Milton Friedman won his Nobel Prize for demonstrating the centrality of monetary policy to an economy. As a profound believer in monetarism, I would be the last to question his wisdom. Nevertheless, there are times when other economic events have made any politically feasible monetary policy entirely irrelevant. In the United States, we now appear to have arrived at such a time.
However misguided its policy, the Fed certainly cannot be said to have been irrelevant over the last decade. In 1995-2000, even after recognizing the dangers of an excessive speculative bubble, Alan Greenspan’s Fed continued to expand the money supply, and allowed the U.S. stock market to inflate to a level unparalleled in world history, more bubbly than 1929, more bubbly than the South Sea Bubble itself, and matched on a smaller scale only by the Japanese property and stock market craziness of the late 1980s.
Then after the stock market bubble burst in 2000, instead of allowing the market to deflate to a level at which it was once more properly valued, Greenspan pumped further liquidity into the system, reducing short term rates to a 1% level at which they were heavily negative in real terms. This created a housing and low quality mortgage bubble that was in some respects even larger than the stock market bubble, producing house prices in real terms far above those ever seen in the land-rich United States, and leading to a mortgage default downturn of which we have only seen the barest beginning.
Nevertheless, at this point, the Fed has ceased to have any influence. Loose money, sustained for a decade, has produced bubbles in stocks and housing, both of which have been followed by damaging downturns, with much destruction of wealth. Having been overdosed with the drug of easy money, the U.S. economy has now become more or less immune to its effects, so that only a spectacular loosening or tightening of monetary policy by the Fed would be likely to affect an economic future that in most respects appears to be “baked in.”
On the housing side, the sub-prime mortgage market has collapsed and no amount of Fed money creation, short of handing out $25,000 to every sub-prime borrower, is going to change that. Mind you, judging by the comments of Senator Christopher Dodd (D.-CT) I wouldn’t entirely put it past this Congress to do that, which would indeed rescue the dodgier end of the housing market, at the cost of an exploding budget deficit and galloping inflation. Thus I don’t claim that it is impossible for anyone to affect the U.S. economy, I merely claim that it is impossible for the Fed to do so by monetary means alone.
Square miles of trees are being cut down to print editorials claiming that the sub-prime mortgage market is tiny, and will affect no other part of the economy. This is nonsense. For one thing, the underlying asset financed by a sub-prime mortgage may be very well be next door to an asset financed by a conventional mortgage. For another thing, according to the Wall Street Journal of 21st March, low or no documentation housing loans (funny how their cute name “liar loans” didn’t become popular until the mortgage market collapsed!) increased to 49% of the total in 2006, and represented 81% of the Alt-A market, itself representing 20% of home-purchase loans. Also 46% of home purchasers made a down-payment of 5% or less in that year.
If this column is right in forecasting a house price decline averaging 15%, most of those loans will go into default. The estimate given here two weeks ago of $980 billion in actual loan losses (which would represent well over $1.5 trillion of defaults) is looking increasingly realistic. Nothing the Fed can plausibly do at this stage will affect this, and it will inevitably cause a deep and grinding recession.
On the other side of the coin, the Bear has been arguing for half a decade that the Fed is keeping interest rates too low, and has suggested several times in the last couple of years that it should raise the Federal Funds rate to around 8%, the minimum level necessary to combat inflation, which when you correct for the distorted U.S. price statistics, is over 4% and rising. (British retail price inflation is currently 4.6%, and Britain never ran so foolish and inflationary a monetary policy – the Bank of England’s interest rate minimum this cycle was 3.5% not 1%.) Without such a rise, real interest rates will remain below their equilibrium level and inflation will continue trending upwards.
Does anyone believe the Fed will actually do this? If it had done it 18 months ago or even six months ago, much good would have accrued, but if it did it now, it would simply be blamed for a housing collapse and an economic recession that are inevitable anyway. Even in 1979, after several years of rapidly increasing inflation, with a predecessor railroaded out of office and with a President generally held to be economically inept if not illiterate, it took great political courage for Fed Chairman Paul Volcker to raise interest rates sharply and conquer inflation. What’s more, he was helped by the election victory of Ronald Reagan halfway through the process, and even then pressure against him from the new Administration was building up dangerously towards the end. There can’t be any question, can there, that if Jimmy Carter had by some malign miracle won the 1980 election Volcker would have been forced to abandon the fight against inflation halfway – after all, the Federal Funds rate reached 19.3% and even 10 year Treasuries came to yield 15.3% before the process was completed.
Having changed its policy last Wednesday, shifting its stance from “tightening” to “neutral” it is in any case likely that the Fed’s next interest rate move will be downwards. This will do nothing for the housing sector, beyond slowing its decline somewhat. The inventory of unsold homes is too great, the downward momentum in prices too well established, and the number of unsound mortgages that will turn into defaults simply by the passage of time too extraordinary for housing to recover in any but the longest timeframe.
While it does nothing for housing, a drop in interest rates, and the consequential further loosening in money, will flow instead to the sectors that are most eager for it. In today’s market there are two such sectors, the “alternative investments” world of speculative private equity funds and hedge funds, and commodities. More money into commodities (not to speak of Elvis memorabilia and other collectibles) will simply accelerate inflation further, until even Ben Bernanke has to do something about it.
The effect of directing more money into hedge funds and private equity funds is more pernicious. Hedge funds have destabilized the world financial market, leaving it perilously vulnerable to the collapse of one of their many speculative shell games (such as the yen carry trade, apparently endangered earlier this month.) Private equity funds are doing even more damage, by breaking up stable and profitable companies, leaving them vulnerable to the next downturn and bereft of their better people and much of their long term assets. There can be no possible economic benefit, for example, in a breakup of Cadbury Schweppes, an icon of British quality, simply to satisfy the ravening maw of the aging raider Nelson Peltz, whose track record is long but distinguished only by the corporate mayhem he has wreaked.
It is possible that a sharp rise in inflation over the next few months will cause the Fed to reverse its perennial tendency towards monetary easing and raise short term rates but so what? If it moves interest rates ¼ point at a time, it will not catch up with accelerating inflation, whereas even the first such move will be used by politicians and witless homeowners to blame it for the chaos in housing. It is thus not surprising that the Fed has not done anything for the last six meetings. Indeed there is very little point in its meeting at all, since it cannot move interest rates either way without getting blamed either for worsening inflation or the housing collapse, both of which are its fault, but only on a long term view.
Believers in the Gold Standard will tell you that the U.S. economy would be much better off with a fixed monetary base and no Fed. That may very well be so, but today we have the worst of both worlds, a Fed which is paralyzed, unable to act usefully in either direction, but whose past misdeeds are leading to a uniquely malign combination of deep recession and accelerating inflation.
The Great Depression was worse, but with all due respect to Friedman and Anna Schwarz’s “Monetary History of the United States” the Fed was only partly responsible for that. Yes, it contracted money supply after the failure of the Bank of the United States in December 1930. However the Fed did not pass the protectionist Smoot-Hawley tariff, nor was it responsible for the completely counterproductive and highly damaging income tax increase (the top marginal rate rising from 25% to 63%) passed by the lunatic Herbert Hoover at the bottom of a deep recession in 1932.
A closer parallel is the Panic of 1837, lost to memory in the mists of U.S. history, but unquestionably longer and more unpleasant than any recession other than the Great Depression. That was caused by Andrew Jackson’s defeat of the Second Bank of the United States, which balkanized the U.S. monetary system after the economy had been constructed on the basis of a central monetary authority and a single currency freely available throughout the growing country.
From 1837 until the National Banking Act of 1862, the United States effectively did not have a single currency. No central authority existed to print banknotes, and gold was scarce, so banks were forced to issue their own notes, and to take the notes of distant banks in payment – naturally, notes of rural banks were accepted only at a heavy discount. Without a common currency, trade was stifled, resulting in a recession that rivaled the Great Depression in depth and lasted for eight years.
It is a sobering thought that when the currently pending problems have fully hit we may have to go back 170 years to find monetary policy errors equaling those of Fed Chairmen Greenspan and Bernanke.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)