With Geoffrey Batt
The latest example of the Federal Reserve not learning from its past errors comes, amusingly enough, from the Federal Reserve. In a June 1938 bulletin (page 456) from the St. Louis Fed, the Fed provided some of the wisest words of caution on how to approach boom-bust cycles, when it was evaluating the lessons learned (and promptly forgotten) from the Great Depression.
The events of 1929 taught us that the absence of any rise in prices did not prove that no crisis was pending. 1937 has taught us that an abundant supply of gold and a cheap money policy do not prevent prices from falling - at least, temporarily and sharply.
This is, in its shortest and most concise form, the lesson that Ben Bernanke is apt to never learn, in his current pursuit of happiness and monetary bliss, based purely on free money and flawed economic assumptions.
Yet the biggest threat to the current cycle comes from observing the parallels with 1937 as disclosed by Charles Kindleberger in "The World In Depression" where he observes precisely the same false sense of calm coming from inventory accumulation, that we are seeing today:
For a considerable time there was no understanding of what had happened. Then it became clear. The spurt in activity from October 1936 had been dominated by inventory accumulation. This was especially the case in automobiles, where because of fear of strikes, supplies of new cars had been built up. It was the same in steel and textiles - two other industries with strong CIO unions. When it became evident after the spring of 1937 that commodity prices were not going to continue upward, the basis for the inventory accumulation was undermined, and first in textiles, then in steel, the reverse process took place. Long-term investment had not been built to great heights and did not fall far. The steepest economic descent in the history of the United States, which lost half the ground gained for many indexes since 1932, proved that the economic recovery in the United States had been built on illusion.
The parallels are endless. The current administration's response has been a more forced one, which has relied on subsidies to spur demand for excess inventory, in essence masking the massive drop in prices. One need only to observe the unprecedented failure that Cash for Clunker has been, as demonstrated by the News N Economics website, which observes:
The net impact on auto and parts sales was, according to the Census retail sales figures, negative. To date, retail sales by motor vehicles and parts dealers (part of the Census advanced retail sales report) is -0.6% spanning the period July 2009 to February 2010.
So, according to this measure, there has been NO additional auto sales created since CFF; no new jobs, no new spending, no aggregate benefit. There was some confusion about the CFF start date, so including July 2009 retail auto sales were up 1.1%. This is positive growth, but still nothing to call home about.
With incremental bulk stimulus measures unlikely to pass, the economy is largely on its own (and relying on an increasingly belligerent China courtesy of stupid political overtures by a variety of domestic politicians).
Yet the biggest variable is the topic we have written endless posts on: the end of Quantitative Easing. The issue here is not so much what will happen to mortgage rates - a short covering squeeze in MBS may be pushing rates lower, although that is unlikely to persist for more than a few months. The biggest question mark is where will banks get their dry powder to purchase incremental risky securities in the future. And this is precisely the one issue that nobody is talking about. Keep in mind that the $1.2 trillion in excess reserves, and the explosion in the monetary base, additionally leveraged with the diagonal yield curve, directly allows bank to exchange risk-free FRNs into risky assets. Once the monetary pump is closed in one week, there will be no additional liquidity feeding bank balance sheets. It's over (at least until a new iteration of QE is announced). As such the consequences of QE's end are not so much what happens to MBS rates, but what will provide additional purchasing power for the financial centers of America: i.e., the only ones that can take advantage of borrowing for free at the short end and doing whatever they wish with this free money. It is therefore not surprising to see a last minute dash to push the market ever higher into fundamentally unjustified territory, which will allow for a higher baseline from which the decline, when it finally commences, can occur.
As for the St. Louis Fed bulletin froom 1938, we are certain that just the same lessons will be applicable to our current situation, once everything unwinds. Instead of learning from the lessons of the past, the great historian Chairman, will not only repeat them, but will lead the country straight off a cliff, as this time around, there is no incremental economic phase transition, there is no endless money printer to absorb the deflation, and there is no China to import US inflation, which just like America, is now neck deep in excess liquidity. The biggest benefit from the 2008-2011 period will be to future historians, who will have ample primary data to deconstruct and prepare their own lessons for the future, which, as 70 years ago, will be largely ignored.