The Scourge of Keynesian Central Banking, Part 1

Once upon a time monetary policy was about Money—its integrity and the stable purchasing power thereof. Indeed, during his landmark congressional testimony of 1912, J.P. Morgan implied that “policy” was not even a matter of debate when he famously said that:

“Money is gold, nothing else.”

At length, US central bankers put increasingly more of a squinty eye on the macro-economy. But at least through the tenure of William McChesney Martin (1951-1970), price stability defined as close to zero CPI inflation over time was the main priority, as was keeping the dollar firmly linked to gold at $35 per ounce.

After Nixon shit-canned the Bretton Woods gold-exchange standard at Camp David in August 1971, however, central bankers were unexpectedly engulfed with unprecedented peacetime inflation.

Thus, during the 12-years between June 1953 and June 1965, and before LBJ forced the Fed’s hand with his giant “guns and butter” deficits, the CPI rose by an average of just 1.3% per annum. By contrast, between August 1971 and August 1983, when Volcker finally wrestled the inflation monster to ground, the 12-year average of CPI increase rose to nearly 8.0% per annum.

Of course, the latter was not supposed to have happened. At the time of Nixon’s Camp David  malfeasance, Uncle Milton Friedman had told Tricky Dick not to worry: The free market would set the dollar’s exchange rate against other currencies and the Fed would dutifully meter out just the right amount of bank reserves to assure stable non-inflationary growth.

Besides, if the FOMC was careful to read Uncle Milton’s biweekly Newsweek column for any tweaking that might be needed to the basic money growth rule—nothing could go wrong. We knew both Arthur Burns and William Miller, the Fed chairman during the 1970s, and can’t say for sure whether they read Friedman’s column or not or whether he was dispensing the fail-safe advice he claimed to posses.

But we do know that once Burns caved to Nixon in order to facilitate his 1972 landslide re-election with a massive eruption of bank credit, the inflationary cat was out of the bag. The Fed became extremely Economy focussed as a result, but it was still ultimately in behest of reasonably honest Money.

That is, the Fed’s big foot was chronically on the brakes attempting to wrestle the CPI sharply lower, but now from a crypto-Keynesian vantage point of not wishing to brake too hard, thereby sending the main street economy into the drink of recession.

The consequence, of course, was a start/stop monetary policy that oscillated between attempting to brake the inflation fever and periodic bouts of “stimulus” designed to cure the three recessions which occurred during that 12 year period. And it was during this time span that the Phillips Curve lamentably also had its heyday.

But it shouldn’t have. The only thing that really happened between Camp David and the onset of the Reagan Boom in mid-1983, is that both variables—inflation and growth/jobs—-got materially worse at the same time.

Thus, in addition to the trend rate of inflation soaring from 1.3% to 8.0%, the average growth of real GDP went in the opposite direction: After posting an average growth rate of 3.5% per annum during the 1953-1965 golden era, it slumped by nearly one-fourth to just 2.7% annually during the 12 years of post-Camp David stagflation.

Worse still, the unemployment rate averaged 5.3% during the 1953-1965 period compared to 7.1% during 1971-1983. Accordingly, both the red bars for inflation and the blue bars for unemployment went in the same higher (wrong) direction!

That is to say, there wasn’t any evidence of the fabled Phillips Curve trade-off. Much, much more inflation was accompanied by much more unemployment.

So even as monetary policy focussed on Economy, it was in the context of a losing battle to protect the value of money.

Needless to say, Volcker did not pretend to be troubled by this mythical Phillips Curve trade-off. He was an old-fashioned sound money man from the traditional world of commercial banking. Perhaps for that reason he understood that bankers did not wish to be paid back in depreciated money and that savers were not keen on earning negative real returns on their deposits.

In any event, Volcker threw on the monetary breaks, refocusing monetary policy on the matter of Money and its integrity as a store of value and efficient means of transaction. So doing, he not only slayed the dragon of double-digit inflation, which peaked at 13.5%  shortly after he was put in charge of the Fed by a desperate Jimmy Carter in late 1979, but he also buried the Phillips Curve once and for all.

As shown in the chart below, the CPI rate fell to the 2.5% to 3.5% range by the end of his tenure—even as unemployment marched steadily lower after the back of inflation was broken by the 1982 recession.

Indeed, the bookends of the chart tell the real story. Volcker inherited the worst pair of variables in modern history–with inflation at 13.5% and unemployment at 7.2% during 1980.

By the time he was shown the door by the Reagan pols in 1987 (and their confederates on the Fed), the CPI was down to 3.5% and the unemployment rate posted at  just above 6%. More people working thus resulted in more output, not more inflation as the Phillips Curve falsely claims.

In fact, real GDP growth averaged a robust 4.6% per annum between Q3 1983 and Q3 1987 when Volcker gave up the reins. Accordingly, at that point the Phillips Curve should have been taken out back and shot; and monetary policy—even in the post-Bretton Woods era of fiat dollars—should have been refocused on Money and true price stability along the zero-bound.

After all, the stunning Volcker accomplishment as conveyed in the respective charts above and below did prove something critically important with respect to the relationship between central banking and capitalist prosperity. To wit, that the latter can take care of itself—-if the state keeps out of the way and its central banking branch focuses policy strictly on Money.

Unfortunately, Volcker’s victory and return to Money focussed monetary policy was not to stand. Within two months after taking office, Alan Greenspan got monkey-hammered by the bad side of the Reagan revival.

That is, the massive structural deficits that had been unleashed by too big of tax cuts, too small of domestic spending reductions and a breakout of defense spending which literally shot the moon, rising from $140 billion per annum to upwards of $350 billion in barely a half decade.

Accordingly, as the US economy moved to a high level of production and private sector capital demands to support housing and business investment, the proverbial “crowding-out” dynamic took hold with a vengeance. During the first 10 months of 1987, the yield on the 10-year treasury note soared from 7% to more than 10%, thereby precipitating the infamous 22% stock market crash of October 19,1987.

Under rules of honest money, of course, the next in rotation sequence would have been a rip-roaring recession.

That’s the very thing which giant government deficits cause when the savings supply is limited and the central bank is not in the business of monetizing the public debt, thereby creating artificial demand for Uncle Sam’s debt emissions.

It goes without saying, of course, that rookie chairman Alan Greenspan panicked in the face of the Wall Street meltdown, and did so as a Washington insider and power-seeker who had given up his gold standard virginity years before.

We know that first hand because during our tenure at OMB (1981-1985) Alan Greenspan was a regular caller, laden with policy and political recommendations, but the restoration of a gold-backed dollar was not among them.

But what did rise to the top of Greenspan’s priorities was a desire to be feted and admired in the Imperial City. As a fawning New York Times profile made clear at the time of his nomination, being a man about town was really what Greenspan was all about:

JUST last weekend, Alan Greenspan attended Henry Kissinger’s lavish 60th birthday party accompanied by Barbara Walters. When not attending such elegant affairs, he can be found on television or in Washington or in the most powerful of corporate board rooms offering his views on economic affairs, politics and the social issues of the day. At age 57, Mr. Greenspan is one of the most popular guests on New York’s party circuit – and one of America’s leading and most sought after economists.

Now, however, the bespectacled, softspoken Mr. Greenspan is being talked about for what would be his most lofty position. He is nearly everybody’s first choice for chairman of the Federal Reserve Board, should Paul A. Volcker, the current occupant of the venerable post, be asked to step aside by the President in early August. The only question is whether he is Ronald Reagan’s choice as well.

”Alan doesn’t have any competition, does he?” said Otto Eckstein, chairman of Data Resources Inc. ”He’s a known quantity in Washington, and he’s acceptable to the financial community because he’s known there, too.”

Needless to say, universal acclaim, on the one hand, and facing down the collision between the massive Reagan deficits and continuance of the Volcker sound money era, on the other, were not remotely compatible bedfellows.

So when the crunch came, Greenspan cranked up the Fed’s printing presses red hot and actually sent his minions down to the canyons of Wall Street to effectively order trading desks to hang-on to underwater securities they would have otherwise liquidated under the rules of the free market.

As it happened, Greenspan’s betrayal of sound money did save Ronald Reagan’s bacon. The recession virtually ordained by his reckless fiscal policy was deferred by several years, thereby giving rise to the mythology that the Gipper had both saved the American economy and proved that deficits don’t really matter.

Actually, what this pivotal episode proved is that central banks can monetize massive amounts of the public debt, thereby deferring the day of reckoning. And so doing, can lead the politicians of Capitol Hill, the financial media and even the attentive public to believe that there really is a free lunch—or, at least, that the fiscal can be kicked down the road with relative impunity.

It also led Alan Greenspan to believe that he could become the toast of the town—the great Maestro—by shielding Washington from the troublesome upsets which arise from honest financial markets. And that by adopting an Economy focused monetary policy, he could also eliminate or substantially mitigate the economic pains on main street that results from Uncle Sam’s sharp elbows in the bond pits and the recessionary downturns that flow from soaring interest rates when borrower demands far outrun the supply of honest savings.

Accordingly, monetary policy based on Money was thrown out the window of the Eccles Building, and officially so in the early 1990s when the rise of sweep accounts and other banking innovations led to the abandonment entirely of Uncle Milton Friedman’s rules for M1 growth and the bank reserves that historically stood behind it. The Ms, in fact, were no longer even meaningfully measurable.

What happened by default, therefore, is that the Greenspan Fed went back to interest rate pegging—a form of price control that is far more damaging than any of the foolish experiments in rent controls, oil and natural gas price control or even the short-lived Nixon effort at comprehensive wage and price controls at the time of Camp David.

But here’s the thing. The very idea that the US main street economy, then weighing in at about $7 trillion, could be managed via the rickety steering gear of the Federal funds rate was ridiculous from the very beginning; and that became all the more true when the statist and mercantilist economies of East Asian began to boom in response to soaring US demand for imported goods and the spread of Fed-style money printing to their own central banks.

Nevertheless, a whole practice and ideology of Keynesian Central Banking emerged and congealed over the subsequent three decades until it reached the absurd Economy focussed pettifoggery that prevails today.

Recently, Powell the Pivot showed exactly how far this has gone off the deep-end. Apparently, now even the machinations of the British Parliament are an input to monetary policy central planning.

Inflation remains near our 2% goal. We continue to expect the American economy will grow at a solid pace in 2019…The caveats, according to Powell, are that “growth
has slowed in some major foreign economies” and “there is elevated uncertainty around several unresolved government policy issues including Brexit, ongoing trade negotiations and the effect from the partial government shutdown.”

As we will show in Part 2, the only thing monetary central planning could possibly deliver was systematic falsification of financial asset prices on Wall Street, serial financial bubbles and busts, and the propagation of destructive signals to politicians, households and the business sector alike to borrow and speculate, rather than save and produce.