Anatomy of a Market Meltdown

0:00Okay, I might mention that the title was suggested to me by the conference organizers. I hope the talk lives up to the title, but I also say if you don't find the talk particularly uplifting, then you want to blame the organizers and not me. We're talking about a meltdown here. But I talk about these same sorts of things in class. And in fact, I tell my class that if they sign up for my course in macroeconomics, they'll get a balanced view. That is one view from me and another view on the network news when they hear from the administration officials, okay? Things aren't quite as rosy as the officials would lead you to believe. The anatomy of a market breakdown. I do teach macroeconomics, so I'm inclined to think in terms of fiscal policy and monetary policy.

0:48In fact, what most of us see brewing right now is a collision course that is going to have the monetary authority at odds with the fiscal authority. And it all hinges on such things as the national debt and the annual deficits, the trends in saving these days, and the Fed's ability to control credit markets and monetary aggregates. So those are the kinds of things I'll be focusing on. And where better to start than what's been in the news lately, which is the federal budget deficits. So on my first slide here, I've pulled up a number of charts, this being the first one that will clue you in about what's going on and put in perspective what you've been seeing on the news.

1:39The yellow line is the zero line, that's a balanced budget. You can see that we had a surplus during the boom years of the Clinton administration, a deficit to follow, and this chart comes from the St. Louis Federal Reserve. Federal Reserve Economic Data, affectionately known as FRED, I've got it linked to my own website where you can click in and see what's going on graphically and otherwise. This chart shows the deficit as of the end of this previous fiscal year, which ended the first day of this month. And it's got an overestimate. It shows just over $400 billion in the red. And if you've listened to news accounts lately, it came in a little less than that, something that the administration ballyhooed quite joyously.

2:32It came in at $374 billion. And in a way I wish it had come in just a little less. I would have liked to have seen the figure 365 billion because that might have reminded a few people that that translates into a billion dollars a day. That's the rate at which the government's borrowing. And in fact, these days it's been borrowing at a clip of about a billion and a half a day. Now, projections for the next fiscal year are for 500 billion dollars or more, and that's from the administration officials. And so my suspicion is it will be more and possibly quite a little bit more. We can add that onto our graph, expect it to go down to about 500 billion, something like that.

3:23And if it goes to 525, that's sort of another interesting figure because that one translates into a million dollars a minute, all right? Again, borrowing at a pretty good clip. It's not even tapering off. If you adjust for the 374 this time, it's pretty much a straight line headed down. Let's take a close-up at this, or rather take a long shot at this same graph and put in perspective the previous depths of debt and the current depths. Because you hear it debated on the news whether or not the current level of indebtedness or the current rate of borrowing, the deficits, is worse than the deficits that were run under the first Bush administration.

4:16So we're entitled to ask, will the Bush 43 deficit of 2004, what we're going to take to be about 500 and that's a charitable figure. Is it worse than the Bush 41 deficit of 1992? Once again let me get those deficits down there where they need to be, okay, something like that and then around 500 billion and if you look at at the point I've shown there that's the 500 and in 1992 deficits were as great is 293 billion. Well, you can look at it and see which one's worse in nominal terms, but the administration is right there to put a smiley face on it, put a happy face on it, and of course the first thing they do is divide it by gross domestic product and show you that it's not so bad now, given that GDP is actually higher and substantially higher than it was in 1992.

5:16The first thing I want to do is warn you against that particular reckoning of the deficit. If you remember your macro from college years, you know that GDP measures essentially everything. It's all spending on consumer goods, net investment, government spending. It's the whole shooting match. It measures everything. And it's almost trivially true that anything is fairly small compared to everything. Okay, it just works that way. It works that way. Okay, and so I show that to you in numbers for those of you who are numbers prone to compare deficit to GDP, 1992 is 4.7 percent, okay, and 2004 with, I'm allowing for a little growth next year, probably a little more than we'll actually have, 4.5 percent, so on that basis we're actually, looks like three tenths The Theory of Money and Credit

6:45Compute the figures and what you'll notice is that the saving has actually been going down in the last two or three years in absolute terms and it certainly hasn't been going up generally as fast as income, partly because of administration policies and Federal Reserve policies. So let's look at saving. So compare deficit to saving. This is my ratio and I'm amazed at how little this ratio ever gets used. In 1992, the government was borrowing the equivalent of about 28.8% of total gross savings, that's private and corporate savings, in this country.

7:42Now, it's up to 35.7, so well over a third of the total savings, right? And I argue that's a large number and it's a substantial increase. I'll show you later why this is a particularly relevant number and in what sense we consider 35.7% to be large, although it may occur to you as obvious that that's a fairly large figure. I might mention at this point that there's been an interesting turnaround In the apologetics about the government borrowing, if you remember back in the old days, the heyday of Keynesianism, the popular bromide, to dismiss any worries about deficits, is that we owe it to ourselves.

8:28You've heard that we owe it to ourselves. That was the old Keynesian bromide popularized by Abba Lerner. And it strikes me as odd that the current bromide is precisely the opposite of that, but supposedly equally effective, rhetorically, I guess. And the way it's typically stated is that, oh, we have access to world capital markets. Now, what that translates into is we don't owe it to ourselves. So watch, and it's not too unusual to find both claims in the same article, okay, don't worry about the deficit, because A, we owe it to ourselves, and B, we don't owe it to ourselves, because we're borrowing the world capital markets, okay, so we need to get it straight, which is it, and it turns out, of course, neither is an excuse for running astronomically high deficits.

9:21Now it's true, as someone might point out, that the federal government isn't literally borrowing 35.7% of your savings, of domestic savings. In fact, if they were, if the only access to saving they had was the saving that's done in this country, then interest rates would be sky high rather than in the basement. In fact, most of the borrowing these days is done abroad. and our foreign trading partners are the ones that are holding the debt and foreign central banks are holding the U.S. debt. But that creates a problem in its own right because there's no reason that we should count on them continuing to be willing to lend our government that much money.

10:07And should they stop, should they decide it's a bad deal, Then we would get the problems in a more dramatic way and in a more at home way with high interest rates. We'll see more about that later as well. Okay, well that having been said, maybe I've convinced you that deficit problem now, at least in comparison to savings, actually worse than before. But you might ask, well, why can't we just do the same thing we did before? or it looks like we got out of it before. In other words, look at your 1992 point. Can't we just do in 2003, what we did in 1992? Okay, and you can see it on the graph.

10:52In 2002, we came out of that borrowing binge, right? And so we can ask, well, can't we do the same thing then in 2003? And I'll show you why we can't, okay? First, let me remind you of what happened in 1992. The upturn started, actually, before the Bush 41 presidency ended. And it started with Bush's taking on of Jim Baker as his campaign advisor to think of something quick so that they didn't lose the election to that guy from Arkansas. And what Jim Baker could think of, of course, was a monetary stimulant, so the Federal Reserve began stimulating the economy in late 1992, too close to the election to have any effect before the election, in other words, too close to save George Bush from defeat, but it started then and eventually it created an economic Boom. Clinton kept the boom going and stepped it up going into 1996 in order to facilitate his re-election and so we had a tremendous boom of the sort that Sean Corrigan was telling you about in

12:16last lecture. Now the way it was triggered of course was by lowering the interest rates, dropping interest rates, getting interest rates low to stimulate investment and create the boom. Now, that can't happen now simply because interest rates are already in the basement. They're already too low. They're out of slack. Or as the way the press likes to couch it. I'm sort of amused by this because you hear this metaphor that Greenspan doesn't have many arrows left in his quiver. That's the way it gets stated. Well, let's take a closer look at that and see what we can make of it. Here, what I've plotted for you, again, I'm getting this straight out of the St. Louis Fed database is the federal funds rate.

13:03That's the interest rate at which banks swap reserves back and forth among themselves at the end of each business day. And the Fed is in there manipulating that rate by sweetening the pie. We'll add to the reserves if it wants the rate lower or subtract from the reserves if it wants the rate higher. Well, you can see if you look in 1992, I'll flag it for you right there, that the interest, the federal funds rate was about 4% in early 1992. You can see in late 92 and throughout 93, the interest rate was held down to around 3%, give or take a little. And that's what got the boom started, okay? But if you look at the situation now, we got a 1% federal funds rate, and so that's the idea that there's not much room left.

13:58And I'll take for you this small portion over here and just, okay, how many arrows are left in Greenspan's quiver? That's the burning question you want to take home with you, I guess. That's just a blow up of the last 10 years of that same graphic. And here, we can see that 1% rate, okay, and realize, though, that the way the Fed is set up, or at least the way it has been set up for decades, is that there's two rates that allow banks to borrow to meet the reserve requirement. One is this federal funds market, that's the 1%, the target rate, that's the rate you always hear on the network news The Federal Reserve, fiat money, fractional reserve banking, Human Action, Man Economy and State, The Theory of Money and Credit

15:09And the discount rate is, I call it an administered rate, which is to say it simply is what the Fed says it is. And the Fed has traditionally held that rate below the federal funds rate. Well, how far below can you go when the federal funds rate is 1%? Well, let's take a look. Here's the discount rate, and in late 2003 it was set at three quarters of one percent, which is a low of lows, okay, it'd be a fraction of a percent, in fact this is one of the reasons, this is one of the things that critics of the Fed would point to, to suggest it doesn't have many arrows left in its quiver, it's just trying to lower the federal funds rate and yet it has to keep that discount rate somewhere below the federal and the Federal Funds Rate, and here at 0.75%.

16:09Well, one thing you'll notice about this chart is that it looks like it stops. In fact, it does stop just short of 2003, but we're well beyond the beginning of 2003. And so it turns out that it's almost under the radar screen. It just didn't get much reporting on the news. But that whole policy was discontinued. The time series is discontinued. The discount policy, as we knew it, was discontinued and what was instituted instead was a system of primary and secondary credits depending on what kind of shape the bank is in and what was called the discount rate is now called the primary credit rate and if the bank is in trouble it borrows at some secondary credit rate which is a little bit higher but let me show you how that works the primary credit rate was at the very beginning of this calendar year at 2.25 percent, okay, so up here, in fact, I'll stick it on there like so, so you can see all of a sudden in just one policy move on the part of the Federal Reserve, it increased that used to be discount rate by that much and then dropped it even later in the year to 2.0 percent and that's where it stands right now.

17:31So now if you tap into the Federal Reserve website each time that the Federal Open Market Committee meets, instead of hearing or instead of reading an announcement about the Fed funds rate and the lower discount rate, you hear an announcement about the federal funds rate and the now higher primary credit rate. Now why do they do this? I suggest that the reason is to give them more room, to give them some slack between where they are, namely 1% and zero, To get that primary rate above the federal funds rate, I've plotted, in fact I pulled this off of the St. Louis Fed site and it's a new series because we just started it beginning this year, so it shows that primary credit rate at 2.5% or 2.25% and then dropping to 2% in middle of June, where it remains.

18:28So, I think I'll summarize down here, the Fed now has a primary credit rate above the Fed funds rate, instead of a discount rate below it, and that might help you out in your Fed watching, if any of you are in the business of Fed watching, to see what it's doing these days. Now, still, it doesn't have much room to maneuver, and some people have suggested that, well, the Fed can do more than just control the federal funds rate, or can do more than just control interest rates, it can control the money supply directly, just target reserves or target the money supply measured somehow. Let me speak first and very briefly about the possibility of it targeting other rates.

19:16This is a possibility and this is what the Fed itself has discussed. There was a conference at the Dallas Fed fairly early in 2003 to discuss the idea of how to deal in a zero-interest economy and what to do. And they're talking about the Fed funds rate possibly getting down as low as zero, at which The average point they conceive of possibly targeting other longer-term rates, of bidding down the long-term treasury rates, buying long-term treasury bills or treasury bonds or something like that, rather than short-term treasuries. It still has an effect on the Fed funds rate because when they buy, the funds they buy with become federal funds. They'll lend out a correspondingly lower rate than before the purchase.

20:03Plus, it's a little bit risky. It's a dangerous thing. In fact, it could be a part of the meltdown. It's a dangerous thing to be twisting that yield curve, to be pushing down long-term rates down close to where short-term rates are. Because if you think of it, the whole business of commercial banking is borrowing short and lending long. That's how profits are made in the banking industry. And if you've got a Federal Reserve in there pushing long rates down relative to short rates, You pretty much destroy the profitability of commercial banking and that would be another problem to deal with that might be worse than the one that they've got now. Now, beyond meddling with interest rates at all, it's certainly possible for the Fed simply to increase reserves.

20:49It always has the capacity to increase reserves and thereby increase the money supply and expand that way. But the Fed simply doesn't have the mechanisms in place to do that, that it once had. And it also stands to do more damage than harm in a very special way. Let me take a look at that now. So I'll ask the question here, should the Fed return to money growth targeting? That's what the Fed did when Volcker became chairman back in the late 70s. and that's what the Fed did for the first several years of the 1980s, only later to abandon it and to go once again to interest rate targeting.

21:40The first question that I would raise is the question of which monetary aggregate would they supposedly target? You see, back in the heyday of monetarism, there was an obvious monetary aggregate look at, and it was called M1. It was a crisp definition of the money supply if only because of the existence of regulations at the time that prohibited the writing checks on savings account and prohibited the payment of interest on checking accounts. You got a virtual black and white distinction between what's money and what's not money. And it gave a crispness to the definition of the money supply. But Regulation Q was phased out in the early 80s, and the monetary aggregates blend one into the other in a way that gives the Fed no clue of which one it should be looking at.

22:39There's even a wonderful soundbite from Greenspan testifying at the Joint Economic Committee Meeting, a sound bite that's made it onto the Jay Leno show, where Greenspan has asked the question, why don't you just control the money supply? And Greenspan said in almost a forlorn tone, well, we just don't know what money is anymore. Can you imagine the fun that Jay Leno had with this? Wouldn't you rather have a chairman who at least knew what money is, would help? But what he meant is that they had lost the crisp target because of the phasing out of Regulation Q. And you can see M1 has grown sort of haphazardly and in an odd pattern.

23:36But one thing that's revealing about the components of this M1, if you remember your Macro Theory, M1 consists of currency and coin, that's one component, it used to be a fairly small component actually, it used to be between 25 and 30 percent, and the rest of it, the bigger share of M1 is checking account money, some of the balances in your checking accounts, all right? And so we can divide this down in its components, and the interesting component to look at is The Currency Component Focus on the last 10 years or so of M1. It looks like it even sags a little and then picks up and so on. But now let's look at the currency component.

24:23It's going up almost in an exponential path, increasing as we go. And it turns out there has been a virtual skyrocketing of M1, or I'm sorry, of the currency component of M1. I've got some statistics on this.

24:44So we've had a dramatic rise in the currency ratio. That's the C currency divided by that basic money supply. During the last 10 years, and I went back and just spot checked and looked at the different currency ratios, They stayed in the mid to high 20% up until about 93. And after that, they begin rising fairly rapidly. So 1993, just 10 years ago, 28.5%, 2003, 50.7%.

25:16So well over half, well not well over, but just over half of the money supply reckoned as M1 is in the form of currency. Now you're suspicious about this. You wonder about this because everything else tells you So that people tend to use less currency these days than before, they tend to use plastic and they use debit cards and so on, they use less currency. And the explanation for this is that most of that currency, in fact, that 50.7% adds up to about $650 billion. Okay, and it turns out that estimates vary, but about 320 billion, in other words, just about half of that currency, is currency held abroad.

26:04Leland Yeager, who is with us today, has compiled some interesting statistics on this currency held abroad. So as much as $320 billion is U.S. dollars held offshore, either in circulation like in Panama or in circulation in Russia or in stashes like we actually discovered in Iraq and some in Iran and the Middle East generally. Tremendous amounts of currency. Something like 90% of all the $100 bills are held outside the United States. And about 80% of the growth in the currency component over the last several years has been currency that has gone outside the United States.

26:58So there's a tremendous amount of currency out there, but offshore. Now, this is a worrisome thing to the Federal Reserve, because it has no control over how long that stuff stays over there and when it comes back, and how fast it comes back, and it would be very hard to react to it. The Federal Reserve has been fairly good at reacting to changes in the currency ratio that are minor changes and are caused by such things as the coming of Christmas. The Greenspan can predict every year, it hasn't missed it once, that Christmas is coming and people carry more cash and makes the adjustment. He predicts vacation times, okay, when people load up their station wagon and drive to California, well, they don't do that so much anymore, but people use currency and vacation times and Greenspan can compensate for it.

27:54But boy, this is the big one. This is a bunch of currency held abroad that could easily come back and could come back in a virtual tidal wave, if you stop to think about it, because people have choices these days. They can hold euros instead of U.S. dollars. Professor Yeager points out that there was a blip, pretty significant blip in foreign demand for currency just provoked by our issuing a new $100 bill. It spooked people. They didn't want to hold as much, okay? And possibly a blimp with this new 20. I don't know. I mean, the government's spending, what, $33 million trying to advertise the new 20.

28:39I hope it's doing plenty of advertising abroad. Okay? Get people to hold this new 20. Okay? But one possibly significant factor is that a hundred dollar bill is the largest bill the U.S. produces, where a euro is produced in 500 euro notes. And so, certainly for some uses, say in certain uses where you carry your money in suitcases, Big suitcases. You don't have to have quite as big a suitcase, if you have 500 euro notes, than if you have 100 dollar bills.

29:24So I can imagine that this is part of the discussion around that big boardroom table at the Federal Reserve. What happens if people substitute out of U.S. dollars and into euros and all those U.S. dollars come back? The Federal Reserve, fiat money, fractional reserve banking, Human Action, man economy, methodological individualism, Human Action, Man Economy and State, The Theory of Money and Credit

30:10The Federal Reserve is a kind of a tipping model, where once the thing starts to tip, it goes. And people dump dollars and use something else instead, euros. If that happens, all the Fed can do is to try to counteract it. And of course, to try to counteract it means to pull in the money supply, to raise federal funds rate, to contract, right? Which is to say to do just the opposite of what the fiscal authority wants them to do, which is lower interest rates and buy U.S. government debt. And in fact, this is the essential reason I say that a meltdown could be the product of a collision course between what the Fed might have to do if that currency comes back and what the Treasury wants the Fed to do given that it's borrowing at a clip about a million dollars a minute.

31:01Okay? This is certainly something to think about, right? I might also note, and I'll pull this graph out of a paper written in 2000 by Bradford DeLong. It's a graph that helps put monetarism of the Friedman brand in a sharp relief, sharp perspective. Because if you remember your monetarism, Friedman depended on a very tight statistical correlation between the quantity of money and the price level. And it turns out that that statistical fit was fairly robust during the heyday of monetarism. When, say, between 60 and 80, this purple line actually here is the pre-1980s trend in the velocity of money.

31:56So the average rate that dollars are spent in the economy had an upward trend, but it was very stable, very predictable. And in fact, you can see the actual movement in the velocity of money deviated very little from the trend. Now, it turns out that that all came undone in the early 80s. It was with the phasing out of regulation Q, I would argue, that started the undoing of that stable velocity, which actually I like to refer to as the irony of monetarism, that the monetarist statistics held only to the extent that there was pretty strict regulations imposed on what you can do with a checking account and what you can do with a saving account.

32:41Pull the regulations off and you lose the Christmas of the money supply and the velocity becomes unstable. It falls well below trend and part of that is because of money going overseas, at least starting in the early 90s. If we plotted this on out, this is the actual velocity of money. If you plotted it on out, what you'd see is this curve peeking out around nine, a little over nine, falling back now to somewhere around 8.4. So it hasn't picked up a different trend. It hasn't just moved to some other trend. It's still jagged up and down and very unpredictable. And so, see, these are the kind of things that made monetarism work at the time that it did work. You had a tight definition of money, well-defined, and you had a strong relationship between money and the price level because of a stable demand for money.

33:33and now you don't have any money supply that's easily controlled, you have worries about currency coming back from abroad and even if you can control the money supply, you don't have a hard line relationship between it and the price level because of this erratic and unstable velocity. There's a heyday of monetarism back there. Okay, now let's go back to the fiscal side of it and look at saving, okay, and you can see that this is a great graph because it's one that puts Keynes in his place, I think. Here is saving during the Clinton boom, income was going up, consumption was going up, saving was going up, everything was going up, okay, that's sort of a Keynes-style process and of course it's temporary and it was bound to turn to a bust but while it lasted the statistics looked very Keynesian but when the bust came then of course income growth slowed down actually turned negative in just a couple of quarters and so if you plotted income it would still be going up but at

34:40a slower pace but saving is going down even in an absolute sense and certainly relative to what it was okay so this is a saving trend which is one of the The things that puts the deposit-to-saving ratio up as high as it is, okay, because you've got reduced saving, probably hit around $1400 billion by 2004. So this makes the deficit-to-saving, puts it in perspective and shows that the Treasury is a big player in credit markets. Look at the likely movements in the deficit-to-saving ratio. The deficit is likely to go up, saving is likely to go down further, project those trends, and you like to have even a bigger player on your hands, which causes lots of trouble.

35:31In fact, here, now, I've summarized for you in a couple of minutes I have remaining what I like to call the short list of bad options. Put yourself in the position of a physical strategist for the U.S. government. What can you do and what should you do? To get the flavor of this, all you have to do is listen to the nine democratic contenders for the nomination debate, because each of them has to choose from this short list of bad options and explain what they would do, you see. So let's look at the options first. You could borrow domestically, start borrowing from people at home, monetize debt, get Alan and Greenspan on your side, borrow abroad, that's what they've been doing largely, raise taxes, you know how that plays in the polls, or continue debating, I mean, that's the current solution, but each of these has consequences, none of which are good, okay?

36:31Borrowed domestically, you're going to get high interest rates. Monetized debt, you're going to get inflation, and this time, a leveraged inflation, because if we start seeing debt monetization in this country and start seeing inflation like we had back in the late 70s and early 80s, then I'll guarantee you that those foreign dollars are going to come home. And when they come home, that's going to put a lot of leverage on that inflation. So, if I want to make one prediction today, and I'm not big on making predictions, but I'll make one, and that is that we won't have just a little bit of inflation, okay? We won't have just a little bit, if we have it, it'll be a lot. A borrower abroad that's going to give you weak export markets and all the problems that causes, raise taxes, you're going to get dampened market activity all around, and do nothing but continue debating, you're going to get market uncertainties, that's what we see now,

37:29The whole investment sector is sitting back because they don't know what the climate is going to be in the coming years because nobody has been willing to set a course and stick with it because they don't want to choose from this short list of bad options. Okay, well let me leave you with a look at the debt. This is debt, not deficit. This is accumulated debt. And look at the recent upturn. Pretty sharp, right? Now, how many are optimistic and think that what might happen between now and 2010? If you're optimistic, pay. You know, pay that sucker off, be that free. Do I have any takers? Okay. Who's pessimistic? Okay, if it's going that way, we're in trouble in any number of ways. Thank you.