[Editor’s note: Below find, as attributed, an open letter to the Fed by Harley Bassman. But first, I’m going to deliver a lengthy preamble.]
As regular readers will doubtlessly note, Harley makes a few assertions that are incongruous with my own take on what is and isn’t possible with regard to modern federal government finance in advanced economies with sufficient monetary sovereignty.
For example, Harley asks, “Why should there be poor people if it is possible to create wealth and offer it to all citizens?” I would posit a simple answer: Because, historically, humans have lived in hierarchical societies, and those at the top of the hierarchy are keen to preserve the system by any means necessary, with myths about the limits of public finance being one of the gentler mechanisms available to the privileged. The upper-middle class, the rich and the truly wealthy (and I distinguish between being “merely rich” and “truly wealthy”) are often “generous” in their philanthropic endeavors, but it’s within the context of a social pyramid atop which they sit.
Additionally, “Why should there be poor people?” is a different question from “Why shouldn’t everyone be rich?” Plenty of people argue that no one should be truly poor in rich nations. Indeed, being openly hostile to the goal of eradicating poverty is political suicide unless you work towards adopting laws aimed at disenfranchising the poor. By contrast, it’s impossible to argue that everyone should be rich. Even proponents of radical economic redistribution don’t suggest that the best way to achieve an egalitarian society is to send everyone a check for $10 million. If everyone is rich, no one is rich. That’s true by definition, but even if it weren’t a tautology, it would be true virtually overnight because while we clearly don’t know what the upper limit is when it comes to handing out free money and stoking hyperinflation, we can be almost certain that it’s lower than $10 million per person. Everyone can’t be rich. But a society where no one is poor can still be arranged in a hierarchy. The absence of poverty doesn’t rule out rich people.
Bassman also asks, rhetorically, “If it were possible for the Sovereign to create the coin of the realm at a pace faster than the growth of the economy, wouldn’t there be a record of that happening successfully before?” I’d suggest that’s an oversimplification of the debate.
The history of money and federal government finance spans everything from simple barley money to precious metals-based systems tweaked (i.e., devalued by way of purity dilution) to meet the needs of the moment to outright pyramid schemes. It is, I’d argue, simply impossible to make definitive statements about the relationship of monetary aggregates and economic output that are universally applicable across all of history dating back to the organization of large societies.
It’s unrealistic, for example, to suggest that societies for which writing and record-keeping counted as new innovations would have a means by which to precisely quantify the rate of economic expansion and compare it to some monetary aggregate. In societies where the the Sovereign’s power radiated out like heat from the sun (strongest nearest the seat of power and fading according to the geographical distance from it), the task of tabulating “national” aggregates with anything like precision was impossible. And because some technically subjugated peoples at the edges of the realm (or occupying the periphery) lacked access to (or even familiarity with) the Sovereign coin, multiple means of exchange were used out of necessity. In those situations, any concept of the “money supply” would have been a very vague one.
Although I generally believe the contours of the “possible” should be sketched more broadly than Harley apparently does, Bassman’s claim to expertise in the other subjects he addresses isn’t up for debate. That being the case, I think the following is well worth a read, and I’m grateful for the opportunity to republish it for my readers.
Open Letter To The Fed
By Harley Bassman
In 1986 Herbert Stein, a University of Chicago economist and one time Chairman of the President’s Council of Economic Advisors, modestly proposed Stein’s Law:
“If something cannot go on forever, it will stop”
As such, with similar modesty, let me propose a few ways for the Fed to “trim the sails” of their monetary support programs before another “Chuck Prince moment” arrives with a deafening silence.
As a reminder, we have a massive debt problem in the US, both public and private; and there are only two paths out of such a situation, either default or inflate, where inflation is simply a slow-motion default.
Thus, the Fed’s program of Quantitative Easing (QE) was well-intentioned, and in fact it did create inflation; such a pity this inflation occurred in asset prices instead of Service (Labor) wages as intended.
Clever quants will say that a statistically significant mathematical correlation does not exist between money creation and financial asset prices; but who are you going to believe, them or your lying eyes?
Below the –lingcod line– is the balance sheet assets of the major Western Central Banks, while the -chili pepper line- is the value of their Global financial markets.
Perhaps on a week-to-week basis asset prices do not move synchronously with the production of fiat currency, but $20 Trillion of money must reside someplace, and with the magic of financial leverage it is quite clear where.
Similarly, while I cannot show a formula that links concentrated wealth creation to significant political unrest, once again I will let your lying eyes consider the -broccoli line- and the -cabbage line- on the chart.
The -saffron line- below was a projection for the growth of the Fed’s balance sheet relative to US GDP; hat tip to Bank of America as the balance sheet presently tops out at $8.24Tn versus a GDP of $22.79Tn, or 35.2%.
At some point, simple common sense must be a viable consideration. After all, if it were possible for the Sovereign to create the coin of the realm (fiat currency) at a pace faster than the growth of the economy, wouldn’t there be a record of that happening successfully before? Why should there be poor people if it is possible to create wealth and offer it to all citizens? It must stop eventually. For better or worse, financial markets are now tightly linked to FED policies, and specifically balance sheet growth that:
- Funds non-investment Fiscal policies
- Controls interest rates
- Suppresses both realized and implied Volatility
Consequently, the notion of a cold turkey reduction of financial support would likely cause a disruption, which while perhaps beneficial over the long-term, would cause too much suffering for both our citizens and policymakers.
As such, let me offer a few ways to improve FED policies without inducing an opioid-like withdrawal.
Reduce Mortgage-backed Security (MBS) purchases
Presently the FED targets buying $120bn a month in bonds; $80bn in USTreasuries and $40bn in MBS. This MBS purchase is too large relative to the size of the market and the appetite for such securities from private investors.
The best single measure of MBS value is the -rhubarb line- yield spread between the par Constant Maturity Mortgage rate (CMM) and the Constant Maturity 10yr Swap rate (10CMS).
The “forever” average is about 72bps; compare this the current 41bps.
Contraction of this spread implicitly leads to lower mortgage rates, which seems like a nice idea, until it is not. It was reported that the year-over-year median national home price has risen by 23.4%; this has pushed -walnut line- home prices out of reach for many current renters.
The reality is that nobody “buys a house”, rather they agree to a thirty-year payment stream that is within their budget. If someone can afford to pay $1800 per month for a home loan, the size of the mortgage they can take out is then limited by the interest rate on that loan.
Pencil to paper, if a Millennial couple can afford a median priced home at $363,300 when mortgage rates are at 2.50%, they could only afford a $319,600 home if mortgage rates rose to 3.50%.
MBS rates have declined by over 150bps since 2017/18, this has likely been the primary driver of the recent increase in home prices.
As the Millennial demographic enters the household formation sweet spot, artificially elevating home prices is not a public policy benefit. In fact, it is a public policy dyspeptic that only adds to wealth disparity.
Reduce the purchase of TIPs
Long time readers know I have never been a fan of USTreasury Inflation Protected securities, if only because I believe CPI is a manufactured number that is constructed to bias reported inflation to a lower level.
There are a few sneaky metrics employed, perhaps the most impactful is the use of -edamame line– “owner’s equivalent rent” instead of -cranberry line- actual home prices to conjure up the cost of housing, the largest input into CPI.
While the FED cannot resolve that issue, they can redirect their purchase of TIPs to shorter-term UST bills and notes.
For reasons that are unclear, the FED altered their purchase metrics such that their ownership of -damson line- TIPs has increased from 10% to nearly 25%.
In fact, the FED is now -concord line- purchasing more TIPs than are being -carrot line- net issued.
The harm here is clearly not to the owners of TIPs, who have benefited greatly; and in fact, not much harm has been done to anyone except the FED that owns a nominally negative yielding security.
Rather the problem is the distortion of information, both to the policy makers and investors. The TIPs market is totally dysfunctional as their market price offers little useful information about market sentiment for distant inflation.
While I shed few tears for speculative Hedge Funds, exactly how can the FED make policy when they have no useful feedback on inflationary expectations ?
Buy fewer long-term securities
The single best indicator for a recession has always been the shape of the Yield Curve, often measured as the difference in yield between the three-month rate and the ten-year rate.
To the extent the FED is holding down long-term rates via excessive purchases of long-term bonds, this important information is being withheld from, or worse distorted to, both investors and policy makers.
Over the past few months, the Yield Curve has flattened by nearly 50bps; the quandary is whether this is due to FED purchases, or market concerns that the COVID Delta variant might send the economy back into a recession.
Once upon a time there was the notion of “facts”, another concept the FED cannot fix. However, to the extent FED policy disfigures the market, nobody can have confidence in the financial facts offered by market prices.
Encourage a steeper Yield Curve
I will not offer yet another chart that describes how the US has migrated from a manufacturing economy to one supported by financial activity; but rather note the plumbing of this system is managed by our Too Big To Fail (TBTF) banks.
This is the raison d’etre for Dodd-Frank; while retribution for the Great Financial Crisis (GFC) may feel good, in fact we need to keep these plumbers solvent to prevent an even greater catastrophe.
[Those of a certain age will recall the somewhat bothersome story of Werner von Braun; we swallowed hard since Plan B would have been a lot worse.]
A steeper Yield Curve supports the plumbing of our financial system. While increasing profits for TBTF banks will garner few cheers, increased revenue for the overall banking system builds a capital cushion to expand lending and reduce systemic risk. Moreover, a stronger capital base will enable banks to keep functioning when the QE money spigot is eventually shut.
Higher long-term interest rates improve the health of our pension and insurance systems, both public and private.
The first quarter rate rise helped close the “funding gap” for the 100 largest Corporate Defined Benefit plans by nearly 8 percentage points.
Just as important is the financial health of our insurance industry. To the extent insurance products become unaffordable, the Government will have to pick up the tab. It is a public policy benefit for private citizens to purchase long-term health care from a private insurance company rather that rely upon Medicare.
The market is well-aware of the relationship between long-term interest rates and the profitability of large insurance companies. Below, the -jamun line- is the UST 30yr rate while the -kale line- is the price of AIG stock.
The FEDs policy of low interest rates has transferred money from savers (civilians) to borrowers (corporations). A steeper curve will rejigger this profile; and be especially helpful to the expanding retirement demographic. It is a public policy benefit for corporate borrowers to enhance retirement income via higher interest rates, and thus reduce the need for Government assistance.
Shorten “Forward Guidance” to reduce Moral Hazard
While a bit hyperbolic, there is a reason the VIX is known as the “Fear Index”.
What is anomalous is its current reading near 17, well under its long-term average. While my summer in Quogue is indeed rather peaceful, how can one not be twitching with CPI printing a 5%-handle, COVID running rampant, and our political class is unsupervised while playing with sharp tools.
The MOVE Index of Implied Volatility for interest rates is low relative to the shape of the Yield Curve, as well as relative to history.
Similarly, either driven by a desperate need for income, or an over reliance upon the so called “Powell Put”, bonds at the bottom of the capital structure do not even return a positive real yield (the return after inflation).
Closing…
As offered in “Lurking at the Scene” – March 16, 2021, I am loath to use the word “always”, but over the course of my professional career, there always seems to be a concentration of short Convexity positioning at the core of extreme market turbulence.
If you own any bond asset that is not a US Treasury, you are short Convexity. Moreover, via bond math I will not detail here, the lower the level of Implied Volatility, the greater the mathematical Convexity (gamma). Similarly, the lower the Yield of such assets, the greater the (negative) Convexity.
The FED has motives for reducing interest rates and suppressing Volatility, but let’s be clear, they are also increasing the Convexity risk. This is what underpins the notion that the FED is creating a coiled spring that will eventually be a trap.
I am not predicting a crash, nor the immediate end of civilization, I will let the bloviating talking heads earn their salaries.
Rather I think the current $120bn a month is fine for now, but a swift rejiggering of that mix would do a lot to signal investors to moderate their risk profiles.
Remember: For most investments, sizing is more important than entry level.
Harley S. Bassman July 26, 2021
Thanks for sharing this H! I largely agree with his suggestions, home values are bubbled and savers are basically being punished for their fiscal responsibility. Both of those need to be corrected. However, I’m still not a believer in this continuation of leverage we seem to be determined to leave with the TBTF banks. Again, these banks destroyed half of American’s wealth in the last collapse and paid exactly zero price for their misdeeds. Why in the world don’t we create a direct lending facility from the FED to small business? This would create competition that could force banks out of their predatory lending practices (Looking at you Wells Fargo), reduce the occurrence of red lining racist lending practices, and potentially demonstrate how eliminating the middle man (banks) could actually transfer wealth from the 1% to lower classes. I feel like this should have been priority #1 in 2009 and all we continue to see is the current model only benefiting banks no matter what happens in the economy.
Agreed Dameworth. What often gets lost in the conversation is that we actually have institutions that are TBTF. This moral hazard would cause ANY institution to take on more risk with the knowledge that Uncle Fed is there to fix things when that ‘can’t fail’ trade doesn’t work as planned.
Bassman’s take that these institutions need to be taken care of smacks of a man preaching to his own (top 1%) choir. When banks aren’t lending but use excess funds to increase dividends and buy back stock, the system is broken.
Elizabeth Warren, etc. are correct, bring back Glass-Steagal (or a modern equivalent) and when risk management isn’t employed by a company, let that entity fail. I am sure the depositor bank down the street will be just fine. Under the current situation, we have no such assurance.
Central Bank and their Apologists have finally shifted their discourse from “it was the only way” to “we had no clue what we were doing and we still don’t”. These bureaucrats with the “Maestro” Alan Greenspan at the helm, have now corrupted the financial system to a point were true price discovery is now seen as undesirable due to the short-term pain we’d all have to endure, perpetuating their position at the core of our system.
Principal-agent problem at its finest.
Bassman offers a reasonable transition but let’s not kid ourselves, Central Bankers have absolutely no incentive to apply ideas such as his. If they did, it would expose the caricature CB’s as institutions have become after Paul Volcker.
There was never (and can never) be “true price discovery.” There’s nothing to “discover.” Stocks, bonds, etc. have no “natural” prices. We made them up. Their prices are what we say they are. They cease to exist the moment humans disappear. Central banks, hedge funds, institutions, SWFs, retail investors and everyday people are ultimately playing the same game. We’re manipulating the price of things that aren’t real.
The vast majority of people who argue for a “grand reset” in which the system is allowed to purge all misallocated capital are prepared for no such thing. Here’s a handy rule of thumb: If you currently have a reliable internet connection, clean running water, electricity and the luxury of spending your days debating the merits of a “grand reset” scenario with other, similarly fortunate people from an expensive computer or smartphone, chances are you’d be among the first to starve in the very scenario you ostensibly want to see play out.
Don’t forget that.
Never in history has there ever been a non-price sensitive marginal buyer of financial assets as current CB’s.
Financial assets prices are a function of the price of money, which was also part of the price discovery paradigm. Once this process is corrupted, everything else in markets becomes infected.
Prices are real as they define a line were agents can or cannot participate in a market. IE an olive producer takes the price as a signal to keep producing or not and impacts his capital allocation decisions, as limited in options as they might be.
As I pointed out, I’m not calling for an Austrian reset and neither is Bassman since I’m sure we’re both aware of the consequences. The fact is CBs have created this problem and have no incentives to solve it.
“The fact is CBs have created this problem and have no incentives to solve it.” In fact, just the opposite is true; they have important reasons not to solve the problem.
“Never in history has there ever been a non-price sensitive marginal buyer of financial assets”
Yes, there has.
You caveat that with “as current CB’s” so that you have plausible deniability. And that’s fine. I’d do that too.
But the fact is, virtually every comment you’ve ever posted here is either a criticism of central banks or else some pseudo-prediction about the deleterious side effects of anything besides a kind of classical, orthodox, straight-out-of-a-textbook view of government finances and markets. That’s no longer a viable lens.
The most interesting point is near the end which links the price of convexity to yield/volatility levels. You might throw in the idea that its all a big carry trade linked to yields and low volatility. It works until it does not. But the key point is you have maximum exposure toward the end of the cycle when volatility is low, convexity is highest, and positioning is most over its skis. I am not here to tell you where we are on that timeline, but it is not the beginning.
I think the question you have to ask is basically… exposure to what? I mean yes the easy quick answer is losses… but what realistically happens then? Do we all the sudden enter an era where the fed doesn’t monetize those losses to bail out institutions? Do people continue to panic sell when they realizes the carry trade is enforced at the point of a printing press? I mean look at the Pandemic… what worse event overcomes the CB capability to print?
I think the bigger risks are not so much the financial as the actual physical capabilities of the system. Supply chain is going to struggle as pricing and availability of raw and value add materials becomes unstable.
What if the risk is not that the spring snaps shut like a trap but that it becomes a straight piece of steel bar incapable of dampening oscillations? What if your 401k says you’re a millionaire but you can’t get critical supplies when you need them because the economy no longer cares about engaging in meaningful value production. You could call it inflation but in that scenario the higher prices would encourage investment. When things are too transient there’s no capability to build new capacity before prices fall again due to demand contraction as people give up on consumption. If Inflation is trying to drive up a hill and burning more fuel than usual and deflation is going down a hill burning less fuel then our injectors and air filter are clogged and our timing chain has slipped, put more gas in the tank or try to accelerate harder and it isn’t going to fix the problem, we need to do some major policy maintenance instead of just raising or lowering rates or running QE or tapering.
Thanks for this perspective!
“You might throw in the idea that it’s all a big carry trade linked to yields and low volatility”
That is most assuredly true.
Yellen had the best take when she was running the FOMC. She stated and I am approximating something like this, “we are shrinking the balance sheet but it will be so slow it will be like watching paint dry”. The FOMC needs to do the same thing with Q/E. So a statement like, “we are going to begin to step away from buying government and agency debt in 3 months-it will be a gradual adjustment and so slow that you will hardly notice it”. I also do not think it is necessary to skew stepping away from agency debt. In fact if my reading is correct, the market has already factored that partially in and spreads have started to widen vs. comparable UST bonds. It may take them 12-18 months once it starts to unwind balance sheet growth. It may take another 6 months after that to raise short term borrowing rates. The more boring the better. We should be far more concerned about fiscal policy, particularly how and where funds are directed to- and how our tax rates and rules are changed. There is a crying need for a better safety net for our citizens, and there is a lot of infrastructure to make the economy more efficient and resilient that needs to be spent. The FOMC is a bit of a side show compared to that.
I learn so much from this site — i.e., H. and the many smart commenters who contribute on a regular basis. Like: Vlad’s allusion to Minsky’s work (“It works until it does not”), calh0025’s suggestion that the macro economy is not the same as a music engineer’s board where faders can be moved up and down at a whim to produce the desired effect, and Ria’s always sensible (to me) prescriptions for getting us out of this mess.
H-Man, it would seem that Harley is simply suggesting that it is time for “Last Call” and see what happens when the bar reopens the next day. By postponing “Last Call” everyone drinks into the wee hours turning a bad headache into a nasty pounder.
At least here we appreciate the great observations and then we must form our own conclusions. In markets something can be true but not all the time. It’s okay to observe deviation from the mean, but that doesn’t guarantee reversion. Early on, I was told today’s price is tomorrow’s headline. I keep repeating that on this site because I I think it’s true and important. I admire people who strive to fly the plan, but are quick to admit they are wrong. I think this stuff is addicting, and if you don’t feel that way, perhaps a longer Buffett type of time horizon is in order….Let;s not forget the Fidelity study where the best long tem performance was where the client had died, and no action was taken for a long time….