At the meeting of the eight bloggers and the US Treasury, one of the differences was whether the recovery was real or not. The Treasury officials pointed to the financial markets, and the bloggers pointed at the real economy (unemployment and capacity utilization).
With T-bills near/below zero, I feel it is reasonable to trot out an old piece of mine about the last recession. But I will quote most of it here:
I posted this on RealMoney on 5/6/2005, when everyone was screaming for the FOMC to stop raising rates because the “auto companies were dying.”
On Oct. 2, 2002, one week before the market was going to turn, the gloom was so thick you could cut it with a knife. What would blow up next?
A lot of heavily indebted companies are feeling weak, and the prices for their debt reflected it. I thought we were getting near a turning point; at least, I hoped so. But I knew what I was doing for lunch; I was going to the Baltimore Security Analysts’ Society meeting to listen to the head of the Richmond Fed, Al Broaddus, speak.
It was a very optimistic presentation, one that gave the picture that the Fed was in control, and don’t worry, we’ll pull the economy out of the ditch. When the Q&A time came up, I got to ask the second-to-last question. (For those with a Bloomberg terminal, you can hear Broaddus’s full response, but not my question, because I was in the back of the room.) My question (going from memory) went something like this:
I recognize that current Fed policy is stimulating the economy, but it seems to have impact in only the healthy areas of the economy, where credit spreads are tight, and stimulus really isn’t needed. It seems the Fed policy has almost no impact in areas where credit spreads are wide, and these are the places that need the stimulus. Is it possible for the Fed to provide stimulus to the areas of the economy that need it, and not to those that don’t?
It was a dumb question, one that I knew the answer to, but I was trying to make a point. All the liquidity in the world doesn’t matter if the areas that you want to stimulate have impaired balance sheets. He gave a good response, the only surviving portion of it I pulled off of Bloomberg: “There are very definite limits to what the Federal Reserve can do to affect the detailed spectrum of interest rates,” Broaddus said. People shouldn’t “expect too much from monetary policy” to steer the economy, he said.
When I got back to the office, I had a surprise. Treasury bonds had rallied fairly strongly, though corporates were weak as ever and stocks had fallen further. Then I checked the bond news to see what was up. Bloomberg had flashed a one-line alert that read something like, “Broaddus says don’t expect too much from monetary policy.” Taken out of context, Broaddus’s answer to my question had led to a small flight-to-safety move. Wonderful, not. Around the office, the team joked, “Next time you talk to a Fed Governor, let us know, so we can make some money off it?”
PS — Before Broaddus answered, he said something to the effect of: “I’m glad the media is not here, because they always misunderstand the ability of the Fed to change things.” A surprise to the Bloomberg, Baltimore Sun, and at least one other journalist who were there.
And now to the present application:
Why are commodities rising amid surplus conditions in storage? Why is it reasonable to take over corporations when it is not reasonable to expand organically? We are in a position where yields on short Treasuries are nonexistent, investment grade and junk yields are low for corporates, and equities are rallying, but there is little growth, or some shrinkage in productive capacity. Why?
The liquidity offered by the Fed is being used by speculators for financial positions, levering up relatively safe positions, rather than speculating on areas that are underwater, like housing and commercial real estate. This is consistent with prior experience. When the Fed does not allow a significant recession to occur, one proportionate to the amount of bad loans made, but comes to the rescue to reflate, what gets reflated is the healthy parts of the economy that absorb additional leverage, not the part that is impaired because they can’t benefit from low rates. They have too much debt already relative to the true value of their assets.
That is why a booming stock market does not portend a good economy. Banks aren’t lending to fund new growth. They are lending to collapse capacity through takeovers. ROE is rising from shrinking the equity base, not by increasing sales and profits.
There is another current application:
Why do we buy commodities as investments? Is it that we fear inflation in the short or long run? Is it that it is a proxy for future prices for consumption in retirement, so we are hedging the future price level in a dirty way?
Think about it. How do you transfer present resources to the future? Most consumable goods can’t be stored, or require significant cost for storage. Services can’t be stored; elderly people can’t store up health care.
Storage occurs through building up productive capacity that will be wanted by other at a later date, such that they will want to trade current goods and services for your productive capacity. Storage also occurs by purchasing goods that do keep their value, and then trading them for goods and services you need when the time come to consume.
That is how one preserves value over time, and it is not easy. It will be even harder if there are such disruptions to the economy that markets that are virtual do not survive. (I.e. paper promises are exchanged, but their is significant failure to deliver at maturity.)
In an environment where the government is playing such a large role in the economy, it is difficult to see how one can invest for the long term — when we are twisted between deflation and inflation, rational calculations are circumscribed, and simple judgments, such as buying out a competitor and shrinking the overall balance sheet are made. In one sense, that is the rational thing. Less capacity is needed. But unemployment will rise.
That’s sad, but wage rates may be too high for some to be employed, given the lack of demand. I view this as true in aggregate, but people that are aggressive in seeking employment are able to do much better. I have seen it. Even in a bad market, those that strive intelligently get hired.