Make Hay While The Sun Shines

by: Thomas Sobon

In recent years Ben Bernanke and the Fed used monetary tools to address economic problems and it is arguable as to how successful their actions were and how enduring the benefits there from will be. History has lessons to teach for people who strive to understand the present and divine the future. A couple of lessons from the past can provide perspective as it relates to quantitative easing and the economic situation extant:

Back in the late 1950's the economy was mired in a recession, the stock market was in the doldrums, and William McChesney Martin was the Chairman of the Fed. The captains of industry and their counterparts on Wall Street clamored for the Fed to reduce interest rates in order to stimulate the economy. But Martin (a man of considerable intellect and courage who led the Fed for 19 years and served during the reign of five presidents) held his position and wasn't swayed by their pleas. He knew that the economy had to complete the correction taking place in order to eliminate the excesses from the boom years of the early-to-mid 1950's and thus clear the way for an ensuing expansion.

So he waited until the economy contracted to the point where the cyclical and secular trends (based largely on demographics) were such that the cyclical factors were stabilized and positioned to respond favorably to stimulation by the Fed. Walla! His timing was such that the economy boomed from 1961, when he lowered interest rates, through 1969 when he raised rates to fight inflation caused by heavy government borrowing and spending due to the Vietnam War. His action was a text book measure that was hugely successful.

How does that economic situation relate to the one extant? The answer should be obvious. When the economy was tanking in 2007-2008 the Treasury and the Fed came to its rescue. The situation was dire so they didn't (couldn't?) wait until it contracted to a stabilized level of supply and demand as determined by cyclical and secular forces. The Fed shouldered most of the burden for salvaging the economy. Thus far its QE policies produced mixed (tepid?) results but that is about all one should have expected simply because a stabilized base from which to expand the economy had not been (and still has not been) established. The degree of success (or failure?) will not be known until (if ever) the Fed undoes what it did while expanding its balance sheet; more anon about the balance sheet.

When those at the Fed or the pundits on Wall Street talk about a Fed stimulus in times like these they are being disingenuous because they are really talking about a rescue (bailout?). There is a big difference between the two. A genuine "stimulus" is a rational, well planned, and measured technique to promote cyclical expansion of the economy according to the underlying secular trends. In such cases the economic expansion resulting from the stimulus can be robust as was the case in the 1960's. A "rescue" is a Hail Mary technique based upon the hope that somehow the weakening economy will magically stabilize and be able to generate self-sustaining expansion. Whereas Martin was betting on a "highly probably outcome" by acting after the economy stabilized, Bernanke was betting on "wishful thinking" by acting before stabilization. But Ben's tooth fairy failed to appear with her magic wand so the expansion did not become self-sustaining simply because waxing of economic activity in one sector was either sluggish or offset by waning in another.

If it was possible (which it wasn't) for the Fed to eliminate the significance of the ruptured secular trends with monetary policy, it would have done so by now and the economy would be booming (which it isn't). The CEOs sensed this early on (along with similar problems in Europe and elsewhere) and prudence dictated that they honker down and sit on mountains of cash instead of investing in plant and equipment. Anyone who knows anything about economic theory should know that consumer spending has a "multiplier" effect on the GDP and business spending on plant and equipment is the "accelerator" that gives rise to robust and sustainable growth. Whereas the policies of Martin activated the "accelerator," none of the policies of Bernanke came close to having that desirable effect. It appears that the only ones who knew about (but never really understood) the kind of rut in which the economy was stuck (judging by their actions) were Bernanke, the doves at the Fed, and the pundits who kept calling for more quantitative easing: QE1 and QE2 expanded the Fed's balance sheet. And then "operation twist" added to the average duration of securities held on the balance sheet.

The Fed then decided on more quantitative easing by launching QE3. Why? Bernanke and others in his camp didn't learn much from the Fed's prior QE actions (mistakes?) where they got little bang for the buck. Increasing the money supply and interest rate reductions only work when the money supply and interest rates have been "restrictive" and such were not restrictive during the time span being referenced. So no meaningful and broad based benefit resulted from QE3. Understandably, the bulls (especially the traders on Wall Street and elsewhere) applauded such action because, having an ax to grind, they stood to gain benefits from it. In effect, the traders benefit, the problems don't get solved, and the bears lament while the Fed is left holding the bag.

A few days ago (2/21/13) the FOMC released its minutes for its most recent meeting (a trial balloon?) and several members of the committee mentioned possibly adjusting the asset purchases of ongoing economic-stimulus efforts because the economy is picking up steam. It was as if someone in a theatre shouted "fire" and the operatives on Wall Street rushed to the exits. Bids were pulled while sellers dumped shares and thus began a wide spread sell-off. The last thing Wall Street wants to see is the money spigot being turned off.

A second lesson from the past can provide additional perspective on the subject being discussed: Back in the 1950's Professor Fellner of Yale wrote a text book about business cycles. And, his theory about "the expansion path of dynamic equilibrium" provides an interesting insight into our current economic situation. Ingeniously, he analyzed the business cycle by eliminating it. In order to sustain economic expansion over an extended time span, two conditions have to be met: (1) interest rates have to be stable at free market rates and (2) domestic savings (private plus public) have to equal domestic investment. Now-a-days interest rates are stable all right but only because they are being manipulated at artificially low levels by none other than the Fed. Can there be any doubt as to what will happen when the Fed no longer manipulates those rates?

Furthermore, the U. S. is a debtor nation so it is not in a position to finance domestic investment from domestic sources of savings; and, it is unlikely that it will be able to do so in nearby years. So the aforementioned items (1) and (2) continue to auger ill for economic expansion in nearby years. It is ironic that the Fed's low interest rate policies encouraged consumption and discouraged saving when exactly the opposite was needed to set the stage for self-sustaining growth. Even if there was no political divide among the politicians in Congress the U.S. economy would still have substantial problems to cope with in nearby years because of interest rate developments and insufficient savings. Regarding items (1) and (2), it won't be dire predictions by the bears that we need to be fearful of in the years ahead. No! It is likely to be the Fed's balance sheet and high interest rates (caused partly by insufficient savings) that hang over the economy like a Damocles' Sword.

When a reporter asked about the Fed's expanded balance sheet about a year ago, Bernanke dismissed the question and stated that he wasn't concerned about undoing it. In a perfect world Ben wouldn't have to be concerned (and neither would anybody else) because he'd be able to put back to the market the securities bought at the prices paid. Unfortunately, ours is not a perfect world and he is not going to put back to the market the securities bought at anywhere near the prices paid. Anyone interested in learning about how high interest rates can go when the Fed no longer manipulates them can look at what happened in the years after 1951 when the Fed lifted its 1.5% peg on 1-year T-bills and its 2.5% peg on the long bond. T-bonds soon became the "Magic 3's", then the "Magic 4's, and (you guessed it) the "Magic 5's. But, no one should look at the current size and composition of the Fed's balance sheet unless he is willing to take two aspirins every four hours.

Thus far I tried to provide some perspective on quantitative easing as it is being used to solve our economic problems and I took some shots at Bernanke. Ben has a difficult job to do and he should be pitied as much as criticized. His job would be a lot easier if he got some help from the politicians in Washington but the political divide there is what it is.

To gain perspective on the political divide extant, consider the following items: (1) H. G. Wells was famous as a science fiction writer but he was also as a good a historian as the world has ever known. In his book called "The Outline of History" he wrote about Machiavellian principles as "Old Nick" expressed them in his book called "The Prince" (published in the 15th Century). Wells concluded that Machiavelli "crystalized what idealist had criticized." And from the 15th century until the present time "the history of the world was shorn of its mystery" because political parties of all stripes would be practitioners of Machiavellian principles to varying degrees. The political divide extant shows that the extremist in Congress understand all too well and are practitioners of the aforementioned principles.

(2) The following quote from Ralph Waldo Emerson will provide more perspective on the political divide: "The theory of politics considers people and property as the two objects for whose protection government exists. Personal rights demand a government based upon the consensus of the people. But property demands a government that favors the owners over the owing. Too much weight allowed in the laws favoring property allows the rich to encroach upon the poor and keep them poor." That pretty much defines the nature of the political divide. When push comes to shove bad things can happen.

(3) A few lines from the Broadway musical comedy "Lil Abner" will provide additional perspective on the divide: "Republicans and Democrats each hate the other one. They're always criticizing how the country should be run. But no one tells the public what the other's gone and done. When no one knows nobody understands. The country's in the very best of hands." The political pundits on the right and left will continue to do their best to obfuscate the situation as it unfolds in the days ahead to gain whatever advantage they can. So we will continue to be bombarded with their propaganda.

(4) John Kenneth Galbraith wrote as excellent book about the crash of 1929 and the depression of the 1930's. In it he opined that "Few people escaped its consequences because few people were meant to escape its consequences."

No one can be certain how the problems associated with monetary policy or the political divide will be resolved or how well the economy will perform in coming years. Even in the best of times life is a mystery to be lived and not a riddle to be solved. And the next several years are not likely to be classified by anyone as the best of times. So anybody who is concerned about what's going to happen will have to cope with the mystery as it unfolds.

As a private investor I am trading the market as I try to "make hay while the sun shines." I believe that the sun will not be shining very brightly when the quantitative easing ends and/or the political divide widens. One thing is certain: what is virtuous about us individually and collectively will survive and what isn't won't.

Disclosure: I am long PDH, RAS. 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.