Chaos Theory in Financial Markets: The Fed’s Dual Mandate

Capitalism at a Cross Roads

The Fed’s Dual Mandate and the Birth of Crybaby Capitalism: Finding the Butterfly

PREFACE

Crybaby Capitalism: n (ca. 2007) 1) a state of whining and miserable self-centered avarice, 2) the antithesis of Masters of the Universe, 3) a psychotic state suffered by free market participants when overfed a steady diet of cheap money. See below:

That’s Jim Cramer, the original poster boy for crybaby capitalism. The fact that he feels empowered to scream and rant about the need for the Fed to cut rates and save his friends’ jobs would be comical if it weren’t so pathetic. Jim Cramer is a good showman and has a reasonably good research firm, directed at stock picking. He has an amazing knowledge and memory of individual companies and is an accomplished advisor to small investors. He is also, however, the archetype of a generation of Crybaby Capitalists fed an ever increasing diet of cheap money by the Fed – which has been desperately trying and miserably failing to answer multiple and contradictory mandates.

The Great Recession is a rolling disaster that the world economy seemingly stumbled into in the spring of 2008 and continues most colorfully today with the slow motion train wrecks of monetary policy in the United States and the collapsing Euro. This rolling economic Verdun was born many years before in a series of ill-conceived and poorly understood policy initiatives championed by consumer advocates and industry groups alike. These reforms – generally characterized as deregulation – were targeted at the seemingly laudable targets of risk mitigation and fairness, and categorically achieved just the opposite.

Each of these examples is a terrific case study of chaos theory at work. In chaos theory, a small action/change in a complex/dynamic system can have enormously disproportionate impact in the future. The classic example is posited by Lorenzo in his 1972 paper, Predictability: Does the Flap of a Butterfly’s Wings in Brazil set off a Tornado in Texas? What is most important to remember here is that chaos theory is very sensitive to initial conditions, and unpredictable beyond very short periods of time. For those making economic policy this requires a constant vigilance for the undesirable unintended consequences of policy changes – clearly the butterfly did not intend the tornado.

It is to the quest of finding Lorenzo’s butterfly that I dedicate this series of articles.

The second such reform considered in this series is The Fed’s so-called dual mandate – the debacle dating back to the Full Employment Act of 1946, but brought to the full flower of fiasco by the Humphrey Hawkins Act of 1978.

The Federal Reserve – A Much Hated American Institution

President Andrew Jackson was a prototype for Ron Paul in many ways, not the least of which was his loathing of the Eastern Establishment and Central Banking. The Second Bank of the United States lost its unique charter in 1836 during the Jackson Administration, although Jackson had attempt to kill it earlier stating, “beyond question that this great and powerful institution had been actively engaged in attempting to influence the elections of the public officers by means of its money.” Sound familiar?

Following the demise of the Central Bank, the US survived and prospered in a system of precious metal backed currency throughout the late 19th century, although with enormous issues surrounding the impact of the currency and banking system on occasional bank panics. In general, however, this was a period of strong economic growth with benign and constant deflation (reflecting the broad economic growth faster than the monetary base).

The Fed in its current incarnation was created in 1913, largely in response to a variety of bank panics of the late 19th and early 20th centuries, the most compelling being the fabled Panic of 1907, the resolution of which depended entirely on the personal intervention of J.P. Morgan.


President Andrew Jackson slays the multi-headed hydra of Central Banking

The explicit impact of politics on the Federal Reserve System began with the Full employment act of 1946 which committed the federal government to pursue the goals of “maximum employment, production and purchasing power.” The Federal Reserve is normally interpreted as part of the federal government (despite its putative independence), and various Fed chairmen have suggested over the years that the goals of the 1946 act are applicable to the Federal Reserve – making the tie to the Federal Government closer than the original documents creating the Fed contemplated.

The real creation of a multi-mandate Fed came in the Humphrey-Hawkins Bill of 1978, which actually created multiple related mandates for the Federal Reserve as indicated in the title of the Act:

“An Act to translate into practical reality the right of all Americans who are able, willing, and seeking to work to full opportunity for useful paid employment at fair rates of compensation; to assert the responsibility of the Federal Government to use all practicable programs and policies to promote full employment, production, and real income, balanced growth, adequate productivity growth, proper attention to national priorities, and reasonable price stability; to require the President each year to set further explicit short-term and medium-term economic goals; to achieve a better integration of general and structural economic policies; and to improve the coordination of economic policymaking within the Federal Government.”

 The guts of this monstrosity created four clearly identified mandates to be considered by the Fed: 1) Full employment and growing incomes, 2) Balanced trade with our trading partners, 3) Balanced Federal Budget, and 4) Reasonable price stability. Dropping this load of impossibly conflicting mandates on the Fed, converted it from a fundamentally focused organization, directed at price stability through interest rate and money supply (open market) activities, into a politically charged and activist organization.

The Fed’s Dual Mandate helps the Fed retain its place as an incomprehensible mess and deserving object of derision in the eyes of all opposition politicians, as the September 12th Republican debate made all too clear. First Rick Santorum criticized the Fed and Dual Mandate, saying, “Make it a single charter instead of a dual charter institution”. Rick Perry, Herman Cain and Mitt Romney all piled on with further encouragement to end the dual mandate, but with very little discussion about the particulars as to the whys or wherefores. Perhaps Perry couldn’t remember, and Romney had taken a contrary position while Governor – but more probably they simply had never thought it through.

The Dual Mandate – as the Fed Sees It

The Fed seems to see no problem in the Dual Mandate, stating on its website,” The Congress established two key objectives for monetary policy–maximum employment and stable prices–in the Federal Reserve Act. These objectives are sometimes referred to as the Federal Reserve’s dual mandate. The dual mandate is the long-run goal for monetary policy, and the Congress also established the Federal Reserve as an independent agency to help ensure that this monetary policy goal can be achieved. The independence of the Federal Reserve in conducting monetary policy is critical to guaranteeing that monetary policy decisions are free from political influence and focused exclusively on achieving the Federal Reserve’s dual mandate.” Those clever folks at the Fed kick the blame back on Congress, but agree to shoulder the burden and press on with a smile, attempting to accomplish the impossible.

The crux of the issue is that classical Keynesian economics instructs that there is a direct tradeoff between inflation and employment. The concept is that “modest” levels of inflation serve to maximize economic activity – sort of a Laffer Curve in reverse.  This became a real problem in the late ‘70’s and through the ‘80’s, when the Fed took it upon itself to break the back of rapidly growing inflation through high interest rates and restrictive monetary policy. This anti-Keynesian approach infuriated many elements in society – remember the farmers driving their tractors to Washington to protest interest rates? The dual mandate was put in place to combat the perception of an out-of-touch Fed, sacrificing American workers on a later day “Cross of Gold”.

The Volker Alternative

The inflation of the ‘70’s was caused by a series of policy disasters which began in the Johnson Administration, and accelerated in the Nixon Administration with the unilateral abrogation of our currency treaties, and the imposition of wage and price controls. The arrival of Paul Volker as Chairman of the Fed ushered in a new era of monetary sanity, and with a real currency came real economic growth. In short, Mr. Volker felt that a strong currency was the path to full employment – not devaluation through inflation.

Beginning with the Greenspan era in 1987, the Fed began a much more activist stance towards its dual mandate, aggressively lowering interest rates and easing monetary policy in response to an increasing number of fiscal crises, culminating today with the absurd situation today of short-term interest rates pegged at zero for multi-year periods and the wild expansion of the money supply through the imaginative QE x-1 programs.

History would suggest that an increasing rate of inflation actually increases the rate of unemployment. Inflation diminishes the purchasing power of most consumers and falling real wages mean reduce discretionary spending capability – decreasing aggregate demand in the economy. The result is always a contraction in net economic activity, and very strange distortions in economic activity. In November of 1974 CPI hit 12.2% leading to the cyclical high of 9% unemployment during May of 1975. Likewise, In 1980, the CPI hit a whopping 14.6% in April, which was followed by 10.8% unemployment in December of 1982. Inflation is clearly not a benign bedfellow for employment.

Crybaby Capitalism and Chaos

The fact that the dual mandate didn’t work very well is pretty clear. But consider for a moment – this activism from the Fed since 1987 was a pretty big change from past norms. Chaos theory would suggest that it probably did make some pretty big changes – just not in the areas intended.

Clearly this torrent of cheap money has not made our Nation rich, nor has it provided financial/employment security as would be suggested by the Fed. But it has created a large and growing cadre of crybaby capitalists. These folks are the only beneficiaries of all of the currency devaluation, and the Cramer rant may be considered their most visible primal scream therapy.

Cheap Money, Financialization & Crybaby Capitalism

Finance is the art of passing money from hand to hand until it finally disappears.“

 Robert W. Sarnoff

Sarnoff was one of the great media tycoons of the modern age, growing RCA into a sprawling behemoth. He knew a fair amount about finance, and clearly had a fairly cynical view of the whole affair. And he fundamentally understood the problem underlying financial activities – they really contribute precious little to the delivery of goods and services to the economy.

Financialization is a late stage economic phenomenon in which creating and trading financial instruments comes to dominate all other economic activity. Nassim Taleb and Kevin Phillips have commented extensively in the Black Swan and American Theocracy: The Peril and Politics of Radical Religion, Oil, and Borrowed Money in the 21st Century about the corrosive and ultimately destructive economic forces that financialization creates. Financial activities have come to dominate the profits and GDP growth in our economy, even as manufacturing and other service areas have contracted.


The concept is really very simple, as the cost of anything goes down; people tend to consume more of it. Since 1987, the Fed has steadily increased the supply of money, and dropped its price, until today, if you are in finance, you can borrow all the money you want, and pay an interest rate at or near zero. The hitch – nobody else can borrow any money at all for any real economic activity. An average investor can borrow at rates less than 3% to buy stock on margin – but cannot even begin to get a mortgage. We are told that lending is “frozen up”, but only for money used by real people for real world applications. The NYSE trades well over $50 billion per day, and total financial turnover is over 300x GDP. Clearly, there is plenty of liquidity from the Fed for finance – just not for anything else. Robert Sarnoff would probably be amused.

The Fed set out on its dual mandate in 1987, and has been futilely pumping excess liquidity into the economy ever since, hoping to promote economic nirvana, and got a bunch of crybaby capitalists instead. These guys need ever increasing injections of cheap money, much like a junkie needs his fix. As in Japan before and Europe now, we’ve reached the point where money can’t get cheaper, the babies are crying, and the economy is stuck in the mud. No amount of economic chicanery is going to pump this economy up through the chasing of the dual mandate. Can you hear the butterfly wings flapping yet?

Wes Chapman
Written by Wes Chapman