Imagine a football coach who hasn't caught onto the game's complexities and continues to run the same play - call it a fullback dive - over and over. When I read calls for more monetary stimulus, I feel as though I'm listening to that coach's brethren in the economist community.
These economists argue that the Fed should simply ramp the money supply higher and higher for as long as some economic statistic - GDP is a popular one - remains below a targeted outcome. Dive, dive, dive, punt and repeat.
There's an important difference between football and economics, though.
One-dimensional approaches are quickly exposed in football, whereas economies don't yield clear and timely verdicts on whether policies are effective. There are far too many moving parts to prove cause and effect in a way that everyone can understand and agree. Therefore, bad economic policies persist for a long time before they're finally found out, and this may be the best way to describe the last 100 years or so of America's economic history.
With regard to today's passion for extreme monetary stimulus, once again there's no scoreboard to tell us whether the Fed is leading us to victory or defeat. Money printing cheerleaders can deny unintended consequences of the Fed's actions, for two reasons:
- Some of these effects aren't directly observed. For example, we know that misallocation of capital occurs when free market price signals are suppressed, but the misallocation is impossible to measure. Also, the public doesn't actually see the Fed's odious wealth transfers to banks even as these transfers put smiles on traders' faces on POMO days.
- Other effects won't materialize for some time. For instance, zero interest rate policy (ZIRP) and quantitative easing (QE) make it easy for politicians to delay action on long-term fiscal challenges, but government debt can grind higher for years and years before the repercussions become clear to all.
Are the clouds beginning to part?
On the other hand, there's one policy flaw that's becoming more difficult to deny. The flaw is this: Much of the incremental growth achieved through extreme monetary stimulus is merely borrowing from the future. In other words, some of the growth that would have accrued in, say, 2015 or 2016, has instead been brought forward to, say, 2012 and 2013.
This approach of bringing future growth into the present defies the old-fashioned goal of achieving "long-run sustainable growth." It's one of the ways that interventionist policies can fail. Central bankers claim to deliver stability when in fact they've simply borrowed from the future. Rather than reducing volatility, we find later that they've increased it.
Half of the last four U.S. recessions followed this pattern; the 1981-82 and 2008-09 recessions were both explained by severe payback for several business cycles' worth of short-term policies.
Where's the evidence that policymakers are again borrowing from the future?
Well, it's been hard not to see it in the past few weeks. For starters, it's become even more obvious that today's positive wealth effect is tomorrow's negative effect. The higher that asset prices are artificially lifted, the faster they fall when prices revert toward underlying fundamentals.
In the same vein, economists are learning a lesson (once again) in the importance of market psychology. I recently shared this telling excerpt from a March interview with former hedge fund manager Stanley Druckenmiller:
Do you know what guys like me are going to do when they sell the first bond out of $4 trillion? And don't think that letting the bonds run off isn't selling. That debt has to be refinanced. If you just let all the bonds run off, that is still $4 trillion in selling … What do you think the markets are going to do when they figure out the exit?
For comments like this, Druckenmiller was ridiculed by Fed supporters who should have instead tried to learn from him. Not only was his warning prescient, but he may have understated the potential for asset prices to reverse direction, since falling prices over the last month had nothing to do with the Fed selling securities. The Fed merely signaled that the pace of security purchases would be ever so carefully tapered, and that was enough to trigger a major liquidation.
In my opinion, the clearest way to interpret the past month's events is with a popular analogy - the one with the Fed as a drug pusher and the economy as an addict who needs ever-higher doses to get the same high. It's hard to see market reaction to tapering in any other way. And by using the monetary drug to the point where $85 billion in monthly security purchases is a bare minimum to keep markets happily stoned, policymakers compromise their future effectiveness.
Wealth effects have stalled out or reversed, mortgage rates have jumped over a percent, banks are laying off refinancing specialists, and countless types of carry trades are being unwound. Potential future growth has once again been sacrificed for the present (or recent past).
A step in the right direction
Refreshingly, one prominent advocate of aggressive monetary stimulus concedes some of these points. While writing on Marginal Revolution about the Chinese credit crunch, Tyler Cowen discussed the Fed's part in creating imbalances that are currently being unwound:
Note that a lot of the cheap credit has been funneled through a dollars mechanism … The relevant lever here seems to have been U.S. interest rates, I am sorry to say.
And then he took the mea culpa further in a post titled, "Krugman and I were both wrong about the Fed and interest rates." He acknowledged that "[t]he low rates really have been an artifact of Fed policy, at least to a much higher degree than many of us had thought."
Cowen also backtracked on his earlier disinterest in the whole topic of "bubbles" (see here), noting that "[e]merging markets tanked on the Fed communication, and so we have indeed been exporting bubbles through a 'reach for yield' mechanism."
With a full dose of truth serum, the money printing lobby might admit to being wrong on other points as well, such as their argument (made by some) that stocks would benefit from a back-up in bond yields if it occurred.
And how about the Fed's theory that the size of its balance sheet determines its effect on asset prices, with the pace of purchases being relatively unimportant? This belief in "stock" rather than "flow" effects seems incredibly naïve to many in the investment and blogging communities, as pointed out repeatedly by Tyler Durden of Zero Hedge. Ironically, the recent market sell-off shows that the truth may be not one but two derivatives removed from the Fed's typically simplistic model. The stock of the Fed's security holdings continues to grow as the flow gushes on, but markets corrected on plans for nothing more than a gradual reduction of that flow.
Unfortunately, we're unlikely to see many more admissions like Cowen's. Most policymakers and pundits just don't operate that way. More commonly, these folks follow Larry Summers' mantra that you should never admit mistakes (as discovered by Ron Suskind in researching his bestseller, Confidence Men). Paul Krugman, for one, came up with a new narrative this week without bothering to acknowledge the failure of his old one (which seems to explain Cowen's confession on his behalf). Cowen should be commended for not only adjusting his views to new information, but confessing prior errors.
Ben Bernanke also admitted some confusion, but that's about as far as he went. In last Wednesday's press conference, he allowed that the FOMC was a "little puzzled" by the sharp rise in bond yields that it prefers to see lower, not higher.
It remains to be seen just how badly the FOMC misunderstood the potential effects of its policies. June could prove to be a blip in long-term upward trends for both stocks and bonds. But the blip is already large enough to demonstrate that some of the apparent benefits of ZIRP and QE are at the expense of future economic performance.
Put differently, we're having some problems with the fullback dive, with the opposition getting well used to it and adjusting strategy accordingly. Some pundits foresaw these problems, and others not so much, but everyone should at least acknowledge that they exist.
Recent events also put a dent in the simplistic idea that current policies should be continued until we achieve a "self-sustaining recovery." I've questioned economists' theories about self-sustaining growth in several posts, including this one. For more recent articles that touch on the same topic, I recommend this post by Detlev Schlichter and also Peter Schiff's perspective on tapering.