Dislocations: Financial and Fundamental
The crash of 2007 was more than a bank panic. Thirty years of excessive borrowing had reached a point where something was certain to topple it. Alan Greenspan deplored "irrational exuberance" in 1996, but only in 2007 did everybody try to get out the door at the same time. The crash announced the switch to deleveraging, it did not cause it.
Why Bother Investing?
In a sense, money is worthless until you spend it.
Right Angle Club: 2013
Reflections about the 91st year of the Club's existence. Delivered for the annual President's dinner at The Philadelphia Club, January 17, 2014. George Ross Fisher, scribe.
Traditionally, the biggest financial problem for governments -- whether kings or democracies -- have been paying for wars. The Revolutionary War (Robert Morris and the King of France), the War of 1812 (Stephen Girard), and the Spanish American War (J.P. Morgan) were essentially financed by a single institution allied with the government. However, the Civil War, World Wars I and II, were so big that ways of spreading the debt had to be found. In all wars, monarchs seek to maintain control of the nation in spite of their own uneasy dependence on funding sources. The Federal Reserve founded in 1913 was thus founded as a private institution with a Federal partner; it was a public-private partnership.
The enormous sums involved created temptations to extend the Fed's power beyond wars into other cataclysmic financial events. The nature of war changed, both as a cause and a consequence. However, in a sense, politics never change. We hear congressional chairmen ask why the private sector has so much to say, and we hear bankers announce the government has no place in private finance. The Federal Reserve itself maneuvers within boundaries of its "independence". Most central banks have a mission statement limiting them to maintaining price stability (against both inflation and deflation), but the United States Federal Reserve has the additional mission of reducing unemployment. Recently, the targets are stated to be 2% inflation and 6.5% unemployment. The Fed Chairman, Ben Bernanke, now seems to feel the traditional tool of manipulating interest rates is inadequate for severe economic shocks, and perhaps inadequate to maintain both goals indefinitely. He has therefore introduced a novel approach, mysteriously called Quantitative Easing.
Acting as the lender of last resort, central banks have used their regulatory power over banks and currency to manipulate short-term interest rates. Because commercial banks make a profit in the spread between low short-term borrowing and higher long-term lending, the "yield curve" controlling short term rates is ordinarily an adequate lever for Fed purposes to control long rates indirectly. This is possible because so many short-term loans are rolled over repeatedly; the extra interest for a similar long-term bond represents public attitudes about the risks of the future. However, in major financial upheavals adjusting short term rates may become inadequate, and Bernanke sought a way to control long term rates directly throughout the private economic sector.
By controlling both ends of the spread, Bernanke gained more control, but with lessened market guidance, he acquired a greater risk of misjudgment. In any event, the Federal Reserve began to accumulate huge amounts of dubious or "distressed" debt. Andrew Mellon once advised Herbert Hoover to "wring the rottenness out of the system". Mellon meant that any bank foolish enough to offer loans to weak counterparties, deserved to go bankrupt, while those foolish enough to accept such loans deserved to be punished. Although such utterances by a very rich man were politically unacceptable during a depression, Mellon was surely correct in observing that extreme financial panics were basically a psychiatric problem. Irrational exuberance occasionally drives markets too high, panic then drives them too low. The modern twist is, at the turn, when everyone tries to get out the door at the same time, markets can freeze up. Mr. Bernanke civilized Mr. Mellon's approach somewhat, but the underlying idea was the same: get the bad loans out of circulation, so bankruptcies and foreclosures stop feeding public overreaction. Underneath this approach runs the assumption most people are not hopelessly overextended; the economy is basically sound. However, bankruptcy has one advantage here, over gentler kinder ways of isolating bad from further injuring the good. When an institution disappears, its problems are permanently removed from the economy. To a large degree, "sterilizing" operations are only useful if market crises are really artificial ones, which fail to notice how sound the economy really is. As our measuring systems get more precise, of course, market crises might someday actually represent the facts of the matter.
Three signal events extended Mr. Bernanke's latitude to act. His personal credibility had been enhanced by successful QE1 management of the 2008 freeze-up of financial markets. He had loaned when others were reluctant, unfroze the markets, and returned a profit for the government. Secondly, the two-decade Japanese recession showed how "zombie banks" resulted from paralyzed inaction on bad loans. And third, the Scandinavian countries had a glamorous recovery from a brief depression, apparently as a result of adopting Calvinistic punishment of economic exuberance. It was a fearsome "good bank, bad bank" approach. The general public may not have this view of events, but they meant a great deal to the Federal Reserve Board of Directors. His credibility allowed Bernanke to survive his unsuccessful attempt through QE2 to stimulate the economy with trillions of dollars in make-work employment financed by the public sector. In essence, QE3 consisted of buying every bond the market refused to buy, even including billions of dollars of mortgage-backed bonds where politicians were excoriating into accepting prices lower than their probably worth. The Federal Reserve accumulated trillions in bonds but did not pay for them by printing money, but rather by increasing the reserves of commercial banks. This allowed them to pay essentially zero interest rates, but maintain a steep interest curve (between short and long term) as an inducement to the banks to loan. So far at least, banks have refused to loan, partly because banks are trying to de-leverage thirty years of excessive lending, and partly because chastened borrowers refuse to borrow. Meanwhile, the "hard goods" the public had accumulated, autos and refrigerators, mergers and infrastructure, were gradually wearing out; someday they would need to be replaced and constitute "growth". In the meantime, the Fed seems to plan to retain the bad debts in its vaults, safely immune to "marking them to market", which is to say holding them until the bond markets assign them higher values while proclaiming their current market value is temporarily under-appreciated. Nevertheless, these bonds will eventually reach their expiration date, and the market price at that moment will reveal the true cost of replacing them with new loans. With charming modesty, Mr. Bernanke admits there are many outcomes he is unable to predict.
Although Ben Bernanke has not announced it, he seems presently willing to hold these bad debts indefinitely. Interest rates are low, so not only is it cheap to hold them, but their value is artificially overstated. Presumably, however, he is unwilling to run a Zombie Federal Reserve indefinitely. Interest rates will, therefore, return to normal, sending the interest cost to the government soaring. Somehow, the public repeatedly fails to appreciate that lowering interest rates increases the market value of bonds by making money appear like magic, whereas raising interest rates depresses bond values by making money vanish. It requires a vibrant economy to withstand such a shock, so raising interest rates can easily precipitate a deep recession. At the first sign of interest rates rising, the prices of all bonds could plummet. Almost every investment advisor in the nation is already advising clients to "lighten up" on bonds. Meanwhile, the elderly small savers holding their savings in banks, are suffering from lack of income; it is remarkable there has been so little complaint, but when it comes, it will persist and have political force. Somewhere the spring is coiling. One real danger is the economy will still be unready for normal interest rates when politics force them to go up. It is frequently estimated to require ten years to be sure that (unlike 1937) a major second depression will not emerge when short-term government debts come due. The big problem with all borrowing that never changes is that someone expects you to pay it back.
Another bleak possibility is that a currency war will break out during the vulnerable interval. The U.S. dollar recently declined sharply, and other countries responded immediately with devaluations of their own. That may have been a test, but if it was, we failed. Just as industries will move to a U.S. state with low taxes, they will move to nations with undervalued currencies. The new multinational corporation permits rapid internal transfers within companies that they need not move their headquarters. Immigrants do move, and if forcibly restrained, will start riots or even revolutions. Currency wars are also very bad news, powerfully inhibiting government action. Consequently, there is a tendency to substitute international debt default, which is the same thing as devaluation in being sudden and done with, unlike inflation which can be insidious. Since it cheats foreigners more than local citizens, politicians prefer devaluation of the currency. But otherwise, there is no great difference between devaluation and inflation.
To repeat, there is little difference between Country A inflating, and Country B defaulting. Mr. Bernanke has temporarily sterilized the inflation alternative by funding his QE3 by expanding bank reserves rather than printing currency. Unfortunately, this has so far hardly stimulated bank lending at all, which itself is beginning to tempt private investors to get directly into the banking business because it offers them a chance for high yield. However, if any significant number of university endowments or pension funds try their hand at being bankers, they are apt to learn there is more to banking than they imagine.
If Quantitative Easing becomes widespread in a world-wide recession, some nation is going to prove to be insolvent. That is, when the central bank has sold off the profitable or break-even securities in the portfolio, the probability exists that some country will find it cannot service its debt. That debt anyway has been shown to be worthless because no one will buy it. Its credit may then be worthless, its currency without value, its markets in an uproar, and its people in revolt. Other countries will be urged to support the failing one, and who knows how panic will spread. Somewhere along the line, the bond markets may take "the bull by the horns" and -- and what? If foreign governments try to intervene, their own currency could plummet. There is, indeed, quite a lot we don't understand.
So it all boils down to two disastrous alternatives for the Federal Reserve to start liquidating QE3 bonds before the economy recovers. Either the bond markets intervene, or the Federal Reserve just continues to hold those trillions of bonds indefinitely, as a Zombie central bank. We could have a second recession, or another rush to get out the door. The prospects are so horrifying that we all have to hope Mr. Bernanke keeps his cool, and gets lucky. As a fallback, whether all that sequestered debt could be transformed into the international reserves for a new Bretton Woods agreement, is now too distant a prospect for outsiders to have a reasoned opinion about. Nevertheless, the interest earnings of debt that large might be able to moderate considerable deflation. Further, the seemingly unlimited ability to create or destroy money through interest rate manipulation should be able to modulate considerable volatility of currencies, perhaps of economies. Ever since the gold window was closed in 1971, it has been asked whether currencies without the backing of some commodity can survive, and the present economic travail may be the test of it. But since an international currency exchange probably cannot be created except in a crisis, let's hope we never have to learn the answer.
Originally published: Wednesday, February 13, 2013; most-recently modified: Sunday, July 21, 2019