Dead Money Vs. Investment, Monetary Policy
The first thing to understand is that dead money always involves speculative bubbles. Moral hazard is when regulatory or lending institutions create the danger of people not properly allocating capital. This occurs when people feel that they are protected or that the authorities will bail them out from any mistake however atrocious. There is always big money or easy money (they are not the same thing) to be made in risky speculation - most people call it gambling.
Moral hazard creates the systematic incentive to move capital from productive investment into gambling because they think that someone else will cover their bets for them.
Nominally Central Banks are supposed to avoid even the appearance of favortism and impropriety in order to avoid moral hazard. This is the theory of central bank neutrality and independence that you will read about in textbooks. In practice a central bank operates through dynamic equilibrium, it is always tap dancing its way through the impromptu jazz rhythms of the shifting economic landscape. Therefore while neutrality and independence often invoke detached or static connotations the practice of a central bank is to be engaged and adaptive to present circumstances.
Every central bank however must deal with political and social realities that it must accomodate that are irrational and therefore outside the framework of economic theory. These are often cultural features that are deeply embedded and the central bank must bow to these realities. When a central bank humors or accomodates these political and social realities it is already departing from the model of the central bank as neutral and independent.
Still the job of a central banker is in fact very hard and without a great deal of sympathy from outside critics or the beneficiaries of the work. Everybody is a critic, as someone said.
The job of a central bank is on order to foster long term productive capital investment while in the short term managing the liquidity needs of practical socio-economic transitions. The problem is that either through complacency or through a constant 'crisis management' mode of thinking that central banks often let the latter mission - managing the liquidity needs of short term socio-economic tranisitions - interfere with their mission to promote long term productive capital investment.
The reason is corruption but not in the venal sense of taking bribes, abuse of authority, or having close associaties form a conflict of interest. It is corruption in the sense that Lord Acton inferred, that power is its own policy and one can become so immersed in the technical details of power that one forgets the long term reason that one is exercising it for in the first place. To forget why one wields power because one becomes lost in weilding it, that is corruption.
In the long term, the economy can not be healthy and grow unless the central bank promotes capital investment. That may seem like a no-brainer. However in the short term the path of least resistance in managing liquidity needs for the economy always lies in working on the side of issues that have political favortism - the protected industries and special interests. Whenever a central bank works with one of these it is not creating investment but it is instead creating dead money.
A central bank fosters a more efficient market and a more productive economy when it fosters real capital investment. But the easiest and fastest way to get things done at any moment in time is not to encourage social change toward more productive investment needs - slow, fraught with setbacks, and expensive in terms of political capital - but to just go along with what the politicians want in order to do it the "quick and dirty way".
So there can be a temptation in order not to just occasionally accomodate the reality of political favortism (protectionism) of various socioeconomic participants but to facilitate it - because its easier.
Every central bank has a limited amount of political capital. This political capital stems from its history of institutional competence in managing both short terfrom which it can signal politicians just what it favors or will tolerate insofar as fiscal freedom and protectionism.
A weak central bank like the BOJ is forced to almost always act in a way that favors protectionism and special interests. This vicious circle fosters a lot of dead money and poor capital investment, creating later liquidity crisis in which the temptation is once again to take the quick and easy protectionist way out rather than attempting to create an incentive for real capital investment. This is why Japan has been floated for the last two decades from one liquidity crisis to another as the BOJ is unable to promote real capital investment but forced to facilitate more protectionism to get through the present crisis only to see a failure of capital investment that creates yet another liquidity crisis.
However the US Federal Reserve Banking system is not weak. It is instead corrupt - not in that it abuses its authority but in that its become addicted to "quick and easy" liquidity fixes favoring protected industries to get through the crisis. This is the "Dark Side" of Central Banking if you will.
Luke stopped as he heard mention of the man, the one who'd killed his father. But, but he was his father wasn't he? He listened as his voice spoke despite his thoughts. "Vader. Is the dark side stronger?"
Quickly his master spoke, emphatic to impress the point upon his pupil. "No! No, no.... Quicker, easier, more seductive."
Luke thought on his words, and the dillemas they presented. "But how am I to know the good side from the bad?"
"You will know," Yoda insisted. "When you are calm, at peace. Passive. A Jedi uses the Force for knowledge and defense, never for attack."
Dead money is not a difficult concept. It comes from considering just four things: supply, demand, currency, and price.
For a constant liquidity of currency, supply and demand will generate a price that reflects the momentary market consensus for that good or service. However if you start adding more currency in circulation, then if supply and demand remain the same the price will rise without anything else changing. That is called inflation.
However in a marketplace where many things are being priced, you could avoid inflation from adding liquidity if instead of all the prices rising just one or a few prices rose very high. As long as that price didn't suddenly decline. Then the extra currency would stay "locked up" in that item. That is it is very hard for social or economic reasons to get cash for that item class. When it is very hard to convert the price of something into raw currency, it is called "illiquid".
So that's dead money, it's just a way of soaking up extra liquidity added to a marketplace by skyrocketing the price of a handful of items far beyond what their supply-demand balance indicates. In practical terms the item being used as a liquidity sink must be illiquid or the effects won't last very long. Housing for instance is illiquid. Yes you can sell your house, but most people selling their house use that value toward buying another house. So housing is an illiquid and can be used as a liquidity sink.
The military-industrial complex can also be used as liquidity sink. Of course when you put money into it, the labor and commodity components generate "economic activity" and so circulate. So does the labor and components of the housing market however - carpenters spend what they earn and buying wood rev's the economy. The housing market however is a good liquidity sink because the prices of the homes can be bid up by much more than the marginal cost - labor and commodities - of production. Remember: location, location, location!
So in the same way the labor and commodities expended in the military-industrial complex also generate "economic activity" and can contribute toward inflation by recirculating liquidity. However the items produced by the military complex can be bid up very high and are illiquid. The Pentagon may be willing to pay $100 for toilet lid covers but would you give somebody a $100 for such a toilet bowl cover? In addition the capital cost structure of their industrial capital infrastructure coupled with generally low efficiency of production all contribute toward making any money you throw at the military-industrial complex "dead money" or money sunk into building big expensive things you can't really sell to anyone for cash.
Right now Alan Greenspan is caught between not one, not two, but three liquidity crises with another on the way. The past liquidity crisis was that in order to finance the economic restructuring of the "new economy" and to smooth over millenium fears he flooded the economy with liquidity. This boosted the stock market, but the stock market was not sufficiently illiquid. The economic downturn caused a stock market correction and suddenly a lot of money started coming out of it.
Taking the quick and easy way, Greenspan dropped interest rates to historic forty year lows. Given the protectionism of the housing market, this caused a real estate and development boom and eventually bubble. However without an economic restructuring -because the economy is in transition- this couldn't lead to an economic recovery but only a stagnation kept afloat by a liquidity injection.
The reason why of course that the economy was in transition is that the petro-economy facing higher competition (demand) for scarce oil commodities and dealing with a moribund capital investment infrastructure in America switched to "cannibalization" mode where it is liquidating or selling off parts of the economy to sustain a bit longer an unsustainable net negative ongoing cashflow problem for the USA.
The low savings rate, the current accounts deficit, the national debt issue, the energy-balance deficit, the capital flight issue, and the regulatory protectionism system are all therefore bound up in the same problem.
The logical conclusion would be to attempt to create capital investment by reforming the regulatory system and removing moral hazard from the marketplace. However this would be politically difficult. Government cannot on one hand protect and openly subsidize petro-companies like Hallburton while successfully incentivizing new capitalization of energy-efficiency and alternative-energy investments. The reason why it is politically difficult is that it is always easy to buy off the public with a boondoggle for a special interest or protected industry but it is hard to convince them to restructure economic patterns even if in the long run that would be more healthy.
However the failure to do so means that the "quick-fix" will be temporary and make the situation worse the next time around.
Now the economy is teetering and not having been fixed and brought up to date from the first petro-correction has seen since 2003 a historic break from the Fed Funds correlation with inflation adjusted oil. What that means in practical terms is that the economy is about to go wobbly again in the coming year. This is why Greenspan is doing anything he can to favor Bush, because to get him through the next crisis he needs a forced savings program like Social Security retirement savings accounts or healthcare savings accounts so that he can make their asset values spiral upward and in so doing so inject enough liquidity into the economy (without generating general price inflation) so that it can get through the next pratfall in 2005 that it is about to undergo.
However while he is doing this the currency value of the dollar is dropping, oil's price is rising - but not rising as much against the Yen or the euro. What that means is that we're running out of time. Over time the Yen and the euro don't see as much of a price increase in the price of oil. That means that over time their economies suffer less from the same price increases. Furthermore it means that other countries will favor putting more and more of their money obtained from exporting to us into Yen and euros.
If this trend continues America will lose its petro-currency commodity trading status and reserve currency status within perhaps five years.
Of course Greenspan is not an idiot. He understands that a switch to either a basket of currencies or a yen/euro standard for oil is probably not only inevitable but perhaps desirable. The globalist concept as I mentioned is to try to export to Europe and get offshoring jobs from them the way that Asia exported to us and got offshoring jobs from us (while trading being the policeman of the world in exchange for them financing our debt). The problem is that the unproductive and inefficient capital investment environment combined with the above outlined problems of debt, political will, etc. make it highly unlikely that we can make such a transition without a sharp drop in aggregate demand, higher interest rates, and super-inflation.
In historical terms the plan isn't working and both the domestic-side application and the foreign-intervention are both going sour. Perhaps they think they can salvage it but already in proven quantities and facts the idea is starting to smell like old fish. Greenspan is however not an idiot. His plan for managing this problem is to promote a super-beyond-porn-sized "dead money" liquidity sink in the USA so that he can inject obscene amounts of liquidity into the system and finance that transition more or less smoothly.
Are you starting to get the pattern? Without confronting the issues that make productive capital investment, the long term mandate of the Federal Reserve, then the Federal Reserve Banking system is forced to go from one liquidity-"dead money" binge/fix to the very next one generated by the waning of the previous one. It truly is a vicious circle.
I'm starting to think that someone should have a talk with Bernacke's and Greenspan's friends and maybe stage an "internvention" because this isn't healthy.
"Dead money" isn't the same thing as investment. As a matter of fact, it's the exact opposite. In a further post I'll explore the inflationary and deflationary aspects of the military-industrial complex, the fundamental basis of capitalism, the role of surpluses versus debt, and begin discussing how various (quite excellent) suggestions of what investments we should make to break out of this liquidity-"dead money" addiction that we've gotten hooked on.
As my readers have astutely pointed out, the truly logical course if one needs a liquidity sink to tide one over is to just bite the bullet and make large long term capital investments. The regulatory changes and the formation of capital can then healthily allow new liquidity to enter the monetary supply without increasing inflation. The capital investment is the very opposite of "dead money". This choice to invest in productive capital rather than use "dead money" is called an "economic restructuring". However economic restructuring is politically difficult, because by definition it means that you have to stop favoring the protected industries and special interests. And the reason why those became protected in the first place was that it was easier to buy them off by favoring them then get a real electoral mandate and voter constituency for change.
So it all comes down to tough choices.
While I completely agree with Stirling, Barry, and my readers as to what the general task must be the reason why I've explained all of this is to outline the institutional motivations and cultural barriers which explain why the logical and rational course of action to remedy the situation has not been taken.
If there's one over-riding economic reason to vote for Kerry over Bush it's simply that Bush stands for using "dead money" to try to prop up the old economic system while Kerry at least opens the possibility (with his proposed energy "Manhattan Project") of beginning to take the necessary steps toward restructuring the economy and productive capital investment. There's no guarentee that Kerry will be able to break the addiction, but it's highly unlikely given Bush's track record that he will even try to grapple with tough choices.