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

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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
services.

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.

(Read more here)