Recently, I was writing a blog post and had the opportunity to quote, once again, Charles (Chuck) Prince, the former Chairman and Chief Executive Officer of Citigroup (C), who will be remembered for a long time for uttering an excuse for some of the financial excesses of the decade of the 2000s: ""As long as the music is playing, you've got to get up and dance."
Right now, the music is playing. The quantitative easing being conducted by the Federal Reserve System has helped to underwrite the economic expansion that is underway, but this aggressive stance of monetary policy is aimed at getting more and more individuals and businesses to "get up and dance."
In fact, the Federal Reserve has stated that it will continue to "play music" until enough people get up on the dance floor and join the crowd.
One of the problems the Federal Reserve is facing is that many people and businesses got hurt during the last dance and are reluctant to get back out on the dance floor. Many people and businesses still want to de-leverage from the last "go around" and are not sure that enough interest has been generated in dancing for them to get out on the dance floor yet.
Still, the Fed keeps pumping reserves into the financial system hoping that either very low interest rates will encourage more to dance or that "wealth effects" coming from asset price inflation…like stock prices…will temp them into the ballroom.
Profits are being made as a result of this Federal Reserve quantitative easing. I have written several posts over the past six months discussing how different groups, generally representing the very wealthy or the already wealthy, who have posted substantial gains in real estate and other areas with speculative opportunities. I have written about the large banks and the fact that they are doing very well. In both cases, the profits that are being earned are not closely connected with an improvement in the real economy, but are the result of trading, asset bubbles, and other activities not related to the production of goods and services.
And, this is the thing that everyone is trying to figure out. The government and governmental agencies want the economy to expand, they want an increase in the production of real goods, and they want these increases to spur on employment and well-being.
Unfortunately, the expansion that is taking place is in the financial sectors and not in the real sectors. This was something that investors, especially wealthy investors, learned very well in the last two or three decades of the twentieth century. The monetary expansion created by the Federal Reserve and all the debt created by the federal government does not have to go into the production of goods and services, production that will lift employment.
Investors learned that all this credit inflation could just be used in the financial circuits of the economy and produce exceptional returns and did not really have to go into the real sectors of the economy at all.
And this was done by chasing more risky deals, by increasing financial leverage, by financing long-term financial assets with short-term liabilities, and by creating new and different financial instruments and structures when the existing ones did not quite do the job.
The best example I can show of this shift from productive efforts to financial rewards is General Electric (GE), which earned more than fifty percent of its profits from its financial services subsidiaries. In the 1950s and 1960s, who would have ever thought that GE would have earned so much from finance?
However, this is the dilemma now. How can we get people and businesses to invest more in capital investment and productive output and not put their funds into the financial arena?
My concern is that as long as the incentives created by the Federal Reserve are maintained, there will not be a robust investment in physical output. Not only does it cost less to invest in financial assets than it does to invest in capital investment and production but the uncertainty faced by manufacturing organizations, I believe, far exceed the uncertainty faced by those doing financial investment.
For manufacturers, the future is very uncertain and has not been helped at all by the political environment. Furthermore, those engaged in financial investment have been told by the Federal Reserve that short-term interest rates will be maintained at current levels well into 2014.
In such an environment, why would a manufacturer want to make majors commitments to expand their output? Why shouldn't the manufacturer just use the money sitting on his balance sheet to invest in the financial circuit where so many people are now making substantial returns?
This, however, does not bring in the "little guy" and does not spread the participation in returns. So, the Federal Reserve is trying to get people to dance, but many that could dance are just not ready to step out on the dance floor. The Federal Reserve has state its commitment to keep the music going.
Of course, until it feels it needs to "take away the punch bowl." Interesting how so much of finance and monetary policy can be described in terms of a party … not in terms of real, get-down-to-work-and-get-dirty productivity.
On the other hand, it still might be the case that enough people got burned in the financial collapse of 2007-2009 that they are still very wary of getting back into the dance. Financial cycles generally start out by producing very high returns for the early participants in the game. These large returns then draw more and more players and the returns begin to decline as opportunities decline. In the later stages of the cycle, less- and less-sophisticated players enter the game and the returns become very small or even become negative.
This kind of scenario reminds me of the experience of Foster Friess, the founder of Friess Associates, LLC, who managed Brandywine Funds. Friess has been called the "longest surviving successful growth stock picker" by Business Week and "one of the last century's great investors" by CNBC.
But, in his record, Friess have to live with the fact that on one occasion he joined "the dance" a little too late. For a long time in the 1990s, Friess stayed away from the dot-com boom in stocks. He claimed that no one really knew the dot-com market nor dot-com stocks, hence they were just a gamble.
He stayed away so long that he found that he was losing customers who moved to other funds that were prospering because of their commitments to dot-com stocks. Finally, in the later 1990s, Friess gave in and moved into dot-com stocks. Unfortunately, this was near the time and within a relatively short period of time, Friess made the front page of the Wall Street Journal. This front page article detailed the movement of Friess into dot-com stocks and the subsequent price that was paid for giving up his long held views about this part of the stock market.
Joining the dance is fine, but timing is everything! Those who were still dancing the last time "the music stopped" may be very reluctant to get up and start dancing again. But, by not dancing, they are thwarting the efforts of the Federal Reserve. But, I don't think this type of behavior is in the econometric models of the central bank.