I was driving to an appointment this morning, listening to NPR, when the station ran a piece on consumer confidence, explaining that it had fallen precipitously in the wake of the government shutdown. “Yeah, right”, I thought to myself. Consumer confidence might have fallen, but it likely had nothing to do with a loss of confidence in the government. I mean really, who anymore has confidence in the government? Nobody out here in flyover land, that’s for sure, and the lack of confidence out here dates to well before the latest round of fiscal chicken playing by the politicians. There was no exploration of other potential causes of lost confidence (Obamacare, anyone?), so I dismissed the piece as just another episode of the echo chamber listening to its echoes.
But it set me to thinking. Consumer confidence is extraordinarily fickle, so any single consumer confidence reading is not much more than just a data point. But confidence in the Federal Reserve—the shadow government ruling over the economic system in total—is necessarily more stable. People who pay attention to the markets and the economic system closely follow what the Fed does to see which way things might be heading. And they have lately watched the Federal Reserve pull out all the stops in its quest to right the economic ship. They are confident, or seem to be, that with the Federal Reserve at the helm, the economic system, and the markets dependent upon it, will make it through this latest, and longest-lived in the post-War era, economic tempest.
Financial markets have gotten so dependent on the Federal Reserve that any time it looks as though the economic system is improving and thereby won’t need as much central banker guidance and manipulation, they tank. In other words, financial markets have become delusional, unhinged from economic reality (or perhaps, inversely hinged to economic reality), because of the Fed’s efforts to save the economic system. They have come to believe that what is bad for the economic system is good for the financial markets, as it will keep the Fed safely ensconced at the helm, steering the ship and directing the burners to full open.
But no matter what confidence level the financial markets have regarding the Fed’s ability to manipulate economic outcomes to their liking, the financial markets depend upon the real economic system to support their valuations. If you think otherwise, just take a moment to recall what happened when it became clear that a goodly portion of subprime mortgages were bestowed on people without any real hope of ever paying them back. The economic system bit the hand that fed it (or surely, that would be the financier’s take on things). And financial markets and the economic system tanked simultaneously. Now the financial markets, thanks to the Fed’s attempt to get the economic system out of the doldrums, are in robust, if superficial, good health. Stocks are hitting all-time highs, and so are bond prices (which move inversely to yields). Even housing prices have climbed, in some areas as much as 20% in a year; in all areas (including even Detroit), in at least low double digits. Financial market strength and confidence has certainly bled over into the real economy, particularly in areas like housing that are financially sensitive. It bled over in the mid part of the century’s first decade, too, which is a goodly part of how the economic system ended up recently pushing the financial system to the edge of the abyss.
The real economy now has what can only be described as a structural employment problem (it had structural problems before the crash, but they were masked by financial market shenanigans). The labor market is not clearing. Unemployment has declined, but mostly because of people dropping out of the workforce. The rate of labor force participation has declined to levels not seen in over forty years.
People out in flyover land probably don’t pay much attention to the Federal Reserve, as much of what the Fed does and practically all of what they communicate is esoteric fodder for the economists, bankers and financiers who comprise their communications target. It’s doubtful very many politicians running the storefront of government much understand what the Fed is doing either, or understand what it is saying about what it is doing. But the financial system seems to only pay attention to the Federal Reserve. It parses its every utterance, behaving like latter day Kremlinologists, looking over its policy pronouncements like Kremlinologists used to examine Mayday parade photos and films, noting body language and positioning on the podium of Soviet leaders, trying to ascertain in which direction the Politburo might be headed next.
Even so, it is clear that no matter what the Fed might say or do in the short run, the financial markets have complete and utter confidence that the Fed stands ready at their rescue, even if the need for their rescue is their own folly (see, e.g., the ’87 stock market crash, the LTCM debacle, the Savings and Loan debacle, the tech stock crash, and most recently and most powerfully, the subprime mortgage induced crash). The markets believe in the Great Put. Which is a travesty and a tragedy, all at the same time.
It is a travesty because financial markets are supposed to allocate capital according to risk and return expectations. If there is no ultimate risk, i.e., no real risk of outright failure, then capital allocation becomes not much more than a guessing game for which sector might next be favored, i.e., it becomes a self-reinforcing momentum play (e.g., Tesla), or it becomes a contest to see which player can dream up the most arcane and alchemical of financial instruments (such as accrued before the Great Recession in derivatives, collateralized debt obligations, and yes, even the subprime mortgages themselves). The Great Put was well in place before the latest, greatest recession, but the Fed shocked the world when it let Lehman Brothers fail, enduring relentless criticism in the breach. The financial markets now know, and depend on the knowledge, that another Lehman Brothers failure would never be allowed to happen. It doesn’t take long for this sort of risk underwriting to completely queer the capital allocation mechanism of markets.
It is a tragedy because the Fed has effectively outlawed failure, which is to say, it has effectively frozen the whole of the economic system in time, and in particular, it has frozen things at the time that obtained just before the Great Recession crack-up (sans Lehman). Vibrant, healthy economic systems are dynamic. Capitalism depends on creative destruction—on a continual stream of competitors seeking to do things better and more efficiently—for the dynamism that makes them such prolific generators of wealth. The Fed, through its Great Put eliminating the prospect that old firms might fail, has commensurately and severely diminished the prospect that new firms might appear and prosper. Think for a moment. How many new firms have arisen since the Great Recession (not how many have floated IPO’s)? There have been maybe a few, and some new products developed in technology (iPhones, iPads, etc.), but we still have three domestic automobile manufacturers (one of which is foreign owned), even if the upstart, Tesla, now exceeds the market capitalization of the smallest of the three (Chrysler). K-Mart, Sears and JCPenny, retailing dinosaurs if ever there were any, are still around. Oil is still the fuel of choice for personal conveyances, and Exxon is still the largest and most profitable oil company in the world. Nothing ever changes if nothing is allowed to fail. Capitalism works best when it most closely mimics nature; when the firms within it undergo a continual striving for survival and are allowed to sometimes lose in the struggle. The Fed, with its tragic prohibition on failure, is effectively like a William F Buckley conservative, standing athwart economic evolution, commanding that it stop.
But what would happen if confidence in the Great Put evaporated? What if the new Fed Chairman (putatively, Janet Yellen) said all the wrong things? What if she did not promise to keep up the stimulus unto eternity if need be? What if she promised to allow any firm that mismanaged risk or lost in the marketplace to fail? What if she somehow realized the error of the Fed’s ways, or simply wanted to stamp her tenure with a bit of initial drama, and immediately moved to end the cash infusions propagated by the Bernanke Fed? Would the world end? Would it be Financial Armageddon? In the short run, yes. Financiers would be in a panic. Their bonuses might be less than enough to buy the rental home in the Hamptons they had their eye on (the one that had just come on the market, which conveniently sat right next to the vacation home they already owned). Their wives, who married them for their money as much as the financiers married them for their looks, would be looking to find new markets to hawk their wares. It would be terrible, horrible, ugly and bad, at least for the financiers. Banks would fail, but mainly just investment banks. Consumer banks should chug along just fine, as their liabilities are insured by another means than the Great Put (i.e., the FDIC).
The real economic system would suffer temporarily. It would see a spike in the unemployed, as prices spiraled downward, making current wages prohibitively expensive. But people have gotta eat. They have to put clothes on their backs and roofs over their heads. Laborers in flyover country would certainly experience a bout of hard times. But the crops would still grow. Roofs would still go up. Like the Hank Williams song, “everything [would eventually] be okay”. And finally, the inefficient and the fraudulent would be exposed, like a pile of smelly clams on the beach when the tide goes out. They would fail, never to be seen again. But most importantly, the potential for creation would instantly increase with all the destruction. And the parasitic financial system might finally have its economic system diet reduced. It might finally again exist to serve the economic system, upending its current configuration of manipulating the economic system to serve its purposes. With a bit of luck, the rage might even yield the actual, not just metaphorical, tarring and feathering of bankers and financiers. And over time, wages would recalibrate to reflect the new economic reality. A McDonald’s Big Mac meal would soon enough cost about the same hour of minimum wage labor as it did before the calamity.
Is there a possibility that markets might lose confidence in the Fed sua sponte, i.e., on their own? Indeed, at some point, regardless of what the Fed does, financial markets will have to awaken to the notion that money doesn’t buy anything, that goods and services buy things, no matter how much intervening additions to the money supply obtain between the transactions. And that demographic realities, not just in the US but in the whole of the developed world and much of the upper tier developing world, mean that robust aggregated economic growth is simply not possible. World populations won’t soon start declining, although in some developed world countries (e.g., Russia, Japan) they already are, but they are growing older, and old people generally need fewer goods and services (except medical care). There are few possibilities for aggregate economic growth in systems with aging and declining or stagnant populations. And this is true no matter what sort of delusions central bankers try to engineer to impregnate their systems with the appearance of growth. Eventually markets will be forced to accede to the reality and recalibrate their confidence that central banks can make everything okay no matter the underlying economic fundamentals. Once this happens, which is apt to take a while, essentially the same processes as would have obtained with the Fed (or other central banks) admitting impotence and shrugging the shoulders will ensue. Asset and consumer prices would decline, perhaps precipitously for a while. Unemployment would spike. Aggregate economic activity would contract, temporarily at least. But people would not simply cease to exist. They would need food, clothing and shelter, as always, and from that base of transactions, economic activity would slowly recover, and in a fundamentally more stable manner, and with a currency that sends truer signals of value and thereby does a better job of allocating capital (presuming the Fed stayed out of things).
Alan Greenspan, in interviews promoting his newly released book, recently observed that stocks appear to have a lot of room on the upside. Greenspan is the architect of the Great Put. His was the first Federal Reserve Board to get directly involved and concerned with stock market events. In particular, Greenspan’s Fed came to the rescue of the seriously overbought stock market in 1987 when it suffered its biggest one day crash in percentage terms since the Great Depression. From there, the notion that the Fed stood as the ultimate underwriter of financial system risk, no matter the quarter from which it arose, gradually accreted to the point it is today (getting a big boost from its rescue of LTCM in 1998), where financial markets see bad news for the economic system as good news for them. Greenspan also famously wondered whether the markets had not become possessed of an “irrational exuberance” in 1996, only halfway into the ascent that would end in tears in late 2000 with the tech stock bubble and crash. In 2004, he celebrated the triumph of adjustable rate mortgages in better managing interest rate risks for both the borrower and the lender. And just before retiring from the Fed in 2006, he proclaimed that any fallout from defaulting subprime mortgages could be easily contained.
If Greenspan is now touting stocks, my impulse is to say it may be time to sell. But the point is that Greenspan didn’t even come close to understanding what might arise from the implications of his Great Put. Though his stock in trade was the confidence engendered by the Great Put, the misplaced confidence ultimately resulted in greater financial and economic instability, not more. The same is true today of the policies Bernanke has pursued (except in letting Lehman fail) since taking over the helm of the Fed just before the onset of the subprime debacle and the ensuing financial market meltdown. Bernanke has no more clue than did Greenspan as to what might result from his monetary machinations. The net effect is greater, not lesser, financial market instability. The Great Put will one day yield to another Great Crash, such is the nature of misplaced confidence.
John Maynard Keynes believed central bank action, coordinated with central government activity, was necessary to lift an economic system out of the doldrums, with the aim of the system achieving its full potential, primarily meaning the full employment of its workers. Through a complicated train of reasoning, he answered the laissez faire economists’ claim that economic systems were self-adjusting by purporting to show an economic system could reach equilibrium in its labor markets at a high level of unemployed labor, justifying the need for central bank and government intervention. His central bank prescription—more and easier credit and money—was intended to bring the cost of labor down relative to the cost of capital so that labor might be fully employed. It is a policy for dealing with economic contractions now employed the world over. And it works. But foremost among the side effects is that it lulls the dynamism of the capitalist economy into a sort of complacency. An unnatural illusion of stability ensues.
Living organisms, such as are economic systems, are never completely stable. Only dead organisms are stable. In a living organism, stability in one realm requires the sacrifice of stability in another. Thus the appearance of stability that occurs when economic systems are juiced to full employment by central bank machinations masks the instability accruing through the misallocation of resources. Eventually the ledgers have to be cleared; events like the Great Recession must eventually accrue. Bernanke’s Fed has managed to just nearly return the US, and therefore much of the world, to the same point as before the Great Recession. The misallocation of resources grows. Another great ledger clearing is on the horizon. But probably not on his watch.
Janet Yellen would be wise to acknowledge the unsustainability of the current situation, and move immediately to end the continual delivery of monetary stimulus to the financial markets by the Federal Reserve. She could do for the Federal Reserve and the welfare it dishes out to the financial system what Bill Clinton did for the federal government and the welfare it dished out to crack whores. She is considered “dovish” on monetary matters, always willing to try more stimulus, just as Clinton was considered a friend of the liberal welfare state. It rendered him well positioned politically to undertake its meaningful reform, and the same could be true for Ms. Yellen.
Everyone it seems, except the Federal Reserve, can see the financial bubbles inflating, even those who benefit temporarily from them. Larry Fink, CEO of Blackrock, the world’s biggest money manager, is saying it is imperative that the Fed begin tapering its purchases of bonds. Bill Gross, chief of PIMCO, the world’s largest bond fund manager, says that all risk assets (are there any others?) are artificially high.
There is a financial reckoning ahead, and one that will take the economic system along with it, at least for a while. The longer the Fed continues pumping a flood of money into the financial system, the larger will be the detrimental impact on the economic system when the dam bursts. In other words, the sooner the reckoning comes, the better and less painful will be the ensuing adjustment, and particularly so for the real economy.
The fundamental weakness of the American economic system, and it has been its fundamental weakness since the 1970’s, is that American labor is too costly relative to its international peers. There have been a succession of work-arounds, from vehicle import tariffs in the eighties, to capitalists offshoring American production to China and others in the nineties, to refusing to enforce immigration laws in the 2000’s while employees replaced income with debt, growing wildly overleveraged. All the work- arounds happened in the context of a Federal Reserve doing whatever it could to achieve its dual mandate of low inflation and full employment. The reality remains. Americans are paid too much in wages and benefits (mainly the latter, which Obamacare will only serve to exacerbate) to compete with their peers internationally. Couple the reality with a workforce that is rapidly aging and a population whose growth rate has fallen, even including immigration, below 1% per year, and there is no possible way that financial market valuations increasing over 20% in a year’s time even remotely reflect economic realities. The sooner the discordance is resolved the better, for both systems.
So it’s time for sanity from the Federal Reserve. Go ahead and break the financial system of its dependency. Yes, Main Street will feel some of Wall Street’s pain. But Main Street is tough and resilient. The folks out here in flyover country are descendants of the people who settled this land and bent it to their will, and they did it long before a financial system arose to tell them how. They’re already in pain, but can stand some more, if doing so will shake the parasitic financiers from their backs.