Guest Post: Janet Yellen's Impossible Task
Submitted by Pater Tenebrarum of Acting Man blog,
As the Bernanke era is winding down, a number of articles have appeared at Bloomberg and elsewhere in the mainstream press with authors opining on the things his successor Janet Yellen must do. That's the problem when you have a job as a central planner: everybody else thinks only their plan is the right one, and they are trying to get you to implement it. Apparently it hasn't yet occurred to anyone that central planning simply does not work. People seem to believe that the power to manipulate interest rates and the money supply somehow means one can do whatever needs doing, if only one puts one's mind to it (and preferably follows their advice).
This time we don't want to discuss far-out ideas such as the one that the Fed should use credit dirigisme to stop 'climate change' (which has to be one of the most hare-brained proposals yet).
There is of course the by now often repeated assertion that 'Yellen needs to cope with too low inflation'. A headline of this sort generally indicates that the author knows zilch about monetary theory and doesn't realize what has actually happened over the past five or six years as a result of the Fed's ultra-loose monetary policy. There is no other explanation that is viable. The broad US money supply has increased by about 90% since 2008, and there are still people clamoring for more inflation. It simply leaves one flabbergasted. What's even more astonishing is that several Fed board members have likewise broached this idea on a number of occasions over the past year or so. It is probably an example of the Peter principle at work. How else can we explain this? The guys actually operating the levers are just as clueless as their countless armchair advisers.
Admittedly, we are armchair advisers of sorts as well, but we have only one very consistent advice and that basically is: abolish the whole enchilada and replace it with free banking and a money freely chosen by the market. We are not trying to 'make plans' for anyone, we want the planning to end.
There is no need to discuss again what the flaws of this '2% inflation targeting' policy are. Anyone who hasn't realized yet what this policy produces has likely been asleep for the past two decades or so. Let us just note here that 1. the policy has created booms and busts of rarely seen amplitude and 2. it may end up creating even worse consequences down the road. We say this because we can quite easily envisage a future situation when even this targeting of a modest rate of change in CPI is ditched because 'more urgent problems' demand to be addressed by the printing press.
And let's be clear about one thing, all the extensive blather about the 'monetary policy tool box' is just so much smoke and mirrors. In the end it always comes down to the printing press, or its 'electronic equivalent' these days (i.e., the whole thing is far less complicated than it is made to look).
This is a good opportunity to show the most important chart in the world again, namely that of the true money supply:
During Bernanke's chairmanship, the broad US money supply has roughly doubled, with the bulk of the growth spurt occurring from 2008 onward. Because Bernanke doesn't understand money, he was surprised by the bust. During his first three years on the job the annualized growth rate of TMS slowed down to less than 3% annualized from a peak of more than 20% annualized in 2001/2. It was this slowdown in monetary inflation that revealed the wealth destruction of Greenspans's echo boom/housing bubble implemented after the tech bubble went belly-up.
Note the important distinction: real wealth is actually not destroyed by the bust. The wealth destruction happens during the boom – that is when scarce capital is misallocated and consumed. When the bust begins one has arrived at the moment when perceptions change: illusory phantom wealth is no longer mistaken for the real thing. It suddenly becomes clear that economic calculation was falsified during the boom, and that what looked like profits was really an accounting chimera – click to enlarge.
Anyway, we have just come across an article discussing yet another problem that Janet Yellen is supposed to tackle, which struck us as quite amusing, especially in view of the above chart (which has in a way almost crystal-ball like qualities: it cannot tell us when it will happen, but it does tell us with apodictic certainty that a denouement of major proportions is coming).
The author starts out by naming Yellen's task, and by stating something that should be blindingly obvious, but apparently it isn't to everyone, so he feels compelled to mention it:
“Janet Yellen probably will confront a test during her tenure as Federal Reserve chairman that both of her predecessors flunked: defusing asset bubbles without doing damage to the economy.
The central bank’s easy money policies already have led to pockets of frothiness in corporate debt and emerging markets. The danger is that unwinding such speculative excesses will end up shaking the financial system and hurting growth.
Yellen is “going to be trying to do something that no one has ever done,” said Stephen Cecchetti, former economic adviser for the Bank for International Settlements, the Basel, Switzerland-based central bank for monetary authorities. She needs “to ensure that accommodative monetary policy doesn’t create significant financial stability risks,” he said in an interview.”
Sometimes we're no longer sure if we're reading Bloomberg or the Onion. Say what? Clearly, it is true that Greenspan and Bernanke have 'flunked the test' as the author avers. It is interesting that there is an almost grudging admission that there may be 'pockets of frothiness' out there, although they sure aren't in emerging markets anymore. Perhaps the author doesn't look at charts much (many EMs are looking rather frayed and have done so for some time now). The biggest bubbles seem to be in a number of developed market stock and bond markets (especially junk bonds). The admission is still remarkable because the mainstream media and central bankers alike have spent months trying to convince us that there are no bubbles in sight anywhere. Ben Bernanke himself has only recently said so again.
Other than that, what can one do aside from having a good laugh? Poor Janet Yellen! She is supposed to accomplish what simply cannot be done, namely 'unmake' the mistakes she and her predecessor have jointly committed (let us not forget, she was vice chair and never once dissented with the decision to implement an extremely loose policy). We mentioned above that it is important to keep in mind that capital consumption and wealth destruction occur during the boom, not during the bust. It is already too late in short. Someone would need to give Ms. Yellen a time machine. But even if it were possible for her to travel back into the past, why would she change anything? The current bubble has not yet burst after all and once it does, it is absolutely certain that she will be just as clueless as Bernanke was when Greenspan's bubble burst in 2007/8.
Mr. Cecchetti from the BIS mentions en passant that “Yellen is going to be trying to do something that no one has ever done”. Well, there is a reason why 'no-one has ever done it': it can't be done. The air cannot be 'let out slowly' from a bubble. Once a bubble is underway, it keeps expanding until it doesn't anymore – and thereafter it collapses, with all the attendant unpleasantness. The idea that the central planners who have lit the fire under the bubble with their inflationary policy will somehow be able to 'fine tune' its eventual demise strikes us as utterly ludicrous.
The only question is really for how much longer and to what extent it will expand before it bursts. This is not knowable in advance. Recall our recent discussion of the 1998 to 2000 period – even a short term crash in asset prices (such as in 1998) would not necessarily constitute firm evidence that the bubble is over. It may merely be the prelude to an acceleration.
We can only make a few educated guesses regarding this point. For instance, we know that the 'tapering' of 'QE' is currently underway and that therefore the probability is very high that the recent slowdown in US money supply growth will continue (in spite of the impressive chart above, the annual rate of growth of TMS has actually slowed down even before 'tapering' began). We know for a fact that this will eventually create a major problem for currently extant bubbles. What we do not know is what lead and lag times will be involved, and what threshold the growth rate must cross before things become dicey (we regard the recent correction still only as a 'warning shot' so far, but obviously that will possibly have to be reassessed depending on developments).
We also cannot be certain yet how quickly and with what measures the Yellen Fed will react to any untoward developments in asset prices. Whether or not the bubble can be extended similar to what happened after 1998 may well depend on these factors. Once again, an educated guess partly based on experience is all we can go by (our current assumption is that they will be slow to react). None of this invalidates our central point though: there is no way for the bubble to end painlessly, regardless of when precisely it ends. All that can be said in addition regarding the timing is 'the later it happens, the worse it will be'.
The Bloomberg article provides a bit more detail and color on the monumental task awaiting Yellen (snicker):
“Yellen faces two challenges in dealing with bubbles: she has to identify and deflate them before they get too big and dangerous; and she has to manage monetary policy without causing them to burst in a way that causes havoc in financial markets and undercuts the expansion.”
Oh well, if that's all there is to it…
After reminding us again that both Greenspan and Bernanke have not proved to be exactly proficient in the bubble spotting department, the article also repeats the credulity-straining story about Ms. Yellen's alleged above average abilities in this regard. A statement by president Obama is quoted in support of the idea:
“President Barack Obama spoke repeatedly last year about the need to avoid what he called “artificial bubbles.” He praised Yellen for “sounding the alarm early about the housing bubble” when he announced her nomination for the job of Fed chairman on Oct. 9. “She doesn’t have a crystal ball, but what she does have is a keen understanding about how markets and the economy work,” he said.”
If she is such a maven in this respect, then surely we can all breathe easier. This is because right now, she sees no bubbles anywhere, just like her soon departing predecessor. Unfortunately we think that she not only lacks a crystal ball, but several of the other attributes listed by the president as well.
“The Fed is devoting “a good deal of time and attention to monitoring asset prices in different sectors” to see if bubbles are forming, Yellen, currently Fed vice chairman, told the Senate Banking Committee on Nov. 14.
“By and large,” she said, “I don’t see evidence at this point in major sectors of asset-price misalignments, at least of a level that would threaten financial instability.”
The fact that she is in fact unable to recognize bubbles or evolving threats to financial stability was revealed in her refreshingly honest testimony to the Financial Crisis Inquiry Commission in 2010 (a recording of it may still be online).
“For my own part,” Ms. Yellen said, “I did not see and did not appreciate what the risks were with securitization, the credit ratings agencies, the shadow banking system, the S.I.V.’s — I didn’t see any of that coming until it happened.” Her startled interviewers noted that almost none of the officials who testified had offered a similar acknowledgment of an almost universal failure.”
We don't believe that she has acquired new bubble and stability risk recognition powers since then. We are rather inclined to agree with Mr. Stockman's assessment of the ways in which she is different from Bernanke (in no way that actually matters, that is). Stockman incidentally makes the not unimportant point that the gaggle of central planners she belongs to are all bureaucrats with not the faintest conception of capitalism and free markets.
Total credit market debt in the US economy: it is the size of this debtberg – the result of unfettered money and credit creation since the early 1970s – that has made deflation into the big bogeyman. This ensures that the vicious cycle of intervention heaped upon intervention will continue to the bitter end - click to enlarge.
Bernanke's Parting Error
We do get some insight into the current thinking about bubbles at the Fed, when Ben Bernanke reveals what its 'bubble prevention policy' currently consists of. In essence he simply repeats his flawed analysis of what caused the housing bubble and this analysis is what the new policy is based on (basically, bubbles have nothing to do with interest rates according to Bernanke – all we need is more regulation and especially alert, super-human regulators):
“The Fed’s zero-interest-rate policy is prompting investors to take greater risks with their money. The extra yield that buyers demand to own older, smaller junk bonds that trade infrequently shrank to an average 0.25 percentage point in the first half of this month from more than 1 percentage point a year ago, according to Barclays Plc data.
Bernanke, 60, has set out a two-stage process for identifying potentially dangerous buildups in speculation. First, officials try to pinpoint asset markets where prices are grossly misaligned. Then they consider whether a sudden drop in those prices would be amplified throughout the financial system, as happened during the housing bust. Such intensification could occur if the investors holding those assets were highly leveraged, illiquid or interconnected with others.
The Fed’s “first, second and third lines of defense” for dealing with such imbalances is to rely on supervision, regulation and so-called macro-prudential policies, such as mortgage loan-to-value restrictions, Bernanke told the Brookings Institution in Washington on Jan. 16. Only as a last resort would it consider raising interest rates.”
So let's get this straight: the zero interest rate policy is “prompting investors to take greater risks with their money” – not according to Bernanke to be sure, but according to the data and common sense. But raising interest rates is only deemed a 'last resort' if the Fed happens to spot emerging financial system risks – which we can already guarantee it won't.
The paragraph in the middle which we highlighted is ludicrous from beginning to end: “First, officials try to pinpoint asset markets where prices are grossly misaligned.” These guys have proved over and over again that they are utterly incapable of recognizing bubbles that are staring them right in the face. It is in fact ridiculous that the same people who are responsible for the misalignment of prices are expected to 'pinpoint' said misalignment. The economy's entire structure of prices is distorted when interest rates are artificially suppressed below the natural rate dictated by society-wide time preferences. All prices are thus 'misaligned' as a result of the policy. There is no need to go out and try to 'pinpoint' anything.
“Such intensification could occur if the investors holding those assets were highly leveraged, illiquid or interconnected with others.” – So where exactly in the current bubble era are investors who are not 'highly leveraged' or 'interconnected with others'? That must be a group of investors stranded on a remote island without access to telecommunication (and presumably speculating in coconut milk futures priced in cowry shells). Even though the banking system is superficially better able to deal with bank runs than prior to 2008 because 'QE' has increased the amount of covered relative to uncovered money substitutes outstanding, there are far more deposit liabilities in existence now. Moreover, there are countless ways in which risk has been shunted into other, even more opaque corners of the financial markets. It is not even necessary to mention the endless rehypothecation chains employed by the shadow banking system or the one quadrillion dollars in outstanding derivatives notionals (in spite of netting out reducing this exposure considerably, these will in extremis depend on the ability of links in the chain to actually perform. We saw what can happen when a big link threatens to break when AIG suddenly realized that the CDS contracts it had written were bankrupting it practically overnight). Just look at this example that concerns one of the biggest currently raging bubbles (one of those neither Bernanke nor Yellen profess to be able to see):
“A U.S. bank regulator is warning about the dangers of banks and alternative asset managers working together to do risky deals and get around rules amid concerns about a possible bubble in junk-rated loans to companies.
The Office of the Comptroller of the Currency has already told banks to avoid some of the riskiest junk loans to companies, but is alarmed that banks may still do such deals by sharing some of the risk with asset managers.
"We do not see any benefit to banks working with alternative asset managers or shadow banks to skirt the regulation and continue to have weak deals flooding markets," said Martin Pfinsgraff, senior deputy comptroller for large bank supervision at the OCC, in a statement in response to questions from Reuters. Among the investors in alternative asset managers are pension funds that have funding issues of their own, he said.
"Transferring future losses from banks to pension funds does not aid long-term financial stability for the U.S. economy," he added.
The breadth of the statement from the OCC is unusual because it technically oversees banks and not asset managers. Regulators are eying a number of risks to the financial system as they aim to prevent a repeat of the mortgage bubble that spurred the 2008-2009 financial crisis. They are not comfortable with different players sharing risk if the total level of risk in the system is getting dangerously high.
That may be happening with leveraged loan issuance, which hit a record $1.14 trillion in the U.S. in 2013, up 72 percent from the year before, according to Thomson Reuters Loan Pricing Corp. A measure of the riskiness of these loans has also been rising – the average size of the debt for companies taking these loans in 2013 was 6.21 times a form of cash flow known as EBITDA or earnings before interest, tax, depreciation and amortization, up from 5.86 times in 2012 and the highest since 2007, LPC said.”
Mind that this is just one example of how Bernanke's echo bubble has once again increased systemic risk. We would be willing to bet that no-one at the Fed has ever raised this particular issue. It is also worth pointing out that the main reason why regulators have become cognizant of this risk at all is because it is already too late to do anything about it. The fact that they have even noticed that something is possibly amiss proves ipso facto that the bubble in this corner of the financial universe has become so gargantuan that all that is left to do is to wait until it bursts and maybe say a few prayers.
There is no point in trying to avert or prevent bubbles caused by monetary pumping by regulatory means. If one avenue for bubble formation is cut off, the newly created money will simply flow into another area. In fact, new bubbles almost always become concentrated in new sectors. If there were a genuine desire to keep the formation of bubbles in check, adopting sound money would be a sine qua non precondition. However, no-one who has any say in today's system has a desire to adopt sound money and give up on the failed centrally planned monetary system in favor of a genuine free market system. Our guess is that the booms and busts the current system inevitably produces will simply continue to grow larger and larger until there comes a denouement that can no longer be 'fixed'.
Janet Yellen: I swear there's no bubble in sight anywhere!
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