In his latest investor letter Jeremy Grantham makes my rants against the Federal Reserve look like child’s play:
If I were a benevolent dictator, I would strip the Fed of its obligation to worry about the economy and ask it to limit its meddling to attempting to manage inﬂation. Better yet, I would limit its activities to making sure that the economy had a suitable amount of liquidity to function normally. Further, I would force it to swear off manipulating asset prices through artiﬁcially low rates and asymmetric promises of help in tough times – the Greenspan/Bernanke put. It would be a better, simpler, and less dangerous world, although one much less exciting for us students of bubbles. Only by hammering away at its giant past mistakes as well as its dangerous current policy can we hope to generate enough awareness by 2014: Bernanke’s next scheduled reappointment hearing.
1) Long-term data suggests that higher debt levels are not correlated with higher GDP growth rates.
2) Therefore, lowering rates to encourage more debt is useless at the second derivative level.
3) Lower rates, however, certainly do encourage speculation in markets and produce higher-priced and therefore less rewarding investments, which tilt markets toward the speculative end. Sustained higher prices mislead consumers and budgets alike.
4) Our new Presidential Cycle data also shows no measurable economic beneﬁ ts in Year 3, yet point to a striking market and speculative stock effect. This effect goes back to FDR, and is felt all around the world.
5) It seems certain that the Fed is aware that low rates and moral hazard encourage higher asset prices and increased speculation, and that higher asset prices have a beneﬁcial short-term impact on the economy, mainly through the wealth effect. It is also probable that the Fed knows that the other direct effects of monetary policy on the economy are negligible.
6) It seems certain that the Fed uses this type of stimulus to help the recovery from even mild recessions, which might be healthier in the long-term for the economy to accept.
7) The Fed, both now and under Greenspan, expressed no concern with the later stages of investment bubbles. This sets up a much-increased probability of bubbles forming and breaking, always dangerous events. Even as much of the rest of the world expresses concern with asset bubbles, Bernanke expresses none. (Yellen to the rescue?)
8 ) The economic stimulus of higher asset prices, mild in the case of stocks and intense in the case of houses, is in any case all given back with interest as bubbles break and even overcorrect, causing intense ﬁnancial and economic pain.
9) Persistently over-stimulated asset prices seduce states, municipalities, endowments, and pension funds into assuming unrealistic return assumptions, which can and have caused ﬁ nancial crises as asset prices revert back to replacement cost or below.
10) Artiﬁcially high asset prices also encourage misallocation of resources, as epitomized in the dotcom and ﬁber optic cable booms of 1999, and the overbuilding of houses from 2005 through 2007.
11) Housing is much more dangerous to mess with than stocks, as houses are more broadly owned, more easily borrowed against, and seen as a more stable asset. Consequently, the wealth effect is greater.
12) More importantly, house prices, unlike equities, have a direct effect on the economy by stimulating overbuilding. By 2007, overbuilding employed about 1 million additional, mostly lightly skilled, people,
not counting the associated stimulus from housing-related purchases.
13) This increment of employment probably masked a structural increase in unemployment between 2002 and 2007, which was likely caused by global trade developments. With the housing bust, construction fell below normal and revealed this large increment in structural unemployment. Since these particular jobs may not come back, even in 10 years, this problem may call for retraining or special incentives.
14) Housing busts also help to partly freeze the movement of labor; people are reluctant to move if they have negative house equity. The lesson here is: Do not mess with housing!
15) Lower rates always transfer wealth from retirees (debt owners) to corporations (debt for expansion,
theoretically) and the ﬁ nancial industry. This time, there are more retirees and the pain is greater, and corporations are notably avoiding capital spending and, therefore, the beneﬁ ts are reduced. It is likely that there is no net beneﬁ t to artiﬁ cially low rates.
16) Quantitative easing is likely to turn out to be an even more desperate maneuver than the typical low rate policy. Importantly, by increasing inﬂ ation fears, this easing has sent the dollar down and commodity prices up.
17) Weakening the dollar and being seen as certain to do that increases the chances of currency friction, which could spiral out of control.
18) In almost every respect, adhering to a policy of low rates, employing quantitative easing, deliberately stimulating asset prices, ignoring the consequences of bubbles breaking, and displaying a complete refusal to learn from experience has left Fed policy as a large net negative to the production of a healthy, stable economy with strong employment.
The saddest truth about the Fed’s system is that there can be, almost by deﬁ nition, no long-term advantage from hiking the stock market, for, as we have always known and were so brutally reminded recently, bubbles break and the market snaps back to true value or replacement cost. Given the mysteries of momentum and professional investing, when coming down from a great height, markets are likely to develop such force that they overcorrect. Thus, all of the beneﬁcial effects to the real economy
caused by rising stock or house prices will be repaid with interest. And this will happen at a time of maximum vulnerability, like some version of Murphy’s Law. What a pact with the devil! (Or is it between devils?)
Read the full letter here.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.
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