A Tiger by the Tail: The Fed and QE3

With the third round of Quantitative Easing (QE3) last fall, the Fed grabbed a tiger by the tail and, for obvious reasons, it cannot let go: Agitated tigers come after you.

The story behind why the Fed created the risks that are now haunting them is a revealing one, and it has perverse implications for the future.

QE3 is a monetary extremum. It arose out of frustration from years of unsuccessfully stimulating the economy the old-fashioned way — by purchasing securities that resulted in mountains of cash being deposited at banks at record low rates with the unfulfilled expectation that the cash would be loaned and spent.

Lead by Bernanke, a still-determined Fed embarked on a policy tweak that they hoped would cause banks to lend, encourage businesses to borrow and invest in plant and equipment, and drive consumers to spend on durables. The scheme also encouraged investors to drive up financial prices, hence creating a wealth effect that would provide the resources for more spending.

The idea was to tweak expectations that arose out of the simple notion that people invest in physical plant or financial shares based on their probabilistic expectations of the cash flows from future economic growth. Key to that projection is what they believe policymakers will do to maintain growth. Inside of academia, this notion became known as rational expectations, a theory that has been glorified with the award of at least two Nobel prizes.

So as it stood last fall, expectations were “rationally” priced into economic activity and market securities, but the rational level of activity was not very satisfying to the body politic or to the Fed. Given the impasse and the mounting fears of a further setback from the looming fiscal cliff, the Fed decided on a Hail Mary policy play. Fortified by the academic acclaim of rational expectations, they thought it clever to manipulate existing expectations to cause agents to do what they wanted them to do, which was to generate more real investment spending.

In rational expectation logic, in order for the policy change to have an effect on the outcome, it needed to be a policy surprise, otherwise the outcome was already reflected in existing activity and prices. Hence, it can be said that the Fed sought to create irrational expectations of growth. What especially makes it irrational is earlier QEs have already revealed that growth doesn’t necessarily follow more money. But if the market believes and acts on it, expectations can become self-fulfilling.

In the good old days of pre-government debt distress and Great Recessions in which commercial banks would take excess cash and actually lend it, the policy options were spoken of as either Open Market or Open Mouth. Open Market means the Fed shapes market prices by actually going to the open market and buying, whereas with Open Mouth, they merely imply they will be buyers, which causes front-running investors to change the prices for them without the need to load up their own balance sheet.

In todays world of the Great Quagmire after more than five years and counting in which at least two other predecessor QEs did not do the trick of extracting the economy the Fed believed the only way to generate some traction would require both Open Mouth and Open Market with breathtaking amounts of monetary increase never previously witnessed, anticipated or priced in.

To do so they needed to oil up the printing press and but also ramp up Bernanke’s Open Mouth skills to exude some confidence in order to move the expectations needle — not an easy task for a rather dry academician. To do this, it is reported that Bernanke hired a media coach and scheduled unprecedented press conferences never before conducted by a central bank Chairman in the manner of King George VI of Great Britain, who needed to announce his country’s entry and progress through WWII.

What was most important in the Fed’s announcement of QE3 was the notion that they would not take their foot off the monetary accelerator until we were out of the Quagmire, however long that would take, in an open-ended commitment. This is something akin to the wartime philosophy, “We do not stop until unconditional surrender.”

And while its way too early to determine the extent of the success of the gambit as it relates to jobs, economic growth, and a little bit of inflation, these effects only occur after a bit of time, which even in less challenging times would require 18 months to be noticeable.

But rather than waiting that long to judge the leading edge of the results, after only about 8 or 9 months or so of QE3, the Fed hinted that it would throw in the towel on Quantitative Easing. To lay the groundwork for exiting, it backed off the timeless open-ended commitment by defining targets of unemployment and inflation that would allow them to exit, and more recently it forecasted time limits for reaching those targets which now is but a fuzzy time limit for QE3. Gone is the open-ended commitment, replaced by a strong hint that they wish to back out.

So now we have it as to why the Fed started QE3 — but why are they now backing off the strategy known in Bernanke (and speech coach) gibberish as “tapering,” which was met with a disconcerting thud in the financial markets.

Basically to date, while there is no clear evidence that real investment is taking place as a result of the policy, but it is clear that financial market participants took the Fed’s promise of growth along with cheap money and ran with it. Given their “do not fight the Fed” culture, they responded to the Fed’s unanticipated announcement in minutes, not the months or years the real economy requires to assess the response.

Basically the financial investors salivated at the ultra-low rates offered to borrow and purchase financial assets — a process known as leveraging — which drives a wedge between financial pricing and the underlying economic income streams they were purchasing. It is also known as an asset bubble, which tends to collapse.

Well, the asset bubble pricing started to collapse on its own weight, prior to the Fed hinting that it will be exiting earlier than planned. That occurred because of a new monetary phenomenon that is important to understand. It involves new realities of global financial intermediation.

QE3, with its eager financial market participants, enabled a great deal of low-quality debt to be not just sold but scooped up by financial leveragers with borrowed funding. Leveragers do, after all, live off the difference in the yields of the assets they purchase less what they pay for the borrowed funds required to purchase the assets. This is known as spread.

So while low-quality debt assets were flying off the shelf into the hands of the leveragers, generally known as the shadow banking system, outstanding amounts of high-quality debt securities in the form of U.S. Treasuries were being scarped up by the Fed in its QE3 operation.

Ironically, this ended up limiting the amount of low-quality assets the shadow banks could purchase, because they are required by their funding sources to collateralize their borrowings with high-quality debt.

The critical nature of the availability of high-quality debt is amplified when they don’t simply borrow once against the high-quality debt, but they instead use their high-quality collateral repeatedly to borrow yet more funds and purchase yet more assets making available Treasuries in the secondary markets the defining limit of their balance sheet size.

It would be like you or I pledging our same house over and over again as collateral to succeeding lenders to borrow yet more funds for unrestricted uses. Yes, borrowing over and over again against the same collateral might not be legal for you or I, but it is legal up to a point in the shadow banking system.  The extent to which this can happen is called the re-hypothecation multiplier.

In this way, by removing Treasury collateral from the available asset pool, the Fed’s QEs caused the shadow banking system to contract. Because the shadow banks are at least twice the size of commercial banks and the only eager lenders at this time, this greatly squeezed credit.

The contraction of the shadow banks showed up in the markets a number of ways: The prices of risky debt fell as shadow bank portfolios shrunk; the prices of the funding currency (cheapest source of funds) such as the Yen and the Dollar rose as leveragers were repaying their funders as they unwound their portfolios; and the leveragers closed shop on expansion by only accepting funds if the funder was willing to pay them for the transaction.

That is, negative funding rates occurred when the funders needed to pay shadow banks to accept their funds, rather than having the shadow banks pay for them.  This is the equivalent of walking into your friendly bank, asking the rate they offer on CDs and being notified that your money will only be accepted for a CD if you agree to pay the bank to take your money! Such is the surrealism in today’s markets.

That surrealism includes the commercial banking system with free cash to lend some great multiple of the available cash — yet they do not lend it, and the larger shadow banking system runs out of Treasuries to expand off. All in all, it is de facto restrictive credit conditions, despite the QEs.

So where are we now? For one, the above has revealed that maximum money is not optimal money. QE, at some point, makes credit conditions worse off. In fact, credit is restrictive. Another way to put it is that we have backward-bending reaction functions that are definitely not part of the Keynesian or monetarist textbook of how more money produces higher prices and improved economic conditions.

The Fed’s ability to move the dial on real investment and financial prices has been shown to have reached an upside limit, and their announcement effects in financial markets are now met with cynicism instead of awe as they vacillate back and forth on QE3.

The recent crumbling of debt and equity prices embarrassed the monetary authority and revealed that Open Market operations do not have the desired effect. This negates their power to move the markets with Open Mouth policy, as there are precious few left who believe the Fed will stick to an announced expansion.

Of course, not wanting to admit to impotence, the Fed claims mysterious “headwinds” prevent the effects they are seeking as a face-saver for those who question monetary policy. They clearly would like to put QE3 in the rear-view mirror and have vacillated between statements of tapering and then damage control to their reputation (and financial market wealth) by dispatching various Fed bank presidents to claim they are still in it until victory. They have the QE3 Tiger by the Tail, and they are afraid to let loose as they know their reputation will plunge on a scale equal to the market plunge that would follow.

Bernanke is lucky as his term as chairman (but not as a member of the board) is over in January. He might even leave earlier, as the president already publicly closed the door on a re-nomination when he said: “He’s already stayed a lot longer than he wanted, or he was supposed to.”

The irony is that he is being chastised for backing off of QE3 by the administration despite it being a doomed and embarrassing policy. One sort of graceful way out is to declare victory and leave, a strategy not without precedent in both war and peace.

The far larger issues ahead are not the future of QE3, or of Bernanke or the stock market, but rather the Fed. The salad days of hard-earned market confidence that allowed Open Mouth Policy to have an effect have been built on 70 years of performance since the Great Depression. That confidence has been sacrificed, and it will not just return with the appearance of a new Fed Chairman in January.

Divining the short list of candidates to replace Bernanke has been tasked to Treasury Secretary Lew, so whoever it is will very likely be a Democrat, not just because of who is nominating but also because the appointment requires an advice and consent majority from a Democratic Senate. So whoever replaces Bernanke is likely to try it all over again in the faint hope that mega QEs both dazzle the financial markets and still provide economic uplift. Good luck to whoever that might be!

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QEs, Currency Wars, the Trillion Dollar Platinum Coin and the Route to “Modern” Inflation

A government faced with financing its deficits in quantities some multiple of private saving must resort to monetary schemes in order to keep its promises to spend. Monetary schemes are essentially costless ways to pay the government’s bills today while ignoring long-term consequences. Understanding the schemes reveals them to be disarmingly simple, but effective.

Some varieties of these schemes include monetization of Treasury debt, monetization of Treasury coin and Treasury currency.

Monetization requires the Treasury to issue something (debt or coin) that the central bank purchases from the Treasury with dollars, which in turn provides the dollars to the government to deliver on its spending promises. In both monetization schemes, consolidating the balance sheet of the government and its financing arm, the Federal Reserve, reveals dollars outstanding as a liability and government investment items purchased (such as infrastructure) as an asset after the financing is accomplished and the money is spent.

The rest is spent for consumption items with no remaining asset to put on the consolidated balance sheet.  In both cases, with each occurrence of monetization, the government becomes more upside-down (insolvent) as long-term asset accumulation is but a fraction of its additional liability issuance.


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To make the debt not just saleable but also costless, the interest consequence of the sale of the debt held by the Fed is negated. This occurs when the Fed, as the owner of the debt, is paid interest by the Treasury (ostensibly from tax proceeds) which it in turn remits to the Treasury, less their costs of operation. How convenient.

This renders the net interest carry paid by taxpayers inconsequential. With the Treasury issuance of coin, interest is not paid and hence there is no need to tax in order to make an interest payment — and hence, there is no need to remit interest. Thus the Treasury coin sold to the central bank is almost the ultimate in costless government finance.

But yet there is another way to accomplish costless government finance and make it even slicker with less fanfare.  This would be Treasury currency issuance that doesn’t involve the Fed at all — nor does it involve selling anything or collecting interest payments. In this scenario, Treasury (not the central bank) prints currency to make good on the government’s promises.

This was done during the Civil War and continued up until 1971. The legislation is still in place, but it would require some fine–tuning, such as eliminating ceilings on issuance of Treasury currency. However, that strategy could become a political nightmare if it is exposed as an end run around the debt ceiling because, by law, Treasury currency is considered to be infinite-maturity, zero-coupon debt. What could produce less friction than Treasury printing cash and making good on the promises to spend, without the need to involve or embarrass the Fed, struggle to sell its debt, or pay interest?

In another dimension of Fed support of Treasuries and the housing market there are ongoing QEs in which the Fed is also purchasing market debt from investors in the public capital markets. Investors who sell securities to the Fed receive cash, which puts them in a difficult position: They would have an investment mandate to earn positive returns in a Fed-induced zero interest rate (ZIRP) financial market environment.

This drives some investors into purchasing foreign assets, which turns the Fed QEs into a global Currency War in the following way: Converting dollars to another currency in order to participate in foreign financial market investments sends the foreign currency price upward relative to the dollar. While these countries might be momentarily pleased by the interest shown in their securities and currency, the capital inflow stiffens their currency values, making exports a more uphill proposition.

The central bank, not wanting to lose what they consider to be their fair share of net exports and trade surpluses, responds by selling its currency into foreign exchange markets. That is to say, the Fed’s QE goes global when foreign central banks seek to offset their currency appreciation, which is fought off with more money issued by foreign central banks and sold in the foreign exchange markets. Japan is the latest recruit in reacting to the Fed, and from all indications, it plans to do so in a big way.

This is the Currency War that is now gripping many countries across the globe. And the recent developments with the Fed’s QE are not the first cases of this happening. Bergsten and Gagnon of the Peterson Institute indicate that 20 countries have been in the currency manipulation business to their advantage for some decades, but that has increased recently due to Fed QEs.

Now monetization is ramping up again with QE3, giving more reason for foreign currency offsets to the Fed’s QE. The recent G-20 meeting to discuss Currency Wars resulted in a conclusion to continue with currency intervention but not talk about it in public and keep it out of the press.

However, despite stonewalling and denials by governments and central banks, we know foreign currency appreciation is being offset simply by observing the balance sheets of the foreign central banks that accumulate foreign exchange reserves.

These assets held by foreign governments or central banks are the byproduct of currency intervention, which can’t be brought back home as it would offset their currency offset. In many instances, their purchase of U.S. dollars in the foreign exchange market gives them the dollar purchasing power to in turn purchase U.S. Treasuries — and they did so to the tune of $555 billion in 2012.

Thus the Fed’s direct Treasury purchases — targeted to be close to $500 billion this year — are more than matched by foreign official purchases, so the promises to spend continue to be met. Certainly a half-trillion dollars in U.S. Treasuries purchased by foreign officials is not the byproduct of taxing their own nationals to purchase U.S. Treasuries. While they might love America, it’s not likely to that extent.

So Currency War deniability is necessary in order to contain inflation expectation pricing in financial markets, but it isn’t something that is likely to occur without U.S. acquiescence. Moreover, the U.S. must be in silent support as long as the foreign officials keep purchasing U.S. Treasuries at ridiculously low interest rates that the private market would not tolerate.

So we are off to a Brave New World of money expansion and money supply multipliers that go global. The inflation is likely to first hit in the emerging market countries that are most participating in defending the cheapness of their currency and with more limited excess supply capability of producing goods. Brazil, for example, has an inflation rate above 6% and rising. Their inflation becomes imported inflation to the otherwise deflating developed countries stuck in economic and financial distress.

Certainly an investor needs to be Brave in this New World of interactive monetary policies that struggle to make good on the government’s promises.

For a video version of this discussion go here.

Currency Wars





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Ben Bernanke and the Implications of The Great Monetary Hail Mary

These are epic times in the developed world’s attempt to deal with the implications of government and consumer over-indebtedness. A general unshakable malaise has set in due to sluggish spending and a deleveraging banking sector, and as a result, employment growth is suffering. Governments in turn are faced with diminished tax yields and deficits remain bloated. As shown in Europe, ultimately they run out of willing buyers of government debt.

Inevitably central banks are called in to treat all these related symptoms of the underlying debt disease. That momentous time has arrived for Europe as the debt symptoms have progressed to adversity in the selling of government bonds. Meanwhile, the more stressful symptom for the U.S. at this time is unemployment.

In the past weeks, the central banks of the developed world have taken the next big step, a monetary Hail Mary, to combat these symptoms. A Hail Mary is an act of desperation associated with putting all the chips on the line when your team is behind and time is running out. The ECB offered to support the bonds of those Euro countries that have lost willing private buyers and Germany — the last holdout — has accepted the offer. This will be a four-decade bond support program given the demographic-related deficits that will occur. For the baby boomer generation, their related entitlement spending has only just begun.

The Fed then made an open-ended Hail Mary of mega asset purchases that will ostensibly continue until the labor market is healed through self-sustaining growth.

This could be a long period of time given Bernanke’s claim that 2 million jobs have been created as a result of $2 trillion of QEs to date. If this estimate is correct — and there is ample evidence that it is an overestimate of monetary effectiveness — it implies that each added job comes at a cost of very close to a million dollars of monetary expansion.  These are very expensive jobs.

The Fed’s estimate is imbedded in its macro model of the economy, which is based on the good old times when the Fed could be effective when not faced with the retardant effects of an over-indebted consumer wishing to deleverage and a banking system that does respond to more base money (See Eisenbeis Critique).

But for the sake of argument, let’s accept the Fed’s estimate of the employment response to base money increases to allow us to ballpark the needed size of the current QE. There are more than 12 million unemployed and 9 million labor force dropouts since the onset of the Great Recession, some of whom would return to the labor force if jobs were forthcoming. Furthermore, in the years ahead there will be new labor force entrants which number over a million per year.

To make this both easy and highly conservative, let’s assume that jobs will be created for only half of the jobless and half of the recent labor force dropouts, setting aside the future labor force entrants. That works out to about 10 million new jobs — a policy victory that the Fed would happily claim.

At the Fed’s implied rate of dollars per job created, this implies an asset purchase/monetary injection of perhaps $10 trillion on top of their original (pre-QE) balance sheet of $1 trillion and a current balance sheet of nearly $3 trillion.  This would take the Fed’s balance sheet to $13 trillion — which, interestingly, is the size of the moribund commercial banking system that contributes no balance sheet expansion in response to the Fed’s base liquidity. Basically a beefed-up Fed would fill the gap of the petrified banking system, at least in term of the quantity of assets held by financial institutions.  Too bad the Fed doesn’t have loan officers to make small business loans to make the effects really comparable.

This lack of commercial banking response to central bank liquidity growth is demonstrated (thanks to Gary Shilling) in the accompanying graph. M2 is approximately the sum of the balance sheets of the commercial banks and the central bank is shown relative to the central bank monetary base. It has shrunk by two-thirds as a result of the tripling of the central bank monetary base without much follow through by the commercial banking system.

Hence, to get the same monetary punch by itself, the central bank would need to expand to be an equally sized banking system as a replacement for the petrified banking system that hopes to survive by not lending.

But this is not the end of the epic monetary growth story. It didn’t take long for these QE announcements to have expectation changes that will lead to further second-round monetary expansion coming from abroad.

In response to the Fed’s actions, investors imbued with the Milton Friedman Reflex of money causing inflation are known to move wealth to countries with less exposure to what they believe is an inflationary future in the countries receiving the high doses of money.  These dollars run to some alternative port that would cause the recipient country’s currency to appreciate, as occurred with QE2.

In anticipation of this, central banks around the world are stepping in with plans to preempt a loss of export competitiveness that occurs when inflows of foreign capital cause currency to appreciate. As a defensive measure, the central bank sells its currency on foreign exchange markets to offset a currency appreciation. But the same money, when deposited in its still-intact banking system, is parleyed with banking system expansion. All in all, this makes inflation more likely with money flowing from central banks worldwide.

Japan will be the first big domino to fall in this monetary knock-down process, and Brazil, Turkey, and Korea are likely to follow. The Swiss are prone to offset currency appreciation, and so is China if capital washes up on its shores. So, the ripples of mega money expansion from the U.S. and Europe in turn creates mega monetary expansion in countries that were simply minding their own business and wishing to buy some protection their currency appreciation as a byproduct of the developed world’s debt problems.

This phenomenon, last seen in the depression years of the l930s, has a few names associated with it in the history books, but the clearest tag is competitive (currency) devaluations.

So now the monetary Hail Mary is “QE Squared” or “QE to the Third Power” (or more, depending on how many follow suit. So where does that take us?

This scaling up of monetary expansion with so little in the way of positive economic impacts calls into serious question the efficacy of Keynesian economics as it is currently understood, but this will not stop academia from teaching it. Keynesianism will likely remain the gospel for some time, but hopefully it will at least be amended to include the important idea that aggregate demand generation only works if there is not a debt load to scuttle spending and a well-capitalized flexible banking system to ramp up the monetary base. These pre-conditions cannot be taken on faith.

Furthermore, this blatant policy failure scuttles the 60-year era of faith in the efficacy of not just monetary policy but also fiscal policy to smooth out the business cycle. Emphasis is shifting to supply-side issues as opposed to more demand-side fixes that, in the words of David Rosenberg, have gone to infinity without positive effects.

While the Fed intended for QE3 to aid the unemployed, little or no mention was made that it has been financing approximately 60 percent of net new government debt issuance in recent years. So, there are both stated and unstated purposes of this monetary Hail Mary. On the sly, the Fed is doing the same thing the ECB is doing, which is treating both the employment symptom as well as the government finance symptom of the debt overload disease.

While the need to treat the government finance symptom in the U.S. will be more evident in coming years, as it is in Europe today, the more immediate goal is to maintain as near to zero nominal interest rates all along the yield curve with a constrained but positive inflation rate. The net result of that magic is that the real cost of borrowing is negative — hence benefitting debtors both private and public. But this is confined only to those able to refinance into today’s negative real interest rates.

This leaves out perhaps the most important stressed consumers: those with upside-down mortgage debt relative to home values.

While this monetary Hail Mary is good news for some debtors, the flip side to investors is known as financial repression. This does significant damage not just to the “moneyed” class (in today’s class warfare terms) but to everyone with hopes for either a private defined-benefit or defined-contribution retirement plan with income generation based on microscopic yields in the fixed income market. This also includes state and muni pensions (which are seriously underfunded to boot,) as well as the Social Security Fund that to the extent it is funded is 100 percent invested in U.S. Treasuries.

So saving the unemployed and creating the ability to honor entitlements today comes at a high cost to future cash flows for retirees and institutions hoping to survive on a steady income flow. The classic Keynesian marginal investment function is not responding to the lowest interest rates ever available. Few benefits and lots of costs have been the result of this over the top monetary Hail Mary.

But given that the inhibition to run the printing press is now passé, the race to the bottom (the cheapest currency) is a race to produce more money that enters the economic system not as money in our pocket but as money chasing assets that have a chance to appreciate. That has included stocks to some extent, though that movement seems overstretched relative to floundering profit growth tied to a floundering economy.

Taking all this policy action and associated responses, the markets will put premiums on real assets, especially those producing income that have some inflation sensitivity. There are not many assets in this category. As an example, the yield on Treasury TIPs has appreciated to the point where the yields are now negative based on the fixed return component, requiring a 2.7 percent future inflation to have an equivalent positive yield compared to the fixed income equivalent.

The most desirable asset class is the long duration and real income producing variety, especially if financed with fixed rates — which augurs well for income producing real estate or infrastructure. This includes the new respect given dividend paying stocks. Gold and precious metals are also up there despite not producing income.  These are the premium assets in today’s markets, especially if found in the few countries that might not move to offset currency appreciation until seriously burned in the export markets. That might be Canada, for example, given its bent for market-determined exchange rates and financial prices.

There are endless issues raised by these historic and monumental QEs. For now I will note a few of them: The Fed will most certainly lose some of its cherished independence as a result of this overreach, especially in that it has created income redistribution. That is, it has stepped on a Congressional prerogative. The only question is how much Congress will dictate future monetary policy. It depends on how inflationary it actually becomes. As a reminder, in the inflationary 1970s, Congress stepped in to restrain the Fed with the Humphrey-Hawkins Act, even under a Democratic majority and president. For better or worse, Ron Paul’s status as cult hero is growing.

Secondly and perhaps most sadly, given the Fed’s inability to stimulate the economy under the circumstances of a consumer and government debt burden and a petrified banking system that fears future losses and an over-dictatorial FDIC driven by self-defense rules. This means the Fed’s Hail Mary is destined to fail under today’s circumstances. The market will consider the Fed de-fanged even if it is not de-fanged by Congress. It will be considered the toothless tiger of Constitution Avenue.

With such a fall from grace, the intangible but important confidence factor in the Fed as a reliable rudder to the system will be lost for a long time to come. The Fed will cease to be held with reverence but rather will be considered irrelevant.

All this invites major Congressional recapture of the monetary compass, which is its Constitutional prerogative and would be the largest setback of all.  For if that were to happen, Congress, not an independent Fed, would at the time of  U. S. government bond market stress be in the driver’s seat to do just as the ECB is doing in Europe. The Fed’s has sadly extended its reach beyond its grasp with ill consequences ahead.

Some will say that academic lessons are sometimes learned well, but not wisely. This could well be the final ultimate test of Keynesianism or more broadly demand generating economic policy. Not only can they not be afforded, but they are also not effective in today’s circumstances, but they will still try.


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The Stock Market, QE3 and Voodoo Finance

As we look across the economic landscape there is an abundance of reason to anticipate a global economic slowdown. It is already well in the works as reflected in anticipatory data. It would not be a garden-variety recession emanating from some lull in spending but rather the grinding process of over-indebtedness and uncertainty due to tax and health care issues.

At the same time, over-indebtedness also creates a withering of financial valuations, which sets off another chain reaction called systemic financial meltdown.  This reduces the value of assets held by individuals and institutions such as banks, which in turn further dissolves financial wealth when assets are dumped in order to pay off fleeing depositors.

As a result, financial intermediation withers so that the process of matching of savers, if there are any, with investments is impeded. This in turn negates future growth. For example, systemic financial forces causing a recession visited the U.S.  in the late 1980s. At that time large commercial banks were overburdened with Latin American loan defaults and simultaneously savings and loan associations (remember them?) were decimated when inflation depreciated their book of long-term mortgages.  This limited systemic financial event resulted in a prolonged 1990 recession.

Hence whether the over-indebtedness first strikes spending or financial intermediation, it is difficult to discern as they interact and both income flows and financial valuations suffer, whichever occurs first.

Today, the developed world’s over-indebtedness reactions of the combined recessionary forces and bank runs are emanating from Europe’s southern tier. Unemployment numbers in Greece and Spain rival those of the Great Depression.

But the question on the table is the ability of Northern Europe and the U.S. (and, for that matter, the rest of the world) to escape at least temporarily the ill effects of the above degenerative process.

To gauge that, the market looks to the ability of monetary and fiscal policy to come to the rescue, and if the rescue is attempted will it work? Given the succession of bailout funds established but without the means to fund them, it is not a realistic option. To the extent country debt has been carried by other contributing countries, it is extremely limited and if, indeed, the Spanish bank bailout takes place, it exhausts all bailout funds from the Eurozone’s willing contributing countries.

Nonetheless, the contributing countries keep promising more and more, with the latest being a bank deposit insurance fund — and the market somehow believes it.

If fiscal resources from other contributing countries are extraordinary limited, what is the extent of monetary funding to aid both a recession and systemic financial meltdown? Well, there is some defense to the systemic financial event as long as the Fed and the ECB and other central banks are willing to keep expanding their balance sheets. There is no theoretical or legal limit to how much can be purchased to keep financial asset valuations afloat in order to prevent imminent financial meltdown, but to go overboard they are willing to give up all discipline of monetary control, and with it, holders of the currency go elsewhere.

Given the vulnerabilities present, how then can one explain stock price buoyancy? Since the beginning of the year the S&P 500 index is up approximately 6% and FTSE 100 index is up 2 percent despite the onset of recession and bank runs.

If there is any logic to it, it seems to be resting on less than a firm foundation. While equity investors rely on current known information such as earnings, they also project forward the value of the claims they are purchasing, hence making financial pricing a mixture of facts and a learned history to project forward.

What you often hear these days is a general awareness of the economic and debt problems but a faith that the bigger the problem, the bigger the government response will be. That is to say, any investor citing “in my 25 years’ experience” is a candidate to be projecting a future based on the Great Moderation Period of Greenspan Puts and currency solidarity in Europe.

Financial prices are inherently an extrapolation of a history, but it’s certainly not the Great Moderation, though that was the dominant influence in the thinking of the 25-year U.S. veteran stock market investor.

But then there is a newer history called the Bernanke Put, best characterized as a succession of QEs or other outside-the-box monetary stimulus, the latest of which is operation twist.

It’s now a common attitude that if the situation becomes bad enough there will be a response equal to the task needed to keep financial values afloat. Now being cited is the above chart showing how equity markets respond to QEs. It seems that the Fed has well trained stock market investors in Voodoo financial logic. The worse the economic problem, the better it is for stocks despite declines in earnings.

As a side note, QE faith stock valuations are throwing noise into the long term relationship of stock prices to earnings and as an early indicator of a recession. This is one of many structural changes that are occuring which implies that one must be careful of which history is chosen to extrapolate.

Before one relies on Voodoo finance and a faith-based QE3, one should note that additional Fed stimulus is almost certain in the face of a systemic financial institution collapse but is less certain and will be less dramatic due to a softening economy. Systemic financial defense was the raison d’etre for the Fed and remains its number one policy objective, but some token form of monetary aid has now become necessary to prevent a collapse of the Voodoo expectations the Fed has created. If that occurs, expectations have become self-fulfilling.


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