Bernanke’s speech and the Fed’s big
problem
Bernanke’s speech at the
Jackson Hole meeting of central bankers last weekend was
met with the full range of responses between the
severest criticisms and complete apathy. The apathetic
are in the majority, but the critics are becoming more
focused and vocal, because they can now with certainty
point to the failure of monetary policies to achieve
anything, in spite of a doubling of the monetary base.
This failure is becoming more obvious because the
prospects for economic recovery are diminishing. The Fed
must be loosing confidence in its own policies, and this
is reflected in the mood at the Fed.
That the results of Fed
policy are disappointing is no surprise to those of us
who see the shortcomings of modern economic theories,
but what might surprise some of our small unhappy band
is the extent of the failure. The Fed and the government
between them planned firstly to rescue the financial
system from collapse, and secondly to rescue the economy
from further recession by a policy of deficit spending
and money printing. The damage to the financial system
is barely concealed in its balance sheets for the
moment, but anyone who knows half the truth about the
insolvency of the banks fears that a second financial
crisis is still likely. The rescue of the economy has
failed, and is making a second financial crisis almost
certain and more immediate.
The failure of Keynesian
policies has trapped the Fed in a cul-de-sac, from which
there is no obvious escape. So far, it has fortunately
managed to keep the economy financed on the back of a
bond market bubble.
We must now consider the
consequences for the bond market of the failure of these
Keynesian policies. The primary result will be a
dramatic widening of the Federal deficit and a matching
increase in the issuance of treasury debt. The Fed will
almost certainly accelerate its QE programme, buying
Treasuries; but the tsunami of new government debt seems
certain to pop the treasury bubble. Quite simply,
Treasuries will no longer be regarded as risk-free, but
instead poisoned with risk. Fed buying of treasury debt
will be understood for what it is: an extremely
dangerous gamble with the value of paper dollars. The
Fed will have lost control of the markets, and the
markets will have emasculated the Fed.
The gamble is made even
more dangerous by the presence of the banks, which have
a total exposure of $4.5 trillion dollars to the
government and the Fed.
This is made up of $2.4 trillion in Treasuries, $1.1
trillion of GSE securities (Fannie Mae, Freddie Mac and
Ginnie Mae), and $1 trillion in reserves at the Fed. And
banks are fickle investors at the best of times.
There is no sign yet
that the Fed is worried about these market dynamics. So
far, it has been able to print money with impunity,
because the markets have given it the benefit of the
doubt. But if QE did not work first time round, the
markets are unlikely to accept it a second time after
the treasury bubble has popped, without considering the
inflationary consequences. And there is now a
significant danger that the bubble will burst sooner
rather than later, because of the deteriorating economy.
The lesson of bursting
bubbles is that they are violent, hurtful events that
catch the unwary, suggesting the yields on Treasuries
have the potential to rise rapidly to unimagined levels.
This would be entirely consistent with a swing in
banking and investor sentiment, from regarding
Treasuries as a safe haven to being laced with risk.
The dangers for the Fed
are acute, and it even risks loosing control over
short-term rates. The penalty of borrowing at far higher
interest rates is an uncosted burden on government
finances, and any attempt by the Fed to shore up bond
prices by buying Treasuries would be viewed with the
deepest cynicism.
For the rest of us
investment strategy will have to be rethought. With
sharply rising yields in a slumping economy, bond and
equity markets will crash, along with commercial and
residential property values. All developed economies
face similar problems, so are also vulnerable. Emerging
markets have attractions, but portfolio exposure to them
is already at record levels, and a knock-on effect can
be expected from sharply rising dollar/sterling/euro
yields. Furthermore, US investors have another problem
to contend with: the effect of the end of the bond
market bubble on the currency.
Faced with rising
yields, foreign investors can be expected to sell both
dollars and dollar investments as quickly as possible to
limit their losses, adding a potential dollar slide to a
bond market crash. So the question for investors
becomes, with stocks, bonds and property all turning
sour, where do they invest their money? The answer by a
process of elimination is likely to be key commodities.
Meanwhile,
as I wrote last week, there is likely to be
accelerating demand for the same commodities from China
and other Asian nations, partly to secure resources for
their own future needs and partly to reduce their dollar
exposure. So we face the prospect of both portfolio and
strategic buyers bidding for commodities at the same
time. The effect, given fixed supply, could be dramatic,
with the cost of food and energy in particular
spiralling out of control. How high will the price of
wheat rise? Five or ten times? How high does the price
of oil go as winter approaches? $300? Or higher?
It would be no
exaggeration to describe such an eventuality as a
hyperinflationary slump.
As proxy for this mess
and perhaps in anticipation of it, both gold and silver
are showing worrying signs of strength, defying all
attempts by both central and bullion banks to suppress
their prices. If these proxies for money are leading the
way, the omens are not good. We have arrived at the
moment when central banks have lost control of bullion
prices to growing private sector hoarding, which so far
has hardly started. When the dust settles, we will look
back at the systemic shortages of these two metals in
disbelief, and wonder how it could have happened.
There is therefore
forward-looking evidence that the US economy is entering
a second recession, the reflationary moves to date
having failed. The catastrophic deterioration in
government finances this implies will change investment
perceptions of Treasuries, collapsing the bond market.
By a process of elimination, these flows can only go to
key commodities with dramatic consequences. The argument
is to strong to ignore, and deserves full consideration,
rather than dismissed.
1 September 2010
