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Pragmatic Capitalism

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THE “BERNANKE PUT” AND THE FED’S TRILEMMA

“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done” – JM Keynes, General Theory of Employment, Interest and Money

Now that the equity market has rallied back to its pre-Lehman Brothers levels it’s becoming fashionable to shower the Federal Reserve with praise for their actions over the last few years.  But let’s not forget that we’ve seen this movie one too many times before.

Over the last 15 years the Federal Reserve has essentially become a price fixing mechanism for an economy that has long struggled with severe structural problems.   When problems have arisen in the economy the U.S. central bank has intervened to lessen the blow to the economy.  In theory, this was intended to reduce the volatility of the business cycle.  Unfortunately, many of their policies have simply exacerbated the problems or helped to generate even greater imbalances.

This all started well before the housing bubble or the Nasdaq bubble.  After the 1987 crash Alan Greenspan was quick to reassure investors that the Fed was there to bolster markets.  This “Greenspan put” was mastered with the bailout of LTCM as the Fed intervened in markets to make sure that losers didn’t have to become losers.  LTCM was the epitome of failed economic theory at work in markets.   A group of brilliant economists believed they had discovered the path to minting money in financial markets.  On paper their equations appeared flawless.  In reality, they were a disaster waiting to happen.  In one fell swoop this collection of geniuses proved that EMH was flawed.  And not two years later the Greenspan Put helped contribute to a market bubble like the United States had never seen.  In the words of David Tepper, it was a “win win” market – or so they believed.

For 18 years Alan Greenspan ran the nations central bank based on theories and beliefs that he later referred to as being “flawed”.  Despite this, much of his work influences the current central bank.  In fact, today’s Fed is more involved in markets than Greenspan ever was.   To some extent this tinkering with markets is justified.  The role of lender of last resort is important, but the modern day Fed has taken its role to an entirely new level.  They are no longer just the lender of last resort – they have become the bailout mechanism of the capitalist system and ultimately a plaque build-up in a system that is increasingly unhealthy.  The Greenspan Put has become the Bernanke Put.  And so the financialization of our markets continue.  In fairness to Mr. Bernanke I can’t entirely place the blame on him.  Due to political ignorance of our monetary system the Federal Reserve has been given the overbearing responsibility of being lender of last resort while also attempting to establish full employment and price stability.  Talk about a trilemma if there ever was one….

What these men haven’t stopped to ponder is whether any of this intervention was actually healthy for the markets.  Perhaps the market crashed in 1987 because an irrational 40% climb in 8 months had created instability?  Perhaps the Nasdaq never should have approached 5,000?  Perhaps LTCM needed to fail?  Perhaps housing was never intended to be a speculative asset?  Perhaps these assets needed to be allowed to decline?   The result has been a slow deterioration in the foundation of the system with each and every bailout.  I recently described why these imbalances continue to pose such a serious risk to the economy as we weaken the foundation from which each subsequent boom is built upon:

“What I fear most about the current cycle is that we have not allowed the markets to sufficiently clear.  If that is the case you can think of the global economy like an obese man who fights to lose weight in an effort to fend off what is an almost certain heart attack.  After a multi decade binge he suffers a massive heart attack (think LTCM circa 1998).  The doctors save him by intervening, but they don’t actually help the man fix his inherent problems (dying internal organs and lack of discipline).  In the case of the economy this is global imbalances, structural flaws in the banking system and a lack of regulation.  The man vows to lose 50% of his total body weight, but after losing 20% of his total body weight he decides the process is too grueling and is taking too long.  A fast food restaurant opens up next door (hello government bailouts!).  He once again feels the need to stimulate his lust for food.  So, he binges again (think Greenspan 2001).  A new boom occurs before he ever becomes fully healthy.  Over the ensuing 7 years his body weight doubles.  He’s now 60% heavier than he was in 1998!  Of course, this is unsustainable.  His body begins to breakdown.  Before you know it he is suffering a total system failure (think Lehman brothers).  But again, thanks to modern medicine (or incessant Fed intervention) the man is once again saved.  Over the following year he loses 25% of his body weight.  It’s an arduous process and certainly not enjoyable, but it must be done.  The good news is he’s 25% lighter.  The bad news is he’s 20% heavier than he was in 1998 when he had his first setback.  Nothing has changed inherently.  He has the same failing internal organs and the same failing disciplines.   But his next binge begins from a weaker starting point and a more dangerous level. You can imagine how this story ends.”

By continually creating a “can’t lose” market we have instilled a belief in investors and speculators that prices will not be allowed to sustain any sort of decline.  In August Ben Bernanke panicked because jobless claims briefly hit 450K.  He implemented an emergency round of quantitative easing.  Since then, his attempts to control the long end of the curve have failed spectacularly and the economic data since has proven that QE2 was never necessary to begin with (not that it would have done anything anyhow).  But what Mr. Bernanke has reinforced is this David Tepper “win win” mentality.  And it’s nowhere more apparent than it is in the commodity markets today.  After all, with an equity market and real estate bubble in less than 10 years where else can these speculators reliably turn to implement their Bernanke Put?  Some people say the Fed is not creating imbalances again, but I beg to differ.  The following charts show the imbalances that have reemerged in recent months as the Fed ensures that there are no losers:

(CRB Spot Index)

(CRB Metals Sub-Index)

(CRB Raw Industrials)

(CRB Foodstuffs)

Of course, there is a component of economic strength here.  I am not attempting to downplay the recovery.  It’s real and it’s here.  But as the past has proven, a bubbly market combined with a Fed that won’t let losers be losers, is a potent mix and an environment ripe for imbalances and instability.   It could take years for these imbalances to fully play out on the world stage, but they are building and the Fed’s constant interference in markets has only made matters worse.

QE2 has proven that the Federal Reserve can substantially influence market prices without creating the positive result  (in this case lower rates) that it so desires.  In my opinion, this is proof that the Fed’s interference is not furthering the prosperity of the private sector, but is merely interfering with natural market forces while creating market disruptions and imbalances.  In the end, this does not help to smooth the business cycle and only helps contribute further to its instability and volatility.

The Federal Reserve’s only true purpose in the marketplace should be to serve as lender of last resort at its target rate.  This rate should be permanently maintained at zero, the natural rate of interest, so as to maintain price stability and reduce market interference.  This would not only reduce the Fed’s role in markets, but would help ensure greater output, price stability, eliminate the Bernanke Put and would substantially reduce the volatility/imbalances in the business cycle that have been largely generated by the Fed’s intervention.

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC.Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services.He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.
Cullen Roche

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