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)