Jelly Donuts

"You guys can...keep the donuts."
--Terry McCaleb (Blood Work)

I've read (and written) my fair share of critiques about Fed policy, but I found this column by David Einhorn among the more thought provoking that I've come across. Thought provoking because he makes a number of points that I found counter-intuitive or particularly insightful. I plan to chew thru this missive a few more times, and to reflect on some salient points on this blog. Here's one of them.

Einhorn first observes what many of us know. The Fed is engaged in policies that it hopes will energize the economy after a credit bust.  Unfortunately, the policies are like jelly donuts, junk food that has little lasting nutritional value. After a brief sugar high, the economy heads back to the doldrums. The Fed's misguided belief is that an ever increasing diet of jelly donuts will do the trick.

Personally, I prefer the drug analogy a bit better because of the dependence and moral hazard fostered by consuming narcotics. But metaphorical choice is not the primary issue here. Instead, Einhorn's real insight comes via his explanation of why such policies are prone to produce undesirable outcomes.

Central to current Fed actions is the lowering of short term lending rates to essentially zero (a.k.a. zero interest rate policy or ZIRP), buying non-performing assets from leveraged financial entities (a.k.a. Troubled Asset Relief Program or TARP, and Quantitative Easing Part One or QE1), and buying longer dated Treasuries to lower longer term borrowing rates (a.k.a. QE2 and Operation Twist). The Fed has also telegraphed that these sorts of policies are likely to be in place thru at least 2014!

The Fed hopes that these policies will a) increase borrowing, and b) force people out of low risk assets (cash, bonds) and into higher risk assets like stocks and real estate.

Neither is happening to a great degree. And while many believe these policies essentially put a floor under the stock markets (a.k.a. 'the Bernanke put'), Einhorn thinks that the real Fed put is under the bond market.

The average person is already carrying significant debt and little real savings. Incrementally lowering interest rates long past the threshold that would have governed behavior in a free market design, is unlikely to to generate significantly more borrowing. As Einhorn observes, if projects don't make sense at 2%, they are unlikely to make sense at 1% or even 0%. This helps explain behavior in the housing market.

Meanwhile, folks invested in stocks over the past ten years have experienced at least two big declines, and many may be out of this asset class for good or at least a long time (I'm reminded of the Great Depression Generation). Not only that, but many of these folks were short on savings to begin with and are now more focused on saving for the future. This intensity may supercede low rates. In other words, people are becoming more interested in return of capital rather than return on capital.

And what asset class is perceived as being ultra safe? Why, Treasuries of course. And, as Einhorn observes, all of the Fed's interventionary policies signal to savers that Treasury prices will not go down.

It should be no surprise, then, that we are seeing huge inflows into Treasuries despite their low rates.

Moreover, Einhorn argues that by telegraphing its long term committment to ZIRP, the Fed has essentially devalued time. Instead of encouraging borrowing and spending in the present, signaling ZIRP thru at least 2014 destroys sense of urgency. Why make a decision to take on risk now if low-cost financing is available thru 2014?

The italicized phrases are the real thought provokers. They run counter to common (read: Fed) wisdom and explain why on-the-ground economic behavior appears to be 'undermining' Bernanke's best laid plains. Fed policies can be seen as promoting saving rather than spending, longer rather than short time horizon, and preference for bonds over stocks.

Not sure you'll find better examples of the law of unintended consequences that torments central planners.