Oz Economics: The Economic Twister And The Fed Response

by: Tim Davis

Since 2008, when the U.S. economy took a rap on the head by a flying window frame in a twister, we have traveled down a hallucinatory road where our officials bear a resemblance to those in our normal life, but whose actions are surreal. On the one hand, our government's decision-making mechanism is as inflexible as the Tin Man without his oilcan. On the other, the Fed has turned what should be a one-time emergency financial stimulus policy into an ongoing practice, lost control of the ropes, and our debt balloons away into an unknown stratosphere. Where did that money go? Not to the Emerald Kingdom of real investment, but, in an unprecedented move, to the "excess reserves" column of private banks.

As a nation we are venturing deeper into a Spooky Forest of debt, where lions, tigers, and (particularly) bears lurk. One day, it will take the Fed more than three clicks of the ruby slippers to prime the economy and bail out the markets. We are increasingly vulnerable to economic shock and are certainly prone to a correction in the equity markets at these lofty levels. Who is to say from which corner the danger will come?

The markets are particularly vulnerable to downside shocks, where volatility picks up. At some point, we see the situation devolving into a protracted bear market that includes a spike in U.S. fixed-income yields and, quite possibly, U.S. dollar dislocation.

A Fed of a Different Color

The Great Wizard of Oz would have you believe: Following the 2008 crisis, the Fed did what it had to, and its actions have been measured in their scale and fiscally responsible to the nation in light of economic conditions.

The Reality back in Kansas is: At a time when the U.S. could not pass a budget much less get to a balanced one, the Fed ballooned the country's balance sheet beyond what should have been necessary. And the vast majority of these funds sit idle at the country's private banks.

Coming into 2008, the country's monetary base had been swelling along just fine. Clearly, the banks were lending aggressively (and repackaging loans) in ways that regulators did not understand, and this was ultimately the root of all the issues. But, then again, everyone was making money. We suppress naysayers who try to upset apple carts, and then we identify martyrs to sacrifice in the aftermath of apocalypses. Such is human nature. Everybody's bad.

Then, the crisis happens. Taking a lesson from the pages of Great Depression history, Ben Bernanke forces the banks to take money and starts to stimulate the heck out of the economy through them. The opening move is to double the monetary base to $1.7B in one shot. Well, that should be enough to get the system flush! And at least a liquidity crisis is averted…

As to restarting the economy, the banks don't want to play ball, though. They pay back the TARP funds (with interest) in short order. Then, they stop lending in large part (as is demonstrated by the M1 Money Multiplier). They have not reopened their doors since 2008. "Congress has been chastising us for years for taking undue risks over the mortgage stuff. Not going to do it again. Nuh-uh. Only those that don't need money need apply." The effect of the banks halving the multiplier effect cancels out the doubling of the monetary base in one fell swoop.

Sadly, the dysfunction did not stop there. In what would seem to be a bizarre and surreal disconnect, the Fed has kept attempting to inject liquidity into the system through the banks time and again through the course of multiple quantitative easing programs. What has happened to that money? The banks have stuck in in their own vaults in the form of excess reserves -- a column of assets they had never heretofore presented on their balance sheets.

Quantitative easing was designed to be a one-time shot in the arm to reignite the economy, but became an ongoing way of doing business. The true travesty in this case is that 85% of the $2.8 trillion (or $2.4T) of quantitative easing since 2008 never reached the economy.

"OK, banks, if you won't pass the money through to the broader economy if we throw $1T at you, how about $2.4T?" If it is not actual stimulus, what is it? Window dressing? At what cost?

By way of context, $2.4T could purchase the world's gold reserves >2.5X over at current prices or all U.S. farmland >5X over (according to the Wizard of Omaha's 2012 estimate).

This is to say nothing of the additional $4T balance sheet of Treasury and agency securities that the Fed will have accumulated between 2008 and the end of this year. These have been purchased in an attempt to stimulate the economy by keeping borrowing costs down, at a time when, in reality, we very much need to borrow a whole lot more. What happens to interest rates when the Fed needs to unload these at the same time as we need to sell a whole lot more to fund our deficit, pay out interest costs, etc.? Uh-oh.

If the Fed were doing this at a time when our books were in order, that would be one thing. However, we struggle to pass a budget and can't balance one to save our lives.

Our revenues as a sovereign nation can cover our entitlement obligations (social security, Medicare, Medicaid, etc.) but nothing beyond that. That means we go deeper into the red for the cost of government, national defense, or interest on our national debt.

Is this a time for the Fed to unnecessarily increase our debt by $2.4T to have it sit idly in private banks' excess reserves? Does this make sense? Is it responsible? Toto, I don't think we are in Kansas anymore. And it will take a lot more than throwing a bucket of water on this Wicked Witch of Debt to kill it.

In conclusion, we find ourselves in a time when we are running out of bullets and cannot prime the economy. Furthermore, we are prone to downside shocks that could come from anywhere.

In order to prepare for such a situation, we recommend putting collar options spreads onto equity positions to lighten up exposure in melt ups and to protect it in meltdowns. We would then use the proceeds to shift assets into gold and other uncorrelated hard assets.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in DIA, IWM, QQQ, SPY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.