An Austrian Wolf In Keynesian Sheep's Clothing
by Guy Haselmann
The world has been kept on life support mostly by government spending of
trillions of dollars and central bank printing of trillions more. Both
have boosted asset prices and given the allure of economic progress.
Over-zealous regulators, market rule changes, and aggressive policy stimulus
have temporarily stabilized markets. Market vigilantes have been hibernating,
because unclear investment rules and uncertainties around the ultimate
magnitude of stimulus have prevented them from attacking bad policies or
distorting asset price valuations.
It is difficult to know the extent that
markets and the global economy have benefited from official policy stimulus;
however, five years after the crash, economic growth and the labor recovery
remain subpar. Strong growth should have been ignited by now.
Most economists still believe in the
‘official position’ that growth is edging sustainably higher and that interest
rates will slowly rise to reflect it. They could be correct, but should it fail
to unfold as expected, confidence in the efficacy of official policy will
diminish and the social contract will break down further. Since markets require
confidence, they will also react accordingly.
Some argue that economic benefits to
stimulus have run its course, while the costs from looming unintended
consequences have not yet been unleashed. Many believe (and I am one) that the
risks and costs of current Fed policy outweigh the benefits.
Most economists still believe in the
‘official position’ that growth is edging sustainably higher and that interest
rates will slowly rise to reflect it. They could be correct, but should it fail
to unfold as expected, confidence in the efficacy of official policy will
diminish and the social contract will break down further. Since markets require
confidence, they will also react accordingly.
Some argue that economic benefits to
stimulus have run its course, while the costs from looming unintended
consequences have not yet been unleashed. Many believe (and I am one) that the
risks and costs of current Fed policy outweigh the benefits.
* * *
The Fed’s asset purchase program (QE) and
Zero Interest Rate Policy (ZIRP) are the foremost factors that have widened
wealth inequalities. The richest few have benefited the most, simply because
the 10% richest Americans own 80% of US stocks. The FOMC believe that its
asset-price-inflation-trickle-down-policy leads to spending which ultimately
leads to job creation, especially for the poor.
However, several FOMC members themselves
have questioned Fed policies, citing that they have not worked as well as had
been hoped, and pointing out that aggregate demand has been weak throughout the
recovery. To his credit Fed Governor Jeremy Stein broached the subject of
unintended consequences of Fed policies when he mentioned in his February
paper, “A prolonged period of low interest rates, of the sort we are
experiencing today, can create incentives for agents to take on greater
duration or credit risk, or to employ additional financial leverage in an
effort to ‘reach for yield’”.
Zero interest rates have incentivized corporations
to issue debt in order to capitalize on the historically low interest rates;
however, corporations have primarily used the money to pay greater dividends,
buyback shares, or modernize plant and equipment. There is a strong case to be
made that holding interest rates at zero for a prolonged period is actually
counter-productive to the Fed’s efforts to achieve either of its dual mandates.
This is because increasing productivity through modernization typically exposes
redundancies: it allows firms to lay-off workers, while the improvement in
competitiveness allows firms to drop prices.
Furthermore, and as I referenced in my
2013 paper, “Should the marginal propensity to consume of creditors exceed that
of debtors, the net effect of redistribution could be to lower household
spending rather than raise it. There are some conservative savers who have a
predetermined goal in mind for the minimum amount of savings they wish to
accumulate over time. Those investors may refuse to move out the risk curve in
search of higher yields (likely widening the wealth divide). To them, lower
interest rates simply mean a slower rate of accumulation, which likely will
jeopardize their minimum goal. The only recourse for this investor is to save
more, which is the exact opposite intention of the Fed’s policy. For example,
if interest rates fall from 4% to
3%, an investor would have to increase savings by more than 20% each year to reach the same goal over 30 years.”
3%, an investor would have to increase savings by more than 20% each year to reach the same goal over 30 years.”
Another negative result of ZIRP is that
banks and other lenders are discouraged from lending due to puny return levels;
and, therefore, the Fed’s desire to expand lending is compromised. Are lower
(or negative) interest rates supposed to increase the incentive to lend money?
To assume such is absurd. Although somewhat counter-intuitive, if interest
rates rose, then the supply of money willing to be lent would increase due to
wider interest margins.
Policies are so unprecedented and unproven
that it is possible that the Fed itself has now become a source of financial
instability. This could be the case either through the potential fueling of
asset bubbles, through its compromised ability to conduct future monetary
policy (due to it unwieldy $4 trillion balance sheet), or due to “unknown
unknowns.”
* * *
In a low to zero interest rate policy
(ZIRP) environment, investors desperately search for yield. This frequently
chases investors into assets to which they are ill-suited and to which they
will miscalculate liquidity and downside potential. Under ZIRP paradigms, riskier
assets become the best-performing. Credit spreads collapse and equities soar.
Massive monetary ‘printing’ by global
central banks has not just emboldened investors, but these actions have
collectively changed their behavior and psychology. There is evidence that
policies have led to mis-allocation of resources. Investors are emboldened to
take what many critics believe is inappropriate or reckless levels of risk. The
motto, “Don’t fight the Fed” has taken on added meaning. Moral hazard and a
deep-seated bullish psychology have become rampant.
Extended Fed promises of lower rates and a
continuation of asset purchases even as the economy heals, are conspiring to
propel prices ever-upward. Investing today has become mostly about seeking
relative yield, rather than assessing value or determining if the investment’s
return is sufficient compensation for the risk.
Simply stated, investors and speculators
receive ever-lower returns for ever-higher levels of risks. Over time, the
ability of an investor to assess an asset’s fundamental value becomes
ever-increasingly impaired. It should a warning sign to portfolio manager’s
fiduciary responsibility to maximize return per unit of risk (see market
liquidity section).
There have been persistent cycles of asset
booms (bubbles) that eventually turned to ‘busts’. Very low or negative real
rates (seen recently) always create economic distortions and the mispricing of
risk, thereby creating asset bubbles. Each ‘boom’ had some differences, but the
common factor has always been easy money which the Fed was too slow to
withdraw. Providing liquidity is always easier than taking it away, which is
one reason why the Fed has hit the “Zero Lower Bound” in the first place.
Eventually (un-manipulated) asset prices
always return to their fundamental value, which is why bubbles always pop. The
FOMC has backed itself into a corner. Current changes in policy are being
designed around efforts to manage the unwind process seamlessly. Central bank
(and government official’s) micro-management appears based on a belief that
they can exert an all-encompassing central control over markets and peoples’
lives. Those in power have come to believe that policies have a precise effect
that can be defined and managed. This is highly unlikely.
In ‘normal’ times there is a more
discernable connection between cause and effect. However, the usual
relationships particularly break down during periods of over-indebtedness,
unprecedented regulatory changes, and official rates reaching the zero lower
bound. Today, the world is far from ‘normal’. It is not difficult to imagine
the looming fallout from policies that have promoted asset price inflation, and
which have materially compromised market liquidity.
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