The US Federal Reserve has gone beyond playing with fire, and may have indeed
set the house on fire. It's one thing to push interest rates to near zero to
stimulate the economy; it's another to monetize the debt by printing money to
buy government debt.
In recent weeks, the Fed has broken outside even those boundaries and become
actively engaged in managing the private sector beyond the core banking system.
Worse still, the steps taken may be difficult to reverse and as such may shape
the US economy for a long time.
These steps are taken with the best of intentions, to "save" the economy. The
only trouble is that we may be on a slippery slope
to destroying capitalism on the way. In "doing whatever it takes" to get the
economy back on its feet, the Fed risks destroying the foundation of why the US
has been able to establish itself as the world's leading economic force.
Actively participating in credit allocation within the private sector, the Fed
jeopardizes the capitalist foundation the US economy is built on. As a result
of these actions, the US may be on its way to becoming a modern incarnation of
a planned economy.
To understand what is so frightening with recent Fed activity, consider that
most central banks focus on interest rates, inflation and money supply to
promote price stability (and maximum employment in the Fed's case).
Generally, they all influence credit creation by managing the cost of
borrowing. Central banks may employ slightly different levers and targets; and
while some central banks are better than others at achieving their goals, what
they have in common is that they traditionally focus on government debt, mostly
short-term Treasuries, to achieve their goals.
This is very much by design as good central bank policy leads to an environment
of price stability fostering long-term economic prosperity. On the other hand,
bad central bank policy may lead to inflation, wide swings in economic activity
or unnecessarily high unemployment. However, free market forces will push the
private sector to make the best of it.
It's when policymakers start subsidizing ailing sectors of the economy that
distortions are created that will come back to haunt us. Traditionally, for
better or worse, elected officials decide on the socio-economic fabric of
society. Now, the Fed decides which areas of the economy need to be propped up.
The hysteria that has been created by policymakers and the media has allowed
the Fed to pursue its recent unorthodox policies. In late September, the world
financial system looked rather dire; the government was able to play a role to
avoid a disorderly collapse; but the government's role should have been limited
to allowing an orderly adjustment of the excesses of the credit bubble.
Instead, the latest salvo to promote the bailouts is that payrolls have dropped
by the largest amount since World War II.
This may be the case in absolute numbers as the population has grown, but more
jobs were lost as a percentage of the workforce in a 12-month period in each of
1982, 1961, 1958, 1954, 1948/49; in many of the cases more than twice as many.
Recessions are no fun, neither are personal or corporate bankruptcies; but they
may be the cure needed to weed out the excesses of the boom. In contrast,
today, hedge fund managers that ran their funds into the ground are raising
hundreds of millions of dollars to start anew. Some of the folks that ran Long
Term Capital Management into the ground in 1998 started fresh only to have
another massive failure in the current credit crisis. We don't expect the new
breed of second chances to be any better.
And while the blame lies with the managers, excessively low interest rates
contribute to irrational risk-taking: all of the bailouts focus on those who
have been over-leveraged. What about the group of responsible savers that rely
on income? With interest rates near zero, many are tempted to engage in highly
leveraged strategies to meet their required income objectives. Pension funds
"must" return 6% per year, leaving them little leeway but to give money to
hedge fund managers to magically turn 1% yields into 20% returns; the way to
achieve this is with leverage.
Actually, there is another way: the Swiss public pension fund system just
announced that it will scale down its long-term return objective to 4% from its
current 6% per annum.
Giving credit where none is due
In late December, the Fed board of governors approved the application by
General Motors' finance arm, GMAC, to become a bank. The vote was 4-1, and the
one board member with experience as a bank regulator, Elizabeth Duke,
dissented. There was another hurdle: GMAC did not have sufficient capital to be
a bank. That problem was solved in early January as the Treasury injected US$5
billion into GMAC; the Treasury also gave General Motors $1 billion so that the
auto company could inject that money into GMAC. Equipped now with a minimum
capital base, GMAC is able to operate as a bank and go to the Fed to access the
Troubled Assets Relief Program (TARP) as well as other regular and emergency
Fed windows.
Shell-shocked consumers are worried about their jobs and have lost a
substantial amount of their net worth in 2008; they simply don't want or need a
car right now. In December, car sales fell off the cliff. But it wasn't only GM
that had problems; even Toyota, which had access to credit and introduced zero
percent financing, recorded a 37% plunge in sales (unlike other carmakers,
Toyota has traditionally not offered zero percent financing).
Incentive programs prior to the bursting of the credit bubble lured consumers
into six-year loans with zero percent financing. Policymakers take this as a
reason to provide money to GMAC that pursues a business model proven to be
ruinous: it simply doesn't make sense to offer cars at zero percent if interest
rates are above that, even if they are "close to zero", as they are now. GMAC
takes money from the Treasury to be able to request more from the Fed. And the
first course of business for GMAC is to extend zero percent financing to
consumers with lower credit ratings than had traditionally qualified.
The Fed is only ramping up its mission to allocate credit where the Fed -
rather than the free market - deems it appropriate. A major program announced
in the fourth quarter and rolled out in early January consists of a $500
billion program to buy mortgage-backed securities (MBS). The perceived positive
is the plummeting of mortgage rates. Consumers with superb credit now qualify
for 30-year mortgages at less than 5%.
One problem with such programs is that the Fed intentionally inflates prices
(lowers the yields) on these securities; in turn, rational market participants
may abstain from buying them. As a result, the Fed risks replacing private
sector activity, rather than encouraging it. Furthermore, the Fed jeopardizes
the dollar as foreigners may be discouraged from buying US government and
agency security debt; given that the US has become dependent on foreigners to
finance its spending needs as well as the unprecedented debt that will be
financed in 2009. This is a very dangerous road to be on.
The Fed may be able to phase out its commercial paper subsidy program or drain
liquidity from the TARP program over time; however, the $500 billion MBS
program may be difficult, if not impossible, to unwind. Indeed, the design of
the MBS program calls for holding of the securities until maturity. For
practical purposes, this means that the Fed's balance sheet is not just
"temporarily" inflated, but that the Fed will permanently keep more money in
the economy.
Traditionally, the Fed's balance sheet is $900 billion. Therefore, even if one
gives the Fed the benefit of the doubt that the current escalation to over $2
trillion is temporary, there will be a significant hangover as not all
additions can easily be removed.
This doesn't even consider that, quite likely, the MBS purchase program may
need to be extended beyond the six-month period it was put in place for. Watch
for bond manager Bill Gross this June calling for the Fed to continue buying
MBS, preferably the ones he has on the books, to save the economy from
collapse. Incidentally, his firm, PIMCO, is one of the firms managing the Fed
program.
To counter the effects of this added money in the economy, the Fed would need
to keep interest rates permanently higher. One realistic alternative, however,
is that the additional money will stay in the economy as draining it would
cause too much economic hardship. This may well embed inflation into the US
economy for years to come. Importantly, note that there is little, if any,
accountability at the Fed monitoring its actions; no one is there to ensure
that the Fed will, at some point, phase out its programs or added powers.
Live free or die
By engaging in credit allocation to specific sectors of the economy, the US is
stepping into a territory traditionally left to governments with a socialist or
communist brand. Communism has shown us that planned economies don't work.
New Hampshire in 1945 added the slogan "Live Free or Die" to its state emblem,
a quote stemming from a general in the Revolutionary war. Translated to the
economic crisis, this should mean that a severe recession ought to be the
lesser evil than a planned economy. And to continue the parallel, when
communism swept Eastern Europe, the standard of living for everyone dropped. In
today's world, we already see that the "re-failure" rate of those who
defaulted, then renegotiated their teaser rate loans, is above 50%. Yet all
taxpayers have to pay the price for the bailouts.
To be sure, we are a far cry from communism. But we must keep our eyes open and
not be blinded by the perceived "help" of money printed by the Fed. Debt is the
origin, not the solution to the problems we face. The Declaration of
Independence's "life, liberty and the pursuit of happiness" may be difficult to
achieve when the country is drowned in debt; building sustainable wealth
without the shackles of debt may be the more appropriate path.
It's not by mistake that the Founding Fathers demanded that the country's
currency be backed by a precious metal that cannot be inflated to give in to
the temptation of the day.
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
