How The Fed Creates Bulls And Bears

by: Roger McKinney

If you grasp this you will be light years ahead of most economists. Bull and bear markets can't exist without the Fed manipulating the money supply. Here's why.

Assume the stock of money is fixed. For example, say there exists only $1 trillion in gold and banks have lent out nine times that amount so that the total money supply of gold plus credit equals $10 trillion because the required bank reserves are 10%. Also assume the population remains constant. If nothing changed, prices would remain the same and the economy would be in a state that economists call equilibrium. Profits would equal the cost of credit, say 5%.

Now we have to look at how many times the $10 trillion is turned over, or changes hands, in order to figure out the total sales for the year. We'll assume that the turnover, or velocity, of money is five. Then total sales for the year would come to $50 trillion. A profit of 5% would mean $2.5 trillion. Now let's assume the P/E ratio, the measure of risk tolerance, is 15. The market cap would be $37.5 trillion.

With a fixed stock of money, productivity increases at zero and the population remaining constant, the stock market would show the same values every day. Planned investment equals real savings.

Now let's assume that productivity increases because someone has invented better tools for workers, such as a new and better computer. The output of goods and services will increase, but because the stock of money is fixed, prices will have to fall in order for the fixed money supply to purchase the new supply of goods and services. The quantity increase in output will offset the drop in prices so that the economy continues to achieve annual sales of $50 trillion.

If we adjusted for deflation, the real economy would have grown an amount equal to the productivity increase, let's say it was 5%. The real economy is now at $52.5 trillion, so people have a higher real standard of living even though the nominal income has not changed. But the price of stocks on the market will not have changed because profits won't have changed since the costs of inputs, labor and materials, fall with the costs of goods and services produced.

So how is it possible for the bulls to stampede the stock market to grow as much as 300% as it has in past expansions? For the most part, extended price appreciation in the stock market can only happen when the money supply grows rapidly.

The other driver of prices on the stock market is risk tolerance. In an economy with a fixed money stock, risk tolerance remains relatively constant. Investors don't experience irrational exuberance or terror. But when the Fed causes the money supply to vary as it has in our economy, risk tolerance varies with it. Investors become highly risk tolerant after long expansions and cause P/E ratios to sore, sometimes to 50:1. Then the Ricardo Effect kicks in and profits fall. Terror captures most investors and risk tolerance plummets and pushes P/E as low as 5:1.

It all begins with banks increasing the money supply through credit expansion.

However, the Fed is not omnipotent or omniscient. The process doesn't work mechanically as most mainstream economists think. Fed monetary policy can and has failed. The first problem is a microeconomic principle - diminishing marginal returns. Most mainstream economists think micro principles don't apply at the macro level, but they're living in a fairyland. When the Fed tries to increase the money supply by reducing interest rates or buying bonds from banks (QE), it can have some impact in the first couple of quarters, but then the effect diminishes rapidly until it evaporates.

Why? Because the Fed is dealing with human beings and not machines. Fed policies work best after a recession in which the state has allowed failed businesses to go bankrupt, get rid of their debt and force banks to write off the loans. And it works well if people have paid down their debt. Then when the recovery starts, banks can find high quality loans to make and boost the economy. Banks loan to the best prospects first and as they continue lending the credit quality of the borrowers falls rapidly. Eventually, businesses and consumers borrow until they can borrow no more and the Fed's money press seizes up.

The Fed was less effective in the latest expansion partly because the government rescued the largest borrowers, such as General Motors (NYSE:GM), Chrysler and AIG, instead of letting them go bankrupt. Consumers paid down debt to some degree, but businesses didn't, so few could borrow more. At the same time, Congress increased bank regulations and made it much more difficult for banks to lend to businesses while the Fed paid banks not to lend by paying them interest on their excess reserves. Investment bankers and hedge funds borrowed most of the new money and put it into the stock market. That by itself probably explains most of the increase in inequality in the US over the past generation.

Businesses didn't borrow to expand operations, but to buy back their own stock because of high taxes and the heavy burden of 500,000 pages of new regulations in the Federal Register since 2008. For monetary policy to be effective at helping the economy, someone has to be willing to borrow and invest in new or expanding businesses and engine of growth was weak in the recent expansion.

Though the Fed ignites the expansion, the real economy ends it as well as causing the stock market to tank when profits fall and bankruptcies increase. The world's central banks will always try to reassure investors that they have the power to re-ignite the artificial boom, but by that time diminishing marginal returns will have neutered the central bankers. They will be powerless to sire another boom until loans have been wiped out and businesses can borrow again.

Most financial experts get their theory of how the economy and market work from mainstream economists who assume that low levels of unemployment and high nominal GDP growth are signs of strength. So they will encourage their followers to "buy the dips" and stay in the market.

Austrians understand that most of the higher GDP and lower unemployment comes from Fed money printing and are signs of the end of the expansion. Followers of Austrian economics will hedge against the inevitable collapse. Hedging can take several forms, but they all cost money. There is no way around the cost. One hedge is to bail out when times are at their best and stay in cash for a while. In that case, investors may suffer opportunity costs by leaving on the table returns they might have earned from a rising market, although opportunity costs over the past year and a half have not been great. Other hedging methods include buying put options, selling call options, and selling futures, but those come with premiums that must be paid, like insurance, until the disaster strikes.

Investors can either fall victim to the harm the Fed does or profit from it, but to profit investors must understand the monetary and business-cycle theories of the Austrian school of economics.