THIN AIR ELASTICITY
EDU DDA Aug. 15, 2024
Summary: Rather than merely review the deluge of macro data from today, it’s worth instead revisiting the topic of money elasticity. Since we're coming up on September, we'll focus on the downside or deflationary side of elasticity. It wrongly gets lumped together with bailouts, though it is understandable why that often is. Aside from it being wrong, though, history is absolutely conclusive on the matter - including the one time we all lived through.
An absolute flood of economic statistics today and all the key ones, too. It started last night with China’s Big Three plus home prices (and an “unexpected” rise in unemployment), then hitting the tape was US retail sales plus America’s own industrial production data. The overwhelming majority was the same as ever, sliding further toward the end of the cycle.
The one exception was US retail sales that beat every single expectation by a wide margin. Even while doing so, revisions (downward, obviously) to prior months only raise more questions along the same lines as those being asked of payrolls. Even US IP got into it with huge downward revisions to its previous estimates, too, though July was decidedly not a good month for American output.
Markets somewhat understandably plucked the US retail spending data out of the rest of the awful mess and ran with those far more friendly numbers. Even Treasuries backed up especially in the middle, though I believe that might just be the beginning of September.
For the full round-up and discussion about the data as well as the September effect, I’ll put today’s Daily Briefing here which has all of it.
Today’s DDA will instead focus on looking ahead into the absolutely critical yet underappreciated and totally misunderstood area of money elasticity - hoping that it doesn’t become an immediate issue; though, again, September is lurking and the last little while has brought it back up and into some focus. Compared to last August, this one is leaning the wrong way.
Elasticity as a concept is grossly misassociated if for understandable reasons. Through no fault of anyone but central bankers and Economists, the general public associates the term with bailouts. Currency elasticity is said to mean the Fed rescuing its friends (or, according to others, its Wall Street masters).
What’s most distasteful about bailouts is they mean the exact opposite of what we all think should happen; and I count myself in this group. When businesses perform poorly for a long enough period of time, the free-market system judges them harshly and puts them out to pasture. Creative destruction requires actual destruction.
The same applies, or should, to the banking system. Subprime mortgages were an abomination. Their purveyors deserved finality and instead it really seems like they all lived onward and, worse, were even rewarded for their grotesque handiwork.
While these might be characterized under a wide umbrella of money elasticity, it’s not so simple and I don’t mean bailing out bad banks. The problem is instead sorting the one kind from the other; the good from the bad. It seems like an easy enough task, but every theoretical assumption does from ten thousand feet on paper.
Did Bear Stearns deserve to be wiped out, for example?
Some might say yes and I would say they are absolutely, 100% wrong. Bear was absolutely not an overactive subprime peddler. What it did do was get involved in various aspects of securitization including using complicated structures as collateral in repo – until it ran out once that collateral got repriced.
Under the old Bagehot school, if you run out of collateral then you are by definition part of the “bad.” Remember it was his Lombard Street which urged central banks (real ones, not what we have today) to lend freely at high rates on good collateral. If you don’t have the last of those, then you’re done.
While that might have worked two centuries ago - and even then it is entirely oversimplifying things (as we’ll see in a minute) - in Bear’s case the collateral it used in repo to finance its operations was not, actually, “bad” collateral. Sure, it was MBS and a few billions were subprime, yet at the end of the day, at the end of the crisis, the vast majority was money-good the entire time.
Yes, “good” collateral.
The reason it became unusable was illiquidity all across the marketplace for that collateral. In other words, the monetary panic had scrambled price signals in every direction. A systemic monetary event makes good assets and thereby good institutions seem bad, themselves illiquid therefore insolvent on the simplest terms.
That’s the thing about monetary panics historically; they end up lumping good and bad together, whether collateral, businesses, or banks. Taking a detached view, the system would risk having useful, productive contributors being ended right alongside the worthless; throwing the baby out with the bathwater, or, in this case, throwing half of all babies out for a small film of spoiled bathwater. The damage that does short and long run is incalculable, as we are witness to yet again here in the 21st century Silent Depression.
And for that reason and only as a start, elasticity is demanded as precaution against such a disastrous downside case.
There are other reasons for elasticity having to do with boomtimes, something the eurodollar’s method managed well enough particularly the Great “Moderation.” That piece of the monetary puzzle deserves its own discussion and treatment, so I’ll save that one for another day so that we can focus here on elasticity in the deflationary sense.
It’s a case has been so completely established by repeated history of depression. Worst of all, it is the little guy, the worker who ends up bearing the brunt of it. As Keynes noted, inflation may tax savings and savers yet deflation destroys work. Neither is good; the latter just evil, to use his word.
But where does elasticity come from? Where should it come from?
One traditional strand of thought comes from hard money proponents, those who support a gold standard alongside Bitcoin maximalists (strange bedfellows). Their argument is that price determined elasticity. No bailouts, no money printing, no funny business. Bad actors are expunged.
If conditions become questionable, money stops circulating at the same rate, in the same way, to the same participants as before, then heightened demand for money will raise its price inducing those with spare funds (which should mean more of them since money isn’t circulating as much in this hypothetical) to lend it taking advantage of the profit opportunity. No additional supply is necessary to be “printed” “out of thin air” by either bankers or central bankers.
It is an elegant and admittedly enticing theory especially to all those who detest statism. In practice, it has been an utter disaster – which is the whole reason why the Federal Reserve exists in the first place; the real reason.
A brief digression: the most frustrating aspect of these monetary debates, and I just had one on Mark Moss’s show with a nice enough fellow by the name of Paker Lewis, both of those two hardcore Bitcoiners (I believe you can watch the replay at Mark’s YT channel), is how their arguments in favor of Bitcoin (or gold) specifically, or hard money generally, are entirely theoretical. What makes it odd and maddening is that they needn’t be; we have centuries of actual practice to draw upon.
But that would mean knowing the history – which too often appears to be too much to ask.
It starts with the 2008 monetary crisis; in fact, right on August 9 and 10 of 2007 from the very beginning. On the 9th, money rates increased just as you would expect in a budding panic; the effective federal funds rate jumped to 5.41%, substantially above the fed funds target (FOMC policy) of at the time 5.25%. LIBOR made a similar move, but we’ll focus on fed funds.
Then something peculiar happened the very next day. Rather than go further upward as you might expect, on August 10 the effective rate dropped to just 4.68% (for reference, there is no single money market rate for any of these markets including fed funds; what you see reported as the “effective” rate is the weighted median of all transactions in the marketplace). Even more astonishing, the 1st percentile was zero (see: immediately above).
What that meant was some participants were willing to park cash in the fed funds market by lending it out while accepting 0% in return. And because the effective rate was dragged well below the target rate, it meant that the weight of the entire market moved in that same direction; not all the way to zero, but tens of billions were borrowed and lent at unusually low rates of return.
Not all transactions took place below target. There were some number of borrowers forced to pay higher rates to secure unsecured (uncollateralized) ST funding.
The price elasticity argument was completely upended by this, the same as what happens in every similar situation through history. What should have happened was market participants reacted to the higher profit opportunity and lent out more spare cash and liquidity to normalize money rates; bring them back down. But the majority of money market lending was…down.
In the case of the Fed, participants would have accessed the Fed’s Discount Window (Primary Credit) in order to arbitrage the same; borrowing from the Fed at 5.25% + the penalty and lending at higher rates to those troubled borrowers (especially those overseas or offshore where LIBOR rates went generally higher).
That would have been price elasticity and some of that did take place – for a little while. Even when it did, it was never enough leaving the system more and more illiquid, making markets the same and therefore causing even good assets to be priced as bad meaning institutions like Bear relying on them would have appeared to have been irresponsible.
Most cash-holders did the opposite of the price elasticity theory. They avoided the potential reward of desperate borrowers willing to pay higher rates, choosing to lend only to those deemed safe to the point of accepting substantially lesser returns. And this continued throughout the rest of the crisis period, where effective fed funds was oftentimes significantly below the fed funds target.
By the time Bear would meet its end, even those dealers who had been responding to price stopped doing so (as discussed in the quote below).
The problem is that price by itself is not enough. What I mean is, the main consideration is not strictly or solely return, it is always and everywhere risk-adjusted returns. When the risks are judged to be high, there is almost no reward that can be offered to make cash-holders (or liquidity holders) recirculate money, currency, liquidity as needed. They fear loss too much.
Hoarding beats price every single time. No exceptions.
Below is another spot-on example from an entirely different era yet leading to the same results. During the 1893 panic, hoarding overwhelmed the profit opportunity afforded by that general panic. The speaker here is Alonzo Barton Hepburn, former Comptroller of the Currency and one of the most recognized monetary and economics (small “e”) authorities of his day.
There is no more money in the country in 1894 than there was in 1893. Now money clogs the vaults of our banks and begs investment at a lower rate per annum than the premium offered, one year ago, for a single service, and which failed to lure it from hiding in safes and vaults.
Just like fed funds later on, banks hoarded cash and money in their vaults accepting zero return to hoard liquidity. What money they did lend they lent only to the safest counterparties, which is why just like 2007 and 2008 Hepburn says the rate of return was lower later on than when the crisis started.
That’s because the stated interest rate only applied to those borrowers who lenders were willing to lend. The realized rate for all the rest – good and bad – was effectively infinity. This is just what Knut Wicksell was talking about when he formalized his natural rate theory, why rates go down during depressionary circumstances.
Nobody wants to take risk so risk-averse cash lenders flock to safe borrowers (such as governments and the biggest companies) and compete to lend them all the funds they could ever want at the expense of the entire rest of the financial and economic system. Hoarding means narrowing the circulation of necessary money.
Deflation. Then depression.
Price elasticity never worked. What did? Many will have heard the story of JP Morgan riding to the rescue of the banking system in 1907. The Fed, it is said, was created so that the US would never have to rely on the whims of a private banker who would hold way too much power in that circumstance.
That’s only the narrative which was crafted to help sell the skeptical American public on a central bank Americans were at best reluctant to accept (most were correctly downright hostile to the very idea). What actually happened was far more complicated, providing yet more unambiguous evidence for not-price-elasticity.
After the panic began in October 1907 at Knickerbocker Trust, the price of money once again soared during the initial stage as desperate borrowers sought financing. As A. Piatt Andrews recalled in 1908, the “price” of currency reached insane (for those times) proportions (we’ll forgive Mr. Andrews for his hyperbolic flourishes).
The panic of 1907 witnessed a premium upon money in New York lasting two months and rising as high as 4 per cent…In England no such general suspension of bank payments and no such premium upon money have occurred since the period of the Napoleonic wars; in France not since war with Prussia; and even in the dire vicissitudes of the latter experience the premium paid for coin rose once to the level of 4 per cent., a surplus price which was frequently paid for currency in New York during November, 1907.
Basically, the price of money absolutely soared to rarely-seen heights -which did nothing to stop the panic. Money instead was locked away in safe deposits and private vaults rather than take advantage of such crisis premiums (it really is the common theme in every depression, including and especially 1929-33 which I won’t get into here).
Mr. Morgan cobbled together roughly $25 million and while a princely sum for the time it was only a fraction of what actually limited the scope of the panic and prevented any Depression of 1908 (there was a severe recession, though short and most importantly one that didn’t leave a depression-sized hole in the banking system therefore the workforce).
The majority of the elasticity was offered first by the US government (no wonder the hard money crowd doesn’t like this story). Treasury Secretary Cortelyou ordered about $36 million in government deposits get redirected to New York City banks, particularly those hardest hit. This wasn’t money printed out of thin air, merely redistributed from existing funds which were not circulating and were not taking advantage of higher prices.
By far, though, the vast majority of the 1907-08 rescue was offered by the various regional clearinghouses, private bank associations which did create a form of quasi-money out of thin air (the forerunner of the Fed’s bank reserves) called clearinghouse loan certificates. Estimates suggest a whopping $256 million ended up being issued.
Both the government and the clearinghouse elasticity had nothing to do with the price of money. They were offered out of necessity rather than profit motive because those with the profit motive saw no return worth the risk of pursuing even with the price of money exceptionally high.
As I wrote above, the reason Morgan gets all the “credit” is the government wanted a villain to sell its Federal Reserve – a central bank which was intended to be a national yet public clearinghouse, meant to function the same way if not better (by standardizing a national approach) than the regional associations that had actually staved off depression with “thin air” elasticity.
There is enormous debate about how such a “thin air” elasticity system might best be structured, though there should be none about its actual purpose. It isn’t bailouts, nor is it “money printing” for the sake of it, rather recognizing how in every depression circumstance – including the one we ourselves experienced – hoarding means illiquidity of the scale and scope which does not distinguish “good” from “bad”, instead treats both and any in between apart from the very the top of the borrower heap as all the same.
With enormously devastating consequences.
As far as the “best” framework by which to avoid them, we should at least be able to agree the modern “central bank” like the Fed is decidedly not it. While you might condone the original version as a worthwhile attempt or experiment, we knew that from nearly its very beginning it wasn’t feasible; after all, Great Depression. Worst of all, everything the Fed did wrong during the thirties it would do wrong again in 2008.
The entire argument against the Fed is itself wrong-footed for this reason. Most people have a problem with either it “bailing out” everyone or the “money printing” used to do it. The real disaster is not that it shouldn’t but that it can’t (nor do we want it to) and so twice it hasn’t.
Another private-run clearinghouse? Far better than the Fed. Some kind of responsive therefore effective means to keep money circulating, doing it regardless of price all the better. Not to bail out Wall Street, preferring to sit around and wait for price to do it for us is the biggest disaster waiting to happen.
This is one critical reason why we have the broken eurodollar system we do. Participants know there is no backstop; the Fed is all pretend meaning hoarding keeps being the dominant feature (this entire stretch since August 9, 2007, obliterates the price elasticity theory). And it could possibly be again one month from now if a whole bunch more goes wrong in between.
Elasticity means a couple different things. Where it comes to the deflationary possibilities, though, history conclusively has shown there is only one thing. Avoiding it isn’t possible by doing nothing. The current Fed isn’t quite nothing, though it is right next to it.
