This Is Why the Fed Sees No Bubbles

October 10 2016

Financial bubbles are about changes in relative prices. Temporarily, prices of internet stocks, real estate or even tulips (as the Tulipmania of 1637 proves) begin moving out of step with their fundamental value and all other prices in a market economy. The Fed is blind, because it knows nothing at all about changes in relative prices. The general price level is what keeps Fed-officials up at night, with all the consequences this might entail.

Money Is Neutral

The old theoretical economic edifice was one build upon the theory of direct trade. The involvement of money, of a medium of exchange and therefore indirect trade, would change little to this theoretical edifice. It only means a simple incorporation of money terms, nothing more and nothing less. Only the historical chapters with extreme high inflation should be studied apart because of their effects on direct trade through money, only the external “shocks.” However, this is a mere sideshow that should be left to economic historians. These exceptional cases prove the general rule: money is a neutral factor in economic theory, as long as the masters of our money go overboard.

The Consumer Price Index (CPI) As the Holy Grail

This idea also dominates within the circles of central banks. Bubbles are a relatively unimportant phenomenon, in the sense that it is never a question of policy (the central bank never takes any blame), but rather that bubbles are negative, external “shocks” to which a central bank might have to adjust its future policy.

In other words: bubbles? Not our fault, central banks say. It is always the too stupid populace, which acts irrationally and is incapable of controlling its “animal spirits.” You are guilty, not we, while central bankers wash their hands of the matter.

This fact can also be traced back to the data which a central bank uses to determine how “successful” its policy is:

  • The Consumer Price Index (CPI)
    As long as the consumer price index (CPI) does not start rising rapidly, there is nothing to be worried about and, consequently, current policy is “optimal.”
     
  • Gross Domestic Product (GDP)
    Another explicit goal of the central bank is to make sure that the economy grows according to its “growth potential.” The fact that this hypothetical growth potential cannot be deduced from anything is completely ignored. As long as GDP rises, and the economy is not in a recession, the central bank is doing a great job.
     
  • Unemployment (sometimes)
    Some central banks, in particular the Federal Reserve, aim for “full employment,” which of course is also a great unknown. To be sure, nobody knows what “full employment” precisely means. Sure, it means that there only exists voluntary unemployment (people that wait for more rewarding job offers or take a sabbatical) and no involuntary unemployment. But exactly at which point have we reached full employment? According to the previous Fed-chairman Ben Bernanke this would have been achieved at around 6.5%. The new Fed-president, Janet Yellen, disagreed and said it would be at 6% unemployment. And later, when she rather not raised interest rates, it suddenly became 5%.

In sum, as long as GDP increases and the consumer price index does not begin to increase rapidly, central bank policy is “optimal.” Nonsense, I argue.

This Is Why These Macro Data Mislead the Fed

However, the consumer price index is only a statistic (which is, by the way, devoid of any scientific foundation) that pretends to measure the general “price level.” This implies that the consumer price index will never be able to reveal extreme deviations in relative prices. Worse yet, the Fed only looks at a consumer price index without food, without rents or housing prices, and without energy. Central bankers are blind. And for good reason.

GDP has similar flaws. Changes in GDP are never able to point out whether or not an increase in GDP is permanent or simply a temporarily illusion. Will the investments that were made help truly to better satisfy consumer demand or are they mal investments because entrepreneurs and investors are misled and begin the wrong projects?

Bubbles: Changes in Relative Prices

Bubbles cannot be recognized with the statistics that the Fed uses. (Unsustainable) changes in relative prices are the characteristic feature of bubbles that inevitably end in a recession.

If the prices of tulip bulbs double ten times and the demand mostly originates from people using borrowed money, then it might be that GDP grows “as normal” and the consumer price index barely moves (what relative weight would a tulip bulb have in such a price index anyway?), but the conclusion that an underlying imbalance is developing that in the future will surface is completely justified.

The negative interest rates in the Eurozone can also be interpreted from this point of view.

While ECB-chairman Mario Draghi lowers interest rates further and further, he thinks that the ECB will not do any harm as long as GDP begins gathering steam again and the consumer price index remains somewhere below (or near) its 2% target.

Mario Draghi, just like his colleagues elsewhere in the world, is sailing blind.

To use a metaphor from sea: some economists appear to think that only a hurricane can put a ship on the wrong course. Guess what. A weak, unceasing wind is also capable of bringing a ship off course and crashing it into the reefs. Unfortunately, these same economists are at the helm of our money.

The ignorance of the Fed and our own ECB will cause great damage. The western economies are on collision course.

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