Currency Wars (and more…)

This article explains in greater detail a subject I addressed in a recent comment in the Wall St. Journal:

“…our macroeconomic models are wholly incapable of incorporating operational measures of uncertainty and risk as variables that affect human decision-making under loss aversion. We’ve created this unmeasurable sense of uncertainty by allowing exchange rates to float, leading to price volatility in asset markets because credit policy is unrestrained.

The idea of floating exchange rates was that currency markets would discipline fiscal policy across trading partners. But exchange rates don’t directly signal domestic voters in favor of policy reform and instead permit fiscal irresponsibility to flourish. Lax credit policy merely accommodates this fiscal fecklessness. The euro and ECB were tasked with reining in fiscal policy in the EU, but that has also failed with the fudging of budget deficits and the lack of a fiscal federalism mechanism.

The bottom line is that we do NOT have a rebalancing mechanism for the global economy beyond the historic business cycles of frequent corrections that are politically painful. The danger is we now may be amplifying those cycles.”

From Barron’s:

Currency Wars: Central Banks Play a Dangerous Game

As nations race to reduce the value of their money, the global economy takes a hit.”

By Randall W. Forsyth

Feb. 13, 2015

It’s the central banks’ world, and we’re just living in it. Never in history have their monetary machinations so dominated financial markets and economies. And as in Star Trek, they have gone boldly where no central banks have gone before—pushing interest rates below zero, once thought to be a practical impossibility.At the same time, central bankers have resumed their use of a tactic from an earlier, more primitive time that was supposed to be eschewed in this more enlightened age—currency wars.

The signal accomplishment of these policies can be encapsulated in this one result: The U.S. stock market reached a record high last week. That would be unremarkable if central bankers had created true prosperity.

But, according to the estimate of one major bank, the world’s economy will shrink in 2015, in the biggest contraction since 2009, during the aftermath of the financial crisis. That is, if it’s measured in current dollars, not after adjusting for inflation, which the central bankers have been trying desperately to create, and have failed to accomplish thus far.

Not since the 1930s have central banks of countries around the globe so actively, and desperately, tried to stimulate their domestic economies. Confronted by a lack of domestic demand, which has been constrained by a massive debt load taken on during the boom times, they instead have sought to grab a bigger slice of the global economic pie.Unfortunately, not everybody can gain a larger share of a whole that isn’t growing—or may even be shrinking. That was the lesson of the “beggar thy neighbor” policies of the Great Depression, which mainly served to export deflation and contraction across borders. For that reason, such policies were forsworn in the post–World War II order, which aimed for stable exchange rates to prevent competitive devaluations.

Almost three generations after the Great Depression, that lesson has been unlearned. In the years leading up to the Depression, and even after the contraction began, the Victorian and Edwardian propriety of the gold standard was maintained until the painful steps needed to deflate wages and prices to maintain exchange rates became politically untenable, as the eminent economic historian Barry Eichengreen of the University of California, Berkeley, has written. The countries that were the earliest to throw off what he dubbed “golden fetters” recovered the fastest, starting with Britain, which terminated sterling’s link to gold in 1931.

This, however, is the lesson being relearned. The last vestiges of fixed exchange rates died when the Nixon administration ended the dollar’s convertibility into gold at $35 an ounce in August 1971. Since then, the world has essentially had floating exchange rates. That means they have risen and fallen like a floating dock with the tides. But unlike tides that are determined by nature, the rise and fall of currencies has been driven largely by human policy makers.

Central banks have used flexible exchange rates, rather than more politically problematic structural, supply-side reforms, as the expedient means to stimulate their debt-burdened economies. In an insightful report last week, Morgan Stanley global strategists Manoj Pradhan, Chetan Ahya, and Patryk Drozdzik counted 12 central banks around the globe that recently eased policy, including the European Central Bank and its counterparts in Switzerland, Denmark, Canada, Australia, Russia, India, and Singapore. These were joined by Sweden after the note went to press.

In total, there have been some 514 monetary easing moves by central banks over the past three years, by Evercore ISI’s count. And that easy money has been supporting global stock markets (more of which later).

As for the real economy, the Morgan Stanley analysts write that while currency devaluation is a zero-sum game in a world that isn’t growing, the early movers are the biggest beneficiaries at the expense of the late movers.

The U.S. was the first mover with the Federal Reserve’s quantitative-easing program. Indeed, it was the initiation of QE2 in 2010 that provoked Brazil’s finance minister to make the first accusation that the U.S. was starting a currency war by driving down the value of the dollar—and by necessary extension, driving up exchange rates of other currencies, such as the real, thus hurting the competitiveness of export-dependent economies, such as Brazil.

Since then, the Morgan Stanley team continues, there has been a torrent of easings (as tallied by Evercore ISI) to pass the proverbial hot potato by exporting deflation. That has left just two importers of deflation—the U.S. and China.

The Fed ended QE last year and, according to conventional wisdom, is set to raise its federal-funds target from nearly nil (0% to 0.25%) some time this year. That has sent the dollar sharply higher, resulting in imported deflation. U.S. import prices plunged 2.8% in January, albeit largely because of petroleum. But over the past 12 months, overall import prices slid 8%, with nonpetroleum imports down 1.2%.

China is the other importer of deflation, they continue, owing to the renminbi’s relatively tight peg to the dollar. The RMB’s appreciation has been among the highest since 2005 and since the second quarter of last year. As a result, China has lagged the Bank of Japan, the ECB, and much of the developed and emerging-market economies in using currency depreciation to ease domestic deflation.

The bad news, according to the Morgan Stanley trio, is that not everyone can depreciate their currency at once. “Of particular concern is China, which has done less than others and hence stands to import deflation exactly when it doesn’t need to add to domestic deflationary pressures,” they write.

But they see central bankers around the globe being “fully engaged” in the battle against “lowflation,” generating monetary expansion at home and ultralow or even negative interest rates to generate growth.

The question is: When? Bank of America Merrill Lynch global economists Ethan Harris and Gustavo Reis estimate that global gross domestic product will shrink this year by some $2.3 trillion, which is a result of the dollar’s rise. To put that into perspective, they write, that’s equivalent to an economy somewhere between the size of Brazil’s and the United Kingdom’s having disappeared.

Real growth will actually increase to 3.5% in 2015 from 3.3% in 2014, the BofA ML economists project; but the nominal total will decline in terms of higher-valued dollars. The rub is that we live in a nominal world, with debts and expenses fixed in nominal terms. So, the world needs nominal dollars to meet these nominal obligations.

A drop in global nominal GDP is quite unusual by historical standards, they continue. Only the U.S. and emerging Asia are forecast to see growth in nominal-dollar terms.

The BofA ML economists also don’t expect China to devalue meaningfully, although that poses a major “tail” risk (that is, at the thin ends of the normal, bell-shaped distribution of possible outcomes). But, with China importing deflation, as the Morgan Stanley team notes, the chance remains that the country could join in the currency wars that it has thus far avoided.

WHILE ALL OF THE central bank efforts at lowering currencies and exchange rates won’t likely increase the world economy in dollar terms this year, they have been successful in boosting asset prices. The Standard & Poor’s 500 headed into the three-day Presidents’ Day holiday weekend at a record 2096.99, finally topping the high set just before the turn of the year.

The Wilshire 5000, the broadest measure of the U.S. stock market, surpassed its previous mark on Thursday and also ended at a record on Friday. By Wilshire Associates’ reckoning, the Wilshire 5000 has added some $8 trillion in value since the Fed announced plans for QE3 on Sept. 12, 2012. And since Aug. 26, 2010, when plans for QE2 were revealed, the index has doubled, an increase of $12.8 trillion in the value of U.S. stocks.

The Sinister Evolution Of Our Modern Banking System

Repost from Peak Prosperity blog. (Link to podcast and blog here.)

Because we’re all about those banks, ’bout those banks…

by Adam Taggart

Saturday, January 31, 2015

I quit Wall Street and decided that it was time to talk more about what was going on inside it, as it had changed. It had become far more sinister and far more dangerous. ~ Nomi Prins

Today, the ‘revolving door’ connecting our political and financial systems is evident to anyone with eyes. But this entwined relationship between Washington DC and Wall Street is nothing new, predating even the formation of the Federal Reserve.

To chronicle the evolution to where we find ourselves today, we welcome Nomi Prins, Wall Street veteran turned financial industry reformist, and author of the excellent expose All The Presidents Bankers.

In this well-detailed interview, Nomi goes into depth of the rationale and process behind the creation of the Federal Reserve, and more important, how its mandate — and the behavior of the banking system overall — metastasized into the every-banker-for-himself regime of sanctioned theft we now live with.

Chris Martenson:   To me, it couldn’t have been more obviously obscene then in 2010, and I believe maybe 2009, right after the big banks had been handed just vast, huge, very favorable handouts and bailouts during the Great Recession — and then they handed themselves record bonuses. I thought optically that was just horrible. As somebody who was inside the banking system: Are they that tone deaf? What’s behind that sort of behavior?

Nomi Prins:   Indeed, they have become very isolated.

It began with the period before the 1970s when different people were rising to leadership in banks, and worsened in the 80s when we started seeing people who had more sociopathic tendencies or less ability to appreciate the idea of the public’s economic stability being beneficial to growing their institutions. They no longer viewed it as necessary.

And with the advent of the larger futures market, the options market, the derivatives market, and all the off-shore elements of banking that were able to be developed, so much capital was now available and off of the books that the idea of maintaining some sort of a connection to stability policy — or even to whatever the Presidency might want — dissolved. At the same time, all the Presidents that were involved in running the country around that time didn’t ask or require accountability towards financial stability from them.

So there was a bunch of things that were happening at the same time, and that’s why the media does a poor job of critiquing this because they’re not looking at all the strands. None of this is simple. A lot of things happened at the same time to create these kinds of shifts. On the one hand, you have no restraint: you don’t have the Gold Standard anymore, so you have less of a strain on having something physical be reserved against your leverage. You now have this ability of petrodollars being recycled. You have the ability to leverage more debt. You have less humility. You have a more technologically-advanced, less transparent global financial system, so you can make and hide money easier. And then you have ascendancies of leadership in banks and in the government that are OK with all this, and allow it to fester.

It’s all defended as some sort of example of a free market and competition — “the best gets the best”, and so forth — when the reality is it just destabilizes the entire system and creates an artificiality. We see central banks supporting all of this mess, as opposed to figuring out what the exit policy is — which none of them have a clue about. That’s really where we’ve evolved to.

Listen to the entire podcast.

Banking Vegas-Style: Casino or Golf?

Banking has a long, colorful history – in fact, it’s probably the world’s second oldest profession and created as much controversy as the first. Banking in modern times was largely a sedate affair, characterized by what is known as the 3-6-3 rule: pay 3% on savings deposits, lend at 6%, and be on the golf course for a 3 pm tee time. But more recently banking has undergone a radical transformation, one that viciously came to light during the 2008 global financial crisis.

This transformation can be noted in the explosive growth of two asset markets: foreign currency exchange (FOREX) and the markets for financial derivatives. Let us consider first some of the changing metrics of the foreign currency exchange market (source: Wikipedia):

The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world’s major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

The FOREX market is the most liquid financial market in the world. Traders include large banks, central banks, institutional investors, currency speculators, corporations, governments, other financial institutions, and retail investors. The average daily turnover in the global FOREX and related markets is continuously growing. According to the Bank for International Settlements,^[4] the preliminary global results from the 2013 Triennial Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in FOREX markets averaged $5.3 trillion per day in April 2013.

Compare this to the total value of global trade in real goods and services for the entire year of 2013, which was only $37.7 trillion. Obviously, there’s a lot of action in foreign currency trading. Why? Because of the volatility of floating currency rates. The original idea of moving from fixed exchange rates to floating rates was that policy differences between countries would be forced to converge on efficient fiscal and monetary policies because of the discipline imposed by currency fluctuations. In other words, bad policies would harm the domestic economy and the markets would sell off the domestic currency, forcing politicians to correct those policies.

Unfortunately, the opposite happened. Bad economic policies caused currency values to fluctuate widely, creating price volatility that attracted the attention of traders into the game, creating the exponential increase in trading volumes (with the economic consequences). And guess who are the major traders of foreign currencies, otherwise called speculators? You guessed it: the major global banks that today are Too Big To Fail.

The volatility of FOREX markets then created the opportunity for financial innovation to create numerous new markets for those wonderful financial derivatives we’ve all heard so much about. To give an idea of the size of the derivatives market, The Economist magazine has reported that as of June 2011, the over-the-counter (OTC) derivatives market amounted to approximately $700 trillion, and the size of the market traded on exchanges totaled an additional $83 trillion.

Don’t misunderstand this – financial derivatives have been around for a long time to hedge the uncertainty of price changes over time. In other words, they can provide insurance against the risk of loss associated with those price changes. This is what commodity futures are about, where farmers can lock in a price for their products, be it corn or pork bellies, before they invest in new production. There is a productive financial role for derivatives, which is why they exist. However, newly created volatility in asset markets can be highly leveraged in derivatives markets (think 100 to 1), to offer gambles with incredible pay-offs. Often this just becomes a highly leveraged play on risk with OPM (Other Peoples’ Money) yielding little economic benefit. In other words, a casino.

The problem is that gambles don’t always pay-off and somebody gets saddled with the losses. As these markets have grown, national governments have had to become heavily involved in assuring the integrity of these markets. Consequently they have been forced into the breach to backstop the losses with bailouts that eventually fall on taxpayers – either in the form of accumulated debt and increased taxes, but also through the slow devaluation of the currency. This helps reduce the value of debts incurred by speculators in the FOREX and derivative casinos.

The upshot is that banking is no longer a boring but secure backwater for the country club crowd. It’s become a hot-bed of furious trading and living on the edge, with incredible pay-offs to the winners and taxpayer bailouts for the losers. We’ve essentially turned finance, which is supposed to fund the real economy with prudent capital investment, into a trading casino where winners and losers result from the throw of the dice.

How do we sober up? That’s a good question that we’re going to have to ponder at some point. It certainly would be nice to send the bankers back out on the golf course. Hopefully before the next global financial crisis wipes us out.

The Bubble Economy Redux

Good article. A little sunshine goes a long way. The reason QE hasn’t caused inflation is because of massive disinflationary forces around the world unleashed by excessive credit and debt creation. People won’t borrow at low interest rates if they already have too much debt, they merely refinance. Banks also do not want to lend in an uncertain monetary environment with distorted prices of collateral, so they leave their excess reserves idle or buy Treasury bonds and earn the difference.

But QE HAS generated much asset price inflation in real and financial assets, hence the booms in select housing, land, art, and financial markets. The Fed thus has caused relative price distortion that is greatly impeding long-term risk-taking, production, and job creation. Is this a secret? I think not. Time for a reckoning of monetary and fiscal policy.

From the National Review Online:

The Other Bubble

Some highly placed people don’t want a serious discussion of quantitative easing.

By Amity Shlaes

Back in the late 1990s and right up to 2007, journalists occasionally wondered about two big enterprises called Fannie Mae and Freddie Mac. Fannie had come out of an obscure period of American history, the New Deal. Freddie had been created more recently, but no one could explain quite how. The official job of the pair was to provide liquidity in the housing sector in various ways, including creating a secondary market in securities backed by mortgage loans. Whatever Fan and Fred did, their form seemed a contradictory hybrid: On the one hand they were “private.” On the other hand their bonds sold at a premium over other bonds, suggesting that the Treasury or the Fed would always bail them out. These “government-sponsored enterprises,” as they were known, were both growing. Logic suggested that the more they grew, the more bailing them out would rattle markets.

Yet if a reporter took a stab at explaining these mystery entities in a story, or even merely spotlighted them, that reporter paid for it. Fannie and Freddie’s big executives, credentialed power brokers from both parties, hopped on the Shuttle and came to New York to bully the newspaper into shutting up. The executives suggested the journalists weren’t bright enough to appreciate the financial mechanics of Fannie or Freddie. This brazen effort at intimidation was unusual. Even senior editors could recall nothing like it — unless they were old enough to have met with a Teamster.

Those writers who experienced this finger-wagging and strong-arming in the conference room will never forget the queasy feeling they engendered. Fannie and Freddie’s lobbyists did not succeed in muzzling big news. From time to time, even after such a visit, editors ordered up and reporters wrote articles probing the GSEs. But when it came to big, sustained investigations, most newspapers turned to easier topics. When, much later, Fannie and Freddie proved to have been ticking time bombs and set off the financial crisis, the reporters told themselves that the very blatancy of the effort to intimidate should have tipped them off. They vowed to respond differently should that queasy feeling ever return.

Well, queasy is back. And this time, the strong arm belongs not to the boss of the company, Janet Yellen of the Fed, but to a media supporter, Paul Krugman of the New York Times. Unlike the old Fan and Fred execs, Krugman isn’t administering his punishment in the privacy of a conference room but rather in his columns and blogs. Example: This week, the professor’s target was actually another man qualified to be a professor, Cliff Asness, a University of Chicago Ph.D. who does his own academic work. Asness also runs tens of billions at a hedge fund, a fact that suggests he has thought about interest rates and the Fed quite a bit. To Asness Krugman wrote: “But if you’re one of those people who don’t have time to understand the monetary debate, I have a simple piece of advice: Don’t lecture the chairman of the Fed on monetary policy.”

What triggered Krugman’s pulling some kind of imagined rank on Asness was that Asness, along with me and others, signed a letter a few years ago suggesting that Fed policy might be off, and that inflation might result. Well, inflation hasn’t come on a big scale, apparently. Or not yet. Still, a lot of us remain comfortable with that letter, since we figure someone in the world ought always to warn about the possibility of inflation. Even if what the Fed is doing is not inflationary, the arbitrary fashion in which our central bank responds to markets betrays a lack of concern about inflation. And that behavior by monetary authorities is enough to make markets expect inflation in future.

Besides, the Fed cannot keep interest rates this low forever. As former Fed governor Larry Lindsey notes, the cycle of quantitative easing has become predictable: “QE1 ends. Stock market sells off. QE2 begins. Then, QE2 ends. Stock market sells off. Operation Twist starts to be soon followed by a full-blown start of QE3. Now here we are in October and QE3 is finally winding down. This time it was ‘tapered’ rather than abruptly ended. Still, stock market sells off.” Concludes Lindsey: “Whenever the Fed withdraws a stimulus it is going to be painful. Whenever officials flinch and ease because of the pain it just becomes harder next time.”

Given all the confusion, it would surely be useful have a vigorous debate on the Federal Reserve law and Fed policy — one that includes all kinds of arguments, and in which nobody calls anybody a “wing nut.” One that asks whether stock prices or, for that matter, housing prices may reflect inflation or deflation, or whether the dollar will always behave the way it does now. The authorities’ response — “We’re smart, so be quiet” — suggests that the greatest bubble of all bubbles may be the bubble of credibility of central bankers. Whenever that one pops, the whole world will feel queasy.

This Wild Market

This Wild Market

Perhaps we can figure out what’s going on in the markets today if we read between the lines.  Prof. Shiller explains that “…the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. Which means that CAPE today is largely a reflection of the Greater Fool Theory of investment.

Then Mr. Shiller states that “[t]oday’s level “might be high relative to history, but how do we know that history hasn’t changed?”

I would guess that history has changed. Starting when the dollar and all other currencies became free floating in 1971, empowering central banks to create credit at will according to political dictates. This credit creation has occurred simultaneously with the expansion of the global labor supply in concert with new technology, both of which have depressed inflationary price signals, permitting central banks to continue their credit expansion at little apparent cost. It’s all good, as the shadow bankers might say.

But the less obvious result has been volatility of asset prices that we see reflected in the 30 year transition of financial markets toward trading away from new productive capital investment. This is how the hedge fund industry has blossomed.

The value of financial assets has departed from cash flow fundamentals and the result is markets that pop one day and deflate the next, depending on the sentiment of the moment, rather than underlying economic fundamentals. We’ve created greater price uncertainty in the economy that hampers productive long-term investment and concentrates the rewards in a shrinking cohort of lucky asset holders. This violates the most basic theory of financial management under uncertainty, which is stability through diversification.

This history was not inevitable, it was deliberately pursued under faulty intellectual models of our market society.

From the WSJ’s MoneyBeat:

Robert Shiller on What to Watch in This Wild Market

By Jason Zweig

You would have to be crazy to think the stock market isn’t crazy.

In three tumultuous days this week, the Dow Jones Industrial Average dived 273 points, then jumped up 275 points, then dropped 335 points.

But you might be even crazier if you think you know exactly when to get out of the market.

Few people understand that better than Robert Shiller, the Yale University finance professor who shared the Nobel Prize in economics last year for his research documenting that stock prices fluctuate far more than logic can justify—and who is renowned for telling people when to get out of the market.

Prof. Shiller predicted the collapse of both the technology-stock bubble in 2000 and the real-estate boom in the late 2000s. And he developed a measure of long-term stock valuation that many professional investors rely on.

Yet the central message that emerges from three conversations with Prof. Shiller over the past few weeks isn’t a cocksure forecast; it is a deep humility in the face of irreducible uncertainty.

Many analysts have warned lately that Prof. Shiller’s long-term stock-pricing indicator is dangerously high by historical standards.

Known as the “cyclically adjusted price/earnings ratio,” or CAPE, Prof. Shiller’s measure is based on the current market price of the S&P 500-stock index, divided by its average earnings over the past 10 years, both adjusted for inflation. It stands at nearly 26, well above the long-term average of about 16.

If only things were that simple, Prof. Shiller says.

“The market is supposed to estimate the value of earnings,” he explains, “but the value of the earnings depends on people’s perception of what they can sell it again for” to other investors. So the long-term average is “highly psychological,” he says. “You can’t derive what it should be.”

Even though the CAPE measure looks back to 1871, using data that predates the S&P 500, it is unstable. Over the 30 years ending in 1910, CAPE averaged 17; over the next three decades, 12.7; over the 30 years after that, 15.7. For the past three decades it has averaged 23.4.

Today’s level “might be high relative to history,” Prof. Shiller says, “but how do we know that history hasn’t changed?”

So, he says, CAPE “has more probability of predicting actual declines or dramatic increases” when the measure is at an “extreme high or extreme low.” For instance, CAPE exceeded 32 in September 1929, right before the Great Crash, and 44 in December 1999, just before the technology bubble burst. And it sank below 7 in the summer of 1982, on the eve of a 17-year bull market.

Today’s level, Prof. Shiller argues, isn’t extreme enough to justify a strong conclusion. So, he says, he and his wife still have about 50% of their portfolio in stocks.

On Thursday, as the Dow fell more than 300 points, Prof. Shiller told me, “The market has gone up for five years now and has gotten quite high, but I’m not selling yet.” He advises investors to monitor not just the level of the market, but the “stories that people tell” about the market. If a sudden consensus about economic stagnation forms, that could be a dangerous “turning point,” he says.

Based on new research he has done into industry sectors, he says, he is “slightly overweight” in health-care and industrial stocks.

The third edition of Prof. Shiller’s book “Irrational Exuberance,” coming out in February, will feature a chapter on bonds.

Is the bond market, as some investors have suggested, a bubble bound to burst?

“A bubble is a product of feedback from positive price changes that create a ‘new era’ ambience in which people think increasingly that prices will go up forever,” Prof. Shiller says.

Today’s bond market, he adds, “is just the opposite of a new-era ambience.” Instead, the demand for bonds is driven by “an underlying angst” about the slow recovery and pessimism about the future. “That’s not a bubble,” he says.

It also is worth considering where Prof. Shiller gets his knack for seeing what others overlook—the kind of gift that the renowned hedge-fund manager Michael Steinhardt has called “variant perception.”

Prof. Shiller is an unconventional thinker who relishes investigating ideas that other people regard as eccentric or unrewarding. “I don’t fit in so well,” he says, shrugging. “I’m socialized differently somehow.”

Prof. Shiller—and his wife, Ginny, a clinical psychologist—suspect that he has “a touch” of attention deficit hyperactivity disorder. “I’m very distractible, although I can be highly focused on tasks that interest me,” he says.

It is that intensity of thinking that leads to rare big insights—and to the recognition that, as he puts it, “a lot of fundamental problems aren’t really soluble.”

One friend recalls meeting him for lunch in New Haven; afterward, Prof. Shiller offered to give him a lift to the train station. But, the friend recalls, “Bob couldn’t find his car. He couldn’t remember where he had parked it.”

“Bob came into my office one day in the early 2000s,” his colleague, Yale finance professor William Goetzmann, told me. “He said, ‘I think we are in a real-estate bubble.’ I listened to him and said, ‘Hmm, that’s interesting,’ and when he left, I went right back to whatever research I was doing.” Prof. Shiller went on to produce the first serious warnings that the housing market would collapse.

Prof. Shiller says both stories sound right to him.

I reached him by phone earlier this month after he had missed an earlier appointment to speak. “I was awaiting your call,” he said, “but somehow never heard the phone ring.” Later he clarified that he might have left his cellphone in the next room but wasn’t sure.

It isn’t hard to imagine him sitting there, oblivious to the ringing phone and every other sight and sound, lost in contemplation of big ideas.

What’s the New Normal?

Better yet, what’s normal about this? The Fed has accumulated massive amounts of Treasury and mortgage-backed securities to prop up government spending and housing prices and kept interest rates at zero in the vain attempt to stimulate economic growth. The question is, now what?

From the WSJ:

How Would the Fed Raise Rates?

With banks chock full of excess reserves, the federal-funds rate may prove useless as a tool to drain liquidity.

By George Melloan

Central bankers at the Jackson Hole symposium on Friday heard a lot of talk from Federal Reserve Chair Janet Yellen about the labor market, over which central bankers have proved to have only limited influence. They heard very little about global asset inflation, over which they could have a lot of influence.Yet the Fed is in no mood to exercise such influence. As expected, Ms. Yellen said the time is not ripe to raise short-term interest rates, ending six years of a near-zero (“zirp”) policy and restoring something more closely resembling financial normality. Wait until next year remains the Fed’s motto.Given the risks of a resulting stock market crash or political uproar, it may not happen even next year unless some crisis, internal or external to the Fed, forces Ms. Yellen’s hand. Meanwhile, savers and investors will continue to be denied a proper return on their investments and multibillion-dollar pension funds will flirt with insolvency.

A question mostly unasked at Jackson Hole is a crucial part of today’s when-will-it-happen guessing game: Exactly how would the Fed go about draining liquidity if a burst of inflation urgently presented that necessity. The traditional mechanism used by the Fed no longer looks to be serviceable.Before the “zirp” binge began in 2008, the Fed’s primary monetary policy tool was the federal-funds market, overnight lending among banks to balance their reserves in compliance with the Fed’s required minimums. The Fed withdrew liquidity by selling Treasurys to the banks and increased it by buying Treasurys. Fed-funds rates moved accordingly, becoming the benchmark for short-term lending rates throughout the economy.

But thanks to the Fed’s massive purchases of government and mortgage-backed securities from the banks over six years of “quantitative easing,” the banks no longer need to worry about meeting the minimum reserve requirement. They’re chock full of excess reserves, to the tune of $2.9 trillion. For all practical purposes, the federal-funds market no longer exists.

Fed economists undoubtedly have given the absence of the traditional interest-rate control mechanism some thought. Stanley Fischer, the International Monetary Fund and Bank of Israel veteran who was brought into the Fed as vice chairman in June, indirectly addressed it in an Aug. 11 speech. Asking himself whether the Fed still has the tools to manage interest rates, he came up with answers that sounded, well, tentative.

Mr. Fischer said that the Fed, for instance, could regulate the money supply by paying higher interest on the excess bank reserves on deposit at the Fed, thus holding them in check. That was an eye opener. The Fed could persuade the banks to tighten credit by bribing them with higher returns on their reserves?

What would these higher interest payments on reserves do to the Fed’s earnings on its $4.5 trillion portfolio? The Fed returned only about $80 billion to the U.S. Treasury last year, not a huge amount to finance the massive largess imagined by Mr. Fischer. How would the politicians react to huge payouts to banks, including foreign-owned institutions, for the purpose of making credit more expensive?

He also mentioned another “tool,” reverse repos, basically overnight borrowing by the Fed. The Fed already is active in the repo market, offering lenders the equivalent of up to 50 basis points in interest. It does this mainly to give favored lenders like Fannie Mae and Freddie Mac a payoff similar to what the banks get on their reserves. But why would it want to destroy its own earnings by borrowing at a higher rate than it does now? The repo market is far broader than the old fed-funds game, encompassing lenders of all stripes. It might not be as easy to manipulate.

Mr. Fischer also mentioned “other tools” that he did not describe. One might take a guess. A new buzzword at the Fed, frequently employed by the academic-minded Ms. Yellen to describe policies available in her toolkit, is “macroprudential” measures. What this expansive word means is not entirely clear, but a simple translation might be “muscling the banks” to bend to Fed diktats. Mr. Fischer used the term often in his speech.

The 2010 Dodd-Frank law, which was enacted on the premise that banks should be punished for the sins committed by politicians, enlarged the muscle power of the Fed and other federal agencies that regulate the financial industry. None of them have been timid about using that power.

The Fed, well attuned to politics, was engaged in mission creep even before Dodd-Frank, having entered the new game of credit allocation in response to the 2008 crisis. It began buying great masses of toxic mortgage-backed securities as a favor to the powerful housing lobby. Paying interest on excess reserves was its gift to big banks, even as Dodd-Frank was putting them under stricter capital requirements and forcing them to write “living wills” describing how they can be “resolved” should a crisis force them into insolvency. (The response from Goldman-Sachs, in essence: “We would declare bankruptcy.” Duh.)

So presumably “macroprudential” measures are now to become a more important part of the Fed’s money management. If the Fed can’t control interest rates, the dollar supply and inflation by any other means, maybe it hopes to do it by fiat. Well, the dollar is a fiat currency so perhaps its management by fiat was inevitable.

But then the question arises: Is anyone at the Fed, even the estimable Mr. Fischer, smart enough to do that without precipitating some new financial disaster?

The Immorality of Currency Devaluation

Quote from Mary A. O’Grady writing in the WSJ:

Few economic injustices are more villainous than stealing from the poor. Yet this is what a government does when it devalues its currency. Pope Francis has stressed the Christian obligation to share with the least of our brothers. Devaluation actually takes from them what they have earned themselves. And while the inflation tax that follows hits everybody, it wallops the low-income population the hardest.

….

Pope Francis is not oblivious to the consequences of monetary meddling. In his November 2013 “apostolic exhortation,” he wrote: “Debt and the accumulation of interest also make it difficult for countries to realize the potential of their own economies and keep citizens from enjoying their real purchasing power.”

Unemployment or Financial Stability?

I think I’d opt for some more stability to encourage fundamental growth in the real economy rather than virtual growth in the money economy. Again, zero interest rates are a sign of a debilitating sickness in the economy – the patient is not recovering.

Reposted from the WSJ:

Investors Heed the Fed at Their Peril

If booming asset prices go bust, the central bank’s credibility would be severely damaged. 

By Marc Sumerlin and Phillip Swagel

Federal Reserve Chair Janet Yellen in her testimony on Capitol Hill this week was candid, as she has been in the past, in telling lawmakers that the biggest economic risk she sees facing the country is the possible emergence of a new permanent class of unemployed workers.

To head off this possibility, the Fed is holding monetary policy accommodative longer than traditional monetary models would recommend. Opinions on the wisdom of this policy are split, but the Fed’s openness about its policy is heralded almost universally as a desirable development.

We are not so sure.

In today’s world the heads of the central bank determine what is immediately deemed common knowledge, and only investors with long time horizons (and a strong stomach) can resist their pronouncements. Ms. Yellen sees considerable labor-market slack, believes this will hold down inflation, and therefore pronounces that the Fed’s near-zero interest-rate policy will continue far into the future. The conventional wisdom is that low rates and low inflation are consistent with an environment in which asset prices rise, so that is what has happened.

This is now the third episode in the past 15 years in which asset-price growth has significantly outstripped income growth. From 1997 to 2000, the net worth of American households rose 40% while national income grew 20%, and in 2002-07, net worth grew 60% as national income grew 30%. Asset prices corrected after each of these rapid increases.

Over the past two years, net worth has grown more than 20% (a similar annual pace as the past two episodes) during a period when national income struggled to grow 6%—and interest rates are still near zero. When the Federal Reserve signals that monetary conditions will remain easy, behavior shifts and a self-fulfilling rise in asset prices is the result.

On Tuesday the Fed stated in its semiannual Monetary Policy Report that valuations were “substantially stretched” in some sectors like biotechnology and social media. Ultimately, however, asset prices should reflect expectations of future income, making them vulnerable to correction when they become too high relative to income.

A problem of having too much certainty on monetary policy is that once the market has come to accept the Fed’s views, changes in the story can be unnecessarily disruptive. Harvard economist Jeremy Stein, a former Fed governor and its leading thinker on financial stability before returning to teaching at the end of May, articulated in his final speech why the Fed’s change in rhetoric in the spring of 2013 was so disruptive.

Mr. Stein noted that a number of investors perceived that quantitative easing would essentially last forever, and they repositioned abruptly when then Fed Chairman Ben Bernanke suggested the program could be finished in a year’s time. The Fed is not responsible for investors who take losses, but the centrality of monetary policy to investment returns leads people to put too much weight on their predictions of Fed actions and too little on fundamental analysis of individual investments.

Mr. Stein warned that “the market is not a single person” and that there might be a similar event if the Fed alters its view on interest rates. This is the big risk for the market now. Ms. Yellen has successfully defined conventional wisdom as a future in which the Fed keeps overnight rates near zero even while inflation and employment approach their respective targets. Indeed, the success of the Fed’s communications in convincing investors that rates will remain low has contributed to low volatility across asset classes, encouraging yet higher valuations. If there is less slack than the Fed believes, monetary accommodation will reverse at a more rapid pace than markets expect.

Imagine a swimmer drifting easily with an ocean current who suddenly discovers he is a long way from shore. Asset prices could be in for a sharp correction. If the U.S. economy were to go through another asset bust cycle, the Fed’s credibility would be severely damaged, and its strategy on reducing unemployment would backfire.

Many monetary experts refer to the 2000 equity crash as a benign event. But the unemployment rate rose by 2½ percentage points after the decline, and the monetary policy response to that rise in unemployment contributed to the housing bubble and the 2008 financial crisis. The Fed will not achieve the stability that it seeks until financial stability concerns are given an equal weight when determining monetary policy.

Financial Crisis Amnesia

 

Alex Pollock, quoted from the WSJ:

It is now five years since the end of the most recent U.S. financial crisis of 2007-09. Stocks have made record highs, junk bonds and leveraged loans have boomed, house prices have risen, and already there are cries for lower credit standards on mortgages to “increase access.”

Meanwhile, in vivid contrast to the Swiss central bank, which marks its investments to market, the Federal Reserve has designed its own regulatory accounting so that it will never have to recognize any losses on its $4 trillion portfolio of long-term bonds and mortgage securities.

Who remembers that such “special” accounting is exactly what the Federal Home Loan Bank Board designed in the 1980s to hide losses in savings and loans? Who remembers that there even was a Federal Home Loan Bank Board, which for its manifold financial sins was abolished in 1989?

It is 25 years since 1989. Who remembers how severe the multiple financial crises of the 1980s were?

Full article (subscription req’d.)

Central banking and inflation.

Quoted in WSJ:

From an interview with former Federal Reserve chairman Paul Volcker (Class of 1949) in the Daily Princetonian, May 30:

DP: [D]oes high inflation matter as long as it’s expected?

PV: It sure does, if the market’s stable. . . . The responsibility of the government is to have a stable currency. This kind of stuff that you’re being taught at Princeton disturbs me. Your teachers must be telling you that if you’ve got expected inflation, then everybody adjusts and then it’s OK. Is that what they’re telling you? Where did the question come from?

DP: Okay. Could you talk a little bit about the justification behind the Volcker Rule and the effect you think it’s had on the market?

PV: The rule is that institutions that are protected by the government, implicitly or explicitly, should not be engaged in speculative activities that bear no real relationship to the purposes for which banks are protected. Banks are protected to make loans, they’re protected to keep the payments system stable. They’re protected so you have a stable place to put your money. That’s why banks are protected. They’re not protected to engage in speculative activities which led to risk and jeopardized the banking system. That’s the basic philosophy. I think it’s pretty well-accepted. . . .

DP: Okay. And to get back to the central banking a little bit, given the trade-off between inflation and unemployment—

PV: I don’t believe that. That’s my answer to that question. That is a scenario and a delusion, which economists have gotten Nobel Prizes twenty years ago to disprove.