Wednesday, August 18, 2010

"The Beatings Will Continue Until Morale Improves"

The title of this post is how a colleague summarized Peter Schiff's editorial on recent Fed actions. Schiff states:

Just a few weeks ago, pundits were asking how Ben Bernanke would shrink the Fed's bloated post-crisis balance sheet. But in its August 10th decision, the Fed signaled that it would "recycle" its debt holdings; in other words, there would be no exit strategy for the foreseeable future. Given the fact that monetary stimulus will not only fail to spark a genuine recovery, but create a never-ending need for successively larger doses, Bernanke should grab a few beers and head for the nearest available emergency slide.
Schiff points out the contradictory premises inherent in the Fed's approach - it promises to "remove" the stimulus when the economy recovers, however, the economy is being propped up by easy money, i.e., the economy can not recover until the Fed removes the stimulus! Schiff states:

Bernanke and his supporters have said that their stimulus will be withdrawn as soon as the recovery takes hold in earnest. This misses the point that any "growth" created by stimulus is totally dependent on stimulus to continue. The "recovery" will end as soon as the stimulus prop is removed.
Bernanke's economic philosophy insures that the Fed will continue to find more and more clever ways to create money through quantitative easing. Just as an addict needs more and more drugs to get high, a highly leveraged economy needs more and more "stimulus" to stop the natural forces of deleveraging and price and wage decreases from occurring, forces which would create some short term pain but would restore a solid economic foundation upon which to rebuild. Schiff states:

Like their patrons in the White House and on Capitol Hill, the Fed is totally dedicated to postponing the short-term consequences that would result from breaking America’s addiction to cheap money and easy credit. Compared to this imperative, the long-term economic health of the country barely gets a second thought.
He rightly concludes:

Unfortunately, no one at the Fed has the honesty and courage to suffer the short-term shock that would accompany any meaningful exit strategy. Withdrawing liquidity and shrinking the Fed's bloated balance sheet would no doubt bring on a severe contraction in GDP, but the moves would also enable the US economy to form a solid foundation of savings, capital investment, and industrial production upon which a real recovery could be built. By contrast, more stimulus simply magnifies the imbalances, including excessive government spending, too much consumption, inadequate production, and artificially elevated asset prices. After decades of abuse, it's time for the Fed to make a dramatic exit, because the US economy can't take it anymore.
For more logical economic thinking, see this excellent interview with Kyle Bass of Hayman Capital. The blog author states some of the themes touched upon in this interview:

...the inevitable restructuring of untenable sovereign debt, the nearly $5 trillion in new global debt that needs to be issued just to plug near-term deficits, the joke that was the European stress test and the ongoing insolvency of the European banking system which is times bigger than its US equivalent, the imminent downward revision of Q2 GDP to sub 1%, the Fed's conflicted position as a political authority whose sole purpose now is not to keep inflation and unemployment low, but merely to keep interest rates as low as possible, as even the slightest shift to higher short-end rates will be seen as a black swan, indicative the Fed is losing control over the economy, and ultimately the futility of Keynesian theory band-aiding of a world caught in a toxic debt death spiral. In short, Bass sees no way the world can get out of its current state absent a huge reset.
Related to Japan and the massive amount of outstanding government debt (one quadrillion Yen!), Bass makes the excellent point that a Ponzi scheme can last as long as there are more new buyers than sellers in the scheme, which in the case of Madoff lasted a very long time. For a government which sells bonds to its own citizens as Japan largely does, the end of this scheme comes when the "costs of servicing the debt exceed revenue." He makes the pragmatic point that Japan's demographics are at a stage where they are entering a kind of tipping point as their savings rate declines and they begin to go outside for funding.

One topic not on many radar screens is state budget deficits. Here is a
great article that lays out the startling numbers related to state budget shortfalls. Related to these facts, I will make a prediction: As state budget shortfalls become a larger headline, and with congressional stimulus off the table, look for the Fed to announce it will buy municipal bonds from states. I have not heard this mentioned at all recently, but it would seem logical they would go this way given their premises and the political fact that most people do not understand the effects of the Fed's machinations. As I claimed a while back, such an approach would be a back door way for state's to print money. State's have always been forced into some kind of discipline since they do not have the printing press as the Federal government does. Such an approach would remove this check on state spending power since the Fed could create money by which it would use to purchase state bonds. Effectively, such an approach would place an inflationary tax on all holders of dollars as a means to bail out profligate states such as California, Illinois, and New York.

If you want to contrast logical economic thinking with Keynesian economic doctrines, i.e., the very thinking that has gotten us into this mess, consider this piece by the very influential Paul McCulley of Pimco, the largest institutional fixed income money manager. Rather than understanding that recession is recovery and that price and wage decreases prevent deflation from occurring - an issue I discussed in detail here and here- McCulley makes the usual mistake of conflating price decreases with deflation and urges the Fed to print money saying:
the central bank has a profound duty to act unconventionally, ballooning its balance sheet by monetizing assets, either government or private, or both.

The central bank has a profound duty to meld itself with the fiscal authority, until the fat risk of deflation is eliminated.
Let's see - painful short term medicine in exchange for a long term recovery or a green light to print money as fast as possible - which option will "Helicopter Ben" choose?

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