QE3, Deflation and the Money Illusion
Update1/Chart -- The announcement last week by the Federal Open Market Committee that the central bank would initiate additional, open-ended purchases of residential mortgage backed securities (RMBS) was more than a little sad. Let us count the ways.
The first reason for sadness was the idea that people here in New York and elsewhere in the global financial community were actually surprised by the Fed’s move. The FOMC is fighting deflation. Credit continues to contract globally as much of the western world goes on a pure cash budget. So while I would like to see the Fed raise short term rates, the fact is that the central bank has little choice but to support the markets. But buying RMBS will neither help housing nor reverse the current deflationary spiral on which we all ride.
The second reason to be circumspect is the fact that the Fed’s leaders continue to pretend that driving down yields in the RMBS markets will have any impact on the housing sector or the economy. The two thirds of the mortgage market that cannot refinance their homes will be unaffected by QE3. In fact, the latest Fed purchases are a gift to Fannie Mae and Freddie Mac, the TBTF banks and the hedge fund community. A fund on the floor of our offices in New York actually started dancing around like little children shouting “QE3” after the Bernanke press conference.
The link below shows a great chart from Credit Suisse of par RMBS vs 10 year constant maturity swap or "CMS." Just how much lower does the Fed expect RMBS yields to go?
“The entire move in MBS prices will go into profit margins,” one mortgage market veteran told the Berlin-New York-Los Angeles mortgage study group last week. “FHFA has made sure that the mortgage market has oligopoly pricing and zero competition for the existing servicers. QE3 is risk free profits for the unworthy. And we wasted 40 years and Trillions of dollars fighting the USSR over the need for a free enterprise system?”
Unfortunately, since two thirds of the mortgage market cannot be refinanced, the effect of the Fed’s largesse will indeed go straight to the GSEs and Wall Street zombie banks. This is the key, historical error being committed by Bernanke and the rest of the FOMC. Instead of looking for ways to stoke consumer demand by restoring income and consumer demand, the Fed is simply feeding subsidies to Wall Street. Since the Fed does not think that savers like grandparents and corporations spend money, the error is magnified several orders of magnitude.
The basic problem with the people on the FOMC today is that they are all Obama appointees who are by and large neo-Keynesian socialists in terms of economic outlook. By spending all of their time trying to prevent the 50% drop in GDP which occurred in the 1930s, the Fed forgets or never knew that this catastrophe was the result of the disappearance of private sector capital – not a lack of government spending. And why did this happen? One word: Fraud. Bill Black has been talking about fraud for years, So does Fred Feldkamp, the father of the good sale in RMBS. And so have we at IRA and many others.
The third sadness is that people still don’t understand that fraud is the core problem in the market economies. Until you deal with fraud and start to restructure the trillions of dollars in bad assets now choking the US economy, no amount of Fed ease will reverse the contraction in credit. This is not so much a monetary problem as much as a political issue.
Just as during the 1920s and 1930s it took years for our leaders to understand that securities fraud was the core issue menacing the US economy, today the same process of discovery and revelation grinds slowly forward. Fear causes investors to withdraw from markets and save cash. But because Chairman Bernanke and the Fed refuse to attack the source of the fraud – namely Bank of America and the other zombie banks – the US economy is destined for years of stagnation and eventual hyperinflation.
Economists at the Fed think that the rising propensity to save is a function of interest rates, but no amount of financial repression is going to convince investors to take first loss on a private label RMBS until they trust the representations of the issuer. Trust me on this since I am in the bank channel right now marketing a non-conforming RMBS offering.
Just as the grey market banking sector collapsed from the peak of $25 billion starting in 2007, the confidence of the great market economies is collapsing under the weight of socialist economic prescriptions and cowardly advice coming from the legions of economists who work for large banks. Most economists have figured out that the old linkages between savings, consumption and debt have broken asunder. Yet none of these captive seers dares to suggest that the banks themselves need to be restructured.
Jeff Zervos of Jeffries is one of the key Fed cheerleaders. He writes in a research comment: “The bottom line is that the Fed is printing money, debasing the currency and devaluing debt. The policy is redistributive, regressive and reflationary. It’s a nasty business for sure, and the truth must be obfuscated from the public. But if we want to avoid a second great depression, it is the right thing to do. Good luck trading.”
Good luck indeed. So long as the Fed refuses to become an advocate for restructuring and merely keeps interest rates low, there will be no progress on the economy or jobs because aggregate credit continues to contract. The Fed’s actions are not really growing the money supply much less credit, it is merely trying to slow the decline. Whether we talk about the run-off of the private label mortgage market or the wasting effect of low rates on savers, the US economy is being put into a no leverage, pure cash model by the happy Keynesians who run the Fed.
The fourth sadness is that mainstream economists from Zervos to Bernanke to Richard Koo at Nomura refuse to even talk about rebuilding private sector wealth creation. In a brilliant luncheon talk last week at the Bank Credit Analyst investment conference, Koo accurately described the breakdown in the relationships between major economic aggregates. He also illustrated nicely the jump in savings in Japan and the other major industrial nations following market shocks.
But Koo, like most of our former colleagues at the Fed, thinks that only increased debt and public sector spending are the answer to the deflation threat. But the key lesson of the Great Depression was that government must avoid actions and policies that cause private sector investors to flee the markets. This is precisely the result we now see from the Fed’s actions.
Now you might argue that the Fed is merely following the advice of Irving Fisher, the great US economist, who wrote in 1933 that vigorous monetary policy is needed in the face of debt deflation. One must wonder, though, if Fisher would not scold all of us today for failing to attack fraud and restructuring at the same time. Like most Keynesians, Fisher believed that government could manipulate income and investment via monetary policy.
Yet even Fisher was guilty of embracing the same fallacy or "money illusion" that government can print money without affecting negatively consumer behavior. As Ludwig Von Mises wrote in the new preface to his classic book, The Theory of Money and Credit:
“There is need to realize the fact that the present state of the world and especially the present state of monetary affairs are the necessary consequences of the application of the doctrines that have got hold of the minds of our contemporaries. The great inflations of our age are not acts of God. They are man-made or, to say it bluntly, government-made. They are the off-shoots of doctrines that ascribe to governments the magic power of creating wealth out of nothing and of making people happy by raising the 'national income'.”
Could it be that the monetary actions of the Fed and other monetary authorities around the world are scaring investors, eroding confidence in private markets and worsening deflation? Most economists never consider that FDR’s anti-business rhetoric and policies helped to drive private capital formation to zero in the 1930s. Likewise today, the Fed’s reckless and arguably illegal actions in terms of monetary policy are terrifying investors and members of the public around the world. But all that Jeff Zervos, Richard Koo and their Keynesian/socialist pals that the Fed have to say is “good luck.”
We need to take a new direction if the economic catastrophe predicted by luminaries like Paul Krugman does not come to pass. The core principles are two: fight the fraud and restructure bad assets. If we hold responsible those who have committed fraud against investors and at the same time move quickly to restructure and break up banks such as Bank America, we can restore public confidence in markets and reverse the deflation which is even now gaining momentum in the US economy. Contrary to the assertions of Zervos and others, there is no need to hide government policy from the public view.
Restructuring is the necessary condition for credit expansion and job growth. Without private sector credit growth there can be no jobs. Without justice for investors, pension funds and banks defrauded to the tune of hundreds of billions of dollars, there can be no investor confidence to support private finance. And unless the Fed and other regulators in Washington break the cartel in the US housing sector led by Fannie Mae, Freddie Mac and the top four banks, there will be no meaningful economic recovery in the US for years. Instead we will face hyperinflation and social upheaval, both care of the well-intentioned economists on the FOMC.