Thursday, March 16, 2017

Why the sudden change?

Central Bank Assets as a Percent of GDP:

Graph #1: Running Close to 5% Until the Big Surprise
(Annual data. Last date shown is 2014.)
The first question has to be Why? Why the sudden change?

My answer: The central bank suddenly felt the need to "catch up".

The line runs flat
Central bank assets ran flat from 1960 to 2008: a little higher at the end, a little lower in the middle. Central bank assets ran flat because the Fed was controlling things. The big surprise in 2008 was the discovery that they were not controlling the right things. And suddenly, there was a lot of catching-up to do.

You should be asking: Catching up to what?

Good question. The purpose of controlling central bank assets is to put a limit on the availability of money. And, from 1960 to 2008, they kept the limit around 5% of GDP. But that doesn't mean the money supply was 5% of GDP, because the money supply expands above the base provided by the central bank -- like dough rising to make bread.

The money supply increases when we borrow money. So you can imagine our borrowings must have some relation to the Central Bank Assets graph.

Note that our borrowings continue to exist until we pay back the borrowed money. The accumulation of borrowings is called "debt". So you may imagine that our debt must have some relation to the Central Bank Assets graph.


Graph #2: Central Bank Assets (blue) and Private Non-Financial Borrowings (red)
Our accumulated borrowings increased more or less continuously, all the while the central bank was "controlling" things. Then suddenly, something snapped. Borrowings started to fall. And the central bank had to make a quick adjustment to bring its assets back in line with borrowings.

The problem (in case you missed it) is that the central bank was keeping its assets in line with GDP but what we really needed was to have those assets more in line with our borrowings. Here is assets relative to borrowings:

Graph #3: Central Bank Assets relative to Private Non-Financial Borrowings
This one looks a lot like the first graph except, if you notice, the "flat from 1960 to 2008" is now a decline. In 1970, central bank assets were around 6% of our borrowings, the same level you see on graph #1 for assets relative to GDP. But by the time of the crisis, that asset level had fallen to not much more than 3% of accumulated borrowings. Half as much.

This graph starts near the 6% level. But if the data was available, I expect you'd see the ratio much higher in the 1950s. That would make the recent high look less daunting. And you would see that the central bank "backing" behind private bank assets was quite high early on, but fell over the years to a low in our moment of crisis. Then in 2008 the central bank suddenly seemed to discover something it should have known all along, and started pushing its assets up, relative to private borrowings.

This next graph uses different data to tell the same story. And it goes back to the 1950s, so you can see the ratio was much higher then:

Graph #4: Fed Holdings of Federal Debt relative to Private Borrowings
On this graph the debt measure is bigger because it includes financial as well as non-financial debt. And the central bank asset measure is smaller, as it includes only the central bank holdings of Federal debt. But the downtrend since 1970 is visible just the same. And the early years show an even bigger downtrend from an even higher level. The ratio was much higher in the 1950s than it is at present.

The Fed was "controlling" things all along. But it was looking at the wrong things. It was looking at assets relative to GDP. It should have been looking at assets relative to the private-sector money that was built upon those assets. It should have been looking at its assets relative to private sector debt.

To prevent the decline that ended in disaster, the Fed would have had to increase its assets faster than it did since the 1970s, or reduce the growth of private sector debt. Since the 1970s or earlier. But nobody likes either of those options. Increasing the assets is associated with inflation. Decreasing private borrowing is associated with economic stagnation.

What to do, what to do.

We need a judicious combination of the two options. A well-designed policy could have increased central bank assets and restrained private debt growth to keep the ratio as stable as the ratio we saw on graph #1. Policymakers do have the ability to keep such ratios stable. They just don't know which ratio to stabilize.

With less borrowing, we'd have less growth. But with more central bank assets we'd have more growth.

With more central bank assets, we'd have more inflation. But with less borrowing, we'd have less inflation.

Meanwhile, there would be less private debt in our economy. There would be less financial cost competing for dollars with wages and profits. Finance -- or "rent" as people call it -- would be reduced. So the cost of our output would include less financial cost. Our output would be a better bargain as a result: more value per dollar. This would allow wages and profits to rise. And it would make us more competitive in world markets.

See how it works? It's a "euthanasia of the rentier" thing. But you knew that.

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