The Death of Money (25 page)

The theory of financial repression was explained incisively by Carmen Reinhart and
M. Belen Sbrancia in their 2011 paper “
The Liquidation of Government Debt.” The key to financial repression is the use of
law and policy to prevent interest rates from exceeding the rate of inflation. This
strategy can be carried out in many different ways. In the 1950s and 1960s it was
done through bank regulation that made it illegal for banks to pay more than a stated
amount on savings deposits. Meanwhile the Fed engineered a mild form of inflation,
slightly higher than the bank
deposit rate, which eroded those savings. It was executed with such subtlety that
savers barely noticed. Besides, savers had few alternatives, as this was a time before
money-market accounts and 401(k)s. The 1929 stock market crash was still a living
memory for many, and most investors considered equities too speculative. Money in
the bank was a primary form of wealth preservation. As long as the Fed did not steal
the money too quickly or too overtly, the system remained stable.

This condition of modest negative real rates for a sustained period of time also worked
its wonders on the debt-to-GDP ratio. During this golden age of financial repression,
national debt declined from over 100 percent of GDP in 1945 to less than 30 percent
by the early 1970s.

By the late 1960s, the game of financial repression was over, and inflation became
too prevalent to ignore. The theft of wealth from traditional savers had become painful.
Merrill Lynch responded in the 1970s with the creation of higher-yielding money-market
funds, and others quickly followed. Mutual fund families like Fidelity made stock
ownership easy. Investors broke free of financial repression, left the banks behind,
and headed for the new frontier of risky assets.

The problem confronting the Fed today is how to use financial repression to cap interest
rates without the benefit of 1950s-style regulated bank deposit rates and captive
savers. The Fed’s goal is the same as in the 1950s—higher inflation and a cap on rates,
but tactics have evolved. Inflation comes from money printing, and rate caps come
from bond buying. Conveniently for the Fed, money printing and bond buying are two
sides of the same coin, because the Fed buys bonds with printed money.

The name for this type of operation is quantitative easing (QE). The first of several
QE programs commenced in 2008, and over $2 trillion of new money was printed by the
end of 2012. By early 2014, printing was proceeding at the rate of over $1 trillion
of new money per year.

Money that sits in banks as excess reserves does not produce inflation. Price inflation
emerges only if consumers or businesses borrow and spend the printed money. From the
Fed’s perspective, the manipulation of consumer behavior to encourage borrowing and
spending is a critical policy component. The Fed has chosen to manipulate consumers
with both carrots and sticks. The stick is an inflation shock, intended to scare
consumers into spending before prices go up. The carrot is the negative real interest
rate, designed to encourage borrowing money to buy risky assets such as stocks and
housing. The Fed will ensure negative real rates by using its own bond buying power,
and that of the commercial banks if necessary, to suppress nominal interest rates.

In order to make the carrots and sticks effective, at least 3 percent inflation is
needed. At that level, real interest rates will be negative, and consumers should
be sufficiently worried to start spending. These powerful inducements to lend and
spend are designed to grow nominal GDP at a rate closer to historical trends. Over
time the Fed hopes this growth becomes self-sustaining, so it can then reverse policy
and let nominal GDP turn into real GDP through an accelerating real growth process.
The Fed is using policies of zero interest rates and quantitative easing to reach
its goals of higher inflation and negative real rates.

Banks can make significant profits by borrowing at the zero short-term rates offered
by the Fed and lending for longer terms at higher rates. But this type of lending
can produce losses if short-term rates rise quickly while the banks are stuck with
the long-term assets, such as mortgages and corporate debt. The Fed’s solution to
this problem is
forward guidance
. In effect, the Fed tells the banks not to worry about short-term rates rising until
well into the future.

In March 2009 the Fed issued an announcement that short-term rates would remain at
zero for “an extended period.” In August 2011 the “extended period” phrase was dropped
and a specific date of “mid-2013” was announced as the earliest on which rates would
increase. By January 2012 this date had been pushed back to “late 2014.” Finally,
in September 2012 the Fed announced that the earliest that rates would increase was
“mid-2015.”

Even this assurance was not enough for all banks and investors. There was concern
that the Fed might bring the rate hike date forward just as easily as it had pushed
it back. The criteria on which the Fed might change its mind were unclear, and so
the impact of forward guidance was muted. A debate raged within the Fed about whether
forward guidance should be converted from an ever-changing series of dates to a set
of hard numeric goals that were more easily observed.

This debate was captured in historic and analytic detail in a paper
presented by Michael Woodford of Columbia University at the Fed’s Jackson Hole Symposium
at the end of August 2012. While Woodford’s argument is nuanced, it boils down to
one word—
commitment
. His point was that forward guidance is far more effective in changing behavior today
if that guidance is clear and framed in such a way that the central bank will not
repudiate the guidance in the future:

A . . . reason why forward guidance may be needed . . . is in order to facilitate
commitment
on the part of the central bank. . . . In practice, the most logical way to make
such commitment achievable and credible is by publicly stating the commitment, in
a way that is sufficiently unambiguous to make it embarrassing for policymakers to
simply ignore the existence of the commitment when making decisions at a later time.

The impact of Woodford’s tour de force on Fed thinking was immediate. On December
12, 2012, just three months after the Jackson Hole Symposium, the Fed scrapped its
practice of using target dates for forward guidance and substituted strict numeric
goals. In customary Fed-speak, the new goals were described as follows:

In particular, the committee decided to keep the target range for the federal funds
rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range
for the federal funds rate will be appropriate at least as long as the unemployment
rate remains above 6-1/2 percent, inflation between one and two years ahead is projected
to be no more than a half percentage point above the Committee’s 2 percent longer-run
goal, and longer-term inflation expectations continue to be well anchored.

The Fed is now publicly wedded to a set of numeric goals and committed to zero rates
until those goals are achieved and perhaps even longer.

Three aspects of the Fed’s commitment stand out. The first is that the numeric targets
of 6.5 percent unemployment and 2.5 percent inflation are thresholds, not triggers.
The Fed did not say that it would raise rates
when
those levels were hit; it said it would not raise rates
before
those
levels were hit. This leaves ample room to continue easy money even if unemployment
falls to 6 percent or inflation rises to 3 percent. Second, the Fed said
both
targets would have to be satisfied before it raised rates, not just one or the other.
This means that if unemployment is 7 percent, the Fed can continue its easy-money
policy even if inflation rises to 3 percent or higher. Finally, the Fed’s inflation
target is based on
projected
inflation, not actual inflation. This means that if actual inflation is 4 percent,
it can continue with easy money so long as its subjective inflation projection is
2.5 percent or less.

This new policy is a brilliant finesse by the Fed. Superficially it pays lip service
to Woodford’s recommendation for commitment to unambiguous goals; but in reality the
goals are slippery and ill defined. No one knows if the Fed will slam on the brakes
at 3 percent inflation, if unemployment is still 7 percent. No one knows how much
time will elapse between the end of money printing and a rate increase. Yet the Fed’s
new policy is consistent with its hidden 3 percent inflation goal under the carrots-and-sticks
approach. The Fed can justify higher inflation if its employment goal is unmet. It
can justify higher inflation if projected inflation is lower. It can justify higher
inflation in all events because the numeric targets are thresholds and not triggers.
The new policy puts no real constraints on higher inflation.

The PDS and BRITS framework and the Fed’s new policies converge around the specter
of inflation, which lurks behind the academic theories and public pronouncements.
Low borrowing costs and higher inflation are the only ways the Fed can improve deficit
sustainability. Financial repression lowers borrowing costs, and quantitative easing
can create higher inflation if the markets believe it will continue. The Fed’s December
2012 policy is a muddled version of Woodford’s recommendations. The Fed is pretending
to have numeric goals while preserving the degrees of freedom it needs to reach any
inflation target it finds necessary, but that involves a certain sleight of hand.

The Fed’s form of theft from savers has a name: it’s called
money illusion
by economists. The idea is that money printing on its own cannot create real growth
but can create the illusion of growth by increasing nominal prices and nominal GDP.
Eventually the illusion will be shattered, as it was in the late 1970s, but it can
persist for a decade
or more before inflation emerges with a lag and steals the perceived gains.

While the Fed’s goals of higher inflation and rising nominal GDP are clear, there
is good reason to believe the Fed will fail to achieve these goals and may even produce
disastrous consequences for the United States by trying.
The Fed’s own staff have expressed reservations about whether forward guidance works
at all in the time horizons the Fed is using. Prominent economist Charles Goodhart
has said that nominal GDP targeting is “
a thinly disguised way of aiming for higher inflation” and that “no one has yet designed
a way to make it workable.”

Perhaps the most compelling critique of the flaws in nominal GDP targeting and the
inflation embedded within it comes from inside the Fed board of governors itself.
In February 2013 Fed governor Jeremy Stein offered
a highly detailed critique of the Fed’s easy-money policy and obliquely pointed to
its greatest flaw: that increased turnover is not the only channel money creation
can find, and that other channels include asset bubbles and financial engineering.

Stein’s thesis is that a low-interest-rate environment will induce a search for higher
yields, which can take many forms. The most obvious form is a bidding up of the price
of risky assets such as stocks and housing. This can be observed directly. Less obvious
are asset-liability mismatches, where financial institutions borrow short and lend
long on a leveraged basis to capture a spread. Even more opaque are collateral swaps,
where a financial institution such as Citibank pledges junk bonds to a counterparty
in exchange for Treasury securities on an overnight basis, then uses those Treasury
securities as collateral on a higher-yielding off-balance-sheet derivative. Such transactions
set the stage for a run on Citibank or others if the short-term asset providers suddenly
want their securities back and Citibank must dump other assets at fire-sale prices
to pay up. The invisible web of counterparty risk increases systemic risk—and moves
the system closer to a replay of the Panic of 2008 on a larger scale.

The scenarios sketched by Stein would rapidly undo the Fed’s efforts if such events
came to pass. A market panic stemming from excessive leverage and risk taking occurring
so soon after the Panic of 2008 would destroy the Fed’s efforts to lure consumers
back into the lending and spending game of the early 2000s.

Stein’s paper has been taken to say that Fed must end QE sooner rather than later
to avoid the buildup of hidden risk in financial institutions. But there is another
interpretation. Stein himself warns that if banks do not take the hint and curtail
risky financial engineering, the Fed might force them to do so with increased regulation.
The Federal Reserve has life-and-death powers over banks in areas such as loss reserves,
dividend policies, stress tests, acquisitions, capital adequacy, and more. Bank managers
would be foolhardy to defy the Fed in the areas Stein highlights. Stein’s paper suggests
a partial return to an older kind of financial repression through regulation.

The Fed’s manipulations have left it in the position of a tightrope walker with no
net, one who must exert all his energy in a concentrated effort just to keep moving
forward, even as the slightest slip or unexpected gust could cause a catastrophic
end to the enterprise. The Fed must promote inflation (while not acknowledging it)
and must inflate asset prices (without causing bubbles to burst). It must exude confidence
while having no idea whether its policies will work or when they might end.

In short, the Fed is caught between its roles as proprietor of the debt-as-money contract
and as the singular savior of sovereign debt. It is unlikely to succeed in only one
of these roles; it shall succeed, or fail, at both.

CENTRAL BANK OF THE WORLD

The optimum currency area is the world.

Robert A. Mundell

Recipient, Nobel Prize in Economics

I haven’t read the Governor’s proposal. . . . But as I understand . . . it’s a proposal
designed to increase the use of the IMF’s special drawing rights, . . . ah . . . and . . .
ah . . . we’re actually quite open to that.

Timothy Geithner

U.S. Treasury secretary

in reply to a reporter’s question about a Chinese government proposal

March 25, 2009

The IMF has refined, repurposed, and restocked its toolkit.

Christine Lagarde

IMF managing director

September 19, 2013

■
One World

To meet Dr. Min Zhu is to see the future of global finance. He stands out in a crowd,
his six-foot-four-inch frame reminding financiers of the late twentieth century’s
most powerful bankers, Paul Volcker and Walter Wriston, who dominated a room not just
with intellect but with physical presence. Min Zhu belongs not to the twentieth century
but to the twenty-first, and it is difficult to name anyone who better personifies
the conflicting forces—east versus west, gold versus paper, state versus markets—coursing
through the world today.

Min Zhu is the IMF’s deputy managing director, among the most senior positions in
the IMF, reporting directly to the managing director, Christine Lagarde. The IMF is
one of the key institutions established at the 1944 Bretton Woods Conference, which
created the framework for the international monetary system in the aftermath of the
Great Depression as the Second World War drew to a close. Since its founding, the
IMF has been the great enigma of global finance.

The IMF is quite public about its operations and objectives. At the same time, it
is little understood even by experts, in part because of the unique role it performs
and the highly technical jargon it uses in doing so. Specialized university training
at institutions like the School of Advanced International Studies in Washington, D.C.,
is a typical admission ticket to a position at the IMF. This combination of openness
and opaqueness is disarming; the IMF is transparently nontransparent.

The IMF’s mission has repeatedly morphed over the decades since Bretton Woods. In
the 1950s and 1960s, it was the caretaker of the fixed-exchange-rate gold standard
and a swing lender to countries experiencing balance-of-payments difficulties. In
the 1970s, it was a forum for the transition from the gold standard to floating exchange
rates, engaging in massive sales of gold at U.S. insistence to help suppress the price.
In the 1980s and 1990s, the IMF was like a doctor who made house calls, dispensing
bad medicine in the form of incompetent advice to emerging economies. This role ended
abruptly with blood in the streets of Jakarta and Seoul and scores killed as a result
of the IMF’s mishandling of the 1997–98 global financial crisis. The early 2000s were
a period of drift, during which the IMF’s mandate was unclear and experts suggested
that the institution had outlived its usefulness. The IMF reemerged in 2008 as the
de facto secretariat and operating arm of the G20, coordinating policy responses to
the financial panic that year. Today the IMF has capitalized on its newfound role
as global lender of last resort: it has become the central bank of the world.

Min Zhu holds the highest-ranking position ever held by a Chinese citizen at the IMF,
the World Bank, or the Bank for International Settlements, the international monetary
system’s three multilateral pillars. His career personifies China’s financial rise
in nuce
. He graduated in 1982 from Fudan University in Shanghai, among the most prestigious
schools
in China. He obtained a Ph.D. in economics in the United States, before moving through
various jobs at the World Bank and the international division of the Bank of China.
In 2009 he became China’s central bank deputy governor. In May 2010 he was handpicked
by Dominique Strauss-Kahn, then IMF chief, to be his special adviser. Finally in 2011
Strauss-Kahn’s successor, Christine Lagarde, selected him to be the IMF’s deputy managing
director.

Zhu has a relaxed demeanor and good sense of humor, but when pressed hard on a policy
he feels strongly about, he can suddenly turn strident, as if he were lecturing students
rather than engaging in debate. His slightly accented English is excellent, but his
soft-spoken style is difficult to hear at times. His background is unique: he has
operated at the highest levels at a central bank under Chinese Communist Party control
and at the highest levels of the IMF, an institution ostensibly committed to free
markets and open capital accounts.

Zhu travels continually on official IMF business, for university lectures, and to
attend prestigious international conferences such as the Davos World Economic Forum.
Private bankers and government officials eagerly seek his advice at the IMF’s Washington,
D.C., headquarters and on the sidelines of G20 summits, while Communist Party Central
Politburo members do the same on his periodic trips to Beijing. From East to West,
from communism to capitalism, Min Zhu straddles the contending forces in world finance
today, with a foot in both camps.

No one, including central bank governors and Madame Lagarde herself, is more aware
than Zhu of the international monetary system’s hidden truths, which makes his global
economic and financial views especially significant. He is an adamant globalist, reflecting
his position between the worlds of state capitalism and free markets. He does not
think of the world in traditional categories of north-south or east-west but rather
as country clusters based on economic factors, supply-chain linkages, and historical
bonds. These clusters intersect and overlap. For example, Austria belongs to a European
manufacturing cluster that includes Germany and Italy, but it is also part of a central
European clutch of former Austro-Hungarian Empire nations, including Hungary and Slovenia.
As that group’s leader, Austria is a “gatekeeper” that gives the Austro-Hungarian
group access to the European manufacturing cluster
through a nexus of subcontracting, supply chains, and bank lending. These linkages
might, for example, facilitate sales by a Slovenian auto parts manufacturer to Fiat
in Italy. The Slovenian-Italian link runs through gatekeeper Austria.

This paradigm of clusters, overlaps, and gatekeepers results in unexpected alignments.
Zhu places South America in
a China–western hemisphere supply-chain cluster, a point also made by Riordan Roett,
a leading scholar of Latin American economics. Zhu’s view is that U.S. economic hegemony
stops at the Panama Canal, while most of South America is now properly regarded as
a Chinese sphere of influence.

Zhu’s cluster paradigm is of more than academic interest because it is beginning to
have a direct impact on IMF policy as it relates to surveillance of its 188 member
countries. The paradigm provides a basis for the study of national policy “spillover”
effects as labeled by the IMF. The IMF treats spillovers in the same way that bank
risk managers talk about contagion—the rapid uncontrolled transmission of collapse
from one market to another through a dense web of counterparty obligations and collateral
pledges, in a blind stampede for liquidity in a financial panic. Spillovers happen
within clusters when national economies are tightly linked, and between clusters when
gatekeepers are in distress. Min Zhu is helping the IMF to develop a working risk-management
model based on complexity, one that is far more advanced than those used by individual
central banks or private financial institutions.

■
Updating Keynes

Zhu is showing traditional Keynesians how their model of policy action, in conjunction
with an individual or corporate response, is obsolete. This two-part action-response
model must be modified to place financial intermediation between the policy maker
and the economic agent. This distinction is illustrated as follows:

Classic Keynesian Model

Fiscal/Monetary Policy > Individual/Corporate Response

New IMF Model

Fiscal/Monetary Policy > Financial Intermediary > Individual/Corporate Response

While financial institutions in earlier decades had been predictable and passive players
in policy transmission to individual economic actors, today’s financial intermediaries
are more active and materially mute or amplify policy makers’ wishes. Private banks
may use securitization, derivatives, and other forms of leverage to greatly increase
the impact of policy easing, and they can tighten lending standards or migrate to
safe assets like U.S. Treasury notes to diminish the impact. Banks are also the main
transmission channels for spillover effects. Zhu makes the point that Keynesian analysis
fails in part because it has not fully incorporated the role of banks into its functions.

Clustering, spillover, and financial transmission are the three theoretical legs supporting
the platform from which the IMF surveys the international monetary system. New concepts
of this kind can percolate in university economics departments for decades before
they have practical effect. Despite a preponderance of Ph.D.’s in its ranks, the IMF
is not a university. It is a powerful institution with the ability either to preserve
or condemn regimes through its policy decisions on lending and the conditionality
attached. Zhu’s paradigm offers a glimpse of the IMF’s plans: clustering implies that
economic linkages are more important than sovereignty. Spillover effects mean top-down
control is needed to contain risk. Financial transmission suggests that banks are
the key nodes in the exercise of control. In a nutshell, the IMF seeks to control
finance, to contain risk, and to condition economic development on a global basis.

This one-world mission requires assistance from the most talented and politically
powerful players available. The IMF executive suite is an exquisitely balanced microcosm
of the global economy. In addition to Min Zhu and managing director Christine Lagarde,
the IMF top management includes David Lipton from the United States, Naoyuki Shinohara
from Japan, and Nemat Shafik from Egypt. Group diversity is more than an exercise
in multinationalism. Lagarde represents the European interest, Min Zhu the Chinese,
Lipton the American, Shinohara the Japanese, and
Shafik the developing economies. The top five managers at the IMF, seated around a
conference table, effectively speak for the world.

David Lipton’s is the single most powerful voice, more powerful than Christine Lagarde’s,
because the United States has a veto over all important actions by the IMF. This doesn’t
mean Lipton doesn’t play for the team; on many issues the United States and the IMF
see eye to eye—including the dollar’s eventual replacement as the global reserve currency.
Lipton’s veto power means that changes will take place at a tempo dictated by any
quid pro quo that the United States demands.

Lipton is one of numerous Robert Rubin protégés, who include Timothy Geithner, Jack
Lew, Michael Froman, Larry Summers, and Gary Gensler. These men have for years controlled
U.S. economic strategy in the international arena. Robert Rubin was Treasury secretary
from 1995 to 1999, after having worked several years in the Clinton White House as
National Economic Council director. Before joining the U.S. government, Rubin was
Goldman Sachs co-chairman; he worked at Citigroup in the chairman’s office from 1999
to 2009, and he briefly served as Citigroup chairman at the start of the financial
markets collapse in 2007. Lipton, Froman, Geithner, Summers, and Gensler all worked
for Rubin at the U.S. Treasury in the late 1990s, Lew at the White House. Lipton,
Lew, and Froman later followed Rubin to Citigroup, while Summers later worked as a
Citigroup consultant.

After being vetted and groomed in midlevel positions in the 1990s, this bland bureaucratic
team was carefully placed and promoted within the White House, Treasury, IMF, and
elsewhere in the 2000s, to ensure Rubin’s web of influence and role as the de facto
godfather of global finance. Geithner is the former Treasury secretary and former
president of the Federal Reserve Bank of New York. Lew currently holds the Treasury
secretary position. Froman was a powerful behind-the-scenes figure in the White House
National Economic Council and National Security Council from 2009 through 2013 and
then the U.S. trade representative. Larry Summers is a former Treasury secretary and
chaired President Obama’s National Economic Council. During his White House years,
Froman was the U.S. “sherpa” at G20 meetings, sometimes seen whispering in the president’s
ear just as a key policy dispute was about to be ironed out with Chinese president
Hu Jintao or another world leader.
From 2009 through 2013, Gensler was chairman of the Commodity Futures Trading Commission,
the agency that regulates Treasury bond and gold futures trading.

The members of the Rubin clique are extraordinary in the incompetence they displayed
during their years in public and private service, and in the financial devastation
they left in their wake. Rubin and his subordinate and successor, Larry Summers, promoted
the two most financially destructive legislative changes in the past century: Glass-Steagall
repeal in 1999, which allowed banks to operate like hedge funds; and derivatives regulation
repeal in 2000, which opened the door to massive hidden leverage by banks. Geithner,
while at the New York Fed from 2003 to 2008, was oblivious to the unsafe and unsound
banking practices under his direct supervision, which led to the subprime mortgage
collapse in 2007 and the Panic of 2008. Froman, Lipton, and Lew were all at Citigroup
along with Rubin and contributed to catastrophic failures in risk management that
led to the once-proud bank’s collapse and its takeover by the U.S. government in 2008,
with over fifty thousand jobs lost at Citigroup alone. Gensler was instrumental in
the 2002 passage of Sarbanes-Oxley legislation, which has done much to stifle capital
formation and job creation in the years since. He was also on watch at the Commodity
Futures Trading Commission in 2012 during the catastrophic collapse of MF Global,
a bond and gold broker. Recently Gensler has shown better sense, calling for tougher
derivatives regulation.