Pragmatic Capitalism

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There has been a lot of chatter lately about the impending reappointment of Ben Bernanke.   There is little doubt in my mind that he will be reappointed (much to my dismay).   I was a harsh critic of Bernanke when he was first appointed.  Why would we select a man with no actual market experience, to run the most important arm of the U.S. economy?  Would you select a General of the U.S. Army who has never fought in a battle or shot a weapon?  Bernanke is a lifelong academic and theorist, but as a banker he has zero hours of experience.  In my opinion, he was entirely unqualified for the position from the beginning.  But I digress….

A number of pundits, politicians and economists have already come out supporting his reappointment.  Even Nouriel Roubini, one of his harshest critics, is impressed with the job Bernanke has done.  The message is fairly universal: he saved the U.S. from the next Great Depression.  In my opinion, this is horribly flawed logic.

My primary problem with the Federal Reserve and Bernanke is the reactive approach to the economy.  How can the most important facet of a proactive market be so reactive?   The last 25 years of Fed policy and the endless boom/bust cycle is excellent evidence of this flawed philosophy in action.  As regular readers know, I am no fan of electing academics into positions of such importance.  Academics by nature, subscribe to the scientific method.  You wait for the evidence to present itself before taking action.  That’s all well and good if you’re running a science experiment, but unfortunately, the market isn’t an experiment.  The market is a forward looking complex system.   Like an investor, if you wait to act when the event actually occurs you’re likely too late.  Fed policy is no different.  If you wait for inflation to present itself the odds are that you’re already behind the curve.   Bernanke is the most classic example of an academic who subscribes to this methodology.  The last 25 years have been an endless cycle of scientific method at work.  The Fed waits for the evidence to present itself, then after it presents itself the Fed is forced to overreact because they are behind the curve.  It’s like a pendulum that gets pushed too far in one direction and comes slicing back at you with equal force.  The results of this approach speak for themselves.

Not only was Bernanke an open advocate of all of Alan Greenspan’s policies (which arguably caused the crisis), but he predicted this impending crisis worse than just about any economist on the planet.   Below are a few of Bernanke’s classic quotes regarding the state of the economy and the housing market in the years leading up to the crisis.  Not only did he see no chance of a recession, but he also said there was no chance that housing prices would even decline:

“Well, unquestionably housing prices are up quite a bit; I think it’s important to note that fundamentals are also very strong.  We’ve got a growing economy, jobs, incomes.  We’ve got very low mortgage rates.  We’ve got demographics supporting housing growth.  We’ve got restricted supply in some places.  So it’s certainly understandable that prices would go up some.  I don’t know whether prices are exactly where they should be, but I think it’s fair to say that much of what’s happened is supported by the strength of the economy.”

– January 2005

“We’ve never had a decline in house prices on a nation-wide basis.  So what I think is more likely is that house prices will slow, maybe stabilize: might slow consumption spending a bit.  I don’t think it’s going to drive the economy too far from its full employment path, though.”

– July 2005

“We expect moderate growth going forward.  We believe that if the housing sector begins to stabilize, and if some of the inventory corrections still going on in manufacturing begin to be completed, that there’s a reasonable possibility that we’ll see some strengthening in the economy sometime during the middle of the new year.

Our assessment is that there’s not much indication at this point that subprime mortgage issues have spread into the broader mortgage market, which still seems to be healthy.  And the lending side of that still seems to be healthy.

– Feb 2007

The global economy continues to be strong, supported by solid economic growth abroad.  U.S. exports should expand further in coming quarters.  Overall, the U.S. economy seems likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008, to a rate close to the economy’s underlying trend.

July 2007

Don’t get me wrong.  I don’t expect a Fed Chairman to be able to predict recessions, but I do expect a Fed Chairman to have some sort of risk management tools in place at all times.  Much like a good portfolio manager, a good Fed Chairman has to at least consider the potential risks confronting the market.  Bernanke was like the portfolio manager who went into 2008 entirely invested in equities.  He had no risk management tools in place just in case something unforeseen occurred.  And it’s not as if there were no red flags waving in 2006 or 2007….

Not only were Bernanke’s actions leading up to the crisis entirely off base and incorrect, but his actions during the crisis actually made things worse.  Bernanke is largely credited with saving the global economy from falling off a cliff when in fact the economy did fall off a cliff.  Let’s not forget that the market did indeed crash.  Global equity markets were sliced in half and still remain 30%, 40% or 50% off their highs.  Unemployment is at 10% in the U.S.  Two years into the recession we are still losing 400K+ jobs per month and experiencing half a million jobless claims every week.  This is the worst economic downturn in the last 80 years and investors are playing it off like we averted crisis.  Ask the 10% of unemployed American’s how the averted crisis feels.  It’s all well and good that the banks are reporting profits again and the stock market is 45% off its lows, but make no mistake – the blue collar working American is still very much in pain.

Granted, you could make the argument that things could be worse, but couldn’t they also be much better?  Many believe we were staring at an impending Depression.  I think that’s hogwash.  I have long maintained that a second Depression was never on the table so the comparisons are off based to begin with.  Not only are there substantial safeguards that protect us from another Depression (such as the FDIC), but most importantly, the U.S. economy is a very different economy than it was in the 30’s.  We are no longer a fast growing economy with poor regulations and little to no infrastructure.  We are quite the opposite now.  This doesn’t mean we aren’t at risk of prolonged and difficult economic periods, but the deepness of the contraction in the 30’s isn’t applicable to today’s U.S. economy.

I would argue instead, that this recession and downturn could have been substantially less destructive had Ben been a bit more prescient and proactive in his policy measures (and yes, I wrote on more than one occasion in 2006 and 2007 that Bernanke should be cutting rates and using a bit more risk management in his policy approach).   The boiling point in Bernanke’s chain of poor decisions came when he decided to let Lehman Brothers fail.  After bailing out every firm that was about to fail, Bernanke somehow came to the conclusions that Lehman should fail.  It was stunning.  It was a total diversion from his previous policy.  I can only imagine how he came to this decision.  My money is on the fact that he got strong armed by Hank Paulson, the former CEO of Goldman Sachs, who strongly believed it was a good idea to let Lehman fail, but save AIG during the same weekend.  Curiously, both actions benefited Goldman enormously.  Unfortunately, the decision, which ultimately falls on Bernanke’s shoulders, led to a near meltdown of the system.  Had Bernanke  not decided to let Lehman fail, there is a good chance that the market would not have crashed late last year.

Most importantly though, I believe it is still too early to judge Bernanke.  As Anna Schwartz, Milton Friedman’s right hand woman says, Bernanke is fighting the “last war”.  Unfortunately for Bernanke, his battles have only just begun.  Schwartz notes in a recent Newsweek article, that Bernanke’s policies have been deeply flawed:

“I don’t believe we would have had a Fed balance sheet currently that has doubled, or tripled, in such a short period of time without any kind of Fed acknowledgment that it was creating a problem for itself [with] inflation already baked into the economy.” In clear, strong tones marked by her New York accent, Schwartz said: “Everybody’s talking about what kind of exit strategy does the Fed have, given that its balance sheet has exploded. It’s something [Fed chair Ben Bernanke] doesn’t discuss. It’s as if he isn’t willing to acknowledge that it is a problem.”

My guess is that Bernanke will go down in history in much the same way that Greenspan has.  If you recall the 90’s it was widely believed that Greenspan was the greatest central banker that ever walked the Earth.  Oh how the tables have turned.  My guess is we will look back in 10 years and notice that the Fed failed to thread the needle.  We will either experience continuing deflation that leads to years of below trend growth and a mostly sideways stock market or we will experience an inflationary environment that rivals the 70’s and creates bubbles in many undesirable places.  Anyone that thinks Bernanke can best Greenspan’s history of creating boom/bust cycles when he is using the exact same methodology is likely bordering on delusion.

To me Bernanke has been like the Fireman who sleeps through the fire alarms, shows up late, sprays gasoline all over the fires making it substantially worse and then claims to have saved the day when he finally puts the fire out after half of your house has already burned down.   Or in other words, the Fed Chairman who completely fails to predict the crisis, implements zero risk management tools in advance, nearly drives the economy off the cliff and then takes credit for not destroying the entire economy.  Unfortunately for him, his biggest mistakes and “lifesaving” recoveries are likely in the years ahead of him.   And unfortunately for the rest of us, we are the ones who are most likely to suffer for his “brilliance” because Lord knows the bankers won’t….

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