No story has dominated the market news flow in the last year like QE2. From its very inception I said the program was a “monetary non-event” and not going to achieve its targets for several reasons (it’s not money printing, it doesn’t alter the amount of outstanding private sector net financial assets, it’s not debt monetization, etc). But perhaps more importantly, I’ve discussed the potential negative effects the program could have through the channels of misconception. In other words, the myths of “stimulus”, money printing and debt monetization were all likely to fuel investors with a misguided perception as to how the program would impact the real economy.
I have called this effect an embedded disequilibrium in the market caused directly by the Fed and exacerbated by market participants who quite simply don’t understand what QE is or how it actually works. From the perspective of the Fed, they thought they could “keep assets higher than they otherwise would be” (infamous last words of Brian Sack of the NY Fed). But because QE had no transmission mechanism through which it could impact the real economy it in fact only created a disequilibrium between market expectations and the real economy via psychological channels. And as the real economy has sunk we’ve seen much of this embedded “Bernanke Put” come out of the market in the last few months.
In just the last 24 hours we’ve seen the wheels come off of the “Bernanke Put” bus. The markets appear to be realizing that the Emperor truly does have no clothes, that QE isn’t all it was cracked up to be and that the Fed can’t save the economy with their magical printing press (don’t worry – the Fed doesn’t print money anyhow, but that’s for another day).
Back in April I wrote a piece describing the enormous risks in the market due to this put:
“In a similar note to thought #1 – there is the potential for a very frightening market development in the coming years (work with me through this hypothetical). Let’s say the Bernanke Put continues to cause asset prices to deviate from their fundamentals – the economy continues to recover (marginally), but the Bernanke Put becomes so ingrained in market perception that the disequilibrium in markets expands. This results in an imbalance so severe that market bubbles appear (could already be occurring in the commodity space). What happens to the market if the disequilibrium Ben Bernanke causes results in some sort of serious market dislocation similar to 2000 or 2008? All it would take is a minor exogenous threat to cause a global panic. It could be surging oil, a slow-down in China, a repeat of the Euro scares….The result would not only be economic slow-down (into an already weak developed market), but potentially crashing asset prices as bubbles have a tendency to overshoot on the downside. But it’s not the recession that would scare the markets. It is the potential backlash against the Fed.
After three bubble implosions in less than 15 years (all somehow directly tied to Fed intervention), I think the public would call on Congress to revisit the Fed’s dual mandate, its impact on markets and whether their actions over the last 20 years have been appropriate. The rational response would be to reduce the Fed’s role in markets. From a societal perspective I think this is an enormous long-term positive. The sooner we get the Fed out of the market manipulation game the sooner this economy can stabilize, definancialize and get back to becoming the economic growth machine that it has been for so long. For the markets, however, this would be a traumatic event. Imagine 20 years of Greenspan/Bernanke Put being sucked out of the market…it might sound far fetched right now, but I have a feeling the Fed will be far less involved in markets at some point in my lifetime. It might be wishful thinking, but I am confident that America will wise up to the destruction this institution causes by constantly distorting our markets and economy.”
Now, I think it’s a bit hyperbolic to say that the markets have lost faith in the Fed entirely, but I think we’re certainly seeing the market lose some faith in the Fed’s omnipotence. 20 years of flawed monetary policy, mythical thinking about the workings of our monetary system and misguided market intervention bring us to this point. Unfortunately, misguided policy has now created such disequilibrium in the markets that the backlash has the very real potential to cause real economic declines. So buckle up folks. We’re living in a golden age of economic transformation and theory. Unfortunately, that means we have to erase the decades of myth and fantasy perpetuated by the same neoclassical economists who got us into this mess in the first place (most of whom are still driving this bus). And that’s going to cause a great deal of policy error, misconception and uncertainty. Hopefully in the end we’ll come out of this a bit wiser. One can hope….
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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