There is little doubt that the current mainstream of economics features an abundance of Great Depression references and observations. It is an easy obsession to explain, with the 1930’s being the last true economic calamity for us to reference. So it is natural human nature to try to define any current conditions that may manifest a new depression as similar to that last example of what one was, and, more importantly, how it formed, lasted and was ultimately overcome. Modern economics, however, has turned the guiding light of the past into rigid laws, rules and models for the present.

One of the key aspects of the US economy in the early 1930’s that turned a nasty contraction into full-blown collapse was something economists call “sticky wages”. As price deflation took hold through a shock to the money supply (from constant bank runs and credit liquidation), the resulting pressure on businesses to cut costs to match declining revenue made labor increasingly expensive. In response to this deflationary pressure on wages, the pool of labor was slow and hesitant to reduce demands for wages or to accept wage cuts. So as businesses foundered with declining prices and revenues, this wage rigidity priced a lot of the labor force out of the market for employment.

The technical name for this is rising real wages. In economic terms, this relatively high cost of labor accelerates the upward trend in unemployment, eventually pushing it far above where it might end up in a more “normal” recession or contraction.

The lynchpin to this dynamic is the perspective of businesses. They are the marginal receivers of deflationary prices and make the vital comparison of the cost of labor, both directly affecting profitability and expectations of future profitability. If the labor pool is excessively rigid in terms of real costs, then businesses have fewer and more extreme options to deal with economic circumstances largely beyond their control.

As we move closer to the three-year mark for this recovery, nothing is so pronounced as the weak labor market. Though headline unemployment has fallen recently, as most people are now aware that “improvement” is nothing more than a function of people exiting the labor force. The employment/population ratio fell to 58.2% at the end of 2009 (down from a cycle peak of 63.4% in December 2006, also well below the all-time high of 64.7% registered in April 2000). Since 2009, this ratio has largely “scraped along the bottom”, getting no higher than 58.7% (April & May 2010’s census “boom”), sitting currently at 58.5%. This presents all manner of economic problems because earned income is simply the most direct and efficient way to create wealth and circulate money within any economy (far better than any “wealth effect” through asset bubbles).

According to orthodox economic theory, the way to alleviate the high real cost of labor is to create inflation by managing inflation expectations. If businesses believe that nominal prices will rise, then their perceptions of labor costs shift favorably. This is the opposite of rising real wages, a lesson learned by careful study of the Great Depression. Whether it extrapolates exactly into the 21st century is the object of this inquiry.

This entire theory hinges on the idea that inflation expectations lead to actual inflation, that is the general rise in all prices . If the most harmful aspect of deflation is falling prices leading to falling revenue, then it is logically assumed that rising prices lead to rising revenue, thus making incremental additions of labor seem relatively cheap. So the Federal Reserve in 2009 & 2010 engaged in economic engineering through quantitative easing, intentionally creating inflationary expectations (including authoring and publishing papers about how increases in oil prices are actually economically beneficial) signaled by negative real interest rates.

Obviously, given the apparent stickiness of unemployment, it has not been such a simple problem, proving much more difficult than expected (and monetary success was expected, QE 2.0 was even quantified as 3 million new jobs by 2012 in a January 8, 2011, speech by Federal Reserve Vice Chairman Janet Yellen). If we think about the mechanics of inflation, we can begin to piece together both where this policy fell short and why this might not be such a good idea in the first place.

Again, this theory rests upon the idea that the general rise in prices leads to increasing nominal revenue for businesses, and thus cheapens the nominal cost of the overall labor pool. From this change in price condition it is expected, directly and unambiguously, that rising employment should result. Monetary intrusion into the stock of money creates the predicate conditions for inflation and inflation expectations. The logic here is that if everyone has more money they will bid all manner of prices higher – more money chasing fewer goods. The key part of that previous sentence is “everyone has more money”. In other words, it is not enough just to increase the stock of money, it has to circulate into a broad and broadening base to be effective. Without that circulation there is no power, or, literally, no money behind any managed inflationary expectations.

To create real inflation, according to the Fed’s own definition, necessarily means expanding the money supply to the real economy . But quantitative easing only creates currency in the hands of the primary dealer network. The modern monetary system requires the Fed to trade newly created digital balance sheet figments known as dollars for government bonds within that special class of global banks. Those twenty or so large, and often foreign, institutions (the number changes, declining recently with MF Global’s implosion into bankruptcy) are then supposed to lend out these brand new “excess” reserves in the wholesale money markets (either Fed funds or eurodollars). That supplies all the cash necessary for the banking system to do its work – to create loans to real economic participants, dispersing those centrally created dollars amongst a broad base of participants. The stock of central bank money therefore increases the stock of credit money, meaning a high proportion of households, consumers and businesses will all end up with the ability to spend more. Some minor inflation results, Bernanke is exalted, and the world is a much better place.

This relatively simple plan, therefore, is utterly dependent on the banking system to perform the circulation and dispersal of credit money. Instead of performing that “duty”, the banking system is mired in its own dysfunction and disease. First, the wider banking system has little balance sheet capacity left after the real estate collapse for new loans. Since bank equity is the functional limitation of credit creation today, losses suffered (both marked and yet to be marked) have eroded equity capital across the entire intermediation landscape. That simply means that banks cannot create new loans without raising new equity capital – even the capital banks were lucky enough to acquire was used to bring their existing leverage ratios down and capital ratios up to merely “adequate” levels. In other words, all the hundreds of billions in new capital obtained in the crisis period has been used to “fund” the real estate bubble after the fact. No additional lending capacity has been created in the years since the panic in 2008.

The fact that the banking system has turned into the functional equivalent of government fundraisers is not an accident. Sovereign debt of OECD nations is afforded (inappropriately) by the Basel rules a risk-weighting of zero, meaning lending to the US or European governments can occur without a hit to bank capital. Without excess balance sheet capacity, nearly every dollar or euro in new lending activity is forced into this asset class. The current PIIGS/European crisis is nothing more than the eventuality of how desperately bank balance sheets remain constrained by a real shortage of spare equity capital.

Theoretically, governments flush with newly borrowed cash could perform the job of currency dispersal, but the typical means of accomplishing redistribution (think welfare, foodstamps and other types of transfer payments) are not efficient enough to accomplish the monetary task of more broadly spreading currency to create real inflation. In reality, however, most governments have used borrowed funds to merely prop up old budgetary levels. They are simply borrowing to fill the massive holes left by the declining tax collections during the recession and recovery. In other words, new money to sovereign governments is simply being used to maintain old levels of dispersal, not broaden that base. In the US, much borrowed money went to the “stimulus” bill and increased transfer payments, the rest was swallowed into the operations of the new level of government. This is not conducive to broad monetary distribution.

Beyond the bank capital shortage, the banking system has actively regressed in its ability to intermediate. Because the herd-like move of banks into the sovereign space was done without considerations of true risks, the banking system once again finds itself atop a mass of unrealized losses in securities that are still zero risk-weighted and supposedly risk-free. As a result, the primary dealer network has essentially refused to even engage in basic interbank lending in the wholesale money markets (either secured or collateralized). Instead, these largest global banks have hoarded all of those digital dollar creations, effectively freezing out the rest of the system in an abnormality all too similar to 2008.

This latest manifestation of substandard intermediation comes on top of a marked increase in credit standards, something that is both predictable and an anathema to exactly what the Fed is trying to accomplish. As the Fed seeks to broaden participation in its monetary inflation-fest, banks are actively repressing the pool of potential borrowers.

The Federal Reserve itself confirms this in the paper it very publicly sent to both branches of Congress on January 4, 2012. That paper served to give Congress some guidance and recommendations on how to get the housing market moving forward again (without recognizing any of the myriad failures up to this point, including the tax credit proposals). But it makes what I feel is a pertinent admission of, and thus an insight into, why these inflationary measures have largely failed:

“Obstacles limiting access to mortgage credit even among creditworthy borrowers contribute to weakness in housing and demand, and barriers to refinancing blunt the transmission of monetary policy to the household sector .”

The Fed can increase the quantity of money, but it is essentially powerless to disperse it. Not only is the banking system unable to lend to any obligor that requires a greater than zero capital charge (meaning anyone not a sovereign OECD government), lending standards have risen to the point that far too many households are no longer “eligible” to receive all this monetary endowment through debt accumulation. These are not trivial setbacks either, but as we have seen in these past two years they have been a monumental miscalculation.

Through determined efforts, the central bank’s actions did indeed create the very expectations it was seeking, however. Commodity prices, primarily energy, food and precious metals, shot higher. But without the follow-on effects of new money being dispersed widely through credit, these inflation expectations acting solely through commodity prices were actually counterproductive (even the commodity price moves were indirect effects of the devalued dollar). Not only were consumer discretionary budgets further stressed (in some parts of the globe they were stressed to the point of revolution), cost expectations on the part of businesses have been re-adjusted negatively.

Business expectations, through commodity prices, have been altered to the point that profitability, the one bright spot in the whole of the past three years, has been jeopardized by commodity price fears. These fears have been realized by the noticeably declining profit margins at both large and small businesses (small businesses have not participated in the recovery to anywhere near the extent of their large, multi-national brethren), leading to the slower growth of corporate profits (to the point that some analysts are expecting profit contraction in 2012). During this margin adjustment, labor/employment became incrementally more expensive as businesses were expecting those rising input costs to absorb proportionally more of their expense budgets. In other words, these one-sided inflation expectations effectively created the exact same conditions the Fed was seeking to alleviate in the first place.

The Fed has been trying to reduce the marginal cost of employment through inflation, but instead it has succeeded in increasing the marginal cost of employment as commodity inputs were the only place inflation expectations intersected within the real economy. This half-baked inflation effect has decreased the attractiveness of rising employment from the perspective of business, effectively creating an effect very much like that of the 1930’s. The relative cost of labor, which appears to still be “sticky”, has remained too high to clear these imbalances. Now, thanks to the Federal Reserve, the inflation-induced effect of commodity prices requires an even greater adjustment for labor costs. The further commodity prices rise, the lower the ability of businesses to absorb new costs, the less attractive labor becomes.

There are, of course, additional factors affecting the cost of labor (healthcare legislation is a big one, as is fear of taxation), but I believe this is the prime reason that employment has been so weak and disappointing. This is more than just some ephemeral notion of “uncertainty”; it is a real world phenomenon of a poorly executed flawed monetary theory. The world does not operate like a mathematical model, and tinkering with economic variables does not follow the linear extrapolations of those math-based predictions. An inflation counter to potential deflation sounds great, especially if your models predict a high degree of control (like turning it off in fifteen minutes), but once it goes awry it spins into the very human realm of emotions.

Operationally, this inflation-stoking obsession by the Federal Reserve and its policies (now exported to the ECB to “combat” the PIIGS problems) cannot succeed, again, without the ability to broaden the effects of money creation. Unfortunately for this policy’s designers, the trillions of dollars and euros created in the past three years have all gone to filling past holes. To get credit actually moving in a positive direction will require hundreds of billions (euros and dollars) of new equity capital, on top of trillions in wholesale currency. Judging by the equity sale that Unicredit in Italy just undertook (at a 43% discount to its stock price), equity capital will be extremely difficult to come by.

Given the negative effects we have already experienced from the previous episodes of trying to increase the stock of money, specifically inflation expectations pushing up vital food and energy prices, new monetary initiatives in this direction would be even more counterproductive. If QE 2.0 helped oil prices above $130 per barrel (Brent), what would a QE 3.0 (or European LTRO) that is an order of magnitude higher do? Again, given the desperate constraints on banking it would do little to disperse credit as it is intended, but it would certainly kick commodity prices ever higher, forcing even more adjustments within the business system that will make employment even more unattractive.

If labor is relatively expensive given current economic constraints, and nagging unemployment is certainly suggestive of that, making it functionally more expensive by depressing business margins further makes little sense. Since monetary policymakers are not likely to admit failure (remaining confused as to exactly where those 3 million jobs went), they will likely pursue the same policies of trying to fix the banking system so that it functions “normally”, or at least is able to disperse money as desired. Outside of that, central banks will have to find a real world equivalent to Milton Friedman’s helicopter.

The former requires something far greater than just money creation. The banking system is fundamentally flawed and nearly everyone knows it. This is not a mathematical question, it is a question of faith and trust. These are not easily papered over by managing the stock of money or interest rate regimes, but require real solutions that will involve real losses through brutal market discipline. Faith, once lost, is not easily regained.

The latter is about as dangerous a proposition as there is, perhaps even more dangerous than full-blown deflation. Printing money on such a scale and diffusing it broadly is nothing more than one-step below hyperinflation – the full-scale collapse of a currency system. As much as the economics profession fears and loathes prospects of deflation, a hyperinflationary collapse is far worse. Again, there is no mathematical calculation that defines the line between inflation and hyperinflation, or guides policymakers to divine just how much debasement is acceptable. Currency collapse comes at the point where the population loses faith in that currency. It is an emotional issue that cannot be predicted or modeled – it simply occurs after reaching some psychological, emotional inflection point. Because of this very human system, the entire range of inflationary designs is extremely perilous.

That begs the question of whether intentional inflation is at all or anywhere an appropriate policy. Realizing these dangers, the Fed and the ECB have, up until now, played it both ways – wanting to create some inflation, but emphatically proclaiming the idea that it can and should be minimized. The entire idea of Nominal GDP targeting is predicated on exactly this hope, that some controlled measure of inflation will cure all economic ills without any disastrous side effects. But at some point repeated failure and doubling down on the same policies will push the stressed system further toward the emotional breaking point. It is a monetary trap unlike anything in the Great Depression-inspired textbook. There are credit losses still to take, and that is deflationary, but creating inflation to offset it ends up in the same place anyway.

No matter which flavor of inflationary policy central banks pursue, I think it would serve them well to review their effectiveness (lack of) these past three years. Everything sounds easy and simple within the cozy confines of mathematical models (do X, Y results). Playing with fire (or inflation) is a dangerous game, no matter how much planning is involved or how much modern economics thinks it has learned the lessons of the 1930’s.

Robert Burns may have said it best in his 1785 poem, “The best laid plans of mice and men; go often awry.”