Tuesday, January 17, 2017

Economic Theory Is Dead. New Normal Means No Recovery

This article was first published by me on Talkmarkets: http://www.talkmarkets.com/content/bonds/economic-theory-is-dead-new-normal-means-no-recovery?post=108622&uid=4798

Economic theory is dead. It is like an emperor who has been stripped of his clothing. It is nothing of consequence in the New Normal. 

And that bodes ill for recovery. Before I get into John Mauldin's timely comments about this sorry state of affairs, we can look to see if monetary theory still applies.

John Maynard Keynes was right about monetary theory in his time. But that was then and this is now. Somebody needs to prove me wrong but I don't think they can until the powers that be change the rules.

Here is what Keynes said, paraphrased:

When interest rates are low, the opportunity cost of holding money is low, and the expectation is that rates will rise, decreasing the price of bonds. So people hold larger money balances when rates are low. Overall, then, money demand and interest rates are inversely related. [Emphasis mine]
Well, it ain't happening that way folks. Bonds are being hoarded even when interest rates are negative, in Europe. And US bonds are being hoarded. Interest rates are low, and real rates are likely negative, and Keynes rule does not work now. The rules have changed, and unless they are changed back, money demand and interest rates are no longer inversely related.  

 The New Normal has forced the rules to be changed. What is the New Normal? The New Normal at Google Search is defined this way:

 A previously unfamiliar or atypical situation that has become standard, usual, or expected.
Why are economists, and investors who listen to them, expecting interest rates to rise? Because they live in that parallel universe of old. That rule does not apply here and now. They are fossils, dinosaurs, and they are wasting everybody's time.

Interest rates and money demand are not inversely related when bonds are being hoarded for collateral. Keynes didn’t have that issue, apparently.

But Keynes got one thing right. Applying it to the New Normal is chilling. It is positively chilling. Keynes said rates rise during expansions. But since they are not rising, we can be assured that we will never have an expansion! Never, never, never, never.

I really wish somebody could prove me wrong, but talk is cheap. The talk of rising rates is endless, blah blah, blah blah blah. Show me. I am not from Missouri, but show me anyway!

So, continuing on with the article above, citing Keynes, there are some good points made:

1. If inflation erodes the purchasing power of the unit of account, economic agents will want to hold higher nominal balances to compensate, to keep their real money balances constant.
That may be true. Certainly, those hollering for NIRP don't think it is true. But if it is true, the New Normal has a big problem.

2.  When interest is high, more people want to supply money to the system because seigniorage is higher. So more people want to form banks or find other ways of issuing money, extant bankers want to issue more money (notes and/or deposits), and so forth.
We know this is true. When is the last time anybody saw new banks? It is hard to expand the money supply if there isn't much competition and aren't many new banks created. The New Normal has seen to that.

John Mauldin made a statement that everyone should take notice of. Central bankers are not alarmed, but they should be. Banks have been booted off American soil before, and they can be again. They can't be too complacent. Mauldin said this in a wonderful article:

Because the Fed is banker-driven, it thinks cost of capital is everything and therefore that a lower interest rate will stimulate activity. They’re right up to a point, but that relationship is not linear. It flattens out as you get closer to zero.
Yellen is aware of this. Her point with Footnote 8 was that interest rates aren’t always an effective stimulant. But also, she isn’t the only vote. She has to convince the other governors and regional Fed bank presidents, and they are all influenced to varying degrees by the banking industry, which loves lower rates.
Come to think of it, this might also explain Footnote 8. Negative rates are death to commercial banks. A -9% NIRP would kill many banks. So maybe that footnote was a warning, the Yellen equivalent of a brushback pitch to overly eager bankers. “Look what can happen if we don’t do it my way.”
I truly don’t think Yellen will take us down to -9% or anywhere close to it. I do think she is mentally prepared to go below zero if she sees no better alternatives according to her personal economic religious beliefs. I also feel very confident that she and her colleagues won’t take rates much higher from here. I think we will see 0% again (and below) before we see +2%.
Look, sooner or later a recession is coming. This recovery, feeble as it has been, is already long in the tooth. I think there is the real possibility we will enter at least a mild recession no later than the end of 2017, brought about by a crisis and recession in Europe. Those of us in the US really should pay close attention to what is going on at the polls in Europe just as we pay attention to the polls in Florida. How will the Fed respond when that recession hits?
The Fed is making those plans right now. If you think 2008–2009 was a wild ride, I suggest you fasten your seatbelt and prepare to take an airbag in the face. The next ride will be even wilder.
Now, it is true that the central bankers think that by keeping yields for bonds low, by setting the table for massive demand and hoarding, and by goosing the stock market, that they can stop the business cycle in its tracks. But if they can't, and Mauldin is right about the need to fasten a seatbelt, then low rates give no comfort in downturn, no margin of comfort at all.

Mauldin also blasts Stanley Fischer, Vice Chairman of the Fed in the same article:

Let’s read that sentence again: “… the idea is, the lower the interest rate the better it is for investors.” They are sacrificing mom-and-pop middle America, the hard workers who have played by the rules and retired and saved and now want to live out their lives enjoying their grand-kids and a little well-deserved relaxation, and they find they can’t do that because the Federal Reserve thinks that protecting Wall Street and wealthy investors and bankers is more important.
The true is, it is likely that Fischer and the Fed are simply satisfied with themselves. As I have said before, they are just happy the big banks are still around and the counterparties are buying bonds. That is all they care about.

But it would seem necessary for insurance companies and pension funds to invest in way more risky investments, which they are constrained not to do, to keep from raising insurance rates and pension contributions to absurd levels.

And what happens if insurance companies get the green light to invest in risky instruments? What kind of insurance is that? Is it like a rock? No, it is jellyfish insurance. Nobody will want it. Or maybe the insurance companies will keep it a secret. 

The theater of the absurd is what the Fed policy is. Fischer is trading sanity for insanity. But we know structured finance and bond hoarding is here to stay until something bad happens. Maybe nothing will happen. If anything, more and more need for collateral, as risk increases, will just drive bond yields down further.

And thus the New Normal will remain true for no telling how many light years, indicating that money demand and interest rates are no longer inversely related. I leave it to the economists to create the appropriate New Normal Equation.

The New Normal is fueled, as I recall Mohamed El-Erian saying someplace, by "ill understood financial innovations". That is an understatement of a disturbing reality, if there ever was one.

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