On Friday, an article appeared in the New York Times which encapsulates all that is wrong with the way America thinks about credit and debt. The piece is littered with counterintuitive logic as suggested by its oxymoronic title: "Rise In Household Debt Might Be A Sign Of A Strengthening Recovery."
In the very first sentence, the author demonstrates either a very short memory or, more likely, an unwillingness to concede the absurdity inherent in claiming that the solution to a recession brought about by the bursting of a credit bubble is the extension of ever more credit:
"For the first time since the Great Recession hit, American households are taking on more debt than they are shedding, an epochal shift that might augur a more resilient recovery."
The preposterous implication here is that the strength and sustainability of the recovery is dependent upon the accumulation of debt. The author's line of reasoning goes something like this: after accumulating massive amounts of debt in the years leading up to the financial crisis, Americans have finally managed to reduce their proportion of household debt to personal income and as such are in a good position to take advantage of record low interest rates by starting to borrow again.
If Americans had learned anything from the financial crisis, their first instinct upon paying down their debt would surely not be to immediately begin borrowing again just because rates are low. Alas the temptation to borrow and spend is too great -- America is, as Marc Faber put it, a "credit addicted economy."
The Fed knows this and is doing everything it can to leverage (no pun intended) Americans' propensity to live beyond their means to create a robust economic recovery. Of course, this means reinflating asset bubbles. Low rates and artificially high asset prices go hand in hand and are meant to reinforce each other. Low rates drive money out of savings vehicles and into other assets which in turn drives up the prices of those assets and creates the illusion of more wealth which then encourages further spending, and so on and so forth. Direct purchases of these same assets by the Fed supercharge the process.
What is disturbing is that no one on the FOMC, save Richmond Fed Chief Jeffrey Lacker, seems to be particularly concerned about the fact that it was asset bubbles that got America into its current predicament in the first place. In his most recent letter to clients, hedge fund manager David Einhorn voiced similar concerns regarding the Fed's seemingly short memory:
"...we just spent 15 years learning that a policy of creating asset bubbles is a bad idea, so it is hard to imagine why the Fed wants to create another one."
The likely answer is that the Fed, like all other Americans, has forgotten that things could ever be otherwise. Indeed the idea that asset purchases by the Fed are now indefinite suggests that bubble blowing has become the FOMC's official policy.
The government and anyone with a bullish outlook is certainly betting that American consumers will be more than happy to participate in this madness. In fact, the government's own forecasts rest on the success of the Fed's programs as noted by The Levy Economics Institute which recently observed that the only way the Congressional Budget Office's GDP growth estimates can coexist with the Office's projections for the budget deficit is for consumers to embark on a debt-fueled spending spree.
Meanwhile, more traditional ways of improving one's lot are falling quickly out of favor as they are crowded out by the Fed's efforts to make the nonstandard standard. The most obvious example of this is the process whereby the combination of asset purchases and low policy rates has robbed savers of their interest income. While the Fed's implicit assumption is that the benefits of the 'wealth effect' will outweigh the harm to savers, this is pure speculation and if it turns out not to be the case, billions in forgone interest income will have been for naught. Einhorn speaks to this point in his most recent letter as well:
"How fruitful is the wealth effect? Is the additional spending that these volatile paper profits are intended to induce overwhelmed by the lost consumption of the many savers who are deprived of steady, recurring interest income? We have asked several well-known economists who publicly support the Fed's policy and found that they don't have good answers."
Einhorn -- who knows a thing or two about gambling -- seems to be suggesting that the Fed is making a bad bet. While there is no evidence to suggest that the wealth effect will create consumption sufficient to offset decreased spending by savers robbed of interest income, there is quite a bit of evidence that suggests the consequences of inflating asset bubbles are likely to be particularly unpalatable.
Notice that on the Fed's current path, there seems to be a contradiction around every corner -- creating the wealth effect produces offsetting effects in terms of lost interest income, buying assets to boost prices and create wealth increases the prices of goods thus reducing the amount of goods that can be obtained with the newly created money, etc. The reason for this is the Fed is searching for something that doesn't exist, namely a 'free lunch'. No matter how hard it tries, the Fed cannot print America back to prosperity. Despite this rather obvious fact, it has become apparent that the Fed isn't turning back. As Einhorn notes,
"It seems as if nothing will stop the money printing, and Chairman Bernanke in fact assures us that it will continue even after the economic recovery strengthens. Apparently, anything less than a $40 billion per month subscription order for MBS is now considered 'tightening.' He's letting us know that what once looked like a purchasing spree of unimaginable proportions is now just the monthly budget."
Whether or not this will turn out to be a positive sum game remains to be seen and if the New York Times article cited above is any indication, the insatiable American appetite for credit and consumption will work alongside the Fed's policy to offset the 'hoarding' effect exhibited by savers stinging from lost interest income.
What investors should keep in mind is that no matter what the short-term results turn out to be, the long-term outcome is virtually certain. There is no such thing as a free lunch and asset bubbles inflated in search of something that doesn't exist will ultimately pop in spectacular fashion. There will be money to be made shorting everything from Treasury bonds (TLT) to equities (SPY) when this diabolical monetary experiment finally unwinds. Those looking to get in on the action are reminded that it is better to be too early than too late.