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Gold Dollars, Rule Dollars, And Yellen Dollars

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On July 7, Congressmen Bill Huizenga and Scott Garrett introduced H.R. 5018, the “Federal Reserve Accountability and Transparency Act of 2014.”  H.R. 5018 would mandate that the Fed articulate a rule for conducting monetary policy.  It would further require that the Fed report to Congress twice a year and compare the actual results with both their chosen rule and with the “Taylor Rule,” which was developed by Stanford economist John B. Taylor in 1992.

Both the Fed itself and progressive economists have reacted to this very mild piece of reform legislation in the way that vampires react to sunlight.  They don’t like it one bit.

During her testimony before the House Financial Services Committee on July 16, Fed Chairman Janet Yellen argued that it would be a “grave mistake” for Congress to adopt legislation constraining the Fed’s management of monetary policy, because this would impair the Fed’s ability to manage the economy, and its ability to respond to financial crises.  She said that such a law “…would essentially undermine central bank independence.”

The independence that Chairman Yellen appears to be seeking is independence from reality.  What is striking is not that Congress is now taking tentative steps to rein in the Fed, but that they have waited so long to do so.  America’s economic performance since the Fed adopted a totally discretionary monetary policy (which can be dated at January 1, 2001) has been nothing short of abysmal.

Article I, Section 8 of the Constitution of the United States provides that:

The Congress shall have Power to coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures.”

It is clear from the text that: 1) Congress has ultimate responsibility for the dollar; 2) what matters the most regarding the dollar is its value; and 3) “the dollar” is a unit of measure, like “the foot.”  Congress can delegate its power over money to an instrumentality like the Fed, but it cannot delegate its responsibility for the results.

A good metric for the real value of the dollar is the 6-month moving average of the Thomson Reuters/Jefferies CRB Index* (CRB6MMA).  When the CRB6MMA goes up, it can be assumed that the real value of the dollar has gone down (i.e., there has been monetary inflation).  Conversely, when the CRB6MMA goes down, it can be assumed that the real value of the dollar has risen (i.e., there has been monetary deflation).

Now, let’s look at the Fed’s performance in managing the value of the dollar during the post-war era, and how the economy has performed under each of the four monetary regimes that have been employed.

It is clear from the chart above that the last thing we should want is for the Fed to have the “independence” to conduct a completely discretionary monetary policy.  The more tightly constrained the Fed has been, the more stable the value of the dollar has been, and the better the U.S. economy has performed.

The reason for this is not just that following a rule is a better way for the Fed to manage the dollar than the ad-hoc, improvisational approach that it has employed since 2001.  It’s that the nature of the monetary policy regime determines what the dollar is, and therefore what the economy can and will do with it.  To put it bluntly, a “Yellen Dollar” is not the same thing as a “Rules Dollar,” which is, in turn, not the same thing as a “Gold Dollar.”

As George Gilder articulated so brilliantly in his 2013 book, Knowledge and Power, the economy runs on information, which is transmitted via market prices.  The dollar is the “carrier medium” for the price signals generated by the economy.

An unstable dollar distorts the market’s price signals.  This harms the economy in two ways: 1) perceiving greater risk, investors direct capital away from real, productive investments and toward inflation hedges, like gold, and/or deflation hedges, like government bonds; and, 2) misled by “unreal” prices, investors make uneconomic “malinvestments,” which must later be written off.

We now have 13.5 years of experience with the Greenspan/Bernanke/Yellen discretionary monetary regime.  The chart below shows what we have observed.  It is not a pretty picture.

While not all of America’s economic problems originate at the Fed, it is certainly reasonable to assume that most of the drama and trauma of the 2001 – 2009 period could have been avoided if, rather than employing its “discretion,” the Fed had followed this simple monetary rule: “Keep the 6-month moving average CRB Index stable.”

OK, so why has our current economic recovery been the slowest in history?  Because the recovery of capital spending has been the slowest on record.  And, why has the recovery of capital spending been so slow?  Because investors don’t trust the Yellen Dollar.

During her recent testimony before Congress, Chairman Yellen said, in essence, “Trust us.  We know best.”  Well, investors don’t trust the Fed, and with good reason.  The Fed has shown us that They Don’t Know What They Are Doing.  Here is a close-up of the past seven years.

The above chart illustrates the abject failure of the Fed’s efforts to “manage the economy” during the period.

On October 6, 2008, the Fed began paying “interest on excess reserves” (IOR), at an interest rate much higher than market for a completely liquid, risk-free asset.  This new and untested policy changed the fundamental nature of bank reserves, which, along with currency in circulation, make up the monetary base.

Before IOR, excess bank reserves had an “Old Maid” character to them.  A bank that found itself with excess reserves would immediately seek to do some kind of transaction with them.  If there were profitable opportunities to make loans, the bank would make loans.  If not, it would use the excess reserves to buy up risk-free assets, such as T-bills.

The Fed began paying IOR at an interest rate of 100 basis points (bp) at a time when 30-day T-bills were trading at 19 bp.  Suddenly, excess reserves were not “the Old Maid” anymore, they were an attractive investment alternative.

IOR, combined with “mark to market accounting” for bank assets during a time of financial crisis, produced a violent monetary deflation.  The CRB6MMA fell by 43.1% over the span of only 6 months, despite a doubling of the monetary base during the period.  (In contrast, the biggest 6-month plunge in the CRB6MMA observed during the Great Depression was only 15.1%, in March 1938).  The plunge in the CRB6MMA did not stop until “mark to market accounting” was eased in March 2009.

In the (almost) six years since IOR commenced, the Fed hasn’t seemed to figure out that IOR nullifies quantitative easing (QE).  The Fed also seems to not have noticed that, despite a quadrupling of the size of the monetary base in the interim, the CRB6MMA was 26% lower on June 30, 2014 than it was on September 30, 2008.

Obviously, with IOR, the monetary base no longer constitutes “high-powered money.”  If it did, we wouldn’t need $4.0 trillion worth of it to run a $17 trillion economy.  In 2Q2008, we managed to produce $14.8 trillion of GDP with less than $0.9 trillion of base money.

Another thing that the Fed didn’t seem to notice (or, at least, admit publicly) is that QE3 produced the exact opposite effects of those intended.  While the first three months of QE3, when the Fed was buying only mortgage-backed securities, saw a slight rise in the CRB6MMA, as soon as QE2 was doubled in size by adding Treasury securities, the CRB6MMA began to fall.  It did not start going up again until the Fed began to “taper” QE3.

So, how would we expect the economy to adapt to the Yellen Dollar?  We would expect to see exactly what we have been seeing:

  • The prices of gold and silver remain disproportionately high, reflecting fears of a hyperinflationary “accident,” something that is all too possible under an experimental, improvisational, and 100% discretionary Fed.  This means that precious growth capital is being, in essence, buried in the ground for safety.
  • Individuals are holding large amounts of cash equivalents, as a hedge against another deflationary accident, like the one that the Fed created/allowed in 2008 – 2009.  This means that capital that could be used for economic expansion is being squirreled away in government bonds.
  • Market interest rates remain at or near record lows, despite the so-called “economic recovery.”
  • In the words of Jeremy Grantham, “…capital spending…has been uniquely low in this recovery, and I use the word ‘uniquely’ in its old-fashioned sense, for such a slow recovery in capital spending has never, ever occurred before.”  Because real GDP, total employment, and wages are all driven by capital investment, this means a sluggish economy.
  • Both investors and CEOs are less willing to fund long-term projects, because they are unsure that today’s price relationships between inputs and outputs are “real.”
  • Investors are less willing to fund start-ups, because such companies are fragile at first, and a violent economic contraction, of the kind that we saw in late 2008, can destroy them.
  • As the result of reduced competition from new capacity (which requires investment), corporate profits are at record highs.
  • Rather than make productive investments, CEOs are using their companies’ high cash flows for acquisitions and stock buy-backs.  They are also taking advantage of the ability of their organizations to borrow at low interest rates to fund these share purchase activities.  The acquisitions and stock buy-backs tend to boost equity market indexes, even if no new economic value is created and total market capitalizations don’t rise.
  • The “Finance and Insurance” industry, which helps individuals and businesses cope with the unstable Yellen Dollar, continues to claim an outrageous share of GDP (10% to 12%, vs. 4% under the Gold Dollar), for activities that add no real value.
  • The jobs market remains terrible, and median family incomes continue to stagnate.

So, what should be done?

Passing H.R. 5018 would be a start.  Committee hearings on H.R. 5018 might wake Congress up, and help them to realize that The Fed Does Not Know What It Is Doing.  From there, it would be a logical step for Congress to demand that the Fed adopt a rule-based monetary policy.  The Rules Dollar that we had 1985 – 2000 was superior to the Yellen Dollar, and it would be so again.

The Taylor Rule would be better than what we have now, but there is no direct, causal relationship between the level of interest rates and the value of the dollar.

For example, right now, the Taylor Rule would call for a Fed Funds rate of 1.25%.  What this means is that the Fed would conduct Open Market operations so as to keep the value of the dollar equal to the value of a promise to pay $1.00003425 tomorrow.  The Taylor Rule describes a system with one equation and two unknowns, and, therefore, yields an indeterminate real value for the dollar.

Scott Sumner’s “Nominal GDP Level Targeting” (NGDPLT) system would also be better than what we have now, but it is not clear that it would work unless IOR were ended.  NGDPLT also would not yield a determinate real value of the dollar.

From where we are now, the best interim step would probably be to require the Fed to end IOR, to give up all efforts to manipulate interest rates, and to stabilize the CRB6MMA at its current level.  This would give investors and managers confidence in the future value of the dollar.  It would also prevent nasty “accidents,” like the one that surprised the Fed and the nation in late 2008.

The long-term solution to America’s (and the world’s) monetary woes is to move to a modernized gold standard.  Such a gold standard is specified in H.R. 1576, which was introduced by Texas Congressman Ted Poe.  America’s economy had its best years under the gold standard, and we need a Gold Dollar to truly prosper.

Chairman Yellen may not like it, but hearings on, and passage of, H.R. 5018 could provide a vital first step toward monetary sanity and economic recovery.

*An index comprising: Aluminum, Cocoa, Coffee, Copper, Corn, Cotton, Crude Oil, Gold, Heating Oil, Lean Hogs, Live Cattle, Natural Gas, Nickel, Orange Juice, Silver, Soybeans, Sugar, Unleaded Gasoline, and Wheat.