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ECONOMYNEXT – Sri Lanka is recovering fast but the country could get hit from an unravelling of advanced economies, particularly the United States, which is skating on very thin ice, after exceptionally bad monetary policy, which has destroyed fiscal metrics as well.
The US was running bad to atrocious monetary policy since 2001, when Ben Bernanke misled Alan Greenspan into printing money to run an 8-year cycle, firing a commodity and housing bubble which collapsed after rates were kept at around 5 percent for about a year.
That was the end of the Great Moderation started by Paul Volcker and continued with some skill under Greenspan, until the Fed was infected by Bernanke, the depression scholar. Keynes was also a ‘depression scholar’, in essence.
Gold prices fell from 800 to 284 dollars an ounce under Volcker-Bernanke, until Bernanke cooked up a false deflation scare with a healthy banking system and started to reverse it, firing the housing bubble and the Great Recession in its wake.
Then came quantity easing after the banking collapse and Frank-Dodd to control banks.
From around Covid and until March 2022, quantity easing resumed no holds-barred with fiscal policy also deteriorating as the government used the money.
It is now almost a year since interest rates have been at 5 percent in the US after Powell started to raise rates.
But this is not the US of 1980 or 2000, and it not just some companies but the government is chocked to the gills in debt after the MMT style stimulus and Covid handouts and perhaps the most aggressive ‘full employment’ policies in the history of the Fed.
Warning Signs
F A Hayek said this of Keynesianism and the policy rate to boost growth through full employment policies (now called targeting potential output in Sri Lanka).
“It was John Maynard Keynes, a man of great intellect but limited knowledge of economic theory, who ultimately succeeded in rehabilitating a view long the preserve of cranks with whom he openly sympathized.”
In continuing with quantitative easing with a healthy banking system, the Fed and the ECB is putting Keynes and John Law to shame.
It was perhaps no accident that the IMF taught Sri Lanka to calculate potential output a few years ago, with this ideology running high in Washington, eventually taking both the Yahapalana and Gotabaya Administration down and driving Sri Lanka to default.
There was an unprecedented overall deterioration of policy around the world that spread from the Fed and US universities, just like in did in the 1920s when the policy rate and deliberate open market operations were invented and the 1960s when its own anchor was busted .
From last year the US broad money supply has been shrinking in absolute terms, something that has rarely happened.
The Fed no longer looks at money supply, under their current framework.
Economist Steve Hanke, who was ad advisor to the Reagan Administration when the landmark action was taken to bring monetary stability back in the early 1980s, and kick-start non-inflationary growth, has pointed out that absolute falls in the money supply is very rare in the US.
Hanke also accurately predicted the 2022 inflation spike from Fed’s inflationism.
Bad Money, Bad Budgets
US budgets are shot.
After years of bad Fed monetary policy (which also helped Sri Lanka borrow in dollars from sovereign bond holders and China), US rates are going up and interest costs are rocketing like in Sri Lanka.
Is it possible for a US Treasuries auction to fail?
In theory no, since the Fed can buy it up as Sri Lanka’s central bank does to cut rates and trigger external crises.
But any such event can send bad vibes which can be the proverbial straw that broke the camel’s back.
The US Treasury had almost a perfect system going until around 2000, with the China and East Asia buying up US debt and importing the stability of the Great Moderation to become investment and export powerhouses.
But US Mercantilists who believe that exchange rate pegs made East Asia export powerhouses, at the expense of the US trade deficit, put pressure on China and other countries to break the peg, losing a big buyer of their debt.
IMF backed Self Destruction
The IMF fully supported these efforts.
China then broke the peg from around 2005 and diverted savings to the Belt and Road project.
When the housing bubble broke, China was in pretty good shape with tighter than US policy until then.
After quantity easing started US rates were low in any case. Sri Lanka was one of the countries that the money was diverted to.
Bond holders, also awash in liquidity started to buy crappy bonds from low rated countries which are now defaulting like dominoes.
The Fed, by triggering commodity bubbles and oil prices that tends to incentivize leaders of illiberal mineral rich countries into war, Arab Israeli wars or Russian aggression.
US dealt itself another blow during the Ukraine crisis.
The lack of knowledge in US policy circles was clearly shown by the freezing Bank of Russia reserves invested in the US.
It prevented Russia’s central bank from using reserves to mis-target rates and sterilizing the interventions with printed money, and helped Russia avoid a monetary meltdown.
Instead of printing money to mis-target rates after intervening to trigger a currency crises like repeated IMF backed countries and Latin America does, Bank of Russia hiked rates to 20 percent virtually the day after reserves were frozen and clean floated.
As a result, the US budget has lost another customer for its bonds. More to the point it has discouraged others from buying US bonds as well. If reserves are frozen, then countries which have bad relations with the US will no longer buy US bonds.
Clean floating countries will not collect reserves in any case.
The steeply rising gold prices now, are partly driven by central bank purchases, who would perhaps have bought more US bonds in the past. If more countries are driven to external crises though flexible inflation targeting, they will also sell US bonds.
The IMF has has started peddling flexible inflation targeting to Vietnam.
In the last Article IV consultation, the IMF also promoted expansionary fiscal policy dealing a death blow the central bank efforts to stabilize the external sector by replacing private credit with government credit.
Curiouser and Curiouser
There is another curious phenomenon seen in Fed statistics that should make people sit up and take notice.
The reserve balances component of the US monetary base (there is no longer a required reserve rule in the US amid the latest deterioration of its monetary framework) is climbing even as the Fed is engaged in quantity tightening.
This is clear liquidity preference behaviour, where the smart banks are getting ready for the worst instead of – say – buying government treasuries.
Sri Lanka saw a similar situation among the best managed foreign banks in Sri Lanka during the country’s ‘mother of all currency crises’.
Fed wants to quantity tighten, but banks are building up liquidity. Essentially the effect on the economy is the same – some banks are not lending. The difference is these banks may be smarter.
There seems to be two types of banks, which are acting in completely different ways in the US.
While some banks seem to be loading up on liquidity others are lending – at 5 percent plus.
Commercial bank credit which stopped growing and fell from the time the Fed started to tighten policy in March 2022 (a very quick response) has started to edge up over the past few months.
It is not clear who is taking the loans, at 5 percent plus which is a very high rate for a highly leveraged economy like the US. At least some of it must be going for commodity speculation.
Meanwhile gold has hit 2,400 dollars an ounce. Gold was only 284 dollars an ounce when Bernanke induced Greenspan to print money for positive inflation targeting by falsely firing a deflation scare in 2000.
There was some expectations by various technical analysts that gold will hit 2,400 an ounce. So, it can be a self-full filling prophecy.
Whatever it is, a commodity bubble at the tail end of a rate hiking cycle is not a good omen. A similar trend was seen just before the collapse of the housing bubble. It is like the dead cat bounce of the commodity world.
Soft-Landing or Disorderly Unravelling of the Powell Bubble?
In the Greenspan-Bernanke bubble it was HSBC’s housing unit in the US that showed that the system was rotten.
The jitters over the Iranian attacks show that US markets are skating on very thin ice.
It is not clear to what extent US companies are over-leveraged. It was mostly a housing bubble that broke in 2008. But this time credit has shifted to other sector.
Government debt is one. The recent bank failures related to marked-to-market long-term government bonds confounding those who promote full reserve banking.
But there are signs that some other companies, including those in infrastructure which tended to be pretty safe, have borrowed and engaged in activities like leveraged dividend recapitalizations.
Over recent years there had been a spate of leveraged dividend recaps.
Jerome Powell said last week that the Fed will continue to tighten with inflation still high.
“The recent data do not, however, materially change the overall picture, which continues to be one of solid growth, a strong but rebalancing labor market, and inflation moving down toward 2 percent on a sometimes bumpy path,” he said.
“Labor market rebalancing is evident in data on quits, job openings, surveys of employers and workers, and the continued gradual decline in wage growth. On inflation, it is too soon to say whether the recent readings represent more than just a bump.
“We do not expect that it will be appropriate to lower our policy rate until we have greater confidence that inflation is moving sustainably down toward 2 percent. Given the strength of the economy and progress on inflation so far, we have time to let the incoming data guide our decisions on policy.”
Under the Fed’s (historical) data driven monetary policy and its dual mandate (which by the way was generally ignored by both Volcker and Greenspan in favour of stability) there is no chance to cut rates, so he is justified in the stance.
But it does not necessarily mean that the historical data he is looking at will lead to a soft-landing or another deflationary collapse.
This time, the US government will have less room than in the past to engage in various macro-economic policies to manipulate the economy given its debt and the political crisis in Washington.
The banking system may also not respond to Fed actions as it had done in the past.
In earlier collapses, gold, dollar notes and US government debt were investments of choice for economic agents, as shown in Exter’s pyramid.
The US so-called ‘weaponizing’ of the dollar has reduced its attractiveness overseas, but not necessarily at home as shown by the recent liquidity preference behaviour.
Sri Lanka hit by bad US policy in the past
In past US monetary crises, whether the Great Depression, the 1960s inflationism (Sri Lanka first started its journeys to the IMF in the middle of that decade and passed the import control act), the 1971 collapse of the Bretton Woods (Sri Lanka closed the economy), the country has been hit.
In 1980s when US improved policy Sri Lanka failed to capitalize on it unlike dollar pegged East Asia.
From 1978, at the tail end of the Great Inflation period, Sri Lanka lost a credible anchor leading to high inflation and social unrest and missed stability that East Asia got by maintaining external anchors with the Fed improving its policy.
The US and the US dollar survived in 1951 and 1980 as hard money people got back into the driving seat and inflationist macro-economists lost favour.
However it did not happen in 2008. Things essentially got worse as it did in the 1930s with quantity easing infecting even once prudent reserve currency central banks, as Keynesianism and the policy rate did after the Great Depression, leading to mass devaluations in the 1930s.
It may be time to look for countermeasures. Sri Lanka at the moment is fixing its budgets and has reasonable monetary policy though the operational framework is deeply flawed. Companies and individuals may also need to hedge their bets.
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