John Hussman: The Destructive Implications of the Bailout

Excerpt from the Hussman Funds' Weekly Market Comment (5/18/09):

One of the features that has enabled the bureaucratic abuse of the public during the past year has been the frantic, if temporary, flight-to-safety by investors. The Treasury has issued an enormous volume of debt into the frightened hands of investors seeking default-free securities. This has allowed the Treasury to finance a massive and largely needless transfer of wealth to bank bondholders so easily over the short-term that the longer-term cost has been almost completely obscured. But by transferring wealth from those who did not finance reckless loans to those who did – providing monetary compensation without economic production – the bureaucrats at the Treasury and Federal Reserve have crowded out more than a trillion dollars of gross investment that would have otherwise have been made by responsible people in the coming years, shifted assets to the control of those who have proven themselves to be irresponsible destroyers of capital, and have planted the seeds of inflation that will cut short any emerging recovery.

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The bottom line is that the attempt to save bank bondholders from losses – to provide monetary compensation without economic production – is not sound economic policy but is instead a grand monetary experiment that has never been tried in the developed world except in Germany circa 1921. This policy can only have one of two effects: either it will crowd out over $1 trillion of gross domestic investment that would otherwise have occurred if the appropriate losses had been wiped off the ledger (instead of making bank bondholders whole), or it will result in a stunning and durable increase in the quantity of base money, which will ultimately be accompanied not by a year or two of 5-6% inflation, but most probably by a near-doubling of the U.S. price level over the next decade. As I've noted previously, the growth rate of government spending is better correlated with subsequent inflation than even growth in money supply itself, particularly at 4-year intervals. Regardless of near-term deflation pressures from a continued mortgage crisis, our present course is consistent with double digit inflation once any incipient recovery emerges.

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The second fact is that as a result of more than a trillion dollars of new issuance of Treasury securities with relatively short durations, it is a tautology that there is a mountain of what is mistakenly viewed as “cash on the sidelines” invested in these securities. This mountain of “sideline cash” exists and must continue to exist as long as these additional government securities remain outstanding. It is an error to view outstanding debt securities as if they are “liquidity” poised to “flow back into the stock market.” The faith in that myth may very well spur some speculation in stocks, but it is a belief that is utterly detached from reality. The mountain of outstanding money market securities is the result of government debt issuance that must be held by somebody until those securities are retired. It is not spendable “liquidity” – it is a pile of IOUs printed up as evidence of money that has already been squandered. The analysts and financial news reporters who observe this enormous swamp of short-term money market securities, and talk about “cash on the sidelines” as if it is spendable in aggregate immediately reveal themselves to be unaware of the concept of equilibrium and of the nature of secondary markets (where there must be a buyer for every security sold, and a seller for every security bought).

If you sell your stocks or bonds or money market securities, they don't cease to exist. Somebody else has to purchase them. Somebody else has to hold them. As I've said numerous times, if Ricky wants to sell his money market funds and buy stocks, then his money market fund has to sell money market securities to Nicky, whose cash goes to Ricky, who uses the cash to buy stocks from Mickey. In the end, the cash that was held by Nicky is now held by Mickey. The money market securities that were previously held by Ricky are now held by Nicky. And the stocks that were once held by Mickey are now held by Ricky. There is exactly as much “money on the sidelines” after these transactions as there was before. Money doesn't go into or out of the stock market – it goes through it. Prices don't move because supply exceeds demand or demand exceeds supply. In equilibrium, the two are identical because that's exactly what a trade is. Prices move because the buyer is more eager than the seller, or vice versa.

Comments

[Clive Corcoran:]

I could not agree more with this point:

"The mountain of outstanding money market securities is the result of government debt issuance....it is not spendable “liquidity” – it is a pile of IOUs printed up as evidence of money that has already been squandered."

May 18 11:06 AM

[Al-USA:]

One of the best articles yet on the futility, in terms of avoiding a Greater Depression, of the $trillions in bailouts of the financial American Oligarchy.

I will forward this article to all the people I know, thanks for taking the time to write it.

May 19 02:58 AM

[Ferdinand E...:]

Interesting refererence to a "grand monetary experiment" in Germany in the early l920s. It really wasn't very grand you know, because what it amounted to was flooding the country with money in order to paralize the German economy, and make it impossible for the country to pay reparations (for the war). That was Hjalmar Schachts idea, although some people thought that in reality he cleaned up the mess.

The interesting thing about it, as I liked to point out to my students, was that the management of the German central bank was INDEPENDENT, and could not be given instructions by the government. Accordingly, independence may not be as lovely as some people think that it is.

May 19 09:35 AM

[Gregman2:]

Fantastic explanation: "Money doesn't go into or out of the stock market – it goes through it." Too often this is forgotten. Thanks for this excellent piece.

May 19 12:03 PM

[Thomas J. G...:]

I just became aware of Hussman today. I am very impressed with the perspectives he takes and how he explains things. He seems a well trained economist and has free market leanings. I do take issue with one of his claims. He really harps on this gov't money going to bank bondholder thing. I am not defending the actions of the gov't but I would have to say that keeping bac and c from publicly going belly up and all the unrest and press firestorm that would have caused is why banks were bailed out, not that paulson worked for gs and was trying to save the bondholders of gs. And I would say that bank/financial bond holders were punished. I'm pretty sure the bond holders of bear stearns, lehman, fnm and fre (fnm and fre preferred holders too) were completely wiped out. If he's saying "just go in and make all the fdic depositors whole if a big bank fails" maybe Hussman has a point. But the gov't was dealing with public confidence and trying to keep very large depositors bases from having the image that they might not be secure, not just trying to keep bac and c bondholders whole.

May 19 05:07 PM