the Fed's quantitative easing program was that it failed to produce significant inflation.  As this chart from Trading Economics shows, inflation during the past ten years has only rarely been above 2%, and only briefly below 0% (deflation) during 2008/2009.

source: tradingeconomics.com

The Consumer Price Index--the change in which is the primary benchmark for inflation--shows the same lack of inflation.

In monetarist economic theory--the primary developer of which was Milton Friedman--expanding the money supply ultimately produces inflation, as too many dollars end up chasing too few goods and services. The lack of inflation after 2008 would appear to discredit much of this.

Or did it?

(If you have hung with me this long, I promise this is where we get to the point of this entire post).

If we set the money supply, the CPI, and various stock market indices to a baseline value of 100, thereby eliminating differences in scale and units of measure, we can look at all of the values together. When we do, something interesting and unexpected shows up.

Prior to 2008, CPI and the M1 track very closely together, with only minor and transient deviations. The stock market indices, however, show absolutely no correlation to changes in the money supply.  The stock bubbles of 2000 and 2008 occurred without any dramatic expansion in the M1 money supply.

After 2008, however, the exact opposite is true.  The stock indices move along roughly the same upward slope as the M1 money supply, and the CPI continues on its same roughly linear trajectory completely divorced from the money supply. Only in 2017 do the stock indices show any sign of breaking free from the M1 trajectory.

What do we make of this? How do we explain this?

To my layman's eye, what this is showing is the reason why the Fed's quantitative easing strategies did not produce measurable inflation--the increase in the money stock never filtered out into the broader economy, but was completely soaked up by financial markets. Within financial markets, we see exactly the sort of inflation we would expect to see when the money supply expands.

There is something else that this chart suggests, something which is fairly disturbing. It suggests that much, if not all, of the economic growth posted during Barack Obama's Presidency was merely inflation--that there was no real growth at all. 

This is further suggested if we reset the baseline to January 1 2008:

The deflationary sag in 2008 is of course the consequence of the financial crisis in that year and the onset of the "Great Recession". Yet the deflationary "sag" never really disappears, as both the CPI and the stock indices run below the M1 growth level, and to an increasing degree over time. The influx of dollars into the economy did not produce a corresponding level of inflation even within financial markets. Moreover, if we were to flatten out the M1 chart (i.e., express the money supply in terms of constant dollars), we would see the stock indices as well as the CPI declining.  This would be especially true after the formal end of quantitative easing, where we see the M1 trend line essentially unchanged but the S&P 500 and DJIA lines appear to flatten out for a time

In other words, quantitative easing only served to mask deflation that was triggered by the 2008 financial crisis.

Only in recent years do we see this trend change.  Resetting the baseline to 2016, we see the stock indices finally running above the M1 curve, showing a rise in asset prices in real term, and not just due to the inflationary effects of growth in the money supply.

Real economic growth did not occur in the United States, it seems, until around 2016-2017. The policy of monetary stimulus begun in 2008 almost completely failed to stimulate, in large part because the money created by the Fed never trickled out into the general economy. Rather, it remained bottled up in the financial markets, which is to say it was parked on the balance sheets of the nation's banks--nominally there, but completely idle.

Thus we have a preliminary answer to the questions posed at the beginning. The Federal Reserve found itself facing a liquidity crisis over the past few weeks because the financial markets have been fundamentally illiquid since 2008, with banks essentially sitting on all the new money created. By the same token, quantitative easing never produced core inflation because the money created never made it into the general economy.

This also means that quantitative easing could not have had any material impact on the general economy, and only a muted impact on financial markets. The monetary stimulus of quantitative easing fundamentally failed to stimulate.

Having arrived at that conclusion, the next step was to test the conclusion using an independent metric.  For this I downloaded the reported Real GDP data from the St Louis Federal Reserve for the same time period, January 1, 1997 to the present, and charted it against money supply growth, again using a baseline of January 1, 1997.

Two things at once leap out. First, prior to 2008 there was rough correlation between money supply, inflation, and GDP growth. Second, beginning in 2008, the money supply decoupled from GDP growth. There is no comparison to be made between the two measures after 2008.  Drilling into the GDP and CPI numbers, however, is insightful.  Notice what happens when we set a baseline of January 1, 2008 for both metrics:

For most of the decade since Janaury 1, 2008, the CPI inflation curve is above the real GDP curve. Thus, even while the economy was technically growing, inflation was growing faster, and the economy overall was losing ground to inflation.  Only when we reset the baseline to January 1, 2016, do we see the real GDP curve rising above the CPI.

From January, 2008, until approximately July, 2017, the CPI curve lies above the GDP curve, yielding the same conclusion that a comparison of the money supply and stock indices produces--that there was little to no actual economic expansion under Barack Obama, and it is only during the past two years that the economy has expanded in real terms at all.  All previous GDP "growth" from 2008 onward can be ascribed almost entirely to inflation.

A further note on Real GDP and inflation: the Real GDP data is "real" because it has already been adjusted to account for inflation, using "deflator" factors calculated by the Bureau of Economic Analysis (these deflator factors are similar in concept to CPI but differ in computation). The Real GDP data currently available from the St Louis Fed reports Real GDP in "chained 2012 dollars". 

Yet if Real GDP is already adjusted for inflation, there should be no correlation between Real GDP and the CPI (the benchmark measure for inflation). Real GDP is supposed to reflect economic growth independent of inflation, and independence precludes correlation. We should no more see Real GDP and CPI following similar trend lines from a common base year than we should see stock market indices and the money supply following similar trend lines. Yet we see both. 

These graphs show that, since 2008, there is a strong and persistent correlation between Real GDP and inflation via the CPI. Only very recently do the graphs deviate from each other. If Real GDP fully accounted for inflation, we should see significant variations between the trend lines, and we do not. We see this lack of correlation between 1997 and 2008, but the trend lines converge in 2008.

As the earlier graphs show, when we start from 2008 and 2016, Real GDP and CPI lie on very similar lines, and only in 2017/2018 do we begin to see any significant variation.

Thus, the conclusion from above is confirmed: The monetary stimulus of quantitative easing fundamentally failed to stimulate. It certainly did not stimulate the general economy. Looking at the trend line in GDP growth, very little if anything has had a stimulative effect on the economy. Stimulus would show as fluctuations in the trend line, appearing as the stock market bubbles did in the early 2000's, rising above the money supply only to drop back down again when the bubbles burst. The trend lines on GDP growth have been almost linear since the Great Recession.

Again quoting Milton Friedman, "One of the great mistakes is to judge policies and programs by their intentions rather than their results." The policies of the Federal Reserve might have been well intentioned, but, looking at the data those policies produced, looking at the results, can we truly say those policies have been appropriate, effective, and successful?

No, we cannot.

These data sets tell a story vastly different from what the legacy media has reported, and continues to report. The legacy media argues that, after the "Great Recession", economic growth resumed and has continued on largely the same trajectory under President Trump as under President Obama. However, that assertion ignores the fact that inflation overcame almost all of the economic growth of the Obama years. While CNN crowed that Barack Obama had been one of the "best" Presidents for the stock market, most if not all stock market gains appear to have been the result of the Federal Reserve printing money during his term of office.

Much like Russian Collusion, the Obama Recovery appears to have been a long, drawn-out hoax foisted upon the American people by a corrupted and co-opted legacy media, pushing a particular narrative without regard for what the objective facts themselves indicate. Not only has the United States gone through a demonstrable "lost decade" of economic stagnation from which it has only recently and still briefly emerged, but it has endured a "false decade" of media denials that such stagnation was even occurring. While the legacy media paints a picture of the US economy being rescued from collapse by the bold efforts of then Fed Chairman Benjamin Bernanke and President Obama, the real story is considerably less flattering: given that Ben Bernanke arguably triggered the 2008 financial crisis with a series of interest rate hikes in 2006, his program of "quantitative easing" failed to clean up the economic mess he helped cause, while the best that can be said of Barack Obama is that he did not make things measurably worse.

The real story is that, in many regards, financial markets have truly not recovered from the 2008 financial crisis, and we are seeing the after-effects of that massive correction reverberate more than a decade on. We are seeing financial markets dependent upon constant streams of new liquidity just to function normally day to day.  We are seeing banks still failing "stress tests" that examine how their loan portfolios respond under "worst case" assumptions. We see large banks such as JP Morgan pulling cash out of their balance on deposit with the Fed in response to the Fed taking steps to trim its own very large balance sheet (the more the Fed sheds its portfolio of bonds acquired in the aftermath of 2008, the more cash banks pull out of the reserves on deposit with the Fed), thus triggering the September liquidity crunch.

The real story is that the Federal Reserve, and perhaps all of the world's central banks, have lost what little control over money supplies, interest rates, and financial markets they ever had. 

The real story is that even as the legacy media covers the real story, it continues to bury the lede, and assure the world that all is well.

The real story is that central banks are locked into a perpetual cycle of money creation, and woe betide the currency whose central bank opts to stop the printing presses. 

The real story is that the great unanswered question even now, more than a decade after the 2008 financial crisis, central banks still do not have an answer to the question "what happens when the music stops....again?"

Is the US headed for a repeat of 2008? It is quite possible--and there is no way to know for certain. The financial crisis of 2008 had its origins in the US, but first boiled over in Europe. Perhaps that history will repeat itself. Europe certainly has its share of banking and economic challenges, with the ECB arguably intentionally poisoning European banking systems with negative interest rates, even as Europe slides into recession and a chaotic Brexit looming on the horizon. It hardly requires a degree in economics or finance to envision a global banking crisis originating in Europe and spreading to the rest of the world.

What is certain is that central bank money printing cannot continue indefinitely. There is a limit, beyond which people lose faith in fiat money, where the printing presses simply will not suffice.

What is also certain is that the "too big to fail" big banks are inextricably tied to the Fed's current liquidity problems just as they were tied to the 2008 financial crisis.

And what is also certain is that this story, as with so many other relevant stories, has been and will continue to be underreported and misreported by the legacy media. There will be no crisis acknowledged until the crisis is too big to be avoided.

Evil Taking Root In Europe....Again.

Writer and philosopher George Santayana once pithily warned that "those who cannot remember the past are condemned to repeat it."

With a week of chaotic, contradictory, and occasionally apocalyptic news having gone by, the question arises if the world is approaching a repetition of its recent past--namely, the 2008 "Great Recession." I, for one, do remember that past, having opined on portions of its aftermath, in particular the 2010 Greek debt crisis and subsequent bailout of Greek finances by the European Union and the International Monetary Fund. In particular, I was struck by the hyperfocus that prevailed among "experts" on defending the credibility of the Euro. The single currency was of paramount importance--a conventional wisdom that was questionable at the time, and that was questioned at the time. My own assessment at the time was an exploration of the Biblical admonition that "the love of money is a root of all kinds of evil...."

That I am writing about this topic again is no victory lap, and there is no "I told you so" here. In large measure I misread how Europe would respond to the crisis at the time, believing the stresses being placed upon Greece would eventually rip the European Union asunder. Clearly, that did not happen.

However, I do intend to return to my conclusion at the time:

When at last the money runs out, Europe may find itself so deep in a financial hole that not a single one of the institutions it has built up since WWII will survive intact.  Such is the destruction that comes when the evil that is a love of money and currency takes root on a national scale.

What occasions a return to this failed bit of prognostication is Germany's recent effort to auction some 2 billion euros worth of negative-yield debt. Even before the bond auction there were doubts about the viability of the issue, and it was readily apparent in the aftermath that the auction was a failure, with the Bundesbank being forced to retain some two thirds of the total issue.

As the economy of the EU has steadily weakened over the past year, more and more the European Central Bank, as well as the central banks of the member nations, have increasingly embraced the untested and seemingly counterintuitive notion of "negative interest rates"--where a bank or bond investor literally pays for the privilege of loaning out money. Recently, Danish banks began offering mortgages with a negative interest rate, a move many banks were more or less forced into in order to counter the profit-draining effects of negative yields on other bank assets.

Nor have the European banks been alone in their misfortunes: China has been nationalizing banks of late--three in the past three months, with another 19 banks potentially at or close to the point of insolvency. Even the Federal Reserve is showing signs of vulnerability, openly discussing a new crisis management mechanism whereby they could order banks to increase their reserve cushion should loan losses be anticipated to climb rapidly over the short term.

These banking concerns come amidst a growing list of other warning signals that the global economy is headed into a contractionary phase:

• US mortgage debt recently reached a level higher than just before the 2008 financial crisis, indicating American consumers may be once again overleveraged.
• The Germany economy officially contracted during the second quarter of this year. Two successive quarters of contraction is the technical definition for a recession.
• The Chinese manufacturing sector has been contracting of late, indicating the second largest economy in the world is on the verge of its first recession in decades.
• The yield curves between US 2-year and 10-year debt "inverted", with the 2 year debt having higher yields than the 10-year debt. Intriguingly, the inversion, which has been associated with pending recessions in the past, occurred at the same time jobs data and other economic indicators were positive, suggesting the financial economy of Wall Street is becoming decoupled from the overall economy of Main Street, at least in the United States.
• The illiquid state of sovereign debt markets was laid bare by turmoil in Argentina, where unexpected election returns presage a premature end to austerity and economic recovery measure, imperiling their sovereign debt. Argentine debt is not the only one with a marked imbalance between the number of buyers and the number of sellers, indicating a small and rather anemic secondary market for sovereign debt.
• So parlous is the state of sovereign debt markets that PIMCO, a leading global investor in bonds, began exiting sovereign debt markets, effectively being the first large investor to "run for the exits"--which if it becomes a trend, would spark a fire sale and collapse sovereign debt markets worldwide.

Nor is this the full listing of economic red flags and warning signals. However, even this partial list makes one thing abundantly clear: debt markets are heading into rough territory, and the European markets are on the leading edge. Economic weakness and contraction is sparking concerns over several nations' debts.

Which brings me back to my thoughts of nine years ago on Greece. Then, as now, there was a focus on currency, on how to stimulate the global economy though interest rate cutting--i.e., driving interest rates even further into the negative range--monetary stimulus, and "quantitative easing", where central banks attempt to inject arbitrary inflation into the economy by the electronic equivalent of burning money. Money is occupying the center of the economic stage. Money and currency are where people's concerns appear to chiefly reside.

And the focus on money is not working very well. In fact, the focus on money is not working at all. The "love of money"--for what else should we call this global obsession with the intricacies of money and currency?--is truly the root of a number of evils.

Perhaps the most pernicious evil this love of money has spawned has been an illusion (or delusion) of economic growth and recovery after 2008.  In a very real and substantive way, the world's economies never truly recovered after the 2008 "Great Recession." An inordinate focus on monetary policies and less on the fundamentals of economic activity--the buying and selling of physical goods and services--is a large part of the reason for the lack of substantive recovery. In the wake of the credit crisis that precipitated the Great Recession, the world's leading central banks engaged in wholesale quantitative easing and monetary stimulus in an effort to reflate a rapidly deflating world economy.  These were ostensibly emergency measures, undertaken with the implicit understanding that the banks' respective governments would step in with fiscal stimulus spending programs to shoulder the long term burden of restarting the world's economic engines. That fiscal stimulus never happened, and the central banks have been trapped having to cover the dangerously reckless bets quantitative easing represented. The belief that money could save the world from economic ruin in 2008 has led the world perhaps to the precipice of an even more devastating economic ruin in 2019, or perhaps in 2020.

To add insult to injury, most of the central bankers have always known the risk. They have always been aware they sacrificed their traditional mechanism of monetary stimulus, the manipulation of interest rates, by dropping interest rate to zero and holding them there, instead of following the traditional path of incrementally increasing them over the expansionist phase of the economic cycle, in order to have the buffer for interest rate cuts during the next contractionary phase. The central bankers have always known there would be a next contractionary phase. We know they have known because economist Larry Summers admitted as much this past week in advance of the Federal Reserve's annual symposium at Jackson Hole, Wyoming.

According to Larry Summers, not only have the central bankers failed to "rearm" after the Great Recession, but their dropping of interest rates to zero and quantitative easing programs quite possibly made the underlying economic situation worse rather than better. Not only did too much focus on money catalyze the financial crisis that became the Great Recession, too much faith in money has only made matters worse since then.

If Summers is correct in his analysis, then not only are central bankers powerless to head off the next recession, but they may very well have set the stage for a financial and possibly economic collapse larger than what was experienced during the Great Recession.

What could central bankers have done differently? What should they do differently now? If we take as a point of departure the Biblical admonition against the love of money, where does that leave monetary and fiscal policies when economies contract, or when a financial shock such as the 2008 crisis hits?

One answer would be to focus efforts on encouraging and fostering real economic activity. Economies grow when there is a demand for physical goods and services, and when there are physical goods and services to meet that demand. Indeed, as we are seeing currently, this real economic activity at least in the United States appear to be in more or less rude health, creating jobs and increasing wages. The real economy continues to grow despite the recessionary warning signals being generated in financial markets. The real economy of Main Street is more or less functional, while the financial economy of Wall Street is increasingly dysfunctional, and will remain so until its focus is oriented back towards what the real economy of Main Street.

If we follow that hypothesis, then the productive policy for central banks would have been to maintain a more or less stable supply of money. If there is a useful purpose to the central bank it would be to ensure there money supply remains stable, and thus overall pricing levels remain stable. Indeed, this is the stated role of the Federal Reserve, as I pointed out last December when the Federal Reserve's interest rate hikes precipitated a steep decline in the US stock markets, and the interest rate manipulations of the Federal Reserve are arguably a violation of their own directive, their own raison d'etre. 

Far from worrying about raising interest rates, lowering rates, or providing monetary stimulus or quantitative easing, the European Central Bank and its counterpart in the Bank of England should be committed to maintaining a constant interest rate and a stable money supply, and allow the price discovery mechanism of a functioning free market to direct flows of capital to such industries as were best positioned to use it to expand and increase the production of physical goods and services in order to service demand. Perversely, instead of endless technical convolutions regarding interest rates and their impact on money and prices, the basic "Economics 101" approach is how a central bank might best discharge its duty as chief steward of the money supply. Instead of attempting to fix what they have arguably broken, the central banks of the world should stand back and allow the economies of the world to heal on their own.

This might be what should be done, but it is not what will be done. For all the talk in some corners of the independence of central banks, the unalterable truth is they are as susceptible to political pressures as any other governmental agency. For all their supposed wisdom, central bankers persistently fail to apply the simple wisdom of 1 Timothy; the pressures to act are too great.

Thus I am left to restate my broad conclusion from nine years ago. When at last the money runs out, Europe may find itself so deep in a financial hole that not a single one of the institutions it has built up since WWII will survive intact.  Such is the destruction that comes when the evil that is a love of money and currency takes root on a national scale. 

Whether this is the time for the money to run out at last or not is a tale still to be told. It is possible that Europe will yet muddle through this coming recession and emerge in much the same state that it is now. It is possible that negative interest rates and quantitative easing of the euro will resuscitate the European economies just enough to stave off the recession that now looms large on the continent.

Yet it is also possible that, this time, these efforts will fail. It is possible that the negative interest rates now being pushed across Europe will overwhelm the capacities of European banks to absorb the stress. It is possible that, far from resuscitating the European economies, attempts at monetary stimulus will bring the banking system crashing down in Europe, and trigger not just a recession but a deflationary depression that will last for an untold number of years. It is possible that we shall discover, to our collective horror, that the coming recession is but a continuation of 2008, that much of the presumed "recovery" from then until now has been illusory. 

If that proves to be the case, then the money will run out at last, and what must follow will pierce Europe with many long lasting economic and political sorrows. Such is the outcome when the love of money overrides better natures and better judgments.

The Federal Reserve's Christmas Gift: A Bear Market

Wall Street has little to celebrate this Christmas holiday, courtesy of a recklessly stubborn Federal Reserve. During the previous week, from 17 December to 21 December of 2018, the Dow Jones Industrial Average shed 6.8 percent of its total--the worst such performance since the 2008 "Great Recession." Such has been the turmoil among the major stock exchanges that Treasury Secretary Steve Mnuchin caught many observers by surprise when he called the major US banks on 23 December to address concerns of financial stability and the general availability of credit.

Yet is any of this really so surprising?

Consider a few basic facts:

• The Federal Reserve voted on 19 December to raise interest rates in the face of steep stock market decline. It is the fourth such rate hike in 2018. In response to the rate hike, banks raised their prime lending rates. This is the expected reaction to a rate hike by the Federal Reserve.
• The Dow Jones index began declining on 4 October, one week after the third interest rate hike on 27 September. Major investment firms such as J.P. Morgan attribute the decline to the rate hike, as well as Federal Reserve Chairman Jerome Powell's public remarks surrounding it.
• In 2006, the Federal Reserve hiked interest rates 4 times during the first six months of the year. The markets responded then with a major sell-off, sparking concerns that the June, 2006 rate hike was one increase too many. By 2007, the US housing market bubble had burst, and by 2008 resulting crisis in mortgage default had metastasized into a general financial crisis.

A reasonable question to ask at this juncture is why would interest rate hikes precipitate stock market declines? The immediate answer is simply this: money.

The total supply of money in any economy varies inversely with interest rates. Lowering interest rates expands the money supply, and raising interest rates shrinks the money supply. The Federal Reserve's tweaking of interest rates is quite intentionally an effort to manage the total money supply in the United States. During 2018, Fed Chairman Powell opted four times to shrink the money supply.

When the money supply shrinks, prices are inevitably pushed downward, for when there are fewer dollars in circulation, each dollar has greater purchasing power, all else being equal. Stock markets, where prices fluctuate by the second, display this phenomenon faster than other portions of the economy, where prices are slower to change.

When the money supply shrinks, there are also fewer dollars available to lend--a reduction in the money supply is a reduction in the availability of credit.

Given that Powell's past two interest rate hikes have precipitated a deep and persistent stock market decline, and given that interest rate hikes are by definition a reduction in the availability of credit, is it really so outrageous that Secretary Mnuchin would be concerned about financial stability and credit availability? Is it not more outrageous that Jerome Powell is not concerned about these things? 

Certainly, Powell has a duty to be concerned, because the primary stated mission of the Federal Reserve is to conduct "...the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy." A price drop among stocks of 6.8 percent in a single week is not exactly what one would call price stability.

Yet Powell has been amazingly "tone deaf" to the consequences of Federal Reserve rate hikes. Within the mission of maintaining stable prices, the time to raise interest rates is during periods of significant inflation--something that has been conspicuously absent from the US economy. When there is no inflation, raising interest rates is an action calculated to destabilize prices--by causing them to drop.  Powell has even acknowledged this by his assertion that the economy is "strong enough" to absorb the rate hikes and corresponding money supply and credit reductions. The stock market decline was what he wanted--he unilaterally decided that stocks were "overvalued" and so elected, on his own initiative, to erase a few trillion of market capitalization.

No wonder President Trump would like to fire him--Trump has been clamoring against the rate hikes, correctly predicting that the money supply shrinkage would precipitate a stock market collapse. Market turmoil and declining share prices are not the way to "...promote maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy." By all appearances, Jerome Powell has been seriously derelict in his duty as Federal Reserve Chairman. If he were the Controller or CFO of any major US company, he would have been fired by now.

Sadly, this bit of financial Kabuki has been played out time and again throughout America's history--dereliction is rather the norm at the Federal Reserve.  Pushing interest rates too high too fast catalyzed bursting the 2006 housing bubble, and thus the subsequent 2008 financial crisis--the metastasis of which was itself the product of both government mistake and lax execution of established government regulatory responsibilities.  

Similar errors occurred in 1999 and 2000, when the Federal Reserve raised interest rates in the face of stock market declines, precipitating a recession beginning in March of 2001.

Even the calamitous stock market crash of 1929, widely viewed as the onset of the Great Depression, was triggered by an abrupt change in monetary policy by the New York Federal Reserve Bank, which raised interest rates to 6 percent.

That interest rate hikes catalyze stock market declines and crashes is absolutely established by the constant correlations between them.  One can view this correlation in one of two ways: The Federal Reserve erred by letting the money supply grow too much, causing the stock market to overinflate into a bubble, forcing a correction to be taken, or the Federal Reserve erred by deflating stock prices in the absence of any signs of price inflation in the broader economy.  One theme, however, is consistent--that the stock market declines and subsequent recessions are the consequence of Federal Reserve error.

Which begs the question of why we continue to empower the Federal Reserve to manipulate interest rates and the money supply in this fashion. Invariably, they get it wrong, and because they get it wrong there has there has not been a single decade of American history since the creation of the Federal Reserve in 1913 when there has not been major stock market and economic turmoil. Too much or too little, but never just enough is the basic pattern of Federal Reserve regard for interest rates.

One could even argue that the Federal Reserve's mission is impossible to complete.  Every interest rate adjustment by the Federal Reserve is an intrusion into the marketplace. Every interest rate adjustment is therefore a disequilibrium of the marketplace--and stable prices require equilibrium. The very thing the Federal Reserve does to carry out its assigned task is the very thing that causes it to fail at its assigned task. At the very least, expecting the Federal Reserve to ward off financial crisis by intruding into the markets is quintessentially insane behavior--repeatedly doing the same thing expecting different results.

Instead of constantly fiddling with interest rates and triggering economic upheavals, perhaps the Federal Reserve should adopt a novel approach to maximizing stability--do nothing.

Or is that expecting too much common sense from government bankers?

Evil Taking Root in Europe -- The Next Day

How will the eurozone survive crushing debt?

Yesterday's announcement of a €750 Billion bailout of eurozone sovereign debt was cause for some celebration in the world's bond markets.  That celebration appears to have been short lived, as by the end of the trading day today bank swaps and the LIBOR inter-bank interest rates showed pessimism over the viability of the bailout, while the Japanese yen rose against the euro.

The market place assessment of the bailout has been simply this: "That's fine for today, now what about tomorrow and the day after next year?"  The bailout may have arrested the free-fall of eurozone sovereign debt in the marketplace, but it does nothing to eliminate the burden that debt places on the economies of Europe.

“Markets realized quickly that this crisis won’t be cured by adding liquidity, no matter how big it is,” said Toshihiko Sakai, head of trading for currencies and financial products at Mitsubishi UFJ Trust & Banking Corp. in Tokyo. “The structural problems of the euro zone will persist. I’m not surprised at all the euro is losing strength again.”

Still unanswered are the lingering questions about how successful efforts to trim deficit spending in the eurozone will be--even fiscally prudent Germany's deficit will be in excess of 5% this year, well in excess of the 3% allowed under euro rules.  Nations such as Greece and even the UK are faced with the daunting challenge of growing their economies while drastically slashing government spending, a task that yesterday's bailout mechanism does not even begin to address.

The eurozone is spending the equivalent of $1 Trillion, not to solve their sovereign debt crisis, but to buy (on credit) a little time before they must resolve their sovereign debt crisis.  That does not seem a wise use of increasingly scarce financial resources.  €750 Billion of new debt will not make the existing debt any less troublesome; it will most likely make that debt more troublesome.

The evil taking root in Europe is simply this: to defend a particular bit of money--the euro currency--Europe is prepared to lay waste to its nations' finances and economies.  The marketplace realizes this, and so the euro's downward spiral against other currencies continues despite Europe's spending their very last euro to reverse that course.

Evil Taking Root in Europe

The Euro is under duress from a slew of unforced errors.

Recently, I speculated on the practical wisdom contained in the Bible verse "For the love of money is a root of all kinds of evil....." Since then, events in Europe have illuminated the Biblical warnings about an inordinate focus upon money, as the $146 Billion bailout of Greece announced on 3 May 2010 failed to soothe global bond markets, resulting in a pan-European debt crisis:

Yields on German two-year debt reached a record low, falling to 0.71pc on safe-haven demand in echoes of credit stress at the height of the financial crisis. This is below the European Central Bank's short-term rate of 1pc. "This is very unusual and indicates concern about systemic risk from sovereign debt," said Stephen Lewis from Monument Securities.

The response of European finance ministers has been to blame the bond markets themselves, laying the need for a fresh bailout of the Euro currency itself squarely on the bond markets:

“In the night, when the markets are opening, we cannot afford a disappointment,” said Finance Minister Anders Borg of Sweden, one of 11 EU nations not in the euro. “We now see herd behavior in the markets that are really pack behavior, wolfpack behavior.”

The solution to the Euro crisis?  Pile on still more money--this time on a scale to rival the US Treasury's TARP program in 2008:

European policy makers unveiled an unprecedented loan package worth nearly $1 trillion and a program of securities purchases as they spearheaded a drive to stop a sovereign-debt crisis that threatened to shatter confidence in the euro.  Jolted into action by last week’s slide in the currency to a 14-month low and soaring bond yields in Portugal and Spain, governments of the 16 euro nations agreed to make loans of as much as 750 billion euros ($962 billion) available to countries under attack from speculators.

Is that really a solution, when every nation in Europe has external debt in excess of one hundred percent of GDP?

• Greece' external debt is 170% of GDP
• Italy's external debt is 147% of GDP
• Germany's external debt is 182% of GDP

European nations are all highly leveraged--far more so than the United States is (external debt is 96% of GDP)--which begs the question of from where do the EU countries presume to get these billions of euros?

Further, how does the creation of still more debt by nations already drowning in debt lend strength and credibility to the euro?  This latest rescue package is still little more than a series of preferential loans to distressed nations--cheaper than what those nations could borrow on the open market, but borrowing nevertheless.  This past week's currency crisis is a debt crisis on steroids, and the European Union's solution is to just borrow more, albeit at more "friendly" rates.  Given that the debt crisis is predicated upon the grave doubt that Greece and other nations will be able to pay off their external debts, further borrowing does not deliver any new assurance that the new debt will be easier to repay than the old debt.

Finally, the bailout mechanism is laden with its own potential instabilities, for it empowers the European Union to reach deeper into the governance of member states than any ratified treaty envisions:

"It is an absolute general mobilization: we have decided to give the eurozone a veritable economic government," said French president Nicolas Sarkozy, once again basking as Europe's action man. "Today we have an attack on the whole of the eurozone. This is a systemic crisis: the response must be systemic. When the markets open on Monday morning we will be ready to defend the euro." 

In the space of a weekend, the EU has determined to arrogate to itself powers well in excess of those contained within the Lisbon Treaty:

But if the early reports are near true, the accord profoundly alters the character of the European Union. The walls of fiscal and economic sovereignty are being breached. The creation of an EU rescue mechanism with powers to issue bonds with Europe's AAA rating to help eurozone states in trouble -- apparently €60bn, with a separate facility that may be able to lever up to €600bn -- is to go far beyond the Lisbon Treaty. This new agency is an EU Treasury in all but name, managing an EU fiscal union where liabilities become shared. A European state is being created before our eyes.

Perhaps this is an inevitable evolution, but it is worth noting that the United States Constitution was hammered out over a summer in 1787, and that the Constitutional Convention was only called after some years of ineffective central government under the Articles of Confederation; similarly, the Treaty of Lisbon--analogous in many ways to the US Constitution--took the better part of a year to craft.  Is zealous defense of a particular currency sufficient impetus to accomplish in a weekend what otherwise would (and, arguably, should) take far longer?

Very likely, the answer will turn out to be "No."  Already, there are consequences to the bailout strategy which reach beyond Athens and Brussels, and even Berlin.  Regional elections in Germany have produced a rejection of German Chancellor Angela Merkel's acceptance of a Euro-centric response to the ongoing financial crisis and with it her control of the Bundesrat, the upper house of the German parliament.

According to a poll on Saturday, 21 % of voters said their decision would be influenced by the bailout.

And the next day they voted the regional coalition of Mrs Merkel's Christian-Democrats (CDU) and their liberal Free Democrat allies (FDP) out of office.

Such are the "sorrows" generated by making currency--money--the center of everyone's attention.  Such are the "sorrows" cautioned against by the Apostle Paul in his letter to Timothy.

The nations of Europe have lived beyond their means for many years--Greece in particular although not exclusively.  For years they have consoled themselves with a conceit that a common currency meant money would always be in abundance.  For years they have ignored the fundamental economic nature of money:

It's time to get back to basic economics. Money--both the paper and electronic varieties--is, in and of itself, worth nothing; it has no intrinsic value. It is a means--and a profoundly important one--of enabling people to more easily conduct transactions without having to go through the clumsy and utterly inefficient barter process.

What the governments of Europe refuse to acknowledge is that the current debt crisis within the Eurozone is not "wolfpack behavior" but a vote of no-confidence by bond markets in those governments' fiscal policies.  There is no denying that is the fiscal policies of European nations that have brought them to this point--the decision to run a deficit is a fiscal decision, after all--and therefore it will be within the realm of fiscal policy that ultimate resolution to the debt crisis will be found.  

This, of course, is the crux of the problem, for no nation wants to take on the hard choices necessary to bring their debts under control.  As Bill Fleckenstein observed in his "Contrarian Chronicles" column:

The ending is not clear, but here's something that is: There's virtually no chance that the Greeks (who have defaulted on debt often in the past) will be willing to adhere to austerity measures just so they can use a colored piece of paper -- the euro. Especially since government workers, the folks who would probably have to give up the most, are the most entrenched.

 Nor is a nation such as Great Britain any more amenable to such policies:

Mervyn King is warning that the victor in next week's election will be forced into austerity measures that will keep the party out of power for a generation, according to the US economist David Hale.

Instead of tackling these issues head-on, the nations of Europe have opted to merely shovel more money on top of the pile, digging themselves deeper into a financial hole, in hope that stabilizing the euro will make all these distasteful duties disappear.

When at last the money runs out, Europe may find itself so deep in a financial hole that not a single one of the institutions it has built up since WWII will survive intact.  Such is the destruction that comes when the evil that is a love of money and currency takes root on a national scale.