Hear Me Now

It is often sadly remarked that the bad economists present their errors to the public better than the good economists present their truths – Henry Hazlitt

In ongoing discussions, there's significant debate regarding whether the Federal Reserve should cut interest rates during an election year, given the potential for these decisions to become politicized. It often seems like a partisan struggle is underway, with one side hoping that the economic challenges stemming from bipartisan fiscal policies and the Fed's accommodative monetary policy will either manifest or be averted before the election.

However, while some FOMC members may align with Democratic or Republican ideologies, decisions are primarily reached through consensus. Dissent against the chair is uncommon, regardless of the impact of the change in monetary policy. This brings me to Tom Hoenig, whom I recently encountered by accident when I stumbled upon an old Politico article from 2021.

If one could say one thing about Hoenig, it's that he stood by his principles during a significant shift in monetary policy, not only in the United States but also worldwide. After serving at the Fed for his entire career, he became President of the Kansas City Fed in 1991 and resigned in 2011.

But let's return to the Fed and their pursuit of unanimity. After the Global Financial Crisis (GFC), Fed Chair Ben Bernanke had just begun implementing unprecedented measures, with many warnings that the substantial expansion of base money could potentially lead to high inflation. Hoenig shared these concerns and consistently voted according to his conscience.

Throughout 2010, the FOMC votes were routinely 11 against one, with Hoenig being the one. He retired from the Fed in late 2011, and after that, a reputation hardened around Hoenig as the man who got it wrong.

Hoenig might not have been entirely accurate about inflation—like many others during that time. However, as Christopher Leonard notes:

But this version of history isn’t true. While Hoenig was concerned about inflation, that isn’t what solely what drove him to lodge his string of dissents. The historical record shows that Hoenig was worried primarily that the Fed was taking a risky path that would deepen income inequality, stoke dangerous asset bubbles and enrich the biggest banks over everyone else. He also warned that it would suck the Fed into a money-printing quagmire that the central bank would not be able to escape without destabilizing the entire financial system.

On all of these points, Hoenig was correct. And on all of these points, he was ignored. We are now living in a world that Hoenig warned about.

The entire article is worth reading, but I'd like to pivot in another direction. First, let me provide a brief market update. As of writing, stocks continue their bull market, indicating that the rally has further room to go, as the market anticipates at least the number of rate cuts promised by the Fed.

Additionally, the expected sideways trend in the bond market persists, with 10-year government bonds up since mid-March but still showing signs of the sideways trend that began this year. In the short term, things are expected to remain stable, although one could argue that the more things change, the more they stay the same. While the market direction remains clear, some expectations have shifted significantly this year, with a 'no-landing' scenario now the consensus among investors.

Published data in the US remains mixed, while in Western Europe, particularly in Germany, it still leans towards the negative side. Weak data has sparked discussions among market participants about when the ECB will cut interest rates for the first time. However, it seems certain that the rate cut will occur before the Summer Break.

Moving into the second quarter, current economic forecasts for this year remain optimistic, including for the Eurozone. Eurozone growth is expected to reach 0.5% in 2024, perfectly aligning with the "soft-landing" scenario some ECB officials claim has already become a reality.

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Now, let's delve back into Thomas Hoenig's story and warnings. He steadfastly adhered to his principles, drawing from the lessons he learned in the tumultuous 1970s.

Bernanke was unpersuaded by these arguments. When Bernanke published a memoir in 2015, he entitled it The Courage to Act. This captured the theory of Bernankeism, which holds that central bank intervention is not only necessary, but even courageous and noble (Bernanke declined to answer questions about Hoenig’s dissents that were sent to Bernanke in June).

Understanding Ben Bernanke's mindset is crucial here, and a later passage in Leonard's article sheds light on it:

According to transcripts of internal FOMC debates, Bernanke defended the plan with an argument that he would use repeatedly in coming years, saying that the Fed faced risks if it didn’t intervene.

Bernanke was later awarded the Nobel Prize for his studies on the Great Depression, and his proponents consistently argue that the Fed's actions in the 2010s "helped to avert a greater financial disaster than the Great Depression." While this justification for the Fed's actions is common, it remains counterfactual. There is no way to ascertain whether the alternative would have been worse.

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As this commentary coincides with Good Friday, perhaps it's an opportune time to delve into more philosophical discussions about macroeconomics and the future trajectory of the economy this week. Over recent weeks, claims about our monetary system and the economy's future path have emerged, warranting theoretical discussions to assess their potential realization.

Let's begin with a claim about our current monetary system, closely associated with proponents of Modern Monetary Theory but also spreading into the financial world. It's the assertion that commercial bank lending nowadays isn't constrained by their reserves and that they can create money "with the stroke of a pen."

What's often overlooked here is that while this claim might hold true for an individual bank—meaning that a bank might not have enough reserves to make a loan but can still lend into the real economy—it cannot be true for all banks.

Let's revisit the basic bank business model: banks profit through maturity transformation. They borrow short-term from customers via bank deposits and lend long-term to businesses or households. The amount they can lend out is dictated by the reserve constraint imposed by the central bank.

For instance, a minimum reserve of 1% implies that if I deposit $100 into the bank, the bank can lend out $99 to Jane, effectively expanding the money supply by $99. Jane and I both hold a claim on $99, totaling $198, even though only $100 physically existed prior. That underscores why base money, consisting of cash and bank reserves, forms the foundation of the monetary system.

The amount of base money in circulation thus restricts the overall lending activity in the commercial banking sector. I'm puzzled as to why economists at the Bank of England concluded in a 2014 paper that banks are not restricted in their lending simply because they can expand their balance sheets.

Hence, while a single bank may indeed be able to lend out more money than the reserves it holds on its balance sheet, this cannot be true for the entire banking system. That is why I mentioned fractional reserve banking earlier, as no one has ever encountered a situation where a bank denied a loan due to insufficient reserves.

What might initially appear to support the claim made by Bank of England economists is, in fact, easily debunked. Such a scenario has never unfolded because a bank can tap into the interbank market and borrow the funds it needs from other banks. So, suppose a bank requires additional reserves to make a loan. In that case, it can simply utilize assets, such as a 10-year treasury, as collateral to borrow from another bank with excess reserves, enabling it to extend a loan.

Individually, it may seem that reserves do not constrain commercial banks. However, this is the reality for the banking system as a whole. If insufficient reserves are available overall, the bank cannot borrow the funds, thus impeding lending.

If you remain unconvinced, George Selgin recently published an excellent working paper on this topic, providing a more comprehensive exploration. He also notes that there's only one bank where the claim of the "thin air" theorists, as Selgin refers to them, holds: the central bank itself.

My argument here is that central bank actions may have contributed to the propagation of this "thin air narrative." After central banks inundated the market with bank reserves following the Global Financial Crisis, commercial bank lending had scarcely any impact. Despite suddenly having an abundance of reserves, commercial banks refrained from lending into the real economy, contrary to the hopes of central banks.

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It's reminiscent of many theories championed by proponents of Modern Monetary Theory (MMT), who assert they merely describe the current state of the monetary system but, in reality, seek to implement Keynesian economic policies through indirect means. However, what surprises me more is how readily many astute minds in financial markets embrace these theories, at least partially, when they align with their narrative.

An example related to the previously discussed topic is the claim that central bank rate hikes will lead to higher inflation and a stronger GDP. The rationale behind this claim is twofold.

First, MMT proponents argue that issuing a government bond—in the issuer's currency—is tantamount to money creation. Their reasoning is as follows: by purchasing a government bond, you effectively place a bond into a "government savings account," while the government retains the money you paid for the bond, doubling the amount of money involved in the transaction.

The second point is that due to the deficit, every rate hike ultimately translates to higher interest income for investors, enabling them to procure more goods and services in the real economy, thereby driving up prices. As inflation escalates, the deficit expands because a significant portion of the US budget comprises social security spending, which is periodically adjusted for inflation.

Below is a chart I shared two weeks ago, illustrating the proportion of government interest expenses to nominal GDP and M2 money supply, along with year-over-year inflation. As evident, neither the level of interest expenses relative to nominal GDP nor the money supply is exceptionally high at present. Moreover, it doesn't appear that an increasing share of these factors is fueling inflation; instead, it seems to be a consequence of prior inflation increases.

Another point to consider is that an increased deficit doesn't necessarily lead to rising GDP, as exemplified by the Eurozone during the 2010s. It's not that a deficit can't temporarily drive GDP growth by stimulating economic activity, but for it to become sustainable, there must be demand. For instance, significant government spending was directed towards climate-related industries. However, Janet Yellen has expressed concerns regarding China's "excess capacity":

"I will convey my belief that excess capacity poses risks not only to American workers and firms and to the global economy, but also productivity and growth in the Chinese economy, as China itself acknowledged in its National People's Congress this month," Yellen said. "And I will press my Chinese counterparts to take necessary steps to address this issue."

It's likely that the US administration fears that many of their "investments" may incur losses due to China's ability to produce at lower costs. Consequently, the stimulative effect of deficits on GDP is questionable. Moreover, if this claim were true, it begs the question of why Eurozone countries like France didn't experience a similar GDP boom despite running a deficit close to 6% in 2023.

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Now, with the debate surrounding the correlation between higher interest rates and inflation, it's evident that this claim lacks substantial support.

To comprehend this, one must revisit the assertion that the issuance of government bonds equates to "money printing," which is inherently false. While it's true that, in a "bookkeeping" sense, the issuance of bonds creates new money, as the bond is valued the same amount as the cash held prior, this notion is erroneous in an economic context.

Issuing bonds is akin to lending money to a friend in exchange for a promissory note. Your friend may have more money to spend, but you end up with less to spend despite maintaining the same amount of money in a "bookkeeping" sense. Economically, you have less spending power while your friend has more, resulting in a net zero.

Similarly, the same principle applies to government bond issuance, even if commercial banks are involved in the purchase. Banks buy bonds with their reserves, thereby not creating additional money unless they borrow funds to purchase the bonds. However, in such cases, the money already exists in the system, canceling each other. Consequently, the transaction isn't inflationary.

The quantity of currency units in the "bookkeeping" realm is irrelevant when the units available for spending remain constant. Thus, government debt issuance isn't inherently inflationary; its inflationary potential depends on how the debt is financed. If investors buy the bond, no additional money is created. However, the money supply increases the money supply increases if the central bank purchases the bond directly or indirectly (via quantitative easing).

Hypothetically, if the Fed were to hike interest rates to 10%, people might buy bonds instead of other assets, causing prices to fall. Nonetheless, this wouldn't necessarily spur higher GDP or inflation without debt monetization to increase the money supply. Moreover, besides its logical inconsistency, there's no historical precedent for this scenario.

Understanding that the above claims lack validity helps us comprehend that the economy won't indefinitely grow solely from continued government spending. It also underscores that inflation won't necessarily resurge as long as money supply growth remains stagnant or aligned with output growth.

Furthermore, since commercial banks rely on funds for lending, the recent Quantitative Tightening (QT) period has constrained their lending ability. Consequently, it's unsurprising that the Fed may need to taper QT at some point as long as lending remains subdued to prevent potential credit market issues.

Monetary policy operates with a lag on the economy, and the extent of intervention in this decade might have significantly prolonged this lag. Additionally, events tend to occur unexpectedly rather than when anticipated. That implies that the shift to a "no-landing" consensus might be challenged soon, possibly even in this quarter.

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This brings us back to Ben Bernanke and his belief that it's better to take action than to do nothing—a mindset shared by most modern-day macroeconomists. However, constantly relying on intervention to solve tough situations overlooks the fact that many problems arise from prior interventions.

Nevertheless, this mindset also holds logical appeal, as everyone seeks to imbue their job with meaning and purpose. If your job involves devising solutions to problems that wouldn't exist without prior interventions, it's natural to find meaning in it. After all, nobody wants to feel as though their efforts are in vain.

I don't wanna live for nothing, just wanna be something
I never knew what it took to win
I don't wanna live for nothing, just wanna be something
I never knew we'd be more than friends

Bad Wolves feat. Diamante – Hear Me Now

Happy Easter!!
Fabian Wintersberger

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All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change in response to evolving facts. It is strongly recommended to seek independent advice and conduct your own research before making investment decisions.