12/07/2001 'Ultimate Discretionary Power of Monetary Policy' *

It was, once again, an extraordinarily unsettled week in the financial markets, with interest rates and equity prices moving sharply higher. For the week, the Dow and S&P500 added 2%. Economically sensitive issues outperformed, with the Transports surging 5% and the Morgan Stanley Cyclical index adding better than 2%. The Utilities and Morgan Stanley Consumer indices gained 1%. The broader market caught fire, with the small cap Russell 2000 and S&P400 Mid-cap indices jumping more than 4%. Technology stocks were strong, with the NASDAQ100 and Morgan Stanley High Tech indices jumping 5%. The Semiconductors surged 10%, with The Street.com Internet index jumping 7% and the NASDAQ Telecommunications index gaining 6%. The Biotechs missed out, generally declining 1%. Financial stocks (for now) ignored the Enron fiasco, as the AMEX Security Broker/Dealer index jumped 7% and the S&P Bank index increased 3%. Gold and gold stocks were basically unchanged. Currencies were volatile, although the dollar ended the week with a small gain.

After a brief respite early in the week, Credit market liquidation returned with ferocity as yields generally jumped to four-month highs. In the thick of the rout, the implied yield on benchmark agency futures spiked 51 basis points in three days. For the week, two-year Treasury yields increased 34 basis points to 3.18%, and five and ten-year yields surged 42 basis points to 4.48% and 5.17%. The long-bond saw its yield increase 31 basis points to 5.60%. Benchmark Fannie Mae mortgage-back yields jumped 31 basis points, while agency yields surged 42 basis points. The spread to Treasuries for the Fannie Mae 5 3/8% Nov. 2011 bond increased 2 to 72. The benchmark 10-year dollar swap spread also widened 2 to 72. Ten-year bond yields generally jumped 30 to 32 basis points in the U.K. and throughout the eurozone. Benchmark Argentine intermediate bond yields jumped another 400 basis points this week to 45.56%.

The Mortgage Bankers Association weekly index of purchase applications jumped to an all-time record last week, with dollar volume up 9.2% year over year. The purchase index has now jumped 23% in the past three weeks. Refi volume has gone the other direction, sinking 40% in three weeks in the face of sharply higher mortgage rates. With an estimated pipeline of mortgages in process exceeding $30 billion, we’ll be closely monitoring Countrywide Credit. Countrywide expanded its balance sheet by 71% over the past four quarters to $31.1 billion, with “mortgage loans and MBS held for sale” more than doubling. Trading securities increased 79% and other assets jumped 124%. They, and many other aggressive players, claim to be “hedged.” This must be a most challenging environment for hedging interest rates and dynamically hedging mortgage exposure in particular. To be sure, the current environment has all the ingredients for a major financial accident.

Dec. 3, 2001 — “November was the busiest month in Chicago Mercantile Exchange Inc.’s (CME) 103-year history, with a record 45.3 million contracts traded, surpassing the previous monthly volume record of 40.3 million contracts set in September. Open interest at month’s end totaled 18.2 million positions, an all-time record. November volume represents a152 percent increase over year-ago levels, while year-to-date trading volume of 379 million contracts is 82 percent higher than the same period in 2000. The underlying value of trading in November represented a record $34 trillion. Volume in CME’s four major product areas has risen year-to-date, with interest rate volume up 102 percent at 253.1 million contracts, equity indexes up 67 percent at 97.7 million contracts, foreign exchange up 16 percent at 20.1 million contracts and commodity products up 9.8 percent at 8 million contracts.” In a sign of the times, eurodollar futures trading volume jumped 180% y-o-y, while NDX futures volume declined 4%.

Dec. 4 – MarketNews International – “Volume figures at the Chicago Board of Trade (CBT) posted an overall increase of 39.9% in the month of November led by financial futures and options.” Financial option trading volume was up 129% y-o-y, with financial futures trading up 54%. Trading in 5-year Treasury contracts is up 79% and the 10-year contract has seen volume surge 61%.

The Mortgage Bankers Association reported that household mortgage delinquencies rose to 4.87% in the third quarter, the highest level since 1991. Delinquencies were up 14 basis points from the second quarter and compare to 4.04% from one year ago. Delinquent FHA loans surged 57 basis points during the quarter to 11.36%, the highest level since the association began reporting delinquencies in 1972. There are currently almost $500 billion of outstanding FHA loans. “Conventional” mortgage delinquencies increased 20 basis points to 3.13%. Curiously, Fannie Mae recently reported single-family delinquencies of 0.45% and Freddie Mac 0.38%.

A CB Richard Ellis survey reported sharply higher national office vacancy rates during the third quarter. National “metropolitan” vacancy rates jumped from 10.3% in the second quarter to 12% (7.7% one year ago). Year over year, national “suburban” vacancy rates increased from 8.6% to 13%, while “downtown” vacancies jumped to 10.4% from 6.2%. Downtown vacancies include Dallas at 24.9%, Indianapolis at 20.1%, Las Vegas at 19%, Detroit at 19.3%, Los Angeles at 14.9%, and St. Louis at 17.4%.

Moody’s reported credit card charge-offs increased 19 basis points during October to 6.37%, and are up from 5.39% one year ago. Credit card delinquencies increased 26 basis points during the month to 5.30%, up from last year’s 4.83%.

Overborrowed consumers may be struggling, but the Fed has thus far postponed their inevitable retrenchment. October saw the largest rise in personal spending on record. With expenditures on durable goods surging 13.8% for the month, spending was up 5% year over year. October personal spending is up 12.8% over two years, 20.6% over three years, 28% over four years and 35% over five years. Personal income was up 3.4% year over year, 11% for two years, 16.2% over three years, 24.3% over four years and 32% over five years. The savings rate dropped to a record low of 0.2% during October, a nominal annualized rate of $18.5 billion.

November auto sales continued at a blistering 18 million annualized rate (vs. 16.4 million Nov. 2000), led by a 14% year over year increase in truck sales. With one month to go, year-to-date total vehicle sales are running just 1.8% below last year’s record pace. GM November sales were up 13% year over year (trucks up 37%, cars down 10.9%)and Ford’s were up 4.4%, while DaimlerChrysler saw sales decline 4.4%. Toyota enjoyed its best November ever, with sales up 9.7% y-o-y. Lexus car sales jumped 30.9% from last year. It was a record November for Honda (up 11.5%) and Mercedes (11.4%). Led by a 27% increase in its luxury Infinity line, Nissan sales were 6.9% above year ago levels. It was the best month in the U.S. ever for Mitsubishi, with sales up 27%. It was the best November for Subaru (13.2%), Hyundai (52.9%), and Kia (34%). Volvo is on pace for its best year ever. Year over year, BMW sales were up 3.2%, Mazda 3.5%, and Volkswagen 1.7%. Mitsubishi sales are about flat. Year-to-date, GM sales are down 1.7%, Ford down 6.6%, DaimlerChrysler down 11%, Nissan down 7.8%, SAAB down 2.5%, and Volkswagen down 0.7%. Hyundai sales are up 41.9%, Kia 41.2%, BMW 15%, Toyota 7.5%, Mazda 6.3%, Audi 4.3%, Porsche 1.2%, and Mercedes 1%.

October construction spending was up 5.2% year over year to an annualized $835 billion, with notable divergences between sectors. Private spending has slowed markedly to up only 2.1% y-o-y, although spending on new housing remains 9.4% ahead of a year ago (led by a 20% increase in multifamily). Non-residential spending was down 7.4% from last year, with industrial construction down 13.7%, office down 13.1%, and hotels down 14.4%. Public spending, however, remains up 16.6% y-o-y, with public housing up 20%, educational construction 34%, military 21%, roads 10%, sewer systems 13%, and water supply 24%. Construction spending is up 34% over five years.

The Fed released third-quarter credit data today and it, as always, makes for interesting reading. Total (financial and nonfinancial) Credit market debt grew at an annualized pace of $2.235 trillion, or 8.1% (compared to 6.4% in Q2) to $28.874 trillion, the highest growth rate since the fourth quarter of 1999. The Federal government borrowed at an annualized rate of 7.7%, its first net borrowing since the third quarter of 1997. Households borrowed at a rate of 8.3% (vs. 9.3% in Q2), while businesses took on debt at a 5.3% rate (7.5% in Q2) and state and local governments 3.2% (8.3% Q2). The financial sector borrowed at a blistering annual rate of $1.02 trillion, or 12%, the strongest pace since the fourth quarter of 1999. GSE borrowings expanded at an annualized rate of 15% ($328 billion annualized), “federal mortgage pools” 19% ($492.6 billion annualized), and “asset-backed security issuers” at a 16% rate ($303.2 annualized). For comparison, these three key sectors expanded at a pace of $278 billion, $237 billion, and $173 billion during last year’s third quarter. These key “structured finance” sectors – GSE, mortgage-back, and asset-back – combined for $1.13 trillion of annualized growth, fully 88% of the economy’s total nonfinancial borrowings during the quarter. Total agency issues (GSE debt and mortgage-backs) expanded at an 18% rate ($820 billion annualized) during the third quarter, while securities broker/dealer assets ballooned at a 35% rate ($471.6 billion annualized). Of the quarter’s $118 billion increase in security broker/dealer assets, $71 billion were financed by an expansion of repurchase agreements. Security broker/dealer assets expanded at a 25% rate during the first three quarters, led by a significant increase in bond holdings. Total mortgage debt grew at an annualized pace of $788 billion (10.8%), with household mortgage debt growing at rate of 9.7% and commercial at 11.7%. For comparison, total mortgage debt expanded by $332.4 billion during 1997 and $284 billion during 1996. Through this year’s first three quarters, total mortgage debt has increased at a record annualized rate of $717 billion (10%), compared to $582 for last year’s comparable period. Importantly, with the change in GDP turning negative, the divergence between economy’s “output” and the expansion of system debt widened to new extremes during the quarter, with unmistakably ominous ramifications for financial fragility.

With the title “The Future of Money and of Monetary Policy,” Federal Reserve Governor Laurence Meyer’s speech this week at Swarthmore College certainly attracted our attention. While his paper is in many ways quite interesting and informative, his analysis of the “future of money” was disappointingly directed at the relatively inconsequential issue of card-based “e-money.” But it was nevertheless worthwhile to peruse some of the Fed’s latest thinking on money: “Today, money consists of currency, coin, and transaction deposits (that is, checking accounts) at depository institutions, including in the United States, commercial banks, thrift institutions, and credit unions.” A footnote provided a key piece of information: “I am defining money ‘narrowly’ to include only the means of payment, not broadly to include other highly liquid deposits.” Well, I can understand why the Fed today prefers to “define” the money supply as M1 – since this aggregate has increased about $85 billion over the past five years, or only a total of 8% to $1.16 trillion. However, the “real story” – and where Fed attention and research should be concentrated - is conspicuous, with the $3.12 trillion (63%) increase in broad money (M3) over this same period to $8.035 trillion. Within M3, money market fund assets have increased $1.45 trillion, or $162% (and fully 17 times total M1 growth!) in five years. For the life of me, I just cannot perceive the relevance or the Fed’s analytical focus on M1. It just doesn’t make any sense. But, then again, focusing on an $85 billion five-year increase in “money” does make the life of a financial regulator pretty simple. After all, how much damage can $85 billion do to a $10 trillion economy?

All the same, Dr. Meyer’s speech addresses key issues in the fascinating evolution of money, financial systems, and central banking. His discussion also provides valuable insight – and what I see as clear support – for our contention that the deep structural issues now imperiling the U.S. and global economy and financial systems have been festering for decades. Furthermore, Meyer’s speech clearly demonstrates the Fed’s continued misguided focus on “narrow” money while remaining seemingly oblivious to the explosion of broad money and credit, and resulting profound financial and economic ramifications. For these reasons, I am including a rather lengthy excerpt from his verbal presentation.

“Now we get on to…how the evolution of money has affected how prices get determined and monetary policy. Now, I think the first thing we need is – you may have learned in your introductory macro class - The Quantity Theory of Money – a very early view but one which has some continuing value as a link in the long-run between money and pricing. The notion is that in the long-run money pins down the price level; the rate of growth of the money supply pins down inflation. For a variety of reasons, particularly because of financial innovations, this relationship is not very precise but it’s been a useful way of linking the evolution of money and the developments in money with impacts on the price level…

Let’s start first of all with commodity money and think about how the price level gets determined. In some sense, there is no money as we think of it today, just various commodities, one of which tends to be used, in addition to its use as a commodity, it’s also used as a means of payment. So really what we have is a whole set of relative prices of goods. We don’t really have money prices per se, but you might think of the price of non-money commodities in terms of the money commodities, as being the money price of the goods… So let’s think about what determines the price of non-money commodities in terms of the commodity money. What determines it? It’s basically the relative supply of the non-money commodities and the commodity money. It’s not something you have direct control over it; it really depends on technology. And maybe if gold is the ultimate commodity in question here, it depends on things like gold discovery. So if gold discoveries increase, then there’s more gold relative to other commodities and the price of other commodities tends to increase.

What tends to happen oftentimes in commodity money systems is that states began to monopolize the production of the commodity money. When that happens, states often face the temptation to debase currency; meaning to keep its value the same nominally but to reduce the gold content of the coin. When they did that that typically led to a big increase in inflation as they increase the money supply, because it wasn’t being tied completely to the gold stock, and these are one of the first experiences with significant inflation induced by government manipulation of the money.

Now, the next evolutionary step is representative paper money. As long as you really have a gold standard, and the representative money is tied back to gold reserves – it doesn’t have to be perfectly, precisely linked, but still a pretty stable link - then you still have the role of the gold standard, that we’ll come to in a minute, as being the ultimate determinant of the price level. (Excluded from his speech but in his written paper: “But the beginning of modern banking, by breaking the direct link between the commodity money and the money supply, added an element of flexibility to the money supply, and further opened up the possibility for inflation”). But there is a degree of flexibility that we’ve introduced into the system, so it’s a little less mechanical, a little less rigid. There’s a little bit more flexibility, a little bit more possibility of discretion and therefore for inflationary impact of government policy.

Then we had the gold standard. The whole idea of the gold standard was to remove discretion. People at the time wanted to stabilize the value of the currency and wanted to get the government out of the picture. They wanted to avoid government manipulation, because they didn’t have confidence in the government doing the job. And so the idea was they put into place what in effect were rules. And the rule was that money should be backed by gold, so it’s essentially gold that determines the supply of money and the price level. And that doesn’t say that prices will be stable. It just depends on what happens to the supply of gold. But it’s out of the hands of government. What happens to the price level simply depends on gold discovery…So I think the gold standard has a sense of automaticity and attempts to take policy out of the picture and to produce a stable price level…

Now one other aspect of this is that when the gold standard broke down what happened was that after WWII countries got together in Bretton Woods and tried to design a new system for international relations, and it was called the pegged rate exchange system. And basically participating governments agreed…to a system of fixed exchange rates but ones that were fixed most of the time, but could be adjusted under certain prescribed circumstances – with agreement. So what we have here was an attempt to re-impose some sense of discipline but also with a little more flexibility than we had under the gold standard. And fixed-exchange rate systems by their very nature impose a kind of discipline. They impose constraints on monetary policy. And think about it this way: If you have a fixed-exchange rate system and imbalances in payments are settled by flows of acceptable assets – in this case gold and the dollar – so you have to be very careful because you have a limited amount of official reserves. Let’s say your France, and your supply of international reserves are gold and dollars. So you have a limit to that. So you have to be very careful that you don’t follow policies that cause your reserves to decline to zero and you still have payment imbalances. You can’t do that. So it imposed discipline. You have to set your monetary policy so it is consistent in maintaining an appropriate level of reserves.

(The next two paragraphs are key…the “seedlings” for today’s forest of maladies)

Now, the U.S. was in a slightly different position. We actually, what we did is, we agreed that we would set the dollar relative to gold. That was our commitment. And everybody else would agree that they would stabilize their currencies relative to the dollar. But the dollar was an international asset -- the so-called reserve currency. And we could produce it as much as we wanted. And as much as we produced it they had to accept it, because they had to stabilize their exchange rate relative to the dollar. This was really nice. We liked it a lot. They didn’t like it so much. But we told them, of course, “don’t worry, after all, the dollars are as good as gold; they’re linked.” And after awhile people sort of realized that the dollars were growing faster than the gold, and there wasn’t enough gold if everybody decided to redeem it. But we said, “Remember, it’s as good as gold” with one asterisk: “as long as you don’t ask for the gold.” Ok, we told them “don’t ask.” And then somebody asked, and of course we had to go off fixed-exchange rate system. It collapsed and we ended up with flexible exchange rates.

And now, we are finally at a system with The Ultimate Discretionary Power of Monetary Policy. We’ve got fiat money that the government sort of creates, so no backing of commodities, and we’ve got flexible exchange rates. No restraint imposed on monetary policy. WE HAVE THE ULTIMATE IN DISCRETIONARY POLICY AND ALL THE SUDDEN NOW CENTRAL BANKS REALLY BECOME IMPORTANT. Because now discretionary policy is what determines the price level and inflation, and that depends on the judgments and decisions made by central banks around the world. So central banks had to learn how to exercise that discretion. And government had to learn how to give mandates to central banks, and tell them what kind of objectives to have – typically price stability, in the U.S. promoting price stability and full employment…”

This is fascinating and goes right to the heart of critical issues. I would really only take exception with his assertion that “we’ve got fiat money the government sort of creates.” Today, importantly, the vast majority of money is privately created. Meyer, however, (understandably) does not address the salient issue of financial evolution and innovation having created unbridled private sector money and credit creation. What we really have experienced is an historic confluence of the “Ultimate in Discretionary Policy” meeting a contemporary financial system where central bankers generally provide the only possible mechanism for imposing system-wide discipline. Yes, the judgment of central bankers, particularly the governors of the world’s reserve currency, became of momentous importance. But economic doctrine, the political landscape, and the individuals involved simply were not up to the newfound responsibility.

Nonetheless, the optimistic Dr. Meyer concludes: “So, the bottom line is no sleepless nights; sit back and enjoy the evolution of the payment system. Maybe we’ll get more e-money in the future. If it does, its main role will be to increase the efficiency of the system to economize on resources, but we shouldn’t really worry whether or not it undermines the effectiveness of monetary policy.” (Sounded rather Greenspanish to end!)

Thanks for the interesting presentation Dr. Meyer, but I will continue to worry. And while I will at times question his views and the direction of his analysis, I do appreciate that Dr. Meyer is a thoughtful and hard-working central banker. After reading through another of his papers, “Inflation Targets and Inflation Targeting,” from the November/December issue of the Federal Reserve Bank of St. Louis Review, I would like to touch upon a few related points. Agreeing with Meyer’s contention that central bankers have attained “The Ultimate Discretion,” it becomes paramount that the Fed adopts appropriate methodologies for monitoring the functioning of the monetary system. Then, within the auspices of the contemporary financial structure and political and regulatory environment, the Fed’s definitions of “inflation” and “price stability” become the very foundation of financial oversight. And within the Fed, it has been the chairmen that have been conferred extraordinary discretion in crafting their interpretations. In this regard, we see right here a fatal flaw in the Fed’s narrow – “transaction medium” - definition of money and, importantly, with the requisite corresponding narrow definition of “inflation” as reflected in changes in basic consumer and wholesale prices. Dr. Meyer presented two working definitions of inflation that are worth brief comments:

“A workable definition of reasonable ‘price stability’ would seem to me to be a situation in which expectations of generally rising (or falling) prices over a considerable period are not a pervasive influence on economic and financial behavior. Stated more positively, ‘stability’ would imply that decision making should be able to proceed on the basis that ‘real’ and ‘nominal’ values are substantially the same over the planning horizon – and that planning horizons should be suitably long.” Paul Volcker, 1983

“We will be at price stability when households and businesses need not factor expectations of changes in the average level of prices into their decisions.” Alan Greenspan, 1994

While the differences may appear subtle, these two important definitions of “price stability” are worth exploring. First, Mr. Volcker’s use of the terminology “pervasive influence on economic and financial behavior” is apt, as it gets right to the heart of the matter. Just as rising good prices would be expected to change behavior and distort demand, generally rising asset prices over a considerable period clearly exert a “pervasive influence” on both the structure of the economy and financial system. Both spheres of impact must be recognized as being significant. Certainly, a protracted period of rising home prices has had a profound influence on both economic and financial decisions, accentuating and distorting the structure of demand, while also significantly increasing (in a self-feeding Bubble) both household debt and financial sector leverage (and financial fragility!). And, importantly, years of rising prices have had profound influence on expectations for future security prices (debt and equity), only exacerbated by Fed and GSEs liquidity assurances. This has directly incited an unprecedented accumulation of speculative positions in the U.S. financial markets, with consequent ramification for market prices and financial fragility. Written in the early 80’s, the genesis for momentous financial, technological, and economic developments, Volker’s definition provided a good nucleus for the future. What was needed, however, was to expand the concept of “price stability” to more clearly recognize strengthening price effects of increasingly powerful monetary processes – specifically real and financial asset inflation and trade deficits.

And while chairman Greenspan’s definition followed Volker’s by 11 years, it was actually an unfortunate big step backwards to a more primitive notion of narrow price effects. First of all, his use of the terminology “average price level” is problematic. Apparently he would be content with “averaging” expectations for, let’s say, increasing housing costs and declining computer and import goods prices in determining “price stability.” But clearly household and business decisions are commanded by individual market prices, not an “average level of prices.” Distortions and instability emanate from changes in individual and relative prices, not from the movement of price indexes. As we discussed last week, in the contemporary world where easily available Credit plays a significant role in the demand for myriad goods (produced domestically and imported), services, and assets (real and financial), one must look specifically outside of a narrow index of average consumer prices for indications of monetary stability. Certainly, in the contemporary environment where the greatest Credit excesses are in the financial sphere (financing holdings of securities), any survey of “price stability” that does not place significant emphasis on the “pervasive influence” on the “financial system” will produce flawed results and inappropriate policy. And the more I focus on Dr. Greenspan’s woefully inadequate definition of “price stability,” the clearer my understanding of the Fed’s misguided analysis and policy prescriptions.

It has been a fascinating discovery to realize that to locate truly penetrating (and pertinent) “academic” discussions of money and credit, one generally has to go back almost forty years. This week, I stumbled across an interesting article in the 1949 American Economic Review – “Memorandum on the Stability of Demand Deposits,” by C.R. Whittlesey:

“What Mr. Hawtrey described as the ‘inherent instability of bank credit’ has long held a central position in discussions of the commercial banking process…The tendency for operations of the commercial banking system to produce inflationary effects in periods of inflation and deflationary effects in periods of deflation has been an integral part of the so-called monetary theory of the business cycle. Measures for combating the tendency for deposits to expand or contract unduly have come to occupy an increasingly important place in central banking; indeed the essential function of a central bank is said to be the creation and absorption of reserves for the purpose of promoting economic stability. The effect of changes in the character of bank assets has been to alter the basis on which the alleged instability of bank credit rests.”

“The theoretical explanation of the ‘inherent instability of bank credit’ is essentially as follows. Creation of demand deposits is assumed to result from the granting of loans and discounts by commercial banks. The volume of loans and discounts will presumably vary with the dollar volume of business. Rising prices and increasing business activity will lead, therefore, to an expanding volume of bank deposits. The expansion of bank deposits, in turn, will contribute toward a continuation of the upward movement of the dollar volume of business. This combination of relationships provides all the elements of a continuing upward spiral…”

“Throughout the 20’s and the early 30’s loans constituted the principal element in the earning assets of commercial banks. The predominance of loans explains why what happened to the volume of loans was looked upon as determining what happened to the total of demand deposits…Loans to brokers and dealers and loans on securities, both of which are subject to severe contraction in a falling market, represented a large volume of bank assets in 1929 but are negligible today. In view of these various changes within the loan portfolio, bank loans can no longer be expected to undergo as great contraction, spontaneous or induced, as characterized major depression periods in the past. A final factor contributing to the stability of deposits is that cash assets, including legal reserves, represent a higher proportion of deposits today than formerly. Indeed, the mere fact that banks are now subject to roughly double the reserve requirements that prevailed before 1936 means that the multiple of deposit expansion – upon which, after all, the ‘inherent instability of credit’ fundamentally rests – is about half what is used to be.”

“In the decade of the 40’s the relationship between loans and government securities in the portfolios of commercial banks came to be the reverse of what it was 20 years earlier. Today the principal element, quantitatively, among the earning assets of banks is government securities. Thus, it would be consistent to argue that changes in their volume will tend to determine the movement of demand deposits…instability might conceivably occur, but it would not be instability of the former type. This conclusion is of substantial consequence…Not only does it appear certain that the volume of bank deposits will no longer behave in the traditionally unstable manner; it is possible to argue that the volume of deposits can be expected in the future to behave in a relatively stable, and perhaps even stabilizing, manner…The present situation resembles that which once applied with respect to the gold standard…

And concluding, under the heading Implications for Monetary Policies, Whittlesey writes, “No one would insist that the present monetary outlook is altogether reassuring. The ability of member banks to convert a large proportion of their assets into reserves, more or less at will, may appear, for example, to constitute a danger of serious credit expansion. For those who still retain confidence in interest and discount rates as regulators of the volume of credit, moreover, efforts to maintain relatively stable interest rates may suggest resulting instability elsewhere. Whatever instability in the volume of credit may exist in the future will rest, however, on a different basis from that which gave rise to the concept of the ‘inherent instability of bank credit.’ The different basis of possible instability of bank credit implies that monetary policy in the future must be of a different character from what it was in the past…”

Whittlesey’s comments may appear rather mundane but, in a period of significant uncertainty as to financial and economic prospects, his analysis proved impressively prophetic. Certainly (and why his work is being highlighted), he was asking the right questions and looking in the right places for answers.

I would argue that what is required today is Whittlesey-style financial asset analysis. What is, after all, the composition of financial sector assets today? Whittlesey’s great insight was appreciating the momentous transformation in the composition of bank assets from the 1920s to the 1940s, and the ramifications of the changing nature, and significantly improved quality, of bank assets for future financial and economic stability. We have again experienced a momentous transformation in the nature and composition of financial assets. Regrettably, however, the major issue today is the dubious character and extreme deterioration in the quality of financial sector assets created during this boom; assets that back financial sector deposits (bank and money market fund) and myriad other financial claims. In the 40’s shaky “loans to brokers and dealers and loans on securities” had been replaced generally by government securities and prudent consumer and business loans made by guarded bankers. Throughout our recent protracted boom period, and specifically over the past few years, the explosion of mortgage lending, non-productive business and consumer borrowings, and extreme Credit creation financing speculative and leveraged holdings of securities has been the driving force behind enormous deposit (and other financial claims) expansion. The resulting precarious ramifications for both financial and economic stability are today palpable.

Attempting to provide clearer insight as to the composition of financial sector assets, it is first worth noting the relative growth in various components of bank credit. During the past five years, U.S. government security holdings have increased 16% (to $822 billion) and “commercial and industrial loans” 34% (to $1.04 trillion). Elsewhere, “other securities” holdings increased 126% (to $650 billion), real estate loans 55% (to $1.74 trillion), Security loans 78% (to $149 billion), and “other loans” 109% (to $449 billion). In total, these four categories of potentially more problematic bank credit expanded $1.28 trillion, or 74%, and now comprise 55% of bank credit (compared to 45% five years ago). Looking at financial sector expansion outside of traditional bank credit, over the past five years GSE assets increased $1.2 trillion (129%) to $2.13 trillion, outstanding asset-backed securities have increased $993 billion (158%) to almost $1.94 trillion, securities broker/dealer assets increased $771 billion (137%) to $1.33 trillion, and mortgage-back securities increased $993 billion (60%) to $2.64 trillion. These four key “non-bank” components of credit creation have, in total, increased $4.15 trillion (107%) over five years, compared to about $1.2 trillion (42%) of non-security bank credit expansion. Right here one can unmistakably isolate what has been an historic transformation in the composition of financial system assets, of a distressingly 1920’s character.

I am often asked to make predictions. Well, I “predict” that this $4 trillion plus (and rapidly counting) GSE, mortgage-back, asset-back securities and security broker/dealer debt will haunt the U.S. financial system and economy for many years to come. We have experienced an explosion of unproductive Credit excess that has fueled endemic asset inflation, gross overconsumption, a precarious misallocation of resources, and the accumulation of massive foreign liabilities that will prove an intractable source of financial and economic instability. And with much of this credit expanded through the issuance of marketable securities and incorporating various aspects of “structured finance” and “financial engineering,” today’s unprecedented marketplace volatility is very likely here to stay. In particular, with volatile mortgage securities having been such a key aspect of systemic monetary expansion, and having become so prevalent in the composition of financial sector assets, this in itself basically ensures considerable systemic instability. That leveraged financial speculators hold such significant amounts of marketable debt and other Credit instruments, and that dynamic hedging derivative strategies have become such a dominant aspect of financial player strategies, only accentuates the inherent instability of the fundamentally weak underlying structure of today’s financial sector assets. It’s a mess.

I will conclude with a final quote from Laurence Meyer: “I remember the first conference I attended after joining the Board of Governors. Two foreign central bankers – each from inflation-targeting countries – lectured me about how ‘good’ central bankers acted in public. They each told me that a disciplined central banker would never admit that there was a cost of lowering inflation. Such admissions, they warned, would only undermine the public’s confidence in a central banker’s commitment to price stability. I responded that this lesson in central banking surprised me. I would not have thought obfuscation about policy objectives or the way monetary policy affects the economy would have enhanced the credibility of a policymaker. I still don’t.”

I think when economic historians looks back at this period there will be recognition that the monumental flaw in central bank doctrine was with its fixation on narrow (CPI) “price stability,” while at the same time “pegging” interest rates and guaranteeing marketplace liquidity. This policy combination virtually begged for precarious speculation and financial Credit excess. Ironically, a misguided fixation on narrow definitions of both money and “price stability” set the stage for unprecedented systemic instability. Perhaps Meyer’s foreign central bank colleagues were trying to convey the danger of nurturing an environment conducive for Credit and speculative excess. Loud and clear signals of system watchdog intentions do not necessarily promote prudent behavior or stable financial markets. It is certainly not “obfuscation” when law enforcement officers refuse to broadcast when and where they’ll be checking for speeders. And one wouldn’t expect parents to communicate precisely when they will be checking in to observe if their children are working diligently on their homework. It is clear that the Greenspan Fed erred in being so anxious to accommodate the financial players, and should never have actively advertised that it was prepared to aggressively cut rates at the first sign of trouble – only ensuring speculative forces would be accentuated and transferred to other markets, with major consequence for the nature, composition, and expansion of financial sector assets. Such policy cultivated an environment of reckless excess and the wholesale abandonment of discipline. Ultimately, the Fed ceded its extraordinary Discretionary Power of Monetary Policy to the increasingly powerful financial community. Such a circumstance is patently incompatible with sound financial markets, systemic price stability, or general economic stability.

I will add two words to an earlier sentence crafted by Dr. Meyer, developing what I believe is much more accurate and pertinent contemporary monetary analysis: Discretionary policy is what determines market price levels and asset inflation. That is, until Bubbles bursts and the Fed discovers that its greatest policy impact has been to foster speculation and unprecedented financial leveraging.