When Does the Day of Reckoning Come?

Even Hayek said something to the effect that there are no good solutions in the bust phase of the market.  Opportunities to avoid the bust come in the bull phase of the market.  How?

  • Fiscal authorities could lessen the advantages of financing with debt, leading to a decrease in debt employed.
  • Monetary authorities could keep monetary policy tight for longer, allowing bad debts to fail, rather than refinancing them with lower interest rates.  Let recessions do their real work of eliminating marginal economic concepts.

The Fed is supposed to take away the punch bowl when the party is getting too wild.  Greenspan (and to a lesser extent Bernanke, because he inherited Greenspan’s profligacy) did the opposite.

Instead of letting markets find their own level in a panic, they aided in the refinance of dud assets.  This led to a buildup of personal debts, particularly those financing housing.

But let’s consider the individual situations.  Start with 1987.  Alan Greenspan, new Fed Chairman reacts to the crash in October by promising loans to back up the market.  Wrong.  Let some market players fail, revealing the bad risks they had taken.  But no, this is the beginning of the Greenspan Put, and all of the malarkey that allowed risk-taking to extend  to every market because it seemed the Fed would rescue every crisis.

The stock market should not be an interest of monetary policy.  Focus on banks, and have them cut their links to the stock market.  Bonds are fine, that is lending.  Banks should not engage in speculation, if their deposits are guaranteed by the FDIC.

Then we come to the Commercial real estate crisis of the early 90s.  More projects needed to fail, but the Fed lowered rates to what were then unprecedented levels, and enough marginal projects that should have failed survived.  The recession should have gone longer, and reduced overall debt levels.  But no, we end up with more debt and a reduced marginal productivity of capital.

In 1994, the residential mortgage market imploded because of perverse bets on the volatility of residential mortgage prices.  The rout led to a self reinforcing rise in interest rates, and then the Fed loosened too soon, once again.

By this time aggregate debt levels had risen dramatically since 1984.  With lower interest rates, the interest burden was lower, but the principal burden was higher, because people refinanced, and began to take money out.

Also in 1994, speculators on Mexican Cetes were partially rescued by the US Government through a set of loans to the Mexican Government.  This led to a greater sense that the US Government would back up speculators if they were big enough group.

In 1998, the Fed could have let investment banks sweat over Long Term Capital Management and Russia, but no, they forced them to cooperate while injecting a lot more liquidity into the system.

As a result, bad loans persisted and the marginal efficiency of capital fell, as companies and people refinanced.

In 2000, the Fed had its last chance to right the system in the midst of the tech bubble.  Instead of leaving rates high, because the general economy was not under that much threat, the Fed loosened down to unimaginable levels, mainly to force a bubble in US Housing, which would lead the economy out of the recession, which it did and then some.

In doing so, the Fed pushed debt levels relative to GDP far higher than they were during the Great Depression.  Because overall debt levels create depressions, I sometimes wonder that the supposed scholar Bernanke, and the toady Greenspan did not consider that they were setting up the seeds of destruction.

By 2007, the situation is too far gone, as the Fed tightens, it reveals systemic weaknesses as debt is too high relative to GDP, and we find ourselves in a structural depression, as opposed to a cyclical recession.

In 2008, if the Fed had not loosened, maybe things would have been worse in the short-to-intermediate run.  I expect that if deposits were protected, and losses of senior unsecured capped at 25%, the system would have survived.

But no, the Fed acted to increase leverage more, again.  In this new era, since 1984, that’s all it can do.

When does the day of reckoning come?  I trust the masses more than the elites.  Where is the bailout for the masses?  The elites got more than their share recently.  Is the helicopter of happiness going to fly over the homes of average people anytime soon?

If Bernanke ever believed in Milton Friedman’s view of the economy, it does not show here.  There is no increase in inflation, at least in the assets that need it.  There is only inflation in the prices of assets that are healthy, and little in those that are sick.

There should be no surprise here; it is impossible to reinflate a dud asset, except at high cost.

My point is this: who pushed for greater austerity when it would not have hurt our republic?  Few.

Instead, the debt grew exponentially as the Fed created the Great Moderation, which in other terms would be eventually be called a liquidity trap.

Though the US government is guilty for its deficits, and fostering a culture favoring debt over equity, the Fed is more guilty for not keeping interest rates higher, letting moderate recessions do their good work of eliminating malinvestment.  That might have prevented this current crisis.

There are no good solutions now.  Bail out this, bail out that.

Eventually there will be a fail of some sort.  I just don’t know what, when or how.

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About David Merkel 145 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I still contribute to RealMoney, but I have scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm.

Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life.

I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

Visit: The Aleph Blog

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