John Hussman On Our Fed-Inspired Bubble, Crash, Bubble, Crash, Bubble (etc) Reality

Tyler Durden's picture

Written by John Hussman of Hussman Funds

Bubble, Crash, Bubble, Crash, Bubble...

"Stock prices rose and long-term interest
rates fell when investors began to anticipate the most recent action.
Easier financial conditions will promote economic growth. For example,
lower mortgage rates will make housing more affordable and allow more
homeowners to refinance. Lower corporate bond rates will encourage
investment. And higher stock prices will boost consumer wealth and help
increase confidence, which can also spur spending. Increased spending
will lead to higher incomes and profits that, in a virtuous circle, will
further support economic expansion."

Federal Reserve Chairman Ben Bernanke, Washington Post 11/4/2010

Last week, the Federal Reserve confirmed its
intention to engage in a second round of "quantitative easing" -
purchasing about $600 billion of U.S. Treasury debt over the coming
months, in addition to about $250 billion that it already planned to
purchase to replace various Fannie Mae and Freddie Mac securities as
they mature.

While the announcement of QE2 itself was met with a
rather mixed market reaction on Wednesday, the markets launched into a
speculative rampage in response to an Op-Ed piece by Bernanke that was
published Thursday morning in the Washington Post. In it, Bernanke
suggested that QE2 would help the economy essentially by propping up the
stock market, corporate bonds, and other types of risky securities,
resulting in a "virtuous circle" of economic activity. Conspicuously
absent was any suggestion that the banking system was even an
object of the Fed's policy at all. Indeed, Bernanke observed "Our
earlier use of this policy approach had little effect on the amount of
currency in circulation or on other broad measures of the money supply,
such as bank deposits."

Given that interest rates are already quite
depressed, Bernanke seems to be grasping at straws in justifying QE2 on
the basis further slight reductions in yields. As for Bernanke's case
for creating wealth effects via the stock market, one might look at this
logic and conclude that while it may or may not be valid, the argument
is at least the subject of reasonable debate. But that would not be
true. Rather, these are undoubtedly among the most ignorant remarks ever
made by a central banker.

Let's do the math.

Historically, a 1% increase in the S&P 500 has
been associated with a corresponding change in GDP of 0.042% in the
same year, 0.035% the next year, and has negative correlations with GDP
growth thereafter (sufficient to eliminate any effect on the long-run level of GDP). Now, even if one assumes - counter to reasonable analysis - that the GDP changes are caused
by the stock market changes (rather than stocks responding to the
economy), the potential benefit to the economy of even a 10% market
advance would be to increment GDP growth by less than half of one
percent for a two year period.

Now, as of last week, the total capitalization of
the U.S. stock market was at about the same as the level as nominal GDP
($14.7 trillion). So a market advance of say, 10% - again, even assuming
that stock prices cause GDP - would result in $1.47 trillion of market
value, and a cumulative but temporary increment to GDP that works out to
$11.3 billion dollars divided over two years. Moreover, even if profits
as a share of GDP were to hold at a record high of 8%, and these
profits were entirely deliverable to shareholders, the resulting one-time
benefit to corporate shareholders would amount to a lump sum of $904
million dollars. In effect, Ben Bernanke is arguing that investors
should value a one-time payout of $904 million dollars at $1.47 trillion. Virtuous circle indeed.

One of the main reasons that stock market
fluctuations have such a limited impact on real output is because
investors correctly perceive these fluctuations as impermanent -
particularly when they are detached from proportional changes in
long-term fundamentals. Recall that the primary source of the recent
financial crisis was excessive debt expansion, consumption, and
speculative housing investment. Consumers observed persistently rising
home prices, and inferred that they were "wealthy" enough to shift their
consumption forward by borrowing against that perceived "wealth." A key
to this dynamic was the fact that U.S. home prices had never
experienced a sustained decline during the post-war period, so the
increases in housing wealth were indeed viewed as permanent. As Milton
Friedman and Franco Modigliani demonstrated decades ago, consumers
consider their "permanent income" - not transitory year-to-year
fluctuations - when they make their consumption decisions.

Rising home prices were further promoted by a
combination of lax credit standards, perverse incentives for loan
origination, a weak regulatory environment, and a Federal Reserve that
sat so firmly on short-term interest rates that investors felt forced to
reach for yield by purchasing whatever form of slice-and-dice mortgage
obligation the financial engineers could dream up. Rising home values
provoked more debt origination, and even higher prices. What seemed like
a "virtuous circle" was ultimately nothing but an overpriced
speculative bubble with devastating consequences.

Bubble, Crash, Bubble, Crash, Bubble ...

We will continue this cycle until we catch on. The
problem isn't only that the Fed is treating the symptoms instead of the
disease. Rather, by irresponsibly promoting reckless speculation,
misallocation of capital, moral hazard (careless lending without
repercussions), and illusory "wealth effects," the Fed has become the disease.

Alan Greenspan contributed to the late-1990's
market bubble by his embrace of the notion that 100 million lemmings
leaping off of a cliff into the ocean can't be wrong. Beyond a single
bit of rhetorical lip service to the effect of "how do we know when
irrational exuberance has unduly escalated asset values," Greenspan
aggressively accommodated that bubble. Once it crashed, the Fed sat on
short-term interest rates in a way that directly contributed to the
housing bubble. Back in July, 2003, I published a perspective called Freight Trains and Steep Curves, which is a reminder that that the recent credit crisis did not emerge out of the blue:

"What is not so obvious is the extent to which the
U.S. economy and financial markets are betting on the continuation of
unusually low short-term interest rates and a steep yield curve. This
doesn't necessarily resolve into immediate risks, but it could
profoundly affect the path that the economy and financial markets take
during the next few years, by making the unwinding of debt much more
abrupt... So the real question is this: why is anybody willing to hold
this low interest rate paper if the borrowers issuing it are so
vulnerable to default risk? That's the secret. The borrowers don't
actually issue it directly. Instead, much of the worst credit risk in
the U.S. financial system is actually swapped into instruments that end
up being partially backed by the U.S. government . These are
held by investors precisely because they piggyback on the good faith and
credit of Uncle Sam... tolerated by the financial system because the
debt has been swapped out through financial intermediaries, so investors
get to hold relatively safe instruments like bank deposits and Fannie
Mae securities. This mountain of debt in the U.S. financial system -
tied to short-term interest rates - is ultimately and perhaps somewhat
inadvertently backed by the U.S. government."

It is difficult to interpret Bernanke's defense of
QE2 as anything else but an attempt to replace the recent bubble with
yet another - to drive already overvalued risky assets to further
overvaluation in hopes that consumers will view the "wealth" as
permanent. The problem here is that unlike housing, which consumers had
viewed as immune from major price declines, investors have observed two
separate stock market plunges of over 50% each, within the past decade
alone. While investors have obviously demonstrated an aptitude for
ignoring risk over short periods of time, it is a simple fact that
raising the price of a risky asset comes at the sacrifice of lower
long-term returns, except when there is a proportional increase in the
long-term stream cash flows that can be expected from the security.

As a result of Bernanke's actions, investors now
own higher priced securities that can be expected to deliver
commensurately lower long-term returns, leaving their lifetime
"wealth" unaffected, but exposing them to enormous risk of price
declines over the intermediate (2-5 year) horizon. This is not a basis
on which consumers are likely to shift their spending patterns. What
Bernanke doesn't seem to absorb is that stocks are nothing but a claim
on a long-term stream of cash flows that investors expect to be
delivered over time. Propping up the price of stocks changes the distribution
of long-term investment returns, but it doesn't materially affect the
cash flows. This reckless policy has done nothing but to promote further
overvaluation of already overvalued assets. The current Shiller P/E
above 22 has historically been associated with subsequent total returns
in the S&P 500 of less than 5% annually, on average, over every
investment horizon shorter than a decade.

With no permanent effect on wealth, and no ability
to materially shift incentives for productive investment, research,
development or infrastructure (as fiscal policy might), the economic
impact of QE2 is likely to be weak or even counterproductive, because it
doesn't relax any constraints that are binding in the first place.
Interest rates are already low. There is already well over a trillion in
idle reserves in the banking system. Businesses and consumers,
rationally, are trying to reduce their indebtedness rather than expand
it, because the basis for their previous borrowing (the expectation of
ever rising home prices and the hope of raising return on equity
indefinitely through leverage) turned out to be misguided. The Fed can't
fix that, although Bernanke is clearly trying to promote a similarly
misguided assessment of consumer "wealth."

To a large extent, the Fed has assumed the role of
creating financial bubbles because we have allowed it. The proper role
of the Federal Reserve, and where its actions can be clearly effective,
is to provide liquidity to the banking system in periods of financial
stress or constraint, by replacing Treasury bonds held by the public
with currency and bank reserves. But to expect the Fed to somehow bring
about full employment is misguided. To believe that changing the mix of
government liabilities in the economy (monetary policy) is a more
important determinant of inflation than the total quantity of those
liabilities (fiscal policy) is equally misguided. Historically, and
across the world, the primary driver of inflation has always been
expansion in unproductive government spending (think of Germany paying
striking workers in the early 1920s, or the massive increase in Federal
spending in the 1960s that resulted in large deficits and eventually
inflation in the 1970s). But unproductive fiscal policies are long-run
inflationary regardless of how they are financed, because they distort
the tradeoff between growing government liabilities and scarce goods and

We are betting on the wrong horse. When the Fed
acts outside of the role of liquidity provision, it does more harm than
good. Worse, we have somehow accepted a situation where the Fed's
actions are increasingly independent of our democratically elected
government. Bernanke's unsound leadership has placed the nation's
economic stability on two pillars: inflated asset prices, and actions
that - in Bernanke's own words - should be "correctly viewed as an end
run around the authority of the legislature" (see below).

The right horse is ourselves, and the ability of
our elected representatives to create an economic environment that
encourages productive investment, research, development, infrastructure,
and education, while avoiding policies that promote speculation,
discourage work, or defend reckless lenders from experiencing losses on
bad investments.

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SheepDog-One's picture

Bernanke grasping at straws? Nah, GS likes it, so it must be sound non-crook policy good for the middle class I'm sure.

anony's picture

Why is it these characters that think Bernanke is a nincompoop get any time here at all?

They are the idiots who think Bernanke has the interest of the 6 billion unwashed on this planet at heart when he is the Tonto of the rich.

hugolp's picture

If you think about it, its a little sad that we had to live during the bubble era.

Internet Tough Guy's picture

Compared to what, the WWII era? Vietnam era? The Great Depression era? Things could be worse.

SheepDog-One's picture

We'll get the world war era back too real soon.

Crab Cake's picture

Correct, because it will be the only possible distraction large enough to keep the masses in their place, and also the only way to keep the Ponzi going.

hugolp's picture

To me, it seems like the western is getting close to the end of this inflationary era. The booms and busts are more and more strong each time.

Bananamerican's picture

"We'll get the world war era back too real soon."

we'll be "The Gray Test" generation....or Soylent Green. still awaiting data


illyia's picture

Compared to the 80s and 90s when up was all the rage and the USoA was the ONLY Superpower...

Blue Skies.

Nothing but Blue Skies from now on...

Djirk's picture

Agreed! Wealth created by debt is not real sustainable wealth.

They should change the FED mandate to: clearing checks and transactions , making sure there is enough capital so you can get cash out the ATM, adequate cash for interbank lending, reserve rates and getting involved if short term interest rates get above 10%

Let the markets decide interest rates, asset prices and currency values.

That said if I was running a public company I would lock in some capital now.


winks's picture

The only reasonable explanation for QE2 is that Treasury has no market for all of the U.S. debt other than the FED unless rates are to rise dramatically. We currently have 70% of U.S debt with maturities of 5 years or less and with costs of between .01% and 1.00%. All of the FED chatter about boosting "stock market" or "unemployment" is a smokescreen.

SheepDog-One's picture

They have no one to sell US debt to, so now we buy it. End of the road.

Sancho Ponzi's picture

I'm afraid you've exposed the Fed's dirty little secret. The UK is broke, China isn't buying, and Japan is broke. Who else is going to fund a $1.5 trillion deficit? It's not like there's a liquidity problem with the banks sitting on $1 trillion in excess reserves.

SheepDog-One's picture

Even Bernankes 'pump the stocks' goal seems quite weak, QE2 rally already over?

Anal Picnic's picture

QE2=bank bailouts



Conrad Murray's picture

The right horse is ourselves, and the ability of our elected representatives to create an economic environment that encourages productive investment, research, development, infrastructure, and education, while avoiding policies that promote speculation, discourage work, or defend reckless lenders from experiencing losses on bad investments.

Repeal 16th Amendment and legal tender laws, and End the Fed.

NumberNone's picture

Never gonna happen.  Elected officials abdicated responsibility of the economy to Fed.  They have given the keys to the Fed with the only mandate being to create/find more money so that they can continue to spend.

High Plains Drifter's picture

Ron Paul was on Squawkbox this morning talking about how much of a clown Paul Krugman is. On the one hand Ron Paul is very anti big government but at the same time he is one of the biggest pork barrel spenders in congress. Go figure. This from a man who many think is a libertarian.

financeguru500's picture

I didn't know that about Ron Paul. Thanks for the info. He has a big group of followers who believes he has the answers to fix our problems but apparently his words arent matching his actions.

We would probably be better off listening to people like Peter Schiff or Gerald Celente before listening to Ron Paul.

zaknick's picture

I like Schiff but his last name is infamous in my book. Celente is excelente!

High Plains Drifter's picture

Let us not forget. This was the same man, who suddenly up and quit during the Presidential campaign, the darling of the tea party. This was after his campaign coffers had acquired the nice tidy sum of about 35 million dollars in contributions from people who truely believed in him via the many internet Ron Paul money bombs. Heck I even bought into it myself for a while there.

There are many people that are asking , what happened to all of that money?
When asked about it, Mr Paul said it would be spent on conservative causes. Oh really says I? What causes are that? The John Birch Society? Give me a break already.

So now he will be in a position of power I guess. We shall see what happens on the FED issue. In my opinion, it will be business as usual. Its like Bernanke told him one time. If you don't like it then change it. So there you have it.

financeguru500's picture

You make a good point. Now that he has weasled himself into a position of dealing directly with Bernanke, we will see his true colors. Though, I believe he already showed his true colors during the presidential race like you were saying.

High Plains Drifter's picture

Well think about it. Paul has been up in Washington for almost 20 years I guess. What has he done? Nothing. Many here in Texas wanted him to come home and run for Governor. That would be a easy shoe in for a guy like him. But no, he wants to remain in Washington,  a place where the beast operates , the same beast he says he hates. His Presidential campaign was taking off and all of a sudden he quits. Personally I think there is something real fishy about that whole situation.  I am not sure if his campaign was infiltrated or not. Yep , it is now shit or get off the pot time for Mr Paul. Matter of fact this morning , he stated he had no intention of trying to get rid of the FED. So how long shall he dance with the devil?  How long before someone stands up and says what needs to be said. We are waiting now.

istt's picture

Do you even bother to read your own links?  It tells you almost every penny was spent on the campaign and he was near the highest rating in terms of disclosure of how the money was used.  As usual, guys like you who are critical of Paul are long on accusations and short on facts.  Do your homework.

High Plains Drifter's picture

Spent it on the campaign?  What campaign?  He did not even run very many televsion ads. If you remember, he quit right after a huge money bomb was orchestrated. I shall look up the link where he said when asked about it, that he was going to spend all that money on conservative causes. A lot of people were also asking why he never seemed to run any ads on televison. This I remember all too well. So sorry pal, the bad taste from 2008 lingers in my mouth and I remember it all , all too well. I am not short of facts either bud.

erik's picture

seriously?  why don't you read up on Ron Paul.  start with his book, "The Revolution".

oh, and check out the recent release showing that Ron Paul returns money to the Treasury every year because he doesn't spend the entire allocated amount for his office, etc.  over $100,000 last year alone.

the man is frugal, plain and simple.  he has every chance to waste that money on lavish bs every year, but doesn't do it.

he stated before that 3rd party candidates don't have a chance, that is why he quit the race.  everyone was disappointed.

nobody is perfect, but attacking Ron Paul for the reasons you have is ridiculous.

istt's picture

Krugman is a clown and Paul is as honest a politician you will find.  These kinds of articles are a waste of time.  You know as well as I do that if Paul could he would end the Fed along with thousands of other tax payer propped up programs.  We need more Pauls and less Bidens.

High Plains Drifter's picture

Oh so you are Paul worshiper huh? Imagine that. I knew they are here. Listen buddy, we are sick and tired of excuses. We are sick and tired of getting along just to get along. We want actions. If he won't do it then get the hell out of the way and find something else to do. Your statement about him being as honest a politician as can be found says a lot. I am sick and tired of the lesser of two evils. I am sick and tired othe color gray. Gray areas are not what we want to hear about. Either you are with us or you ware with them. There is no compromise. None.

erik's picture

ha!  channeling GWBush now.

must be black or white.  there is simply no understanding for nuance or complexity.  "we want actions"  really?  well how about Ron Paul trying to audit the fed. 

i'm not sure i understand from where your anger emanates but try to steer it in a positive direction at least.

Assetman's picture

If, indeed, you're "sick and tired" of the Ron Paul's of the world, you need to take the initiative and run for political office.

Put up or shut up.  Better yet, provide us with some alternatives if you aren't willing to make the plunge yourself.

For who/what platform does "us" represent, anyway?

potatomafia's picture

Are you that stupid?  So he should just let the government take money from his district, and not get them anything in return?  Just let it be spent everywhere but where the money came from? 

You dont think if he could end pork spending he would?  It is because that is the way our government works right now, and he is basically hostage to it..  HE WANTS PORK SPENDING BY GOVERNMENT ENDED, PERIOD.  But since its not ending, he must at least appropriate for some of the funds to be spent IN HIS DISTRICT!!


Fucking lunatics!!  The only man in our government trying to right the ship....

Crab Cake's picture

"We will continue this cycle until we catch on."

These bubbles and crashes aren't accidents, or mistakes of judgement, they are an ongoing criminal enterprise. What kind of world do we live in that a bank robber steals thousands of dollars and goes to jail for decades, but a banker steals millions and gets bailed out by the government? Is it really going to take stringing up the Bernankes, Blankfeins, and Dimons of this world to get the fucking FBI to do its job, or to affect economic & fiscal policy that benefits all not just the few?

These people are criminals worse than most you will find at a state prison. If law enforcement won't do its job, we soon will have to do it for them, and if we don't we will soon be living in a feudal dictatorship; instead of the quasi one we have now.

yipcarl's picture

May I?


I would correct you only to say orquestrated comments, not ignorant.  The central bankers are taking orders and know exactly what is happening.  I would venture to guess 50% of the people here knew what Greenspan was doing when he said he made a mistake.  BS, they are bought and paid for.

erik's picture

We have SPY with an RSI of 80, a potential evening star formation (if today closes between 121.28 and 122.26), we're at the top of the rally trend channel (since late Aug), and we've had an upper bollinger band break.

this weakness is expected.  most likely, a short-term reversal is at hand.  likely target is 200 wk moving average between 1195-1200 in the S&P.

today's POMO notwithstanding of course...

erik's picture

There have been 9 instances since 1997 (too lazy to go further) of RSI ~80 in the SPY.  Each instance had led to a short-term correction within 3-10 calendar days.  Avg correction is 2.5%.  1.48% Lowest.  5.69% Highest.

Upper bollinger band breaks usually lead to snapbacks within the bollinger band.  That would equal ~1215 on the S&P at last glance.

Returning to middle of rally trend channel means ~1210 in the S&P.

TradingJoe's picture

Whatever wealth Benjie "creates" via the stock market is immediately obliterated by inflation, people withdrawing funds to pay down debt of simply live of it since there is no more money out there! Benjamin is one big contradiction of an "economist"! This QE2 will go to banks and banks ONLY, we still are looking at a huge deflationary crash, then followed by the much anticipated hyperinflation and the rundown of the US $, there will be one more, last, US$ bounce, a truly dead cat bounce that is!

godfader's picture

Looks like poor Hussman got wasted in this little liquidity-inspired short squeeze. When will people stop trade on (noisy and manipulated) fundamentals and simply learn to respect market direction? It's not a rocket science is it.

anony's picture

Because they want to have the world make sense, rather than the chaos it is.

They can't get it thru their heads that unless you are a Lord Blankfein or a clone of his, they are in a crap shoot and the shooter has loaded dice.


Bearster's picture

John Hussman, Chicago School Monetarist.

"...the Fed has _become_ the problem."  When it was formed in 1913!

"The proper role of the Federal Reserve, and where its actions can be clearly effective, is to provide liquidity to the banking system in periods of financial stress or constraint..."

In other words to replace electrical fuses with pennies during times of electrical stress.

While it is always good to see someone who is prominent and well respected criticize something that needs to be criticized, Hussman is part of the problem and not part of the solution.

Central planning of credit and money does not work any better than central planning does in any other area.  It results in simultaneous shortages (small business credit, anyone?) and gluts (big bank credit, anyone?), mal-investment, corruption, perverse incentives, moral hazard... and collapse if practiced too consistently for too long.

Buddha_Gorilla's picture

Not surprised Tyler highlighted this article -- it's one of Hussman's best.  Bernanke's hubris -- whether motivated by the intellectual echo-chamber or by kleptocratic malice -- has damned us to a fortuneless future, and the magnitude and duration of that future will only grow.  Ben has backed himself into a corner: pulling back on the reins would precipitate both a disastrous fall in the economy and risk assets, and also destroy his academic credibility.  This is a man with everything to lose, and his only glimmer of hope is "more and bigger".   On his best days, he may delude himself into thinking it will work, while on his worst he has the knowledge that he can blame failure on some future austerity measure passed by Congress, and hope that history remembers the fiscal pin-prick instead of the size and cause of the monetary bubble.

Bartanist's picture

And so that is what it comes down to. An entire nation, and essentially the world, is held hostage to the pride of one man?

It is no wonder that "pride" is not listed amongst the virtues.

snowball777's picture

"virtuous circle" == "virtual circle jerk"

goodrich4bk's picture

So when will the WashPo print this rebuttal to Bernanke?

Bartanist's picture

Or, do it the Chinese way. Make all banks part of the government. Flood money into the system to create massive amounts of hard assets from the money and then wipe out all of the debt because there is nothing in the private sector that can pay for the actual cost of the assets ... only the government can...

.... and maybe that is actually what we have done here in Amerika, except we have replaced the government with the Fed and its owner banks. Only THEY can afford anything because they create money and destroy debt at will with no apparent effect on their viability. They play by no rules and abide by no laws.

Gimp's picture

The Fed will end up making the U.S. Dollar an unwanted medium of exchange globally as other countries get tired of us printing notes and buying our own debt. Once the dollars power and our influence worldwide diminshes we have one trick left - WAR - Achtung Baby!