FED FAILS TO LEARN
By
Doug Noland – Credit Bubble Bulletin.
December 5 2013
"To understand the Great
Depression is the Holy Grail of macroeconomics. Not only did the Depression
give birth to macroeconomics as a distinct field of study, but also - to an
extent that is not always fully appreciated - the experience of the 1930s
continues to influence macroeconomists' beliefs, policy recommendations, and
research agendas. And, practicalities aside, finding an explanation for the worldwide
economic collapse of the 1930s remains a fascinating intellectual challenge."
Ben S Bernanke, Essays on the Great Depression 2000.
No longer is the understanding of
the Great Depression the "Holy Grail" of
economics." It's been
supplanted by understanding today's extraordinary ongoing global Credit and
speculative Bubble cycles.
Dr. Bernanke and others focus
primarily on what they believe were policy errors during the Thirties, with
surprisingly little attention paid to "Roaring Twenties" policies and
excesses. If only the Fed had understood the need to open up the monetary
floodgates, they claim. Fed Money
printing could have been used to recapitalize the banking system, rectify
insufficient demand and reflate consumer and asset prices. The Great Depression
could have and should have been avoided.
Indeed, today's policymakers
believe they are adeptly fighting and winning an epic battle against
1930's-type deflationary forces. They are determined to "do whatever it
takes." Having failed to learn from misguided 1920's policies that sustained
dangerous financial Bubbles and attendant economic maladjustment, they today
replay them.
A Federal Reserve that was
created in 1913 to regulate Credit fatefully accommodated a historic Credit
boom that became increasingly unwieldy in the latter years of the '20s. Over
time, speculation and asset Bubbles were recognized as increasingly
problematic. Yet there was a critical compounding problem: the ongoing downward
pressure on commodities and consumer prices.
Global financial and economic
backdrops had become increasingly unstable and confusing. Competing interests,
analytical frameworks and ideologies ensured policymaker impotence at the
Federal Reserve. In the end, a historic Bubble was allowed to run unchecked.
Benjamin Strong, president of the
New York Fed and the leading figure at the Fed, administered his famous stock
market "coup de whiskey" in 1927. The results were spectacular. The
Dow Jones Industrial Average more than doubled in 18 months. Yet Fed stimulus
had little impact other than to significantly exacerbate the divergence between
inflating asset prices and weakening fundamental prospects. Looking back, a
rather obvious lesson went unlearned: No shots of whiskey, especially into a
speculative backdrop. Market operators are today fully intoxicated by the
latest Trillion dollar body shot.
Policymakers today struggle with
a serious dilemma uncomfortably reminiscent of what manifested during the
late-Twenties: How to administer monetary policy in a backdrop with downward
pressure on some prices (as opposed to the general price level in the late-20s)
yet intensifying speculative excess propelling a securities market Bubble.
Similar to today, policymakers were confounded by a complex interplay of
Credit, speculative and economic dynamics. There was general acceptance that
market speculation was posing an increasingly
dangerous systemic risk. Yet
faltering global growth and a weak pricing backdrop were viewed as the more
pressing issues.
The longer it was left unchecked
the more apprehensive central bankers were to pricking the Bubble. Moreover,
virtually everyone was oblivious to the degree of fragility associated with
protracted financial excess - fragility that was greatly exacerbated by a final
speculative blow-off.
There was a crucial debate within
the Fed: How to spur Credit growth for the real economy without feeding market
speculation. One school of thought held that proper Credit allocation was the
key. The Fed should channel Credit for investment in the real economy, while
working to tighten broker call lending and other speculative Credit feeding
into stocks. An opposing view held that such Credit allocation efforts were
destined to fail. No matter the avenue of how money and Credit initially made
their way into the system, there was little the Fed could do to thwart the
intense magnetic pull into an inflating market Bubble. As the guardian of
system stability, the Fed needed to pop the speculative Bubble -and the sooner
the better.
My objective is not to rehash
history but to offer insight to help explain today's confounding environment.
Top Fed officials have stated their objective of focusing monetary policy on
system reflation, while relying of regulatory means to ward off potential asset
Bubbles. They have apparently discerned no Bubbles in bonds and fixed income
over recent years. Now, with U.S. stocks having become a primary recipient of
QE3 liquidity, the Fed's policy doctrine has turned more openly suspect.
With the average stock (The Value
Line Arithmetic index) up 40% in 12 months, "global government finance
Bubble" excess has certainly turned more publicly conspicuous.
Predictably, there is more than ample rationalization and justification.
Valuations are not at "Bubble extremes", is the popular refrain. But at
least there's some superficial attention paid to the "Bubble" issue.
At the same time, the predominant attitude in the markets seems to be "if
there's a lot of talk of Bubbles, then the markets surely have much further to
run." I found Byron
Wein's Wednesday comment on CNCB
telling: "You don't stay out of the market waiting for the moment of
truth."
There are several aspects of the
"granddaddy of all Bubbles" thesis that have been more prominent of
late. As noted previously, with the equity market Bubble now in full force, the
Bubble in securities markets has turned fully systemic. As part of the irony of
speculative Bubbles, market participants assume more intense speculation
ensures central bankers will tread even more gingerly when it comes to
withdrawing stimulus. In the U.S. as well as on a global basis, central bankers
must now contend with excess liquidity gravitating to unwieldy speculative
financial Bubbles. Friday from Bloomberg: "Abe No Friend to Emerging Bonds
as Nikkei Jumps Most Since 1972." With Japanese investors jumping on the
equities train, flows into emerging bond funds are running half the pace of
recent years. We'll have to see how significantly the push into equities comes
at the expense of bond flows.
The late-stage of protracted
Credit Bubbles takes on troubling dynamics. The late-stage of protracted
speculative Bubbles takes on troubling dynamics. When the two combine on a more
globalized basis - as they did in the late-twenties - the upshot is a
precarious situation and monumental policy dilemma.
First of all, after repeated
market bailouts over the years market participants have become fully
conditioned to presume central banks will eagerly backstop global securities
markets. This is one of those rare instances where the global economy is seen
as vulnerable and atypically susceptible to any general waning of financial
market liquidity. This backdrop seemingly provides market operators a bright
green light to speculate. So-called "moral hazard" has never been as predominant.
I have argued that "too big to fail" risk distortions have evolved to
encompass global securities markets generally.
There is by now abundant evidence
supporting the thesis of a global environment uniquely conducive to systemic
speculative excess. Clearly, speculative dynamics have built powerful momentum
over the years - while policymakers have essentially promised to look the other
way. Is the Fed really pre-committing to keeping rates near zero for another
several years?
While there's a good book to be
written on late-stage Credit cycle dynamics, I'll attempt a few pertinent
insights. In general, things really run amuck late in a Credit boom - and
policymakers extend the Bubble's duration at all of our peril.
To be sure, finance is
over-issued and misallocated. The poor allocation of Credit throughout the real
economy ensures maladjustment and progressive stagnation (i.e. less economic
bang for the Credit and speculation buck). And as we've witnessed, if
policymakers throw only looser "money" at the problem the end result
will be more speculative asset markets and runaway Bubbles. Maladjusted economic
structure coupled with asset Bubbles ensure a problematic
redistribution of wealth toward a
small segment of society. Meanwhile, the mountain of suspect financial claims
grows ever taller.
Today's conventional economic
thinking ("inflationism") believes that so-called "insufficient
demand" can be rectified by monetary policy. Yet the additional late cycle
"money" printing gravitates predominantly to inflating securities
markets. At the corporate level, various forms of financial engineering are
employed with the objective of supporting higher stock prices. On the one hand,
little of the liquidity makes its way to the type of sound investment necessary
to support sustainable wealth creation. On the other hand, that much of the
population fails to benefit from monetary inflation becomes an important facet
of late-cycle economic stagnation.
A globalized boom, as has been
the case over the past couple decades, adds another important dynamic. Loose
"money" and Credit globally ensure ongoing investment boom
distortions in the more manufacturing-based economies (China and Asia, in
particular). This helps explain - today, as it did in the late-Twenties - some
of the downward price pressure on manufacturing goods in the face of abundant
system Credit and marketplace liquidity. To be sure, prolonged Credit and
speculative booms progressively raise of the risk of devastating busts. And a policy
course focused on "money" printing and reflation to combat perceived deflation
risks only more precarious Bubbles and economic maladjustment.
The Fed plans to use
"forward guidance" to hold down long-term interest rates as it winds
down QE. Perhaps such talk will exert some impact on Treasury bond prices. I
doubt when they were formulating this strategy the Fed anticipated a stock
market melt-up scenario. An increasingly unstable equities market Bubble will
require ongoing real liquidity buying power beyond assurances of low rates.
That's the nature of speculative Bubbles.
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