The second Bernanke crash
By Martin Hutchinson
The turbulence in financial markets in the last couple of weeks has been ascribed by reporters to doubts about the long-term stability of the euro, and concern over the finances of southern European countries. This is over-optimistic. Whether or not the current market downdraft proves temporary, monetary and fiscal policies in the United States and worldwide have been excessively stimulative since the September 2008 market meltdown. Thus we are at some point in the near future going to suffer the second Bernanke crash.
As I have frequently discussed, there were a number of causes of the 2008 crash, some of them rooted as far back in the past as financial theories devised in the 1950s and housing regulation designed in the 1960s. Nevertheless, if one single cause has to be assigned, it would be the excessive money creation in the United States after 1995 and worldwide after 2002. This caused a massive asset bubble, initially in stocks and later in housing. Once the bubble had inflated, a commensurate crash was inevitable.
Had monetary policy returned to sanity after September 2008 (and fiscal policy not itself relapsed into madness) that would have been the end of it. Banks would have been provided with unlimited funding, as Walter Bagehot recommended in his 1873 Lombard Street, but at high interest rates. The global economy would have undergone a sharp recession, steep because of the deflation of value that had become necessary, but by the middle of last year would have begun a healthy and sustained recovery.
Apart from the direct bailouts of the basket cases Citigroup and AIG and the "stimulus" packages, the important difference between what happened in 2008 and what should have happened lies in the interest rate charged for the liquidity supplied in the crisis. A great deal of capital had been destroyed in the subprime mortgage meltdown, and risk premiums had gone sky high. Accordingly, while capital should have been made available by the world's central banks to their banking systems, it should have been available only at penalty rates. Rates of 8%, even 10% would have been appropriate levels for the federal funds rate and the rate for Fed "quantitative easing".
There would in that case have been no banks borrowing money from the Fed at ultra-low interest rates and investing it in Treasury bonds or government guaranteed mortgage bonds. Conversely, since money at high interest rates was readily available, high-yield uses for that money, such as lending to small business, would have remained quite attractive to the banking system.
A high interest rate in 2008 would have balanced the limited available supply of funds (other than at penalty rates) with the demand for them, balancing financial markets naturally. Instead, we have seen another explosion of leverage, as banks and above all hedge funds have borrowed money at current exceptionally low interest rates to invest in whatever seemed attractive that week. That explosion of leverage has been made worse by the Fed's persistence in keeping ultra-low interest rates for at least a year after the excuse for them had vanished. With the US economy bottoming out around May 2009 and the "stress tests" of that date showing that the banking system was now in decent shape, ultra-low interest rates should have been raised quickly and short-term rates should now be at normal levels, at a minimum in the 3-4% range.
As in 2002-03, ultra-low interest rates caused the stock market to bottom out excessively rapidly at a level well above its natural floor and to engage in an explosive rally that rapidly pushed stock prices above their sustainable level to a point at which equities once again represented poor value.
This has caused two problems. First, the US savings rate, which had shown encouraging signs in the downturn of returning to 8-10%, a level at which consumers have some chance of saving for their retirement and the economy some chance of financing itself, quickly dropped back to below 3%. With overvalued stocks (which both look expensive and make investment portfolios look fatter) and interest rates below inflation, it's surprising anybody saves at all.
Second, the excessive leverage that caused such problems in 2006-08 has returned. Risk premiums on lower-tier corporate and emerging markets debt have declined artificially towards the levels of 2007, at which they were clearly inadequate to compensate for the risks involved in holding those assets.
An additional hidden but connected problem is the further intensification of Wall Street's trading culture, exemplified by the explosion in "fast trading" volume, now three quarters of the trading volume on the New York Stock Exchange. This trading simply exploits the benefits of insider knowledge of money flows; in aggregate it subtracts value from the economy. Its participation in the recent "flash crash" in which over US$1 trillion was wiped off the value of US equities in 15 minutes is symptomatic of the problem - with "fast trading" computers in control, doing thousands of trades a minute there seems no reason why that loss should not have been $10 trillion or even more.
Maybe the theory that advanced galactic civilizations don't exist because they wiped themselves out with super-atomic weapons before developing interstellar travel is wrong. Maybe they simply invented computerized fast trading and reduced their civilizations to impoverished rubble that way.
With excessive leverage and inadequate saving, the US capital base is not being renewed as it would normally be after a speculative blowout. In the financial sector, this brings additional risk of a meltdown such as occurred in 2008. In the rest of the economy, it means in the long run that the US will no longer have sufficient capital supporting the skills of its workforce. If the US comes to have capital per head equivalent to that of China, and its education system is no better, why should it enjoy higher living standards?
Only those of us in the media, who live on reporting and analyzing excitement and chaos, can rejoice that the monetary policies of Federal Reserve chairman Ben Bernanke are unlikely to produce gradual, civilized decline to the living standards of China. Instead, because of the leverage and speculation they generate, they are much more likely to produce a gigantic bursting bubble, with major financial institution bankruptcies. The destruction of wealth will be greater than that of a slow decline, but the impoverished masses will be able to blame the evil private sector bankers instead of the public sector follies of the Fed.
It seems increasingly likely that the generator of the second Bernanke crash will lie in the global public sector. Budget deficits of 10% of gross domestic product (GDP) are not a normal response to economic downturns, and so we have very little idea what pathological market behavior they will produce. Currently, long-term US dollar interest rates are falling rather than rising, as crazed investors "fly to safety" into the bonds of a polity whose current fiscal policies are unsustainable and which under the current administration is showing no significant sign of reforming them. That seems very unlikely to last for long.
Should investor enthusiasm for US Treasuries disappear quickly, as it did for Greek government bonds, the crash in the Treasury market will doubtless be dismissed by Wall Street's risk managers as another "25-standard-deviation event" - or even, this time, a 50-standard-deviation event if the bang is big enough.
The justification for bailout at taxpayer expense will again be trotted out that the crash should not have happened in the lifetime of a billion universes, according to Wall Street's best risk models. The government will look for excuses to get round the new banking legislation and institute those bailouts. However, the one disadvantage for Wall Street of a financial calamity caused by a crash in the Treasury bond market is that taxpayers will not be available to fund bailouts through additional state borrowing. Thus bailouts will have to be funded by direct Fed money printing, making the experience more unpleasant for Wall Street and a lot more unpleasant for the rest of us.
The result of the second Bernanke crash, particularly if it is indeed centered on the Treasury bond market, must therefore be high inflation. I can't see how it can be avoided. Only by robbing the nation's savers of a large portion of their remaining savings through rampant inflation will the government be able to achieve its twin aims, of reducing the value of government's outstanding obligations and reducing the living standards of Americans to a level at which they are once more competitive, given the country's diminished capital base.
For investors, the only safe haven is of course gold. I have written elsewhere how I expect the gold price at some point to enter a "spike" like that of 1978-80 in which it soars to $5,000 - given the monetary expansion since 1980 that price, not the mere $2,400 given by an inflation calculation, is the equivalent of 1980's peak of $875.
Before gold bugs go into their victory dance, however, I would point out that when gold gets to that level, $5,000 may not buy very much.
By Martin Hutchinson
The turbulence in financial markets in the last couple of weeks has been ascribed by reporters to doubts about the long-term stability of the euro, and concern over the finances of southern European countries. This is over-optimistic. Whether or not the current market downdraft proves temporary, monetary and fiscal policies in the United States and worldwide have been excessively stimulative since the September 2008 market meltdown. Thus we are at some point in the near future going to suffer the second Bernanke crash.
As I have frequently discussed, there were a number of causes of the 2008 crash, some of them rooted as far back in the past as financial theories devised in the 1950s and housing regulation designed in the 1960s. Nevertheless, if one single cause has to be assigned, it would be the excessive money creation in the United States after 1995 and worldwide after 2002. This caused a massive asset bubble, initially in stocks and later in housing. Once the bubble had inflated, a commensurate crash was inevitable.
Had monetary policy returned to sanity after September 2008 (and fiscal policy not itself relapsed into madness) that would have been the end of it. Banks would have been provided with unlimited funding, as Walter Bagehot recommended in his 1873 Lombard Street, but at high interest rates. The global economy would have undergone a sharp recession, steep because of the deflation of value that had become necessary, but by the middle of last year would have begun a healthy and sustained recovery.
Apart from the direct bailouts of the basket cases Citigroup and AIG and the "stimulus" packages, the important difference between what happened in 2008 and what should have happened lies in the interest rate charged for the liquidity supplied in the crisis. A great deal of capital had been destroyed in the subprime mortgage meltdown, and risk premiums had gone sky high. Accordingly, while capital should have been made available by the world's central banks to their banking systems, it should have been available only at penalty rates. Rates of 8%, even 10% would have been appropriate levels for the federal funds rate and the rate for Fed "quantitative easing".
There would in that case have been no banks borrowing money from the Fed at ultra-low interest rates and investing it in Treasury bonds or government guaranteed mortgage bonds. Conversely, since money at high interest rates was readily available, high-yield uses for that money, such as lending to small business, would have remained quite attractive to the banking system.
A high interest rate in 2008 would have balanced the limited available supply of funds (other than at penalty rates) with the demand for them, balancing financial markets naturally. Instead, we have seen another explosion of leverage, as banks and above all hedge funds have borrowed money at current exceptionally low interest rates to invest in whatever seemed attractive that week. That explosion of leverage has been made worse by the Fed's persistence in keeping ultra-low interest rates for at least a year after the excuse for them had vanished. With the US economy bottoming out around May 2009 and the "stress tests" of that date showing that the banking system was now in decent shape, ultra-low interest rates should have been raised quickly and short-term rates should now be at normal levels, at a minimum in the 3-4% range.
As in 2002-03, ultra-low interest rates caused the stock market to bottom out excessively rapidly at a level well above its natural floor and to engage in an explosive rally that rapidly pushed stock prices above their sustainable level to a point at which equities once again represented poor value.
This has caused two problems. First, the US savings rate, which had shown encouraging signs in the downturn of returning to 8-10%, a level at which consumers have some chance of saving for their retirement and the economy some chance of financing itself, quickly dropped back to below 3%. With overvalued stocks (which both look expensive and make investment portfolios look fatter) and interest rates below inflation, it's surprising anybody saves at all.
Second, the excessive leverage that caused such problems in 2006-08 has returned. Risk premiums on lower-tier corporate and emerging markets debt have declined artificially towards the levels of 2007, at which they were clearly inadequate to compensate for the risks involved in holding those assets.
An additional hidden but connected problem is the further intensification of Wall Street's trading culture, exemplified by the explosion in "fast trading" volume, now three quarters of the trading volume on the New York Stock Exchange. This trading simply exploits the benefits of insider knowledge of money flows; in aggregate it subtracts value from the economy. Its participation in the recent "flash crash" in which over US$1 trillion was wiped off the value of US equities in 15 minutes is symptomatic of the problem - with "fast trading" computers in control, doing thousands of trades a minute there seems no reason why that loss should not have been $10 trillion or even more.
Maybe the theory that advanced galactic civilizations don't exist because they wiped themselves out with super-atomic weapons before developing interstellar travel is wrong. Maybe they simply invented computerized fast trading and reduced their civilizations to impoverished rubble that way.
With excessive leverage and inadequate saving, the US capital base is not being renewed as it would normally be after a speculative blowout. In the financial sector, this brings additional risk of a meltdown such as occurred in 2008. In the rest of the economy, it means in the long run that the US will no longer have sufficient capital supporting the skills of its workforce. If the US comes to have capital per head equivalent to that of China, and its education system is no better, why should it enjoy higher living standards?
Only those of us in the media, who live on reporting and analyzing excitement and chaos, can rejoice that the monetary policies of Federal Reserve chairman Ben Bernanke are unlikely to produce gradual, civilized decline to the living standards of China. Instead, because of the leverage and speculation they generate, they are much more likely to produce a gigantic bursting bubble, with major financial institution bankruptcies. The destruction of wealth will be greater than that of a slow decline, but the impoverished masses will be able to blame the evil private sector bankers instead of the public sector follies of the Fed.
It seems increasingly likely that the generator of the second Bernanke crash will lie in the global public sector. Budget deficits of 10% of gross domestic product (GDP) are not a normal response to economic downturns, and so we have very little idea what pathological market behavior they will produce. Currently, long-term US dollar interest rates are falling rather than rising, as crazed investors "fly to safety" into the bonds of a polity whose current fiscal policies are unsustainable and which under the current administration is showing no significant sign of reforming them. That seems very unlikely to last for long.
Should investor enthusiasm for US Treasuries disappear quickly, as it did for Greek government bonds, the crash in the Treasury market will doubtless be dismissed by Wall Street's risk managers as another "25-standard-deviation event" - or even, this time, a 50-standard-deviation event if the bang is big enough.
The justification for bailout at taxpayer expense will again be trotted out that the crash should not have happened in the lifetime of a billion universes, according to Wall Street's best risk models. The government will look for excuses to get round the new banking legislation and institute those bailouts. However, the one disadvantage for Wall Street of a financial calamity caused by a crash in the Treasury bond market is that taxpayers will not be available to fund bailouts through additional state borrowing. Thus bailouts will have to be funded by direct Fed money printing, making the experience more unpleasant for Wall Street and a lot more unpleasant for the rest of us.
The result of the second Bernanke crash, particularly if it is indeed centered on the Treasury bond market, must therefore be high inflation. I can't see how it can be avoided. Only by robbing the nation's savers of a large portion of their remaining savings through rampant inflation will the government be able to achieve its twin aims, of reducing the value of government's outstanding obligations and reducing the living standards of Americans to a level at which they are once more competitive, given the country's diminished capital base.
For investors, the only safe haven is of course gold. I have written elsewhere how I expect the gold price at some point to enter a "spike" like that of 1978-80 in which it soars to $5,000 - given the monetary expansion since 1980 that price, not the mere $2,400 given by an inflation calculation, is the equivalent of 1980's peak of $875.
Before gold bugs go into their victory dance, however, I would point out that when gold gets to that level, $5,000 may not buy very much.
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