A Conversation with Cato the Eldest
Michael Booth’s nom de Net is Cato the Eldest, and until recently he ran a terrific website he called Cato’s Domain. Cato’s is still up, and if you’re curious why he’s no longer updating it, read the last post. Mr. Booth now contributes to Stubborn Things.
For years, Booth worked in the private sector and in academia in the fields of finance and economics. Given his background, I was interested in what old Cato had to say about the following. The questions were submitted by email, and the answers have not been edited by the interviewer.
1. It’s a commonplace that when the Federal Reserve buys assets, such as the U.S. treasuries it purchases in quantitative easing, that it is creating money “out of thin air.” But, when Congress runs deficits and has to borrow money, it is creating assets “out of thin air.” And those assets (U.S. treasuries) must eventually be accounted for with… money. So which is worse, the Fed buying treasuries with the “funny money” it creates, or Congress creating those treasuries (ex nihilo) in the first place?
First, it's impossible to separate macro finance as practiced by central banks and economics as theory from the politics that saturate our age. They are welded together. The politics is progressive beneficial (i.e., democratic) welfare statism. The economics is Keynesianism, which posits a central government large and powerful enough to overwhelm and 'manage' the private economy. The macro finance is monetary intervention using fiat money.
Second, since the modern progressive era began with the failure of the Bretton Woods system in the 1970s, no beneficial welfare state has ever fully funded itself without eventually 'printing money", because deficit spending is the very heart and soul of it. Typically, taxes will rise to the politically possible max, then borrowing until that becomes counterproductive, then devaluation of the national currency, that is, printing money to spawn inflation, which is propagandized as a virtue. Note that welfare states in Europe, taxed and borrowed to the max, that cannot print and devalue the Euro are falling apart.
So, those as givens, the answer to this question is: neither is worse. Deficits and money printing are Siamese twins. Neither could exist without the other. A balanced budget would obviate the need to print money but would rip the guts out of the welfare state, which is why progressives will fight to the death to prevent balanced budgets. And why Euro-socialists are screaming for Draghi's European Central Bank to start printing!
2. With America’s “fractional-reserve banking” system, new money is essentially created every time a commercial bank makes a loan. Should reserve requirements for commercial banks be raised?
Take as givens: 1) that regulators are totally incompetent to foresee financial crises, making regulatory oversight and bureaucratic judgment completely worthless, and 2) that breaking up banks... into small enough pieces that each piece could fail without damaging the economy... would effectively destroy American global financial power. In globalized, international markets size is capacity, and capacity rules.
Those as givens: yes. Banks should be required to boost capitalization. Capitalization should, however, be based on the type of assets and liabilities that bank creates and holds, not some arbitrary percentage of the asset base. Banks that choose to own or trade in volatile instruments like swaps and derivatives should have higher cap rates, up to 100% of the position based on experience and potential loss. Those that hold less volatile and less historically risky assets or trade in smaller, 'tamer' markets should have lower cap rates. This will burden more aggressive banks while not burdening less aggressive ones, regardless of size. Then let banks go where they will and choose to compete in markets as they will. One other thing. It should be made absolutely clear to bank equity and debt holders there will be zero bailouts.
3. In 1933, Congress enacted laws that separated commercial banking from investment banking. In 1999, those separation provisions were repealed. Given what’s happened since -- two major stock market meltdowns, the mortgage crisis, the 2008 financial crisis, and the crummy economy -- the repeal appears to have been a mistake. Should Congress again enact something along the lines of Glass-Steagall?
This question is predicated on the fallacy that complex... or "evil" ... banks are the root causes of stock market meltdowns, recessions etc. I think that predicate is incorrect. If you think "banksters" were the villains, remember that banks are bound up tight by political regulations. If you think banks are rotten you can rationally only blame the politicians who control them.
The root cause of all the mayhem we've seen since well before 1999, back into the late 1960s, is the ascendancy of the trio I detailed in Question #1: Keynesian economics, central bank fiat currency manipulation and the rise of the beneficial welfare state in the US, starting with LBJ's War on Poverty and Great Society.
Out of the deep failings of the welfare state grows the thorny thicket in which we... and Europe and Japan... now find ourselves.
It's worth mentioning that banks were scapegoated in the Great Depression, too. Glass-Steagall was the Dodd-Frank of the 1930s; the politicians way of deflecting blame and public rage. Growing international trade, securitization and globalization of finance rising rapidly in the 1980s killed G-S in a wise, near-unanimous bipartisan vote. By then G-S was clearly doing much more harm than good. Reinstating G-S or anything remotely like it today would be stupidity squared... which is why I consider Dodd-Frank and the Volcker Rule etc to be stupidity squared. Asset-sensitive cap rates, or something similar, is a better way.
4. The Federal Reserve’s main policies over the last six years have been quantitative easing (QE) and zero interest rates (ZIRP), which are aimed at preventing continued deflation of housing and stock market prices. Are these twin policies wise, especially in the long run?
QE in 2009 was a tourniquet to stop fatal blood loss, in my view, and wisely used. ZIRP was the intravenous drip that replaced lost vital fluids and stabilized an economy severely damaged by the total failure of redistributionist "affirmative credit". 2008 could easily have been a self-reinforcing global nightmare, worse than most could possibly imagine. Once the economy was ambulatory by early 2011, however, QE and ZIRP should both have been phased out as quickly as possible.
Everything the Fed has done since late 2010 has been solely aimed either 1) at funding the "transformational" designs of progressives in Congress and the White House or 2) papering over the political fallout of "affirmative credit". The Fed has funded about 40% of federal deficits and bought about $1 Trillion in mortgages, all to cover transfer payments and massive, futile "stimulus" programs, including a mountain of money to rewrite failed mortgages. Create a crisis ... dispense money to ease the crisis... take a bow.
As noted in Question #1, without the Fed printing money to pay for these blowout and in retrospect useless programs they could not have been funded. This is because it's very doubtful private credit markets, given the state of distress of the rest of the developed world, would have been any more willing to fund that much US debt than markets were to fund Italy's or Ireland's or Spain's. Certainly not at the unnaturally low rates the Fed accepted.
So. Short run: the result of a decade of corruption of the mortgage markets made QE and ZIRP necessary. Long run: a total capitulation of the Fed to progressive politics, which has created a paradox for the Fed in 2014, but that is also another story.
5. Since 2008, Congress has borrowed trillions of dollars and the Fed has “printed” trillions. Why isn’t inflation worse than it is?
Inflation has been quiescent for one primary reason. The Fed has 'sterilized' the money it created to purchase Treasuries and mortgages. Technical details aside, the money was "printed", exchanged at the Treasury for bonds, and spent into the economy by the US government. That money... all money in fact, except a very small bit of coin and paper... ends up in commercial banks as deposits. Those banks can either lend it out or stash it at the Fed in the form of excess reserves.
American banks have trillions in excess reserves at the Fed... it went through the economy once, then was sequestered by Fed policy in the commercial banks. It's only money that continuously circulates that impacts inflation. So roughly an amount printed to fund Obama's designs has been safely locked away in the Fed as bank reserves. "Sterilized".
Temporarily. For now. One of the stickiest problems the Fed faces is how exactly to pull all that money out of the economy permanently without selling off $4 Trillion in Treasuries and mortgages, sales that will drive up market interest rates a lot, which in turn will squash a weak recovery. But what happens to inflation if that bottled up tidal wave of money starts leaking into the economy and the Fed can't plug the leak?
6. Which is the greater evil, deflation or inflation?
Inflation and deflation are not understood by most of us. Inflation is not rising prices. Prices rise for lots of good reasons. Inflation is the deliberate debasement of a currency for political reasons by a central bank. It takes more $$'s to buy "the economy" today than it did yesterday. Savings are punished. Yet 2% inflation, 25% devaluation of the $US per decade, is the declared policy of the Federal Reserve and lauded by Keynesians as a wonderful and desirable thing. Why?
Deflation is not falling prices. Prices fall for lots of good reasons. Deflation is the uncontrollable increase in the purchasing power of a currency. That's not the politically correct way you've been conditioned to think about deflation, is it? The value of a currency rises. It takes fewer $$'s to buy "the economy" today than it did yesterday. Savings are rewarded. Yet to a progressive fostering a welfare state deflation is unmitigated evil. Why?
The answer to "Why" in both instances is the same: control. No welfare state can allow its fiat currency to sustain value over decades. Why not?
Look, inflation is not desirable... unless you are committed to a welfare state ideology in which deficit spending and borrowing is unavoidable, and you desperately need to devalue that debt by 25% a decade by printing the currency in which that debt will be repaid. Printing creates inflation. Inflation is a tax, yes. But more importantly it's a means of rolling default on government debt. Therefore, deflation is propagandized as an unmitigated evil by progressive mantra, design, and policy.
I'm not extolling deliberate deflation, which comes with its own set of ills. I'm extolling not making inflation an economic sacrament. Zero as a target, plus or minus 1% over decades, as a policy would 1) destroy the underpinnings of progressive control and 2) make the Federal Reserve the caretaker of the currency instead of its manipulator.
7. It’s been said that the extraordinary measures taken by government in the wake of the 2008 financial crisis saved the nation from a second Great Depression. But that’s a counterfactual; there’s no way to prove it, and we don’t know if there would have been a stronger recovery with different measures. So, were the government’s extraordinary actions the right ones, and if not, what should have been done?
There may well have been better ways to deal with 2008's mess. The best way, of course, would have been to never have politically corrupted the mortgage market to begin with. There was no crash in corporate bonds, was there? Nor in municipals nor in US Treasuries? Only mortgages crashed because only mortgages were used in pursuit of redistributionist "affirmative credit". Given the corroded realities of 2008 as I understand them, the Fed did what it had to.
8. In early 2000, the dot-com bubble began to burst, and it destroyed some $5 trillion in the stock market over the following two and a half years. In 2006, the housing bubble began to burst, wiping out trillions in home equity. And then in 2008 we had the seizing up of the financial sector. What’s the next big bubble coming to America?
If by 'bubble' you mean a system that everyone thinks will grow bigger forever, then one day the realization hits that's not going to be the case and all hell breaks loose, then the next truly big one will be Medicare. Sometime prior to 2025, I'd expect.
THANK YOU, Mr. Cato, for you time and thoughts.
Jon N. Hall is a programmer/analyst from Kansas City.