The Fed, Debt, and Forecasting

There's a room where the light won't find you
Holding hands while the walls come tumbling down
When they do
I'll be right behind you
--Tears for Fears

Wanted to reflect on some thoughts expressed by Fleck in his fine Rap last night. The hysteria in Washington could not have reached this point without the Federal Reserve. The Fed has been the great enabler.

Although the predicament we now face was ensured when the Fed was chartered into existence one hundred years ago, the situation clearly escalated in the 1990s. Fed chair Alan Greenspan forced conditions of easy money during a vibrant economy and consequently blew a huge stock market bubble. When that bubble burst in the early 2000s, Greenspan eased monetary conditions further, and then handed the baton to Ben Bernanke who did more of the same.

The result was a massive real estate bubble that almost took down the financial establishment when it popped. Fortunately for the big banks, the Fed came to the rescue once more. It lifted 'troubled' assets from bank balance sheets in exchange for cash, it provided access to near no-cost loans that enabled banks to regain their speculative form, it influenced changes in accounting regs that no longer required banks to mark troubled assets to market, and it undertook bond buying programs that allowed banks to lock in sweet profits from bond purchases.

This last step, which as come to be known as 'Quantitative Easing,' has also been important to the federal government. Because it is buying $40-45 billion/month of Treasuries, the Fed has created demand for US sovereign debt that would not be there at these prices. By monetizing debt, the Fed is keeping borrowing costs of the federal government well below free market rates.

Fleck contends that despite all the disaster the Fed has wrought on this country, people still view this institution as a capable manager of financial and economic systems. He is amazed at how foolish or at least how gullible people can be.

He may be right, but a counter view is that many people, particularly those who shape power structure, know exactly what is going on. They understand that the Fed has massively distorted financial and economic systems to the point where failure is nearly certain. However, they believe that the day of reckoning remains far off, and that it might even be pushed farther out into the future. Meanwhile, these people are interested in grabbing as much as they can before, as Chuck Prince once famously alluded, the music stops.

Because the Fed's inflationary actions almost magically transfer wealth into the hands of the power structure, these people will be the last ones to call out the Fed.

Overspending and massive debt are classic consequences of central bank policy. The Fed has blown this debt bubble. The greater the debt, the shorter people's time horizons. This is because growing leverage drives greater sensitivity to smaller unanticipated changes in price. If action isn't taken on these unanticipated price changes, the system can quickly slide into insolvency.

Unfortunately, the shorter people's time horizons, the lower the capacity for accurate forecasting--meaning that people are less capable of anticipating the very price changes that they must anticipate in order to manage a hyper-leveraged system.

Perhaps this is the most severe consequence of all. The policies of the Federal Reserve are destroying our capacity to reasonably peer into the time tunnel and anticipate the risk of an oncoming train.