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Monetary Base Expansion: The Seven Stages of Addiction

Monetary base expansion is a powerful drug. Used correctly and judiciously, it has a critical role to play in the successful management of a complex economic system that relies heavily on fractional reserve banking. However, the powerful and immediate effect of monetary base expansion makes it a highly addictive drug.

In this week’s post, we will attempt to illustrate the highly addictive nature of monetary base expansion by applying the “seven stages of addiction” model for methamphetamines to the current cycle of monetary base expansion. There are striking parallels between the methamphetamine addiction cycle and the economic/market cycle that occurs following a dramatic expansion of the monetary base.

“The Seven Stages of Addiction” for methamphetamines are: (1) the Rush, (2) the High, (3) the Binge, (4) Tweaking, (5) the Crash, (6) the Hangover, and (7) Withdrawal.

The view of The Money Enigma is that markets and policy-makers are currently passing from the “Binge” stage into the “Tweaking” stage, a stage characterized by increasingly erratic (market) behavior and delusions so strong that the participants become disconnected from reality.

For first-time users, monetary base expansion has a positive and immediate impact on the economy (the “Rush”). This immediate success creates a false sense of confidence among both market participants and policy makers regarding the long-term economic prospects of society (the “High”).

This false sense of economic confidence fuels more monetary expansion (the “Binge”) and higher levels of current economic activity. Moreover, it engenders great confidence in the value of fiat currency, thereby suppressing prices as measured in money terms. Ironically, this occurs just at the point when the value of fiat currency is most at risk.

Over time, each additional round of monetary expansion becomes less effective: the market has become accustomed to the drug and every additional dose of the drug has less impact. This occurs right at a point where dangerous extremes in market sentiment have become commonplace. Market behavior becomes increasingly erratic and volatile (“Tweaking”). Markets begin to behave in ways that are “out of character” from a historical perspective and would be impossible without the drug: for example, negative nominal yields on debt securities.

Finally, the longer-term consequences of monetary base expansion become clear (the “Crash”). As confidence erodes, the value of fiat money falls and prices begin to rise. Policy makers discover that the drug no longer has any net positive impact on the economy and the economy enters into a prolonged period of stagnation (the “Hangover”). In the final stage, new regulations are introduced to prevent the future abuse of such a potent and important policy tool (“Withdrawal”).

A Powerful Drug with an Important Role to Play

Monetary base expansion is an important and powerful instrument for the conduct of economic policy. The ability to create money allows a central bank to perform a “lender of last resort” function that is critical in maintaining confidence in a fractional reserve banking system.

Moreover, the central bank’s ability to “print money” allows the government to respond quickly and decisively when other non-banking crises occur. For example, if a major war started today, monetary base expansion provides the government with a mechanism to quickly finance any emergency war-related spending.

In this sense, we can think of monetary base expansion as the morphine of our economic system. Morphine is a vitally important drug that has clear positive benefits when used judiciously. However, just like morphine, monetary base expansion only tends to mask the symptoms of underlying structural problems, rather than “curing” the patient. Nevertheless, printing money has a clear and positive role to play in times of genuine national crisis.

Unfortunately, monetary base expansion shares another common characteristic with morphine and other powerful drugs such as methamphetamines: it is highly addictive.

Why is Monetary Base Expansion so Addictive?

The history of monetary base expansion abuse is nearly as long as the history of civilization itself. For example, we know that the Roman Empire systematically reduced the gold and silver content in their coins, an act that ultimately resulted in a dramatic devaluation of Roman currency.

Invariably, experiments with currency debasement end badly. So why is the history of civilization littered with examples of currency debasement and money printing?

Monetary base expansion, or “printing money”, has always been an attractive option to politicians and governments. The reason for this is twofold:

The creation of vast sums of money, seemingly out of thin air, allows politicians and governments to achieve short-term ends that would be impossible without that ability; and
In the short term, printing money can seem like a “free” source of financing. Printing money allows politicians to avoid raising taxes or issuing more debt to pay for government expenditures. Moreover, if expectations are cleverly managed, then printing money may have no short-term impact on the value of money and, consequently, no adverse short-term impact on the price level.

In many ways, monetary base expansion can seem like a “miracle drug”. It has immediate positive effects on the economy and, at least in the short term, it can appear to have no negative side effects.

This raises an interesting question. If the long-term side effects of monetary base expansion are well understood (expansion of the monetary base at a rate higher than real output leads to inflation), then why is it possible for monetary base expansion to have no adverse impact on the value of money and the price level in the short to medium term?

This is a question that was addressed in a post earlier this year titled “Why is there a lag between money printing and inflation?”

The view of The Money Enigma is that fiat money is a financial instrument and only has value because it is a liability of society. More specifically, fiat money is a long-duration, special-form equity instrument that represents a proportional claim on the future output of society.

That’s a mouthful: so what does it mean?

In simple terms, we can think of fiat money as a slice of cake that we hope to eat at some point in the future. The value of fiat money varies according to the expected size of that slice of cake. The cake is future output and the number of slices the cake has to be cut up into is determined by the size of the future monetary base.

The expected size of our slice of future output cake can shrink either because (a) the expected size of the cake shrinks (expectations for future output growth fall), or (b) we expect that the cake will need to be cut up into more slices (expectations for future monetary base growth rise).

So, why is it possible for central banks to print money with no adverse short-term impact on the value of money? The answer is that the value of money depends on long-term expectations.

If market participants believe that an expansion in the monetary base is only “temporary”, then this means that the cake (future output) will be divided up into a small number of slices. However, if expectations shift and the market decides that the expansion in the monetary base is more “permanent” in nature, then our future output cake will need to be divided up into more slices: the expected size of each slice falls and the value of money falls.

Readers who are interested in learning more about this theory should read “Money as the Equity of Society” and “What Factors Influence the Value of Fiat Money?”

In summary, monetary base expansion is a powerful drug that appears, at least in the short term, to have limited negative side effects. This potent combination makes it highly addictive to both markets and policy makers.

Unfortunately, excessive monetary base expansion has terrible long-term consequences, a concept that is (or at least should be) well understood by policy makers and markets.

So why has the Federal Reserve not made any attempt to reduce the size of the US monetary base nearly seven years after in began to experiment with quantitative easing? Moreover, why are markets failing to price assets to reflect the increasing risk of severe inflationary outcomes?

In order to answer these questions, it helps to think about the psychological cycle that accompanies monetary base expansion. This can be illustrated by comparing the monetary base expansion cycle with the addiction cycle associated with methamphetamines.

The Seven Stages of Addiction

1). The Rush – The rush is the initial thrill that market participants and policy makers feel when monetary base expansion is first announced and implemented. For those societies with little recent experience of monetary base expansion, the impact of this new policy is immediate and exciting.

The initial implementation of monetary base expansion has an almost immediate narcotic effect on the markets. Risk assets rally in a knee-jerk reaction as market participants realize that the safety net has been activated. In the case of QE1, markets that had ceased to function, such as the market for mortgage-backed securities, begin to return to life.

In a crisis, there is tremendous pressure on policy makers to appear to be doing something. When monetary base expansion is announced, the immediate political pressure on policy makers is relieved, even if the action is considered by many to be controversial.

2). The High – The early success of monetary base expansion begins to shift the focus of markets away from “risk” and towards “opportunity”. Early doubts about the effectiveness of the policy begin to dissipate. Market participants and policy makers begin to feel more confident in the economic outlook.

This rising confidence begins to feed the delusion that “this time is different”. Rising confidence in the long-term economic future of society not only leads to higher asset valuations and higher current levels of economic activity but also, somewhat ironically, acts to support the value of fiat money, thereby depressing prices as measured in money terms.

As discussed earlier, if fiat money is a proportional claim on the future output of society, then rising levels of confidence regarding the long-term growth of real output will support the value of fiat money. Furthermore, near-term economic strength fuels the belief that the monetary expansion is only a “temporary” phenomenon. A temporary increase in the monetary base has little to no impact on the value of fiat money because fiat money is a long-duration asset.

Those who might have warned against the inflationary consequences of monetary expansion look foolish as rising levels of confidence actually bolster the value of fiat currency and, in turn, create a deflationary environment. This outcome seems to vindicate the bold action of policy makers and sets up the environment for the next stage of addiction.

3). The Binge – The binge is a period of uncontrolled, or poorly controlled, use of the monetary expansion drug. In the context of recent experience, QE2, QE3 and QE Japan/Europe could all be considered to be part of “the binge”.

After the initial apparent success of the experimentation with monetary base expansion, markets and policy makers both start to believe that if a little is good, then a lot must be even better. Moreover, since the initial experimentation occurred without any obvious negative side effects, people begin to believe that it must be reasonably safe to continue with additional stimulus.

The binge is characterised by increasingly aggressive and risk-seeking behavior on the part of markets and overconfidence on the part of policy makers.

Market participants begin to lose touch with the underlying reality of the economic situation. In the case of QE, monetary base expansion allows the Fed to purchase long-term government bonds, thereby pushing up the price on those bonds and lowering the long-term interest rate, or “risk free rate”. This creates a waterfall effect across the entire spectrum of risk assets. As the risk free rate falls, the required return on capital for all assets falls, thereby pushing the price of all risk assets. See “Has the Fed Created the Conditions for a Market Crash?” for a full discussion of this issue.

Markets begin to create myths to sustain the binge. One of these myths is that elevated risk asset prices can be sustained by strong economic growth even when the monetary base is reduced (see article above for why this is a complete fiction). The second myth that begins to take hold is the notion that there will be no adverse inflationary consequences even if the central bank fails to reduce the monetary base from its historically high levels.

This second myth is fed by “economic principles” for which there is little empirical support such as the notion that “inflation is caused by too much demand”. Markets begin to believe that there will never be inflation as long as the central bank prevents the economy from “overheating”: the size of the monetary base is somehow irrelevant, despite the fact that long-term empirical evidence overwhelmingly supports the notion that “money matters”.

4). Tweaking – Market conditions are most dangerous when they cross into the “tweaking” phase, a condition reached when, after a long period of binging, the market begins to experience diminishing marginal returns from the application of additional monetary stimulus.

Judging by historical standards of behavior, markets might seem to have completely lost touch with reality. Markets become increasingly erratic and momentum driven. Asset pricing outcomes that previously might have seemed impossible become commonly accepted. Negative nominal interest rates on government securities and the second coming of a “once-in-a-lifetime” tech and biotech stock bubble are just two of the more obvious symptoms of this delusional-type behaviour.

Ironically, this is also the point where confidence in fiat money is at its highest and sentiment regarding anti-fiat assets (gold and other precious metals) is at its lowest. Despite the fact that the market is still benefitting from a high dosage of the drug in the system, the market is supremely confident that either the monetary base can be reduced with no ill effect or that inflation can be contained even if the monetary base is not reduced. Confidence in policy makers and the economic future of society is so strong that inflation is regarded as a complete “non-issue”.

Nevertheless, warning signs begin to emerge. Various segments of the global markets might begin to break down in a violent fashion. Stock market breadth begins to falter. More and more countries and industries begin to experience difficult economic times. All of these signs are explained away as being special cases, but each new event begins to highlight the underlying fragility of the system.

5). The Crash – The crash occurs as the positive effects of the drug suddenly wear off and the bubble of overconfidence begins to pop.

This sudden erosion of confidence sets up a negative feedback loop that begins to feed on itself, just as the bubble of confidence associated with monetary expansion created a positive feedback loop.

In the first instance, a sudden erosion of confidence leads to a lower risk appetite and a higher required rate of return on risk assets. Asset prices fall and economic activity begins to falter.

When this first begins to happen, markets may comfort themselves in the belief that the central bank will be able to provide more monetary stimulus “if things get really bad”.

However, this loss of market confidence is likely to coincide with a second and very unwelcome development: a sudden erosion in the value of fiat money and an unexpected rise in the general price level.

The view of The Money Enigma is that fiat money is a proportional claim on the future output of society. Therefore, we can think of the value of fiat money as a vote of confidence in the long-term economic prospects of a society.

If people start to believe that their society is built on shaky economic foundations, then they may start to doubt the long-term economic prospects of that society. In that scenario, people might decide that (a) long-term economic growth will be much weaker than previously expected, and (b) long-term growth in the monetary base will have to be much higher than previously expected. This combination of shifting expectations can lead to a sudden decline in the value of money and, conversely, a sudden rise in prices as measured in money terms.

6). The Hangover – At some point, markets and policy makers begin to realize that “this time wasn’t different”. Monetary base growth far in excess of real output growth leads to the same end results as it did every other time: higher inflation.

The required nominal rate of return on risk assets surges higher, leading to forced sales, massive private sector deleveraging and a cycle of declining asset values. Policy makers that seemed to be invincible are suddenly impotent. Real economic activity declines sharply while higher prices erode the general standard of living.

7). Withdrawal – Society vows “never again”. A major new round of regulations are introduced to prevent future generations from repeating the same mistakes. Unfortunately, they will.

Has the Fed Created the Conditions for a Market Crash?

NOT INVESTMENT ADVICE

Has the Federal Reserve inadvertently created the perfect conditions for a stock market crash? Over the past few years, many market commentators have accused the Fed of “blowing bubbles”, i.e. using monetary policy to feed the speculative market environments that enabled both the Nasdaq bubble of 1999-2000 and the US housing bubble of 2006-2007. But has the Fed’s experiment with quantitative easing set up equity markets for a historic fall in the next few years? Will the Fed be held responsible for the next share market crash?

The view of The Money Enigma is that the Federal Reserve has backed itself into a corner, at least in regards to financial market conditions.

If the Federal Reserve makes any concerted attempt to reduce the monetary base, then this will raise the required rate of return on capital across all global markets, triggering a major sell off in both bond and equity markets. Just as quantitative easing drove down the cost of capital (as explicitly desired by Ben Bernanke), so reversing quantity easing will drive up the cost of capital, thereby placing downward pressure on the price of all risk assets.

Conversely, if the Fed does not reduce the monetary base, then high-single digit inflation will return, an event that will create chaos in markets that are priced to achieve very low rates of nominal returns. The view of The Money Enigma is that inflation has been kept in check over the past few years because the increase in the monetary base has been perceived as “temporary”. However, if market participants begin to believe that the US economy is addicted to these higher levels of base money, then confidence in the long-term economic future of the United States will suffer and inflation will return.

The Recipe for a Stock Market Crash

While every commentator will have a slightly different view on the exact mix of conditions that are required for a stock market crash, the basic recipe is fairly straightforward.

As a general rule, in order set up the right environment for a stock market crash, you need to create a situation of extreme overvaluation across a fairly broad range of stocks: certainly not all stocks, but enough to matter.

This is harder than it sounds.

While overvaluation in certain segments of the stock market is a fairly routine occurrence, extreme overvaluation of large portions of the stock market is not. While there is much debate in academic circles about whether “markets are efficient”, there should be no doubt that markets are efficient in the sense that people aren’t stupid. Very few people will intentionally rush out to buy a business for more than it is worth. Therefore, in order to convince lots of people to buy a wide range of businesses for more than they are worth (at least, more than they are worth in retrospect) requires a special set of conditions.

First, you need a strong fundamental catalyst: a new “reality” that forces investors to think differently either about the future prospects of a wide range of businesses, or justifies, at least temporarily, a lower required rate of return on risk assets.

Second, you need to create a set of flawed expectations: a series of new “myths” that allow investors to justify ever-increasing valuations. These myths encourage new investors to buy into the excitement and lull existing investors into a false sense of complacency.

In this sense, the recipe for a stock market crash nearly always involves a mixture of “myth” and “reality”. The recipe for a market crash of historic proportions requires a small dose of reality and a large dose of myth. It is this potent mixture that allows stock market valuations to climb to extremes. Moreover, it is the large helping of “myth” in the mixture that sets up the perfect conditions for a sharp reversal of fortune.

A classic example of this phenomenon is the technology bubble of the late 1990s.

There is no doubt that the technology bubble of 1990s started with a set of important realities: dramatic advancements in semiconductor and computing technology that enabled a corresponding advancement in software and networking technology. These advancements reached a critical tipping point when they enabled the development of the Internet.

The Internet represented an important paradigm shift not just for the technology industry but for the way all businesses operate. Looking back today, some of the early projections about how business would migrate to the Internet were quite conservative. In this sense, the technology bubble of the 1990s was born of an important reality.

While this reality may have set the foundation for the rise in technology stocks, the mania that developed in technology stocks required the invention and propagation of several myths. Basic finance theory was thrown out of the window, as new myths developed regarding how business model success should be measured and how such “success” should be valued. Suddenly, “eyeballs” mattered more than sales and sales mattered more than profits. Moreover, many investors seem to feel that the paradigm shift was so strong that basic business cycles were a thing of the past: demand for networking equipment and IT services would grow at double digit rates every year.

At some point in the year 2000, the myths began to pop. At first it was recognized that a few very silly Internet-based business ideas wouldn’t make it. Then, the realization began to hit that the panic spending on IT would, at some point, begin to subside.

The Nasdaq lost over 80% of its value from peak to trough. All this time, the “reality” never changed: the Internet has dramatically altered the way we all live and do business. But the myths that surrounded the early development of the Internet and began to implode.

Today, global markets are caught up in what I believe is another highly speculative environment. This speculative environment is more insidious than the technology bubble of the late 1990s because it involves far more assets classes: sovereign bonds, corporate bonds, equities, venture capital, private equity, real estate and fiat currencies. In this sense, it makes it much harder to identify the “bubble” because it is harder to see the bubble in any given asset class on a relative basis: it is not clear that stocks are dramatically overvalued compared to bonds or that private equity is any more speculative than venture capital.

However, the view of The Money Enigma is that there is a high level of broad based speculation across all asset classes. This speculative environment has been generated by the actions of the Federal Reserve and the other major central banks. In particular, it has been created by the reality and the myths that surround the now widely adopted program of quantitative easing. The key for investors today is being able to distinguish between the important reality that drove markets higher initially and the myths that are sustaining current speculative conditions.

Quantitative Easing: Distinguishing between Myth and Reality

The current speculative environment in global markets is a function of one reality and two myths regarding the massive expansion of the monetary base otherwise known as quantitative easing.

Let’s begin with the reality: a massive and sudden expansion of the monetary base that is used to buy sovereign bonds will drive down the required rate of return across all risk assets and, all else remaining equal, will drive up the price of those same risk assets.

For those not familiar with how financial markets operate it may seem surprising that buying government bonds will force up the price of equities. After all, what does the price of government bonds have to do with the price of stocks? The answer is “everything”.

There are two ways to think about this: we can think about it in theoretical terms or in more practical terms.

In theoretical terms, the market value of a business is determined by the net present value of future cash flows that investors expect to receive from that business. Note the use of the term “present value”: $100 in ten years is not worth the same as $100 today. Therefore, we need to discount expected future cash flows using a discount rate to covert those future cash flows into their present value equivalent.

While the discount rate that we use to calculate net present value will vary between one business and another, depending upon the nature of that business, the discount rate is always some function of the “risk-free” rate. The “risk-free” rate is the required rate of return from a risk free investment. Theoretically, the calculation of a discount rate for a business always begins with this “risk-free rate” which acts as the foundation rate upon which other discount rates are built.

In our modern society, it is widely accepted (at least at the present moment) that the risk-free rate is best proxied by the interest rate on government bonds. Therefore, if central banks create money and use this money to buy government bonds, then this forces down not only the interest rate on government bonds, but forces down the risk free rate which is used as the baseline for all risk asset valuations.

The valuation of a long-duration risk asset is highly sensitive to the long-term discount rate and, therefore, the risk-free rate. Moreover, the valuation of the stock market is much more sensitive (at least in principle) to the risk-free rate than to near term business conditions. This is an important point that we will return to shortly.

We can also think about this issue from a more practical perspective.

Government bonds, corporate bonds and equities are, at least to some degree, substitutes for each other. They are not perfect substitutes, but they are substitutes.

If the Federal Reserve begins to buy lots of government bonds and forces down the interest rate on government bonds, then this will induce investors who invest in both government and corporate bonds to seek higher yields in corporate bonds. At the margin, the Fed’s “investment” in the government bond market crowds out private investors in the government market. These investors turn to the next best substitute: corporate bonds.

In turn, this forces down the yield of corporate bonds. Those investors who invest across the corporate spectrum (corporate bonds and equities) will now, at the margin, chase the higher expected return in equities, forcing up the price of equities.

In this way, the Fed’s actions create a domino effect across all asset classes: investors shift from government bonds to corporate bonds, corporate bonds to low-risk equities, low-risk equities to high-risk equities, high-risk equities to venture capital.

In more technical terms, the massive expansion of the Federal Reserve’s balance sheet lowers the required cost of capital across all asset classes, stimulating higher prices across the entire spectrum of risk assets.

At the margin, this whole process has had a positive effect on the economy. By lowering the required cost of capital for all investments, more investment activity has been stimulated: the shale oil boom, the biotech boom, the pick up in small business activity are all, in part, a function of a lower cost of capital.

This is the reality of quantitative easing.

Now, let’s discuss the myths.

The market has created two myths regarding quantitative easing that have been absolutely critical in sustaining the positive momentum that the equity markets have enjoyed over the past few years. So, what are these two myths?

Myth #1: If the Federal Reserve begins to reverse quantitative easing (reduces the monetary base), then the underlying strength in the economy at that time will offset any weakness that occurs because of tightening “liquidity conditions”.

Myth #2: If the Federal Reserve does nothing and leaves the monetary base at the current exceptional levels, then there will be no adverse inflationary outcome. More specifically, inflation is caused by “too much demand”, so it doesn’t matter if the Fed leaves the monetary base where it is, as long as the economy doesn’t “overheat”.

The Federal Reserve has done little to discredit either of these myths. The reticence of the Fed to even discuss a significant reduction in the monetary base suggests that the Fed understands that the first myth is a falsehood. The Fed seems desperately keen to invent new reasons for why a “normalization” of monetary policy is not required “at this time”. (Ever notice how the Fed’s “natural rate of unemployment” target keeps getting lowered?) I doubt there is one single member of the FOMC who wants to be on the FOMC the day that a surprise reduction in the monetary base in announced. After all, “you break it, you own it” and who wants to “own” a broken stock market?

More worryingly, the Federal Reserve has done nothing to dispel Myth #2. In regard to this point, it may be that the Fed really believes its own myth. The notion that “money doesn’t matter” and that “inflation is caused by too much demand” is a fashionable idea in mainstream economics. The view of The Money Enigma is that this New Keynesian approach to the issue of inflation is fundamentally flawed and that if the monetary base is allowed to stay at these levels, then inflation will surely accelerate.

We have discussed the relationship between money and inflation at length over the past few months (for example, see “Does Too Much Money Cause Inflation?” or “Why is There a Lag Between Money Printing and Inflation?”) and we will touch on it again in a moment. But before we do, let’s discuss Myth #1.

Myth #1: Stocks Won’t Fall if the Fed Reverses QE

Myth #1 is a favorite of the chattering class on CNBC who don’t understand the fundamentals of equity valuation. In essence, their argument is that when the time comes to reduce the monetary base (by the way, when is that?) the economy will be strong enough that investors will look past the fact that long-term interest rates are rising: rather, investors will focus on strong near-term earnings.

So, here is a simple theoretical question? Is the value of a long-duration asset more sensitive to (a) changes in near term cash flows, or (b) changes in the long-term discount rate?

The answer is (b).

Clearly, the answer depends slightly on definitions (e.g., how do we define “near-term”?) but the principle is simple. The value of a business depends upon the sum of an expected stream of discounted future cash flows. The net present value of a business is only marginally impacted by a 10% change in the expected cash flows that will be produced in the next one or two years.

However, what happens if the discount rate rises by 10%? A rise in the discount rate impacts the present value of all future cash flows, not just the value of future cash flows that are expected this year and next, but the value of cash flows that are expected to be received 10, 20 and even 30 years from now.

If the Federal Reserve reverses quantitative easing, then, all remaining equal, the interest rate on government bonds will rise, the risk-free rate will rise and the required cost of capital for all risk assets will rise. The negative impact this will have on the valuation of risk assets will far outweigh any marginal benefit to near-term earnings from a strong economy.

Discussion regarding “tightening liquidity conditions” miss the point: yes, it won’t help the stock market when bond and equity investors suddenly need to sell a trillion or two in corporate debt and equity in order to buy government bonds from the Fed. But more fundamentally, the issue is one of valuation. As the Fed reverses QE, the required rate of return on capital will rise across the entire spectrum of risk assets and, all else remaining equal, the net present value of stocks will fall.

Myth #2: The Size of the Monetary Base Doesn’t Matter to Inflation

Myth #2 is more pernicious than Myth #1 and, unfortunately, is much harder to debunk. Dissecting and dismantling Myth #2 requires us to revisit the very foundations upon which the science of economics is built. More specifically, we need to fully reexamine (a) how prices are determined, and (b) the nature of money. The Money Enigma is dedicated to both of these topics and we have explored each at length over the past few months. Clearly, we don’t have time to cover all this ground today, but we shall touch on a few core concepts.

Before we do, let’s start with a simple observation: “money isn’t free”.

Government and it agencies, most notably the central bank, are empowered by our society to “create money” (expand the monetary base). In this sense, the central bank can create something of value “out of thin air”. However, this does not mean that creating money has “no cost”.

If there was no fundamental economic cost associated with the creation of money, then there would no constraint on how much money our society creates and no limit to our prosperity: we would simply keep the printing presses rolling until everyone had everything they ever wanted.

So, what is the cost associated with money creation? At the most basic level, the economic cost associated with creating money is a decline in the value of that money and a commensurate rise in the price of all goods as measured in terms of that monetary unit.

Now, this is not a simple process. While the long-term relationship between the “money/output” ratio and the price level is well established, there is no simple or predictable short-term relationship between the size of the monetary base and the value of money.

For example, over the past six years, the Federal Reserve has quintupled the monetary with little to no impact on the value of the US Dollar or consumer prices in the United States.

Many commentators seem to believe that since the expansion of the monetary base in the past six years has not produced high levels of inflation, we are safe to assume that the link between the “money/output” ratio and the price level is “broken”. In other words, many seem to believe that the quantity theory of money, one of the strongest long-term empirical relationships ever demonstrated in economics, is now defunct.

The view of The Money Enigma is that the long-term relationship between money and prices is well and truly alive. Moreover, the longer the Federal Reserve delays a “normalization” of monetary policy, the greater the risk that inflation accelerates.

So, what explains the subdued levels of inflation that we are currently experiencing? Why does inflation lag monetary expansion, in some cases by many years?

In order to understand why the price level doesn’t immediately jump as soon as the Fed prints money, we need to understand a couple of key concepts.

First, we need to understand how the price of a good, in money terms, is determined. The view of The Money Enigma is that every price is a relative expression of market value. The price of a good, in money terms, depends upon (1) the market value of the good, and (2) the market value of money. The price of a good, in money terms, can rise either because (1) the market value of the good rises, or (2) the market value of money falls.

For example, if one apple is three times more valuable than one dollar, then the price of an apple, in dollar terms, is three dollars. This relative value differential can be impacted by a change in either the value of the apple or the value of the dollar. All else remaining equal, if the value of one dollar falls, then one apple will become more valuable relative to one dollar (even if the value of the apple itself has not changed when measured in absolute terms) and the price of one apple, in dollar terms, will rise.

[Economics struggles with this simple concept because economics has not developed a “standard unit” for the measurement of market value and, consequently, doesn’t appreciate the difference between the absolute and relative measurement of market value. This issue is explained at length in a recent post titled “The Measurement of Market Value: Absolute, Relative and Real”, a post which I strongly encourage everyone to read.]

We can extend this microeconomic theory of price determination to a macroeconomic theory of price level determination.

The view of The Money Enigma is that the market value of money is the denominator of every money price in the economy and hence is the denominator of the price level. All else remaining equal, as the market value of money falls, the price level rises.

This raises the next obvious question: what determines the value of money?

This is a complicated subject and one that has been discussed at length in two recent posts: “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

The view of The Money Enigma is that fiat money is a financial instrument and, in common with all financial instruments, derives its value from its contractual features. More specifically, fiat money is long-duration, special form equity instrument that represents a proportional claim on the future output of society.

Consequently, the value of fiat money is primarily dependent upon expectations regarding the long-term path of both real output and the monetary base. If the market expects long-term real output growth to be strong, then this supports the value of the fiat money issued by that society. Conversely, if the market expects long-term monetary base growth to accelerate, then the value of fiat money will fall.

Now, let’s think about what this theory might mean in the current environment.

The view of The Money Enigma is that an increase in the monetary base that is perceived to be “temporary” will have little to no impact on the value of fiat money. Why? The value of money depends upon expectations of the long-term path of real output relative to the monetary base. A change in the current level of the “real output/monetary base” ratio only impacts the value of money to the degree that it leads to a shift in long-term expectations regarding that ratio. Conversely, an increase in the monetary base that is perceived to be more “permanent” in nature will have a considerable impact on the value of money.

The reason that QE has not triggered a fall in the value of money and a rise in the price level is because the market perceives QE to be a “temporary” phenomenon. Over the past six years, quantitative easing has been routinely represented as an “emergency measure”: an extraordinary policy for an extraordinary time. Almost by definition, emergency measures are temporary actions (we can’t live in a permanent state of emergency).

Despite the many delays in “normalizing” monetary policy, the markets still seem to be convinced that the recent expansion in the monetary base is “temporary” in nature.

The question that no one wants to discuss is what happens if the “temporary” expansion in the monetary base becomes more “permanent” in nature? Moreover, what happens if instead of reducing in the monetary base, the Fed is forced to further expand the monetary base?

The view of The Money Enigma is that either of these scenarios will lead to a loss of confidence in the long-term prospects of the US economy, a fall in the value of money and a significant rise in the price level.

A return to high single digit inflation rates would represent another bad scenario for global stock markets: risk assets that are priced to achieve low nominal rates of return don’t respond well to a sudden acceleration in inflation.

In summary, the Federal Reserve has backed itself into a corner. If it reverses quantitative easing, then risk assets are likely to perform poorly as the required return on capital rises across the entire risk spectrum. However, if the Fed fails to reverse quantitative easing, then inflation will accelerate, a scenario for which global investors are not prepared.

The Case for Unwinding QE

Ben Bernanke, former Chairman of the Federal Reserve, says in his new book that it took “moral courage” to embark on the path of quantitative easing. I suppose that history will be the judge of that statement. What is clear, seven years later, is that the Fed’s failure to reverse QE does not represent an act of courage, but rather a lack of courage.

Quantitative easing (“QE”) is, without doubt, the most controversial of all monetary policy programs conducted by the Federal Reserve in its one hundred year history. This week we will consider the benefits and the costs associated with reversing such an unprecedented and aggressive program of monetary base expansion.

While the near-term costs of reducing the monetary base may seem to outweigh the benefits, there is a terrible risk associated with the path of inaction. If the Federal Reserve fails to act, then the Fed risks losing not only its credibility, but any significant control over economic outcomes.

In many ways, the decision by the Fed to reduce the monetary base is similar to the decision that many of us might face when we think about returning to the gym after a period of long absence. It may be tough to get back on the treadmill after weeks of inactivity, but most of us understand that the benefits are worth it. Moreover, the long-term risks of not any taking action are, quite frankly, unacceptable.

Reversing quantitative easing is a good step for the long-term health of the economy. Capitalism, just like the human body, works best when it is constantly being tested. When the capital markets are working efficiently, good ideas thrive, while bad ideas are quickly discarded. By removing the trillions of excess capital that have flooded the global markets, both debt and equity markets can once again begin to send the right price signals to investors and entrepreneurs.

However, getting back into a regular exercise routine is tough. Similarly, removing a couple of trillion dollars from global financial markets is not going to be easy. There will be inevitable negative consequences in both the financial economy (a fall in the value of most financial assets) and the real economy (recession and higher unemployment), consequences that will make it politically difficult for the Fed to persist.

Nevertheless, while reversing quantitative easing will be no walk in the park for the global economy, the alternative is much worse. If the Fed fails to reduce the monetary base, then high levels of inflation will return. In a world overburdened with both private and public sector debt, a return of high inflation would have terrible consequences on the ability of the West to maintain current levels of leverage and, consequently, the global economy.

What is Courage?

Courage is the mental or moral strength to act in the face of fear and difficulty. Last week, Ben Bernanke claimed that it took “moral courage” to embark upon the path of quantitative easing. While it may have taken a certain intellectual “conviction” to commence quantitative easing, it is not clear that it took great “courage” to embark upon a program that the markets, and the public more generally, welcomed with open arms.

In contrast, reversing quantitative easing and reducing the bloated balance sheet of the Federal Reserve will require an act of great courage.

Let’s be clear on this point. In late 2008/early 2009, when the financial markets were in turmoil, the public-at-large, Wall Street and most politicians demanded that the Fed take dramatic action. With the Fed funds rate sitting already sitting at an extraordinarily low level (the fed funds rate was 1% at the time the depths of the crisis hit), the Fed had backed itself into a corner. It had little choice but to attempt something new.

Consequently, it didn’t take an act of “courage” to do something new and drastic in early 2009. However, this isn’t to say that it wasn’t the right thing to do: the first round of quantitative easing (QE1) represented a novel approach to crisis management and, at least in my personal opinion, it was an appropriate response in the circumstances at that time. Arguably, the most important mandate of the Fed, a role that is far more important than aggregate demand management, is “crisis control”. In early 2009, the Bernanke team did what had to be done. But it could hardly be described as an act of great courage.

Courage, in the political sense, is having the intellectual and moral strength to do the right thing in the face of tremendous opposition. It didn’t take great political courage to embark upon the path of QE, but it will take great political courage to substantially reverse QE.

In order to understand why there will be great opposition to any reversal of QE, we need to think about the impact that QE has had on both the markets and the economy. The best way to do this is to put the trillions of dollars created by QE into context.

Benefits and Costs of Unwinding QE

A few months ago I wrote a post titled “2015: A Happy New Year for Markets?” which attempted to highlight the incredible scale of the Fed’s quantitative easing program. The $4 trillion that has been created and “invested” in the global markets by the Federal Reserve over the last six-year period is an astonishing sum.

It is hard for most people to put this amount of money into context, but here is one example. If we assume that every car in America was bought with cash (no loans, no leases), then the American public would have to give up all new purchases of cars for six years in order to save and invest the same amount of money that the Federal Reserve has created and invested in the markets. You can see the math behind this in the original post mentioned above.

With this example in mind, it isn’t hard to see how the Fed’s actions have created a massive distortion in capital markets. In the normal course of business, the $4 trillion created by the Fed and invested in fixed income securities would need to be saved by American consumers, a process that would have created a severe economic recession. As the Federal Reserve bought government bonds (and limited amounts of other fixed income securities), this lowered the expected rate of return across all investment classes (government bonds, corporate bonds, listed equities, private equity, etc.), pushing yields to record lows and equities to record highs.

As you might imagine, just an incoming tide will lift all boats, so an outgoing tide will lower all boats. The problem is that there are a lot of people sitting in boats that are going to hit the rocks as the tide goes out. And this brings us to our first key point: it is going to be very difficult politically for the Federal Reserve to reverse quantitative easing.

By lowering expected rates of return across all assets, the Federal Reserve has induced a boom in global financial markets and a recovery, albeit sluggish, in the global economy, particularly in those sectors leveraged to cheap money (the shale oil industry is a great example of this).

However, not only does this process work in reverse, but it will probably follow a more volatile path. As the Federal Reserve sells the bonds on its balance sheet, someone has to buy them. At the margin, this means that someone has to sell corporate debt and equities to buy government bonds. If lots of people try to do this at the same time, then it is very easy for prices of these securities to adjust rapidly in order for equilibrium to be restored.

Aside from the very real potential of a market crash, reversing quantitative easing will have a short-term negative effect on the real economy (jobs etc.). As the cost of capital rises across the economy, new business projects will stall and many businesses that have survived on cheap debt and equity funding (shale oil, early-stage biotech, etc.) will suddenly find themselves with few backers.

Clearly, this doesn’t sound like a great scenario. So why should the Fed reverse quantitative easing?

First, let’s consider the benefits of reversing QE and then we can consider the long-term costs associated with a failure to reverse.

The key benefit from reversing QE is simple, but surprisingly difficult for most people to grasp. The long-term health of any society depends upon the efficient allocation of its scarce resources. Quantitative easing distorts the markets and removing this distortion is a good thing for our society.

While this point should be obvious to an educated person, there are many in the political classes who don’t seem to understand this important principle.

In a small tribal economy, the survival of everyone in that tribe depends upon the efficient use of the scarce resources. If people waste time gathering food that won’t store or making tools that the community doesn’t need, then this will imperil the ability of that small community to get through the tough times.

While the dynamics of a modern industrialized economy are much more complex, the principle is the same. Our society has limited resources and for our society to grow and prosper it must allocate all these resources to the right economic activities. This process begins in the capital markets: the markets for equity and debt securities need to send the right signals in order for everyone in our society to make sensible decisions about consumption, saving and investment.

A reversal of QE will remove much of the “froth” that currently exists in global capital markets, thereby enabling these markets to do their job more effectively.

This may sound like a bad deal: an economic recession and a fall in asset values all for the sake of “efficient capital markets”. Why should we as a society choose this path short-term pain?

The answer is simple: long-term gain.

We can use the analogy of returning to a regular exercise routing after a long absence. For most of us, running on the treadmill isn’t a lot of fun. “Rewarding” perhaps, but not “fun”. So why do we do it? The answer is that we trade off short-term pain for long-term gain. By physically stressing our bodies today, we prepare them for the challenges they face in the years ahead.

We can say the same for our society. By getting back on the treadmill of free market capitalism (and let’s face it, it is a treadmill and the experience is often not that “fun”), we prepare ourselves for the challenges that our society will face in the future. If we start making the right decisions today, then we don’t have reverse poor decisions in the future. Furthermore, the longer we put off making the right choices, the harder it will be when we have to.

Avoiding the Unthinkable

So far we have considered the benefits and costs of unwinding QE. But what happens if the Fed chooses not to unwind QE? Is there a happy ending?

The short answer is “no”.

But before we get into a discussion of economic theory, let’s return to our simple analogy and think about what happens when we keep avoiding regular exercise and a healthy lifestyle.

In the short-term, it doesn’t make much difference whether you get back the gym or not. You may start to notice that you are a little out of breath walking up the stairs at work or maybe the belt needs to be let out one notch.

However, in the long-term, it makes a very noticeable difference. More importantly, the “long-term” can suddenly and very painfully catch up with us (diabetes, heart attack, etc.)

Failure to return to a regular exercise routine probably won’t lead to disaster overnight, but it dramatically increases the risk of a whole series of outcomes that are “unthinkable”.

Similarly, central bank intervention will not lead to disaster overnight: thoughtful and temporary intervention by the central bank in capital markets will often make sense, particularly in a time of crisis. But if markets become addicted to central bank intervention, then it dramatically increases the risk of a whole series of “unthinkable” economic outcomes.

The best of these bad outcomes is a return of high inflation.

Many economies can sustain relatively high rates of inflation (5%-15% per annum) without a dramatic collapse in real economic activity or investment. In some ways, this type of inflation is the type 2 diabetes of economic life: you can live with it, but it isn’t great.

However, inflation can create very poor economic outcomes if coupled with other pre-existing economic conditions (just as diabetes can create very poor health outcomes if coupled with other pre-existing medical conditions). Most notably, economies that have become increasingly addicted to very low nominal interest rates and credit expansion are very vulnerable to even a modest increase in the rate of inflation.

So, why will inflation return if the Fed fails to reverse quantitative easing?

There are two ways to answer this question: there is a simple answer and a more complex answer.

The simple answer is that, in the long run, the quantity theory of money works. Over long periods of time, an increase in the monetary base that is in excess of an increase in real output, will lead to a corresponding increase in the price level.

This shouldn’t be a controversial point. The long-term empirical relationship between the “base money/real output” ratio and the price level has been extensively documented and discussed. While economists have developed many different theories regarding inflation (cost push, demand pull, output gap, inflation expectations, etc.), the only theory that has clear empirical support for explaining the long-term evolution of prices is the quantity theory of money.

Recently, many commentators seem to have become comfortable either ignoring quantity theory or dismissing it outright. It is very easy to fall into this trap because quantity theory does not hold in the short-term. For example, in the United States, the massive increase in the monetary base has not resulted in any inflation (at least not yet!).

Unfortunately, most commentators don’t understand the role of expectations in determining the value of money and, consequently, the price level.

The view of The Money Enigma is that the value money depends primarily upon expectations of the long-term (20-30 year) path of the “real output/base money” ratio.

Despite the massive increase in the monetary base, the markets still believe that QE is a temporary phenomenon. In other words, the markets expect that the Federal Reserve will reduce the monetary base over the next few years. Moreover, markets remain optimistic about long-term economic growth in the US, despite the threat of this reduction in the monetary base.

However, if the markets begin to doubt the Fed’s commitment to reducing the monetary base, or if the markets become more pessimistic about long-term growth in the US, then the value of the US Dollar could decline sharply and the price level could rise rapidly.

Why does the value of money depend upon distant future expectations regarding the size of the monetary base relative to real output? Those readers who are interested in the answer to this question should read “Money as the Equity of Society”.

In short, the view of The Money Enigma is that money is a proportional claim on the future output of society. Just as common stock is a proportional claim on the future cash flows of a business, so money is a special-form equity instrument that represents a proportional claim on the future cash flows of society.

We can use this concept to create a valuation model for money. The absolute market value of money (the market value of money as measured in terms of a standard unit for the measure of market value) depends upon the discounted future benefits that the marginal unit of money is expected to bring. The valuation model for money highlighted below suggests that the market value of money is positively correlated with long-term expectations of real output and negatively correlated with long-term expectations of base money.

In simple terms, the value of a fiat currency depends upon the expected long-term prosperity of the society that issues it. Currently, the markets are very optimistic regarding the long-term prospects of the United States. But if the Fed blinks and that faith is tested, then the value of money could decline quickly, leading to a return of inflation.

On a final note, there is one more compelling reason for the Fed to unwind quantitative easing: the magician always needs to keep something up their sleeve.

If the US economy was to plunge into recession today, what could the Fed do? Increase the monetary base by a further $4 trillion? At some point, the markets will realize that the Fed is out of bullets (or at least one’s that work). At this point, the value of money will collapse, inflation will return and the Fed will lose any control over economic outcomes. This is the “unthinkable” and a scenario that none us want to experience.

In summary, The Fed needs to act now. It’s time to get back on the treadmill. If we don’t choose to do it now, we will only be forced to do it later.

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