James Madison and the Credibility Trap

Justice is the end of government. It is the end of civil society. It ever has been and ever will be pursued until it be obtained, or until liberty be lost in the pursuit. 

But what is government itself, but the greatest of all reflections on human nature? If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself. A dependence on the people is, no doubt, the primary control on the government. 

 
 - James Madison, Federalist No. 51

A group of humans is a system of complex systems (each agent is a complex system of their own) and there are dynamic feedback loops to ensure the system does not disintegrate. Madison refers to these dynamic loops to ensure system integrity when he talks about the primary control on the Government.

Jesse talks about the credibility trap here:

A credibility trap is when the regulatory, political and/or informational functions of a society have been compromised by a corrupting influence and a fraud, so that they cannot address the situation without implicating, at least incidentally, a broad swath of the power structure including themselves. 

I think the checks and balances do not exist to ensure system integrity therefore increasing the risk of a catastrophe.

Open ended QE

The Federal Reserve announced open-ended QE last week, which is unprecedented for any central bank and its implications (positive or negative effects) are not very well understood yet.  Here is the Fed's press release.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month.

The Committee will closely monitor incoming information on economic and financial developments in coming months. If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will, as always, take appropriate account of the likely efficacy and costs of such purchases.

In addition to the ongoing Operation Twist (extending duration of the Fed's portfolio), the Fed has also decided to purchase agency-backed MBS for the tune of $40 billion a month, until the labor market improves. They have not clearly specified the target they are looking at, which is worrisome.

In any event, this press release and the decision making by the Fed is seen as a victory for the Market Monetarists such as David Beckworth, Scott Sumner and a few others. These people have been vocal about the need for the Fed to target NGDP (nominal GDP) and therefore set market expectations that it will do whatever it takes to restore NGDP to trend growth. This, they believe will alter the market psychology (because the Fed is a monetary super power) and therefore boost spending, hiring, wages and the road towards recovery.

But the whole thesis is hinged on one simple assumption: aggregate demand short fall. Is that the real reason behind the economic malaise? What is the root cause if it is not aggregate demand? Is aggregate demand merely a symptom of a system that has taken on too much private debt? Is the system too centralized and therefore prone to fragility? Consider this post by John Aziz.

My theory is this: our depression is not a problem of insufficient demand. It is systemic; most prominently and immediately financial fragility, financial zombification, moral hazard, and excessive private debt, alongside a huge number of other long-term systemic problems.

What if the Fed and the market monetarists are completely wrong? What if all central banks engage in a competitive devaluation strategy and these currency wars precipitate into trade or real wars? Here is Ed Haddas from Reuters:

It is a dangerous way to conduct monetary policy. A large trade surplus may have helped create jobs in China, but the accumulated funds helped finance the asset bubbles which eventually popped, leading to the current global malaise. The Fed’s previous rounds of quantitative easing just might have helped the American economy, but they almost certainly pushed up commodity prices, which stimulated economic and political tension in many poor countries. They also spawned ill will among the central bankers who were forced to deal with collateral damage from the U.S. war against domestic financial disorders.

Analyzing quantitative easing

I am using this post as a vehicle to document the different views on quantitative easing and their relative merits/demerits. The conventional view point is as follows:

GDP = C + I + GS + Net exports

C= Consumption  (private sector)

I = Investment (private sector)

GS= Government Spending (public sector)

Net exports = the difference between total exports and total imports

In order to boost GDP, one should be able to increase any of the 4 factors. It is a well-known fact that households and the private sector are saturated with debt and the deleveraging process has just begun. Therefore consumption cannot be easily boosted if debt levels are elevated.  Even though interest rates remain repressed through QE, the lower interest rates cannot immediately spur further borrowing because this borrowed money cannot be easily serviced when wages are stagnant. Although the Fed's reasoning is that lower interest rates will encourage more consumer spending, it cannot sustain itself because of saturated debt levels.

Investment can be boosted by reducing effective corporate tax rates, but there should be consumption capacity for the investment to take place. When consumption capacity is low, then regardless of the tax rates -- new investments cannot happen. It is a vicious cycle.

The political appetite for government spending determines whether it can be increased. Clearly since 2011, the debate on the US political spectrum has shifted towards the debt ceiling and therefore the political appetite for increasing spending is waning.

This leaves us with net exports. Exports can be increased either by exporting more goods and services or by exporting the same goods and services but devalue the currency. Devaluing the currency has negative consequences as well. US imports are much higher than US exports, therefore the cost increase in imports (since a devalued dollar means US pays more for imports)  could overwhelm the gain in exports and net effect can still continue to be negative. There's quite a bit of non-linearity in all this discussion, so it is important to bear this in mind. Cost of imports may not immediately increase, for example because the dollar inflation is not immediately detected (dollar being the world reserve currency).

James G Rickards, a renowned financial expert explains the above as the Fed's rationale for QE2 and further QE, in his popular book Currency Wars.

There are two other alternative views which I would like to highlight. Professor Fekete writes about the risk-free bond speculation in his article There is no Business like Bond Business, Still. Here's his 2010 article on the same subject. The professor makes a valid point that the primary dealers can front-run the Fed (since the Fed announces when it is going to buy and how much before market opens) and then flip the bonds back to the Fed at a higher price and pocket risk-free profits.

This means that interest rates keep going lower and lower until this game cannot continue.As interest rates keep going lower and lower, it is harder to service the previously acquired debt because the income stream keeps reducing. It is a perverse effect since the Fed is trying to fight deflation, but actually making the pain worse. He compares the current paradigm to an economic resonance with a built-in runaway vibration that can snap the whole system(similar to Tacoma Bridge collapse of 1940). Here's an excerpt from his article titled 'Premature Obituaries (for the dollar)'.

When the energy level of the self-boosting system overwhelms centripetal forces, the system snaps like a broken chain, releasing the surplus energy most destructively. This is the substance of every crack-up boom. Like Mises, I also object to the use of the word hyperinflation, albeit for a different reason. It suggests that the phenomenon is linear and follows the laws of the Quantity Theory of Money. The more money is printed, the higher do prices go. However, we are here facing highly non-linear phenomena. Our economy is torn to pieces by runaway vibration. We are victimized by the self-destruction of the monetary system subjected to oscillating money-flows boosted by the resonance of fluctuating interest rates resonating with fluctuating prices.

The other alternative view that I want to highlight is that of a popular blogger, FOFOA who writes on two topics: a) dollar hyperinflation and b) Freegold monetary theory. In his post Inflation or Hyperinflation, he details how QE is all about managing the unstoppable flow of Treasuries.

The USG today is spending $3.6B more than it is taking in, each and every day. That's a big mess of dollars flooding out of the USG. $1.5B per day is flooding outside of our zone while $2.1B is staying right here on our front lawn. This is all flow. It is ongoing and unstoppable. And it all must be mopped up by someone. And by someone, I mean either the foreign sector, the domestic private sector or the Fed buying up US Treasuries. $3.6B per day, an unstoppable, unending broken water main gushing out dollars. Marginal flow!

Don't be fooled by the misdirection. QE, twist, whatever; it's not about interest rates or helping the economy recover. It's 100% about disguising and managing this uncontrollable, unstoppable mess. It's more like a broken sewer line than a water main now that I think about it.

Sure, the Fed needs to keep interest rates from rising. Because what happens when interest rates rise? The value of the entire $35T bond market starts to collapse and bond holders panic. The Fed doesn't want that, so don't bet on them letting interest rates rise. But as I said, I'm not worried about the stock of dollars. I'm worried about this broken sewer line we call the federal budget deficit which means no one has to sell a single bond. In fact, someone has to continuously buy $3.6B more each and every day, including weekends and holidays.

In another post titled Moneyness, FOFOA writes:

The USG thinks (and truly believes) that the key to rejuvenating the US economy is trashing the dollar as a short cut to increasing exports (reducing the trade deficit). But what it can't see (nor anyone that focuses solely on the monetary plane for adjustment) is that the huge trade deficit the USG wants to quit is actually its own heroin fix. This is a deadly combo for the US dollar.

The key point to take away is that Budget Deficit and Trade deficit are inter-related in the sense that government spending towards goods and services increases our imports, therefore worsening the trade deficit.

To summarize, following are the stated or unstated effects of quantitative easing:

1. Lower interest rates to boost consumer borrowing and spending (Fed's take, but not true in the real world because the transmission mechanism is broken when debt levels are saturated)

2. Increase exports through cheaper dollar, which causes global inflation and boosts US GDP (Rickards's take in his book -- this is supported with some empirical data and real world evidence)

3. Risk-free bond speculation reinforces a feedback loop of lower and lower interest rates leading to capital destruction until the system cannot handle this anymore (Fekete's take -- interest rates are heading lower even though they take a wibbly wobbly path)

4. Manage US Government budget deficit and sustain the US trade deficit amidst political gridlock and unwillingness to raise taxes or cut spending (FOFOA's take -- plausible explanation)

But one aspect is quite clear. QE is a grand experiment where consequences are unknown and there are several negative effects (because of the fact that it is implemented on a complex system with non-linear effects) which are hardly discussed by the Fed.