The Fed's Misdirection

Confusion never stops
Closing walls and ticking clocks
--Coldplay

Another talking head that appears utterly clueless about Jim Grant's remarks on monetary policy. Grant notes that the Fed is now trying to 'enforce the symptoms of prosperity,' such as higher assets prices, without the underlying commensurate productivity.

Grant also astutely responds to the interviewer's comment about not giving the Fed enough credit for warding off deflation. The Fed's definition of deflation, notes Grant, is falling prices. Falling prices are in fact a natural outcome of a more productive society, and people spend large parts of their economic lives seeking to better their economic situation by buying goods and services at lower prices.

Central banks have fingered lower prices as the enemy, one that must be vigorously fought. The opposite is true. Falling prices are a gateway to higher standard of living. Our incomes can buy more so that we can satisfy our needs to a greater extent.

Of course, what the Fed is really concerned about is falling asset prices. This concerns the Fed for at least two reasons. Falling prices of things like stocks and real estate reduce what's known as the 'wealth effect,' a theory that posits people will spend more when their asset account balances are higher (btw, empirical evidence suggests that the strength of this relationship is quite weak). When consumption represents 2/3 of the economy as it currently does here in the US, then anything that weighs on consumption alarms bureaucrats who think that they need strong GDP numbers to win elections.

The larger concern about falling asset prices is that they stress leveraged systems toward insolvency. Leverage is using borrowed funds (a.k.a. debt) to magnify potential returns in the here and now. In investment contexts, leverage could drive higher returns on capital. In everyday life situations, leverage can promote higher standard of living today. An individual who borrows to buy a house is leveraged; this leverage is often assumed because the person wants comfort, privacy, et al that a house can provide.

But leverage works both ways. When asset prices decline, then losses decline. If there is much debt in the system, i.e. when systemic leverage is high, then it does not take much of a drop in prices to drive the value of assets below the value of liabilities, thereby creating a condition of insolvency.

This is what took out Bear Stearns and Lehman, and what brought the financial system nearly to a stop in 2008. If markets were left in their natural state, then market forces would have driven prices, debt, and leverage lower while driving savings rates higher until a certain balance was restored.

The Fed has been doing all it can to keep those market forces at bay. It has been printing $trillions to keep asset prices higher, buying distressed debt so that the debt does not get liquidated at lower prices, and fixing the price of credit near zero to encourage borrowing (certainly by the US govt) and keep leverage high. As Grant eloquently notes, 'The problem with the Fed generally is that it is imposing false values on a range of markets.'

At some point market forces, which continue to build potential energy as they are held back by monetary and fiscal intervention, will not no longer be able to be checked by the Fed and other central planners. Interestingly, this week Fed chair Bernanke confessed that he couldn't quite explain why economic 'headwinds' remain strong, which helped send his public approval ratings to all time lows. Not long ago this man held Man of the Year and superhero status).

When all of that potential energy finally turns kinetic, we may suddenly realize that it would have been much better to let the system balance out long ago.

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