Currency Wars_ The Making of the Next Global Crisis - James Rickards [94]
The Fed has another problem in addition to the behavioral and not easily controlled nature of velocity. The money supply that the Fed controls by printing, called the monetary base, is only a small part of the total money supply, about 20 percent, according to recent data. The other 80 percent is created by banks when they make loans or support other forms of asset creation such as money market funds and commercial paper. While the monetary base increased 242 percent from January 2008 to January 2011, the broader money supply increased only 34 percent. This is because banks are reluctant to make new loans and are struggling with the toxic loans still on their books. Furthermore, consumers and businesses are afraid to borrow from the banks either because they are overleveraged to begin with or because of uncertainties about the economy and doubts about their ability to repay. The transmission mechanism from base money to total money supply has broken down.
The MV = Py equation is critical to an understanding of the dynamic forces at play in the economy. If the money (M) expansion mechanism is broken because banks will not lend and velocity (V) is flat or declining because of consumer fears, then it is difficult to see how the economy (Py) can expand.
This brings us to the crux. The factors that the Fed can control, such as base money, are not working fast enough to revive the economy and decrease unemployment. The factors that the Fed needs to accelerate are bank lending and velocity, which result in more spending and investment. Spending, however, is driven by the psychology of lenders, borrowers and consumers, essentially a behavioral phenomenon. Therefore, to revive the economy, the Fed needs to change mass behavior, which inevitably involves the arts of deception, manipulation and propaganda.
To increase velocity, the Fed must instill in the public either euphoria from the wealth effect or fear of inflation. The idea of the wealth effect is that consumers will spend more freely if they feel more prosperous. The favored route to a wealth effect is an increase in asset values. For this purpose, the Fed’s preferred asset classes are stock prices and home prices, because they are widely known and closely watched. After falling sharply from a peak in mid-2006, home prices stabilized during late 2009 and rose slightly in early 2010 due to the policy intervention of the first-time home buyer’s tax credit. By late 2010, that program was discontinued and home prices began to decline again. By early 2011, home prices nationwide had returned to the levels of mid-2003 and seemed headed for further declines. It appeared there would be no wealth effect from housing this time around.
The Fed did have greater success in propping up the stock market. The Dow Jones Industrial Average increased almost 90 percent from March 2009 through April 2011. The Fed’s zero interest rate policy left investors with few places to go if they wanted returns above zero. Yet the stock rally also failed to produce the desired wealth effects. Some investors made money, but many more stayed away from stocks because they had lost confidence in the market after 2008.
Faced with its inability to generate a wealth effect, the Fed turned to its only other behavioral tool—instilling fear of inflation in consumers. To do this in a way that increased borrowing and velocity, the Fed had to manipulate three things at once: nominal rates, real rates and inflation