Insider-Traders Of Last Resort: Fed And ECB Will Be Solvent Longer Than Markets Are Irrational

by: Andrew Butter

The synchronized announcement of QE-3, plus the capitulation of the German hard-liners to the money-printing plans of the ECB caused a knee-jerk jump in the price of gold, and a collective sigh of, "Here we go again."

Surely Hayek is turning in his grave?

Perhaps not:

Hayek's Big Idea was that when governments or their agents in the Central Banks pump up the supply of credit; that causes mal-investment, which leads to boom-bust. But who says QE-X will prove to be a mal-investment? In any case what's supposed to be happening now is turning bust into boom, which is something else.

There is no question that irresponsible lending, particularly when facilitated by or delivered by government, leads to mal-investment.

There are an abundance of recent examples; the most obvious were the credit that got extended to the housing market in the U.S., which caused a boom and a bust, plus the honeymoon lending in the flush of the New-Renaissance, to finance "investment" in the luxury of tolerating rigid labor markets and political cronyism in peripheral European countries, which caused the euro crisis.

No arguments there. Yes if there had been a "sound money" policy starting in say 2000 then the booms would not have happened, and neither would the busts; characterized now by what Mises once called, "the slow painful process of recovery."

The argument of the Gold-Bugs is that a gold standard automatically imposes fiscal discipline on governments, and in an ideal world there is no place for a central bank; and thus the sooner that happens, the better. The other side of that coin is that in a democracy, if the majority of the population decides to be fiscally irresponsible and sell their grand-children down the river, that's their democratic right.

And in any case if gold was the only money then economic growth would cause the value of gold to go up and the price of goods and services in gold to go down, since the supply of gold is pretty much constant. Which is the deflation that central bankers fear as much as vampires fear silver.

Although it's hard to understand why anyone saving their money in gold should not benefit from their fiscal prudence by staying ahead of the game thanks to the appreciation of the value of their savings, just as these days, anyone saving money in U.S. Treasuries is rewarded with an interest payment, which supposedly beats inflation.

But the central bankers say that mal-investment is not all bad. So what if someone paid too much or the foolish banks, which financed those transactions, lost money? The point is that for every looser there was a winner.

For every unfortunate who borrowed to buy a house in USA for $500,000 that today can only be sold for $250,000 there was a winner who probably bought that house in 2000 or before that for $250,000 who made a $250,000 windfall profit…so long as they rented from 2007 to now.

What the much maligned Ayn Rand had to say about that was that the "economic terrorist" in such a transaction was as much the seller who got paid too much, as the foolish buyer. In Rand's book someone like George Soros who made billions selling over-priced assets bought on credit, to losers, was the bad-guy. If he hadn't sold, the losers would not have bought.

The difference between bubble economic transactions and "normal" transactions is that they are zero-sum. For every winner there has to be a looser. In an economic transaction that creates value, both sides are winners; that's the difference. Ayn Rand said that it is the responsibility of everyone to make sure the other side wins too.

That's an interesting viewpoint; certainly in my personal experience, the best salesmen are the people who genuinely care about what value their customers can derive from what they bought; those people will always find buyers for whatever they sell. By the same token, I don't imagine the folks selling collateralized debt obligations at Goldman Sachs have a particularly loyal customer base they can tap into for their next great deal; economies don't grow out of the corpses of losers, they grow when everyone wins.

Perhaps what the central banks are trying to do, is belatedly perform CPR on the losers?

But as of now, the booms and busts of recent years represent one of the largest transfers of wealth from one set of pockets to another set; in the history of mankind. Outside of war or forced nationalization, or as in the case of Russia, forced de-nationalization.

In the case of the U.S. the transfer was mainly from the poor, many of whom couldn't qualify to get on the train at the start; to the rich, who had homes in the beginning and could qualify for mortgages in the beginning. In Europe it was savers, via pension funds and insurance companies, who lost money subsidizing exports from Germany and France to peripheral countries living beyond their means, paid for with credit.

Then on both sides of the Atlantic there was the government and their agents the central banks, who were left to pick up the tab of the losers, supposedly in the public interest and for the greater good.

One thing that runs through most periods of boom-fueled mal-investment is the role of government and/or central banks.

They are usually not the prime mover. They are the facilitator providing an unspoken and opaque back-stop, which clouds valuations.

The South Sea Company was originally conceived by Edward Harley and John Blunt as a way of raising money to pay for The War of the Spanish Succession without going to the monopoly Bank of England, which at that time was privately held. The new company, in which the government had an interest was a private-public partnership, granted a monopoly concession, supposedly a license to print money, and in the short term, everyone was a winner.

Fannie & Freddie were de-facto monopolies in private-public partnership. So were the European banks, which paid too much for PIIG debt and were implicitly guaranteed by their governments, and allowed to operate on razor-thin capital bases.

For governments it was all about having your cake and eating it. The housing boom in the U.S. created the illusion of wealth so money got spent, tax revenue went up and the government and the central bank, congratulated themselves on their steady hand on the tiller, and let the good-times roll.

Everyone was a winner and when 65% of the electorate owns their own homes, and the price of homes goes up, well that's election-candy on speed. In Europe there was prosperity too. The easiest way to deal with unions and legions of under-employed public servants is to give them pay rises, more holidays, and the promise of index-linked pensions; so then they go out and spend and the good-times "trickle-down."

That was then, now is now.

The money that paid for the housing bubble was not printed by the Federal Reserve; it was created by securitization back-stopped by Fannie & Freddie who were implicitly and later explicitly back-stopped by government. The buyers were insurance companies and pensions funds, mandated by government to buy the "investment-grade" toxic assets; it wasn't the Fed that caused the bubble, the money came from securitization.

The credit that created the mal-investment in current expenditures in Europe, to fund lavish social services and pay union workers and public servants more than the market rate, was implicitly, and is now explicitly, back-stopped by government.

Then reality struck and the Federal Reserve stepped in to buy toxic-debt when no one else wanted to buy it, and prices went through the floor; and now the ECB is doing the same thing.

Whether the break-down of the markets was "irrational" is debatable, but was that mal-investment?

Well, probably not. The Federal Reserve bought assets for a song and Italian 10-Year bonds yielding 7%, were a steal; so long as you have the money to keep going, and to sit on your investment, and keep buying until yields go down to 4% or less, at which point you can sell at a tidy profit.

That's the beauty of a central bank. For ordinary investors, in the words of Keynes; "Financial markets can remain irrational far longer than you can remain solvent." But central banks have no such constraint, or in other words, "Central banks can remain solvent far longer than financial markets can remain irrational."

If that's not an insider-trade made in heaven, I don't know what is?

When the value now of a legacy mortgaged backed security, mark to market, is dependent on what the government or the central bank does in the future, rational valuation is impossible.

So, on the face of it, Hayek might have been delighted with the response of central banks to launder away the down-side of the mal-investments of the past. Because there is good reason to suppose that they will make a profit in the end; so that's not mal-investment.

Whether that process doesn't have elements of private-public partnership and the distorting monopolies that spawns, is something worthy of consideration. What are the "unintended consequences" of super-low yields on U.S. and German government debt?

Certainly the beneficiaries of that are not savers who are being herded towards risks that they don't want to take. Plus the simple fact of life is that many valuations of assets savers are being pushed to buy are based on expectations of both future revenue streams, which are always uncertain, nothing changed there in a free-market, plus the "risk-free-rate" used for discounting those future cash flows; which is increasingly determined by government edict rather than by the marketplace. And is thus impossible to predict with any certainty.

With regard to what happens to the money channeled into the system, there is of course a risk of inflation and more mal-investment.

But not necessarily, the hyper-inflation that many were predicting as the consequence of the first round of QE-X didn't happen. There wasn't even a decent bout of inflation. That was partially because the money didn't find a road to "main street" and partially because monetary inflation is a function of increase of money-supply plus the increase of velocity; money supply went up (nominally), but velocity went down.

If QE-X in Europe and the U.S. is used to buy time whilst structural changes are made, notably to the tax code and the current incentives in both the USA and much of Europe to frighten away new enterprises and investment with rigid labor markets (more so in Europe), bloated unionized public sectors, and subsidies for house prices (in Europe, particularly France, Holland, and still in Spain), then there might be a happy-ending.

The Gold-Bugs, evidently, are skeptical. Certainly what happens next wouldn't be the first time a hurriedly cobbled-together public-private partnership didn't end in tears.

The rationale behind QE-X and the latest round of money-printing by the ECB, is supposedly not "saving the banks" anymore, although that's debatable in Europe. The sticker says the new measures are about creating the right conditions for employment and economic growth.

But Steve Jobs didn't create the iPhone because some banker offered him a line of credit, neither did Mark Zuckerman create Facebook for that reason. So I'm not sure exactly how printing money will create anything more that the illusion of wealth and jobs that are not needed for anything except mal-investment.

Granted both the Fed and the ECB have pointed out, there is only so much you can do with monetary manipulation, and real economic growth has to be in the hands of the politicians, not the central banks. Or more to the point, the politicians have the power to stop real economic growth, by cronyism, de-facto monopolies and red-tape.

In the short term for every Get-Out-Of-Jail card handed out by the central banks, there is an incentive for popular politicians to leave the hard choices they have avoided making for ten years or more until after the next election…and the next.

And in the short term there is no point in doing rational valuations of bonds. According to me, the fundamental yield of the 10-Year Treasury is about 3% now.

The reason it's almost half that, is because of the actions of the central banks. So anyone who based their investment decisions on the "fundamentals" is a to stay irrational, forget fundamentals, follow the lead of the central banks, at least until they become insolvent.

The unintended consequences of that strategy are hard to predict, all anyone can say is that they will probably be unintended.

That's the risk to keep an eye on when you buy risky assets. And the free market, well, forget about it, that's some ancient idea. Time perhaps to build a museum using some of that printed money so that our grandchildren can learn about where they came from.

But would that be a mal-investment?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.