- We have had a series of economic potholes since the Panic of 2008.
- These have included the Horizon oil spill, the Flash Crash, the Greek default scare, the US debt ceiling crisis, the MF Global Bankruptcy, and the Fukushima nuclear disaster.
- Despite these setbacks, aggressive monetary policy has enabled us to avoid a relapse into deflation.
- The old mantra "Don't Fight the Fed!" has a lot of truth to it; monetary policy is still a very powerful tool indeed.
When I went to a summer camp (Coindre Hall) on the north shore of Long Island in a large building, which had been the mansion of a "captain of industry" decades before, one night each week we had the showing of a "serial." This was a movie broken up into 10 or 15 half hour episodes each of which ended with a "cliffhanger." The first example of the genre had been the "Perils of Pauline" and the phrase "cliffhanger" came from the fact that many episodes ended with the heroine hanging by a fingernail from the crest of a cliff or mountain. The serial I saw involved a hero who was constantly on the verge of demise at the end of each episode with the following episode starting with his miraculous escape and a plot line devolving into a new "cliffhanger" just as the new episode ended.
When I listened to Janet Yellen's speech Wednesday I was reminded of this serial. She spoke about the expectations of the Fed and how on several occasions the expectation was that recovery was picking up steam and that the Fed Funds rate would be increased in the near future. She then expressed - with some frustration - her realization that the projections of the Fed for economic growth and inflation did not materialize and, instead, softer growth and weaker inflation led to a continuation of zero bound Fed Funds rates and, in addition, various phases of quantitative easing. Thinking about the period since the Crash of 2008, I began to realize that, in many respects, it resembled a serial with constant near disasters, many of which could have tanked an already weak economy. Here are a few of the "cliffhangers" we have endured organized in loose chronological order.
1. The Horizon Oil Spill (April 2010) - This was obviously an environmental disaster but it also reduced domestic oil production and led to a suspension of certain offshore drilling. It disrupted the economies of a number of Gulf states and threw a lot of people out of work. I am sure it shaved a chunk off of GDP for a quarter or two and it created uncertainty about future oil production.
2. The Greek Default Crises (April 2010 - ...) - Greece has been in and out of default crises since roughly April 2010 with the panic level rising and falling from time to time. Lesser default scares have afflicted Portugal, Ireland, Spain, Cyprus and, to a lesser extent, Italy. Each time, there has been the emergence of "risk off" momentum in the markets.
3. The Flash Crash (May 2010) - Remember this one? Like a clipper ship overwhelmed by a White Squall, the market suddenly declined for no particular reason and then, just as suddenly, righted itself (thanks for the lead keel). Just what we needed. Best of all, no one has really come up with a convincing explanation for why this happened nor can anyone really guarantee it will not happen again. All kinds of markets - the market for corn, the market for baseball cards, the market for crystal meth... are more stable and rational than this.
4. The Great Municipal Bond Panic (December 2010 - 2011) - A highly regarded pundit predicted record defaults on state and municipal bonds and all hell broke loose. It turned out to be a great buying opportunity but it probably also made it much harder for state and local governments to get financing and likely led many of them to tighten their belts. Whew! This one looks like a false alarm.
5. Fukushima (March 2011) - Japan's tragic tsunami cum nuclear meltdown was a hot topic on TV for several weeks. It disrupted supply chains, undermined the Japanese economy, led to the closing of other nuclear generating stations, and, of course, undermined the nuclear industry in the United States. For a period of time, there was speculation that radiation might affect Tokyo and have even more disastrous effects on the Japanese economy.
6. The Libyan Civil War (Spring 2011) - The breakout of civil war in Libya did result in the removal of its tragicomic dictator but it also disrupted oil supplies to Europe at a time when the Eurozone was haltingly trying to recover its footing.
7. The Debt Ceiling Debacle (August 2011) - Republicans in Congress played "chicken" with the debt ceiling just long enough to lead many people to believe that the United States would really default. It was also enough to lead the S&P to downgrade US debt. Wall Street managed to sell people "credit default swaps" on treasuries although one wonders whether the buyers fully appreciated counterparty risks. I guess the thought was that a CD swap sponsored by a "too big to fail bank" would ultimately be made good by the US government. This is certainly as sensible as most other things conjured up by the Wizards of Wall Street.
8. The MF Global Bankruptcy (October 2011) - At this point, most investors were too numb with fear to notice the failure of a large commodities trading firm. Too much leverage and a cavalier failure to respect the boundaries between house money and customer account money characterized this debacle. One would think that there would be at least a "decent interval" between the collapse of overleveraged institutions in 2008 and the next big blow up of the same kind, but three years is a millennium in the evolution of financial engineering. This particular disaster had surprisingly little real impact on the already shell shocked financial markets.
9. The Fiscal Cliff Crisis (Fall 2012 - January 2013) - The journalist who coined this phrase must have gone to the same summer camp that I attended and watched the same "cliffhanger" serial those summer nights. Once again, dire warnings occurred as we counted down the hours to a new deadline and anticipated the worst. But, after this many false starts, the markets were becoming jaded and maybe even a bit complacent. Still, businessmen had yet another excuse to postpone new investment and to delay more hiring until the fog cleared.
Somehow, through all of this, we avoided an actual recession and the economy continued growing. This is really remarkable because at the time this serial catastrophe began, the markets were fragile and skittish, having the vivid memory of the Panic of 2008 and the nasty bottom of March 2009 fresh in mind. Like a patient recovering from open-heart surgery, staggering under a tower of tubes plugged into various parts of his body and given a violent shove by a Sumo wrestler, the economy was frail and should have fallen flat on its face. Nevertheless, most of the time, financial markets righted themselves although it was often after nasty setbacks. Bond markets behaved especially well as risk spreads tightened and credit gradually but steadily eased. The question we have to ask ourselves is "why?" and what the answer portends for the future.
I really think that our survival of this series of cliffhangers is best understood in terms of the power of monetary policy. Once having demonstrated the ability to rescue the economy from the brink of disaster in 2008 and to make liquidity available as the economy recovered, the Fed earned the trust of market participants sufficiently to quell the panics, which well might have attended some of the events described above. Americans are optimistic and a grudging confidence has emerged that the Fed will "come up with something" rather than allow us to slide into a deflationary recession.
In an economy with fiat money and with a relatively high level of self-sufficiency so that exchange rate issues are secondary to internal macroeconomic concerns, a central bank can adopt whatever expansive policies are necessary to forestall a deflationary recession. Put more basically, we do not have to worry that lower interest rates will weaken our currency, make it impossible to import food, and lead to bread riots. The Fed should have the tools to prevent a repeat of the kind of catastrophe my parents suffered through in the 1930s. The fact that we have survived some nasty "cliffhangers" may have also - paradoxically - given markets sufficient confidence in the Fed so that markets will right themselves before those tools have to be used.
I just watched the documentary about Donald Rumsfeld and I am well prepped on "unknown unknowns" which, I guess, are, by their very nature, unknown. Investors have to recognize that the next big thing is probably something very few, if any, of us anticipate today. And it may be something, which overwhelms even the Fed's impressive power. But our ability to survive the shocks we have had since the Panic of 2008 provides perspective and should give one some confidence going forward.