Depressions, and severe recessions, attract protectionism.? It’s the nature of the beast.? So long as political pressures are “to do whatever it takes to create prosperity” at home in the short-run, governments will target spending to domestic firms (an increasingly squishy concept in a global world).? What politician would defend to local constituents a bailout package where foreign firms directly benefit from the expenditure of domestic tax dollars?
Though I did not vote for him, I appreciate the principled approach that President Obama is taking here.? He is taking a longer view, and wants to avoid trade wars.? Few politicians take the longer view; that is why they not statesmen.
By their nature, economic crises make people short-termers.? They look to what will help themselves survive amid volatility.? The long-term good of many would involve patience, and a willingness to not press for short-term advantage.? Perhaps Kings could do that, though often they didn’t, but democratic officials are on a short leash from their electorates.
Even Authoritarian places like China tend toward protectionism, though.? Their legitimacy is based on their ability to deliver continued prosperity.? There is increasing unrest in China during this slowdown; expect the Chinese government to do what it can to appease its populace, including measures that protect local businesses.
That’s why I am not surprised at protectionist impulses at this time.? They are short-term rational for politicians, while long-term irrational for economies.? This is just another reason why we are foolish to trust in politicians to assure our economic well-being.? Their short-term orientation is out of sync with what it takes to manage an economy.
We will be best off if after this crisis we realize that the government played a starring role in creating it, and mismanaging it.? Were there businessmen to blame?? Yes, but they took their cues from financial regulators that stopped regulating, and an accomodative monetary policy.? The government did not do its job right, assuring the value of currency/credit.
2) Speed really benefitted us during the original passage of the TARP, right?? No, it didn’t.? So where does Timothy Geithner get off urging speed at this point?? Speed does not eliminate bad debts.? Speed does allow for many venal legislators to push their own pet projects, and use a crisis to disguise their efforts.
3) Read Yves Smith’s piece:The Bad Bank Assets Proposal: Even Worse Than You Imagined.? Our government resists letting banks fail, and then letting the FDIC/RTC2 reconcile them.? They would rather intervene to let marginal or defunct entities live.
What I am about to write will sound out of character.? In writing, I often try to strike a balance between what should be, and what is possible.? In this piece, I am temporarily ignoring what should be, for what could help solve our economic problems at minimum societal cost.? Please understand that I am a principled man who hates inflation, but with the doofuses that mismanage the Fed, I am aiming for “second best” policies here.
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Al McGuire, past coach of Marquette Basketball, was once asked (something like), ?Would you rather have an A student or a C student at the free throw line in a tense situation??? His answer was the C student, because he wouldn?t think about the situation, he would just act, and sink the free throws.
The current Fed is clever.? Too clever by half.? They have aimed for a trifecta of fixing short-term lending markets, not raising inflation, and stimulating the economy.? Though they may have had modest success with the first goal, the second goal has been rendered irrelevant, and the third goal is a failure.
It would have been better if the Fed had simply revved up the printing presses (virtual as most of them are), and began monetizing the government debt.? That is too crude of a strategy for our central bankers, who have delicate constitutions, and are fighting a war that ended 20 years ago.
How would higher inflation help the current situation?
Wages and the nominal value of collateral underlying loans would rise, reducing credit stress.
People and institutions would stop sitting on their savings waiting for prices to fall further before acting.
Inflation would cheapen the dollar, making imports more expensive and exports cheaper, stimulating the US economy.
Inflation would reduce the real value of debts owed to foreigners.
The Fed is wasting its time with its alphabet soup of credit easing programs.? They accomplish almost nothing for the real economy, while lavishing liquidity on markets that tangentially help financial institutions.? That is a great way to aid average Americans, not.
Far better to fire up the helicopters (that’s a figure of speech), and mail a check for $1000 to every person with a Social Security Number (or their parents if they are in their minority).? All of the complexity in the TARP and in the stimulus bills could be dispensed with, if we trusted the American people.? Give them the money, not the credit markets.? The people know better than the Fed.? After all, who is the Fed supposed to serve?
Historically, In times of extreme credit stress, the US has acted in this way, to relieve the stress of an indebted population through inflation.? (Think of bimetallism.)? Though I am not crazy about inflation (it will hurt me), nonetheless it would be good for the nation as a whole.? (Of course, with harm to those on fixed incomes.)
Mortgage rates would rise, and other interest rates would rise, harming economic activity, but the economic tempo would still increase as people would seek to use their money before it declines in value.? Inflation is a cost worth paying in order to get the economy moving again, giving debtors some breathing room.
This post is supposed to be a kind of “catch up” post, where I write about a number of small things that I thought were interesting, but weren’t worth a full post.
1) The government can’t fund everybody. The recent backup in the US treasury note market is a great example of that.? As the demands for funds now in exchange for funds later has increased, Treasury interest rates have risen.
I have several biases, but one of them is that the Government can’t unilaterally create prosperity.? It can create conditions that encourage economic activity, through predictable and fair laws, but it can’t make us immediately better off through deficit spending, or tax-and-spending.? The Government does not know what is needed to a better degree than its citizens do individually.
But let the government fund or guarantee everybody.? When they do that, there is just one overleveraged credit that matters, and it will fail, taking us with them.
2) Equity Private is one clever lady.? Fair value accounting primarily exists to deal with investments that are as volatile as equities. How are publicly traded equities valued?? At market.? How about volatile assets where the value is derivable from market prices?? They should be valued at pseudo-market.? If we were back in the old days, and all of our assets were bonds, we wouldn’t need fair value accounting.? Even if we did it, the values wiould not vary much. ? But when you slice and dice the various pieces of bonds, the volatile bits jump around a lot.? To value them at their initial value is ridiculous, the value is too volatile.
3) Felix is right.? There needs to be more of a debate over bank nationalization.I’ve written my pieces there, influenced by the better regulations of the insurance industry, and how they deal with insolvencies.? Mark assets to market.? Do the triage.? Send insolvent institutions to RTC 2, and take stakes in some marginal institutions.? That is where the money will do the most good.
4) “We have to buy up assets that are selling at fire sale prices.? We will even make money for the taxpayers.” So go the arguments of those that want to create a “bad bank”.? Oh, please.? Profits are rare in bailouts.? They happen by happy accidents, a la Chrysler (80s, not now), which possibly could have made it without a bailout.
Assets are at fire sale prices because there is not enough balance sheet capacity to buy and hold them over a period where the realization of value is likely.? I’ve seen structured assets rated AAA where the collateral is okay, and the likely realization of value is in the 90s, if you can hold it for 5 years.? Where does it trade?? Around $60.? Another asset, which would likely be worth $35 if it could be held for 15 years, where does it trade?? It doesn’t trade, but you could get rid of it to a broker for zero.
Strong balance sheets can’t be created out of thin air, though.? Remember how formidable Fannie and Freddie used to be, or many of the FHLBs?? Strong balance sheets only exist through investments where the cash flows will not be needed for decades, like pension and endowment plans.
5) Some commentators complain that the current crisis destroys the concept of efficient markets, because a trust in markets led us to failure. Oh please.? First, all of our markets were by no means free from government mismanagement, and many of the distortions came from poor regulation.? Our dear government had many lending programs pre-crisis, and even more post-crisis.? They further encouraged the increase in debt through the tax code.
Why is debt finance tax deductible, and equity finance not?? What might the system have been like if interest payments could not be deducted on taxable income, but dividends could be?? Leverage would have been a lot lower, and the system would be a lot more stable.
Market efficiency means many things.? In the short run, it means that no one can do better than the current situation. In the intermediate-to-long term, markets are efficient in a different way.? They reveal problems that need to be solved.? Some might call those market failures but they aren’t.? In the present crisis, the invisible hand is saying to us: reduce debt levels; your economic system in too inflexible.? The visible hand, the government, says: “Have some more of the hair of the dog that bit you.? We need lower mortgage rates.? We need more consumer lending.? We’re going to borrow more than ever before in an effort to create prosperity.”? Caroline Baum takes a similar view, and as usual, she expresses it well.
Market efficiency does not mean things are trouble-free, but it gives us sharper incentives to solve our problems.? Some things become revealed as truly public goods that the government needs to regulate.? But that is not the majority of human actions.
6) AIG is one black hole for cash.? Selling or IPO-ing units during the bust phase, when valuations are compressed does not seem to be an optimal strategy here.? If all of the assets were sold, would there be enough for the junior debt or preferred shareholders to get paid?? (Forget the common.)? So, in the face of it, do they IPO partial stakes in enterprises, with an eventual end of IPO-ing or selling the whole thing later?? If so, there is little free cash flow being generated to pay down debt.
What this implies to me is that the huge loans that the government made to AIG will likely hang out there for a long time.? Is this the best use of the government’s credit?? I think not.? If there are still systemic risk issues, wall those off separately, and send the rest of AIG into liquidation.? The insurance units are intact; let others buy and manage them.? Speculating on a future boom in asset prices is not a reaonable government policy.? Hope is not a strategy.
7) It is simple to blame the US for the current global crisis.? Simple and wrong. The US deserves blame, true, but not even the majority of the blame, just a slightly larger than proportionate amount for its size.
But when China blames the US, it goes too far.? In the era of neo-mercantilism, China had political goals to achieve.? Industrialize the country.? Get surplus workers off of the farms and into the cities.? Keep the currency undervalued to support export-led growth.? Force savings through restrictions on imports.? As a result, suck in developed country debts and companies where strategically desirable and possible.? Do these deals in their currencies because of the need to keep the Yuan cheap.
China made its bed, let it sleep in it.? They knew that they were lending to the US in its own currency; it was a necessary part of the bargain to achieve their own goals.? Just as the mercantilists sucked in gold, and then found it to be less valuable than they imagined when they had to draw on it, so it will be when nations want to draw on the US dollar assets that they have hoarded.
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My phrase, “the humility of realism” is meant to get us thinking about the system as a whole, and about the long-term consequences of societal actions, whether by the government or private parties.? Humility says that sometimes we have to say, “No, we can’t.”? It also says that we should think carefully about major policy actions, and not let ourselves get bullied by those who rush, shouting “crisis, crisis,” while quietly angling for their favored pet projects to get swept in while no one is looking.? Realism sometimes means the government has no good solutions, so it should inform the public that they aren’t omnipotent, and humbly say the crisis must be borne with grace.
The problems generated by the short-termism of the past three decades will not get solved by more short-term thinking.? The present rush to assure prosperity will not end well, in my opinion.
How do you create a Black Swan? It’s not that hard.? Start with something that you know is seemingly useful, true or good.? Then slavishly rely on that idea until it fails.? I’ll toss out a few here:
The more people that live in houses that they own, the better.? The government should encourage home ownership.? You should own the biggest house you can afford.? (In 1986, a Realtor pitched me with that idea, and I thought it was dumb then.)? Residential housing is an investment for the masses; the prices never go down for the nation as a whole.
Continually maximizing return on equity will maximize stock prices.? Optimal capital structures and all times.
We all want high, smooth returns from our investments — high Sharpe Ratios, everyone!
Proper central banking practice can lead to near-permanent prosperity with moderate volatility.
Our government can borrow without limit to promote or common prosperity.? Our central bank can cleverly intervene in markets with their assets, and fix things without getting stuck, or creating inflation.
Many ideas that are good marginally aren’t so good if pressed to their logical absurd.? By duping marginal homebuyers into buying what they could not afford, we create a black swan — I remember commentators who were saying as late as 2006 year end, that home prices never went down across the nation as a whole.? It wasn’t true if you looked at the Great Depression or episodes in the 19th century, but people beieved that housing prices could not go down, so they piled into it creating a boom, a glut, and now a bust and a glut.? Behold the Black Swan!? Rapidly falling housing prices across the nation as a whole.
Consider the buyback craze, now deflated.? Was it good to buy back like mad in 2004-2006?? I would tell insurance management teams to leave more of a buffer for adverse deviations.? But it was always easier in the short run for insurance CFOs to buy back more stock, and earnings would rise.? Stock prices would improve as well, and that’s fine during the boom cycle, for then, but many would issue expensive hybrid junior debt with an accelerated stock repurchase.? Short term smart, long term dumb.
The insurance industry is my example here, but it went on elsewhere.? How many acquiring CFOs wish they had used stock rather than cash for the last major acquisition that they did?? Most, I’m sure.
There is always a boom-bust cycle, and there is ordinary trouble during a normal bust phase.? But when the boom phase has parties abandoning all caution, possibly with government acquiesence, the boom gets huge, and the bust too, where the Black Swan appears — things you thought could never happen.
The craze for smooth, high, uncorrelated returns led to a boom in alternative strategies in the investment business.? Return correlations change not only due to cash flows on the underlying investments, but also due to investor demand.? Not so amazingly, as alternative investments go mainstream, the returns fall and become more correlated.? When an alternative is new, typically only the best ideas get done.? When it is near maturity, only the marginal ideas get done.? Alternative asset prices get bid up along with the boom in conventional assets.
Now we get a Black Swan — all risk assets do badly at the same time.? Investors in private equity don’t want to fund their commitments.? Some venture capital backed firms will fail (here and here).? Many hedge funds raise their gates, all at the same time, because investors want out.? Liquidity is scarce.? Companies pay in kind where they can, whether it is on “covenant lite” loans, REIT dividends, etc.? The era of buying back at high prices gives way to equity issuance at low prices.
Now for my final Black Swan, and perhaps the most controversial.? Monetary policy is “optimal” when it follows the Taylor Rule.? A good central banker, applying the rule, should minimize inflation and macroeconomic volatility.
My argument here, which seems intuitively correct to me, but I can’t yet prove, is that continuous application of the Taylor Rule will eventually lead us into a liquidity trap.? That might be more due to the human nature of sloppy central bankers like Greenspan, who want adulation, and err on the side of monetary lenience.? Or, it might be that the central banker overestimates the productive capacity of the economy.? Whatever the reason, we followed something pretty close to the Taylor rule for 15 years, and now we are in a liquidity trap of sorts.? I’ve suggested it before, but perhaps monetary policy should not focus on (at least solely) price inflation or unemployment, but on the level of total debt relative to GDP.
As with so many things in a complex capitalist economy with fiat money, there may not be a right answer.? Optimizing for one set of variables often leads to unforseen pessimizing (a new word!) another set of variables.? What works in the short run often does not work in the long run.
In closing, consider a Black Swan of the future.? Governments globally nationalize financial institutions, run huge deficits and borrow a lot of money to do so.? They “stimulate” the economy through targeted spending, and ignore the future consequences of the debts incurred.? They do it in the face of the coming demographic bust for the developed nations plus China.? My expectation is that these “solutions” will not do much to deal with the economic weakness induced by the debt overhang.
As Walter Wriston famously said, “A country does not go bankrupt.”? Perhaps what he should have said was the country remains in place, only the creditors get stiffed.? Short of war, it is tough to reorganize or liquidate a country.? But I’lltake the sentiment a different way and say that most people believe “A developed country does not go bankrupt.”? That is the black swan that will be displayed here, and Iceland is the harbinger of what might be a future trend of developed country sovereign defaults, or their close cousin, high inflation.
The Federal Open Market Committee decided today to establish akeep its target range for the federal funds rate ofat 0 to 1/4 percent.
Since the Committee’s last meeting, labor market The Committee continues to anticipate that economic conditions have deteriorated, and the available data indicate that consumer spending, business investment, and industrial production have declined.? Financial markets remain quite strained and credit conditions tight.? Overall, the outlook for economic activity has weakened furtherare likely to warrant exceptionally low levels of the federal funds rate for some time.
Meanwhile, inflationary pressures have diminished appreciably. Information received since the Committee met in December suggests that the economy has weakened further.?Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending.?Furthermore, global demand appears to be slowing significantly.?Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight.?The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant.
In light of the declines in the prices of energy and other commodities in recent months and the weaker prospects for considerable economic activityslack, the Committee expects that inflation to moderate furtherpressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.
The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability.? In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.
The focus of the Committee’s policy going forward will beis to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustainare likely to keep the size of the Federal Reserve’s balance sheet at a high level. As previously announced, over the next few quarters the The Federal Reserve willcontinues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand itsthe quantity of such purchases of agency debt and mortgage-backed securitiesthe duration of the purchase program as conditions warrant.?The Committee is also evaluating the potential benefits of purchasingis prepared to purchase longer-term Treasury securities.? Early next year, the if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.?The Federal Reserve will also implementbe implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal ReserveCommittee will continue to consider waysmonitor carefully the size and composition of using itsthe Federal Reserve’s balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Christine M. CummingWilliam C. Dudley, Vice Chairman; Elizabeth A. Duke; Richard W. FisherCharles L. Evans; Donald L. Kohn; Randall S. Kroszner; Sandra Pianalto; Charles I. Plosser; Gary H. Stern; and Dennis P. Lockhart; Kevin M. Warsh.and Janet L. Yellen.? Voting against was Jeffrey M. Lacker, who preferred to expand monetary base at this time by purchasing U.S. Treasury securities rather than through targeted credit programs.
Quick Hits
The ZIRP will continue for a long time, like Greenspan’s ill-considered 1% policy.
Credit easing will persist.? Lacker seems to want the less complex quantitative easing.
The Fed will purchase longer duration debt than is ordinarily done.? I will continue to buy mortgages and agencies.
They are hoping for recovery to begin in late 2009.
We will not see a normal Fed balance sheet for a long time.
So, though I am nowhere near as good a writer as Mr. Woodward, perhaps my knowledge of the markets might give me a good perspective on what Ben Bernanke should try to understand from his predecessor’s tenure.? With Greenspan, since monetary policy works with a lag, we have a better perspective today on what the true effects of his tenure were.
1) How you accept contributions from lesser players has an effect on policy.
Dr. Laurence Meyer gave a speech once, called Come with Me to the FOMC.? He explained how Alan Greenspan ran FOMC meetings, among other things.? When Greenspan wanted to assure a certain result, he would vote first.? If he was certain of the outcome, he would vote last.
Greenspan also enforced message discipline on FOMC members — there was a party line.? Give Bernanke credit, he lets the main players of the FOMC speak their own minds.
Because Greenspan had quite a reputation for promoting prosperity, this led to groupthink at the highest levels of the Fed.
2) A willingness to throw liquidity at every market fire creates the Greenspan Put.? The promise of liquidity is not free, because economic actors become more aggressive as bad debts are rescued rather than liquidated.
It began with the crash in 1987.? Greenspan was more than willing to throw liquidity at the crisis. Better he should have been silent, and let the market work its way out of the crisis.? He did the same thing with Mexico and RMBS in 1994, Commercial Real Estate in the early 90s, LTCM/Asia/Russia in 1998, Y2K in 1999-2000, and the aftermath of the tech bubble in 2001-2002.
Throughout his tenure the debt/GDP ratio grew, exceeding levels last seen during the Great Depression.? Bad debts grew, leading to our eventual crisis today.
3) Monetary policy should consider asset prices.
Greenspan was unwilling to consider the effect of asset prices on monetary policy in any major way until the end of his term.? Consider this CC post:
When Alan Greenspan Talks, the Market Listens (Apologies to E.F. Hutton)
8/26/2005 10:32 AM EDT
As Alan Greenspan does his “Farewell Tour,” today in Jackson Hole, Wyo., he said the following in his speech:
The structure of our economy will doubtless change in the years ahead. In particular, our analysis of economic developments almost surely will need to deal in greater detail with balance sheet considerations than was the case in the earlier decades of the postwar period. The determination of global economic activity in recent years has been influenced importantly by capital gains on various types of assets, and the liabilities that finance them. Our forecasts and hence policy are becoming increasingly driven by asset price changes.
The steep rise in the ratio of household net worth to disposable income in the mid-1990s, after a half-century of stability, is a case in point. Although the ratio fell with the collapse of equity prices in 2000, it has rebounded noticeably over the past couple of years, reflecting the rise in the prices of equities and houses.
Whether the currently elevated level of the wealth-to-income ratio will be sustained in the longer run remains to be seen. But arguably, the growing stability of the world economy over the past decade may have encouraged investors to accept increasingly lower levels of compensation for risk. They are exhibiting a seeming willingness to project stability and commit over an ever more extended time horizon.
The lowered risk premiums–the apparent consequence of a long period of economic stability–coupled with greater productivity growth have propelled asset prices higher.5 The rising prices of stocks, bonds and, more recently, of homes, have engendered a large increase in the market value of claims which, when converted to cash, are a source of purchasing power. Financial intermediaries, of course, routinely convert capital gains in stocks, bonds, and homes into cash for businesses and households to facilitate purchase transactions.6 The conversions have been markedly facilitated by the financial innovation that has greatly reduced the cost of such transactions.
Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they perceive as newly abundant liquidity can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums. In short:
Greenspan is factoring asset prices more into FOMC decisions.
Greenspan sees market players as more willing to take risk than before, and thus “risk premiums” are low. (Low credit spreads, investor-owned housing has negative carry, flat yield curve, etc.)
The stability engendering the willingness to take more risk has allowed financial institutions to lever up more.
Greenspan thinks this won’t work out well in the long run.
No one can tell what Greenspan’s successor will do, but rhetoric like this indicates an inverted curve until excesses (real or imagined) can be wrung out of the system.
The market reacted badly when his speech hit the wires. It will do worse if the FOMC carries through on the logical implications of what he has said. (Leaving aside for a moment the friendly foreigners that are more than undoing the FOMC’s tightening actions…)
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Now this had little effect for most of his term, but at the end he was worried.? Reality was catching up with neoclassical dogmatism.
4) Greater length of monetary tightness is a good thing, as is shorter lengths of monetary looseness.
Greenspan had a willingness to loosen for too long, and an unwillingness to let monetary tightness really bite.? This was another part of the Greenspan Put.? He was never willing to disappoint the asset markets for too long.? There is some evidence that he used Fed funds futures to set policy; during the Greenspan years, it was a very good predictor of policy.? I began to wonder whether the tail was wagging the dog.? Fed funds was such a good predictor of Fed behavior one month in advance of FOMC meetings that one did not have to consider much else.
5) Don’t tolerate bad bank loan underwriting.
The Federal Reserve leads bank regulation in the US, and they encourage bank examiners to be tough or loose.? There was a long period of encouraging looseness in bank regulation, and it has led to significant loan losses in our banking system.
In a fiat money system, control of credit is the key thing.? Allowing the banking system to run amok is not helpful to free market economics, because of the resultant depressions.? The ability of banks to extend credit should be limited; without limits, or with loose limits, banks encourage the economy to overexpand, leading to recessions, and occasional depressions.
6) Don’t allow banks to own any assets that you don’t understand, or can’t be valued in tough market environments.
Regulators must bar regulated entities from buying financial instruments that cannot easily be valued.? Regulated entities must be safe institutions even if it hurts their ROEs.? Greenspan encouraged a simple-minded approach to derivative instruments, without considering the systemic effect from their use.
Securitization was another tough concept.? Banks and pseudo-banks originated loans that they would not have if they had to retain them themselves.? That created more systemic risk.
Banks should have been barred from holding assets that were new.? By new, I mean any class of assets that has not suffered market failure, so that the loss potential and illiquidity during a bear market could be estimated fairly, and the proper risk-based capital level set.
By encouraging banks to use their own internal risk models, Greenspan and those that favored the Basel II framework encouraged banks to make aggressive assumptions, and do more business than their capital could bear.
7) Don’t become a tool of the Executive branch, nor of Congress
Greenspan happily sat beside First Ladies during State of the Union Addresses.? He met with the executive branch more than any other Fed Chairman.? He facilitated the economic politics of the government, regardless of who was there.? Consider the plunge protection team during the LTCM era, or his statements after Black Monday in 1987.
Better Fed Chairmen dissed both Congress and the executive, and did their duty.? Consider Volcker during the hard times, William McChesney Martin, or Thomas McCabe.? They opposed the political establishment, and left monetary policy tighter than the politicians would have liked.
8 ) The Fed Chairman should not be the Chief Economist of the US
Perhaps it is another way of running down the shot clock when in front of Congress, but the Fed Chairman is not supposed to be a political figure.? Questions not pertaining to maonetary policy should be ignored.? Score a few points for Ben Bernanke.
Aside from that, Greenspan had many dumb comments over — Irrational Exuberance, ARMs, and Derivatives including Credit Derivatives.
9) Obfuscation pays, but jawboning the markets only works in the short run.
Adam, your question is very applicable. My view on Greenspan is that he tries to get the market to do his bidding, rather than always using the explicit policy tools that the Fed has. He speaks ambiguously for a number of reasons:1. If he speaks too clearly, the market will immediately adjust to what the Fed is going to do, and the actual use of their policy instruments will have little impact.
2. He genuinely tries to express the degree of uncertainty inherent in the data and theory underlying economics, as well as the political backdrop.
3. If he answers too quickly and directly, he will get more questions. In basketball, this is called “running down the shot clock.”
4. I think he uses obfuscation tactically to make it easier to adjust market expectations. He can give occasional clear statements to bump the bond market where he wants it tactically to go in the short run, which may be different than where he thinks it has to go in the long run.
5. I think he enjoys it.
At present, I think Greenspan wants to keep things near where they are, which allows the economy to grow fairly rapidly to absorb labor market slack. To me, that means targeting the 10-year Treasury between 4% and 4.50% or so. Unless there is a marked pickup in his favored inflation gauge, or a huge decline in the dollar, I don’t see the FOMC being compelled to raise the fed funds rate. To raise rates for the abstract reason of reducing leverage in the fixed income market will not play well politically, particularly in an election year.
All my opinions, but I have been watching the Fed for 20 years…
No stocks mentioned
In addition, because Greenspan had such a good reputation during his time as Fed Chairman, obscure comments would be reinterpreted to favor the the views of the one questioning Greenspan.
We are currently in an era where jawboning does not work well, because of the overleverage in the financial system. Jawboning works when economic actors are unafraid of systemic worries, and are only concerned with relative performance in the own local markets.
But it led market players to think”Hey, the Fed has my back,” and so they could take more risks on average.
10) Merely because measured employment is strong, and measured inflation is low, does not mean monetary policy is being conducted properly.
There are three factors that led to monetary policy to be more asset-inflationary, leading the more credit-sensitive monetary aggregates to expand more aggressively while measured consumer price inflation remained low.
First, foreigners were willing to stimulate the US economy in excess of the Fed in order to build up their own manufacturing bases. As such, foreign central banks bought in our debt, financiang our current account deficit, helping our interest rates go below where they would have been in their absence. Bernanke and Greenspan called it the “savings glut,” but they should have tightened policy to compensate.
Second, demographics favored high employment and low inflation, as the Baby Boomers entered the prime of life. Through their institutional agents, pension plans, and their own private actions, a greater amount of risk was taken to finance the future cash flow needs of the Baby Boomers. P/Es were bid up, and interest rates bid down through the 80s, 90s, and 2000s.
Credit spreads were bid down as well, culminating in three major credit boom-busts, which peaked in 1989, 2000, and 2006, respectively. Monetary policy facilitated those cycles by being too aggressive in providing liquidity, creating the boom. The punchbowl should have been taken away sooner. At least, margin requirements should have been raised.
Third, through securitization, more credit was extended than in previous periods relative to the Fed’s ability to control it. Some securitization went on outside of the banks, so it was outside of the Fed’s direct control. Some went on through the banks, but the banks bought many of the securitized debts, the creditworthiness of which is presently suspect. As I argued above, the Fed should have not allowed the banks to invest in asset classes that had not been through a failure cycle.
The Fed should have leaned against the wind on all of these factors to slow down the aggressive growth of debt that now paralyzes our economy. To the extent that that is not in their charter, blame should be laid at the door of Congress. But since the Fed has responsibility for the health of the banking system, they should have addressed these three factors, and considered monetary policy in broader terms.
Instead, Greenspan aided every boom, and never let the busts clear away marginal investments by coming to the rescue too soon. That is his legacy, and we are living with it now.
Since 1996, I’ve been aware of research that indicates that momentum works in the stock market.? My quandry as a value investor has been to figure out how to incorporate it, if at all.? My approach was to play for the weaker mean-reversion effect, and have a lower turnover rate than would be needed in a value plus momentum strategy.? I am now questioning that decision, even though I have done well in the past. I just finished the initial stages of an analysis that will be available to my clients highlighting the value of momentum strategies.? Using the industries in the S&P 1500 Supercomposite, from October 1995 to December 2008, investing in the Supercomposite yielded an annualized price return of 4.0% (with dividends 5.5%).? The annualized price return for each momentum quintile, where momentum was defined as return over the previous 200 business days, was as follows:
Top — 11.3%
Second — 4.4%
Middle — 6.5%
Fourth — 1.7%
Bottom — 0.2%
Now, there are several weaknesses with this analysis:
No trading costs.? (I think those could be minimized.)
Some industry groups are small, and could not accommodate a lot of money.? (Probably a large problem)
That said, even with those difficulties, there should still be some excess return from following a momentum strategy.? What industries would that imply at present?
Education Services
Brewers
Biotechnology
Water Utilities
Insurance Brokers
Environmental and Facilities Services
Hypermarkets & Supercenters
Health Care Services
Packaged Foods
Pharmaceuticals
Gold
Multi-Utilities
Restaurants
Tobacco
Household Products
Home Improvement Retail
Food Distributors
Distillers & Vintners
Reinsurance
Food Retail
Integrated Oil & Gas
Health Care Technology
Airlines
Health Care Supplies
Electric Utilities
Distributors
For a quick summary, think staples, utilities, health care (excluding insurance), and other industries with stable cash flow.? This is about as bearish as it gets, so be careful for now, and don’t speculate on when the turn in the economy will come.? Focus on what consumers always need. Or, as James Grant once said (something like), “Could this be a bull market in cash?” 😉
This leson goes way back with me, to my graduate student days, where I was assisting the teaching of Corporate Financial Management.? At UC-Davis, this was the class that attracted the bright and motivated students.? I happened to get it as my first assistant role at UCD, not realizing it was a plum role.
One of the things we taught was that most firms suffer financial distress from a failure to manage cash flow properly.? That is a salient lesson in the current environment.? I learned it again as a young life actuary, because life insurance companies can die from credit risk, run-on-the-company risk, or both.? Consider Mutual Benefit, which wrote fixed-rate GICs [Guaranteed Investment Contracts] putable on a ratings downgrade, or General American and ARM Financial, which wrote floating-rate GICs putable on a ratings downgrade.? The downgrades hit.? They were toast.
Illiquid assets must be funded by equity or long-term noncallable debt, where the term is as long as the asset’s horizon.? (Near asset price tops, longer, near bottoms, long enough for comfort.)? This is the first step in orthodox risk management: assuring that you can hold onto your assets under all conditions.
But in this current crisis, this rule has been violated many times:
Investment banks and mortgage REITs that relied on short-term repo funding.? Bye-bye, Bear and Lehman.? Mear miss to Merrill, protected by Bank of America.? Many mortgage REITs dead, or nearly so.
Derivative counterparties like AIG do not factor in the need for more collateral during times of credit stress.
ABCP and SIVs presume that easy lending terms will always be available.
This is the advantage of the actuarial model of risk over the financial model of risk.? I have previously called it table stability versus bicycle stability.? A table always stands, whereas a bicycle has to keep moving to stay upright.? What happens if markets stop trading in any reasonable fashion?? WIll you be broke?? I submit that that is not an acceptable risk to take, because markets do fail for moderate amounts of time.
Better to manage such that you can buy-and-hold for moderate lengths of time, with enough financial slack to tide over rough patches in the market.? Analyze your cash flows over pessimistic scenarios, and ask whether you can carry your positions with sufficient certainty.? Sell down your positions to levels where you are comfortable.
When I was the risk manager for two life insurance companies, one of the first things that I did was analyze the illiquidity of my assets and liabilities, making sure I had liquidity adequate to fund illiquid assets.? The second was analyzing cash flow needs and making sure there was always more cash available than cash needed, under all reasonable scenarios.
This is risk management at its most basic level.? Many on Wall Street looked at short-term asset/liability correlations, and missed whether they could adequately finance their businesses under stressed conditions.
With that, I ask you:
Do you have an adequate liquidity buffer against negative events?
Are you only risking money that you can afford to lose in entire?
Are the companies that you own subject to financing risks?
Asset allocation is paramount in investing.? Bonds and cash get sneered at, but they play an important role in risk reduction for both individuals and institutions.? As my boss at Provident Mutual taught me, “Never risk the franchise.”? That motto guided me, and I avoided crises that other companies suffered.
Will it be the same for you and your assets?? Analyze your survivability in personal finance, and that of your assets, and make adjustments where needed.
Required reading: a word from my favorite deflationists — bond investors that have beaten all others handily, at Hoisington Investment Management.? They agree with my view that most of the actions taken by our government are useless or even counterproductive.? They cite Kindleberger, Schumpeter, MInsky and Kondratieff.? I would add in the Austrians.? High levels of debt and debt complexity lead to large recessions/depressions eventually.
High levels of debt and debt complexity rob an economic system of flexibility.? So long as the debt is increasing, there can be one tremendous boom.? But when the asset cash flows can no longer carry the debt, the system goes into reverse, with falling asset values. During that time, monetary policy is useless, and fiscal policy is useless, until the debt levels are reconciled.
We are in the midst of a great experiment.? Are the Neoclassical heirs of Keynes right?? Can you prevent a depression via loose monetary and fiscal policy?? Since loose monetary policy led to this crisis, why should looser policy solve it?
Also, fiscal policy has been loose for seven years — should extremely loose fiscal policy solve the problems?? And what of those who lend us money?? Should they be happy with dilution of their claims on the US economy?? What if they stop lending, which is in their long-term interests to do, but not in their short-term interests?
As for the Federal Reserve, with all of their cleverness regarding credit easing versus quantitative easing, the problem sill remains.? The central bank attempting to fix a lending market becomes a new offeror of credit, at rates the private market won’t touch.? As the central bank brings the rates down, grateful borrowers borrow, but private lenders would hang back, unless they became convinced that there was nothing to fear in the absence of central bank lending.? That’s pretty tough to achieve.
I don’t like quantitative or credit easing.? If we are going to be Keynesians here, let’s let the money supply expand, creating real inflation, and raise the nominal prices of homes that are currently underwater.? Rather than trying to be too clever, and trying to solve all problems without inflation, let’s have inflation.? I don’t think the problems can be solved without a rise in the price level, which will also make foreign countries adjust their policies to match US actions.
I don’t find the Federal Reserve exit strategies credible.? As we have learned before, introducing subsidies is easy, removing them is hard, and it doesn’t matter if the subsidies are monetary or fiscal.
My view is that we will go through continued deflation until the pain is too hard, and then we will experience inflation in a big way.? Thus I continue to advocate TIPS, and short corporate debt.? Away from that, I encourage caution — focus on companies that can survive the worst.
When assets deflate, a lot of hidden problems emerge.? Long term guarantees seem quite expensive, as the ability to safely receive cash flows in the future diminishes.
That affects defined benefit [DB] pension plans.? When times were good back in the late 90s, DB plans raised their expected earnings rates on assets, which depressed contributions, and made the plans look even better funded than they were.? Flash forward to today — one decade later pension assets have done little to nothing, but the liabilities have inexorably accrued forward at their discount rate.? Now corporations and states need to make contributions to their DB plans when they can least afford it.
Think of endowments.? They are shrinking at a time when it is more difficult to get charitable donations.? Charities are shrinking activities as a result, at a time when more charity could be socially useful.
Think of charitable giving from the rich, which stems from the donation of appreciated assets.? There are few appreciated assets at present, and who wants to give extra from their operating cash flow when times are so uncertain?
Consider companies that bought other companies near the peak of the boom, or soon thereafter.? They are facing a hard road in debt service.? This applies to private equity as well.
Now think of governments.? They happily expanded programs, with little care for the future, as long as real estate and stock values were expanding.? The wind was at their back.? But now, with asset prices down, and transaction volumes diminished, the economic winds are in their faces.? What state (aside from Alaska) has a big enough “rainy day” fund?? Now states and municipalities are squealing for bailout cash.? Wonderful.
Even the Federal Government in in the same spot, but they have a printing press behind them, whether they issue money or debts.? They don’t have to run a balanced budget, so long as lenders comply.
Even foreign countries are exposed to hidden leverage.? Countries with large export sectors, where the government helped promote economic growth though subsidizing imports, are hurting now.? There was only so much additional demand that could be generated, and those markets are saturated now.
“You don’t know where the rocks are in the harbor until the tide goes out.”? Well, the tide is out, and most of the rocks are visible.? Firms with bad balance sheets have been revealed.? Entities relying on prosperity are being shamed.
I have said for a long time that leverage needs to come out of our economic system, and our government is fighting something that is inexorable.? We pushed too hard at the limits of what our economic system could deliver, and now the system demands a big pause to reconcile bad debts.
We will go down kicking and screaming on this one because the Keynesian received orthodoxy is so blind.? But eventually the need to reduce total financial leverage will be heeded, after every other wrong solution is pursued.
. There would certainly be a good parallel piece there.”
