A Financial Warning Shot

The bailout of the overnight repo market by the NY Fed has raised a lot of questions. Why was the financial market unable to respond without Fed help? What caused such an unpredictable surge in demand that caused rates to double overnight? Such conditions are ripe for theories and I have mine.

Never attribute to conspiracy what can be explained with incompetence. It is possible that the traders converged in a perfect storm and failed to comprehend the impact of a confluence of large trades in a short period of time. I do not find that satisfying. Perhaps a foreign sovereign (Iran) liquidated Treasuries to raise cash pending a conflict. This would seem to be easily verifiable, so I find this lacking.

Markets will always have short term periods of unusual and hard to predict volume and markets usually have the capacity to absorb them. Perhaps this is a warning shot that Dodd Frank has crippled the ability of the markets to absorb such incidents.

For years astute bond traders have been concerned about the capacity of the bond market to absorb a large volume as a result of the restriction of the market making capacity of the traders under the regulations of Dodd Frank. With record low interest rates, a surge in rates would cause a mass exit challenging their ability to handle the volume.

Bond mutual funds are particularly vulnerable since such a rush would cause them to sell the higher quality holdings first and degrade the quality of the remaining inventory. I have avoided these funds.

In 1998 the demise of Long Term Capital and the subsequent bailout forced on the large Wall Street funds by the Fed under Alan Greenspan was a warning shot to the outsized risks taken by the best and brightest of the investment world. Long Term Capital was made famous for its Nobel prize winning PhD economists, and their belief that quantitative models could reduce risk and thus justify extreme leverage. They replaced a philosophical understanding of risk with delusional mathematical certainty.

Long Term was treated as an outlier rather than a sign of systemic hubris which became far more obvious ten years later. The lessons we should have learned only become obvious too late. If the lesson here is the restraint of the capabilities of the market by excessive regulation in the wake of the 2008 collapse, now is the time to make the necessary adjustments.

I am way out of any field of competence here and there may be other factors at play that I can not comprehend. Bad regulations can be as harmful as no regulation and due to the complexity of the field, the two are often confused.

The New Challenge of a Growing Economy

Phill Gramm and Thomas Saving write A Booming Economy Will Challenge the Fed in the WSJ

I recommend reading it entirely, but you may encounter a paywall.

The authors articulate a concern I have expressed that an expanding economy with put upward pressure on interest rates with increased monetary velocity while the Fed seeks to reduced the liquidity it has flooded the market with for the past 8 years. Higher interest rates increase our debt and slows the economy. Can this tax bill stimulate enough growth to withdraw liquidity without spiking interest rates and inflation?

I don’t think it has ever been done before, but it seems it would take far better than normal growth to accomplish this, and a very cautious and measured Fed management.

Most do not realize that we have not yet paid the bill for the recession and the Obama spending. Obama depended on the Keynesian multiplier to stimulate the economy. It failed because too many other friction costs counteracted it; including higher taxes, increased regulations, and a generally unfriendly business climate in DC. Even without these friction costs, the benefit of the multiplier is limited.

The Republicans are trying a dramatically different approach. While it should stimulate the growth we need, this growth brings a new set of problems. It will be a challenge for the Fed.

Prosperity and Inflation

from Steve Forbes, The Fed Needs A New Leader–And New Policies, Too:

Yellen openly and unapologetically made clear that our central bank still hews to the discredited theory that prosperity causes inflation. “The economy is operating relatively close to full employment at this point,” and therefore higher interest rates will be warranted. The idea is that a hike in the cost of money would ensure that the economy didn’t get too strong. Otherwise, employers would aggressively bid up wages, which could fuel too much inflation.

Yellen confuses changes in prices that come in response to supply and demand in the marketplace with movements in prices that result from changes in the value of the dollar. It’s the dollar changes that wreak havoc. When the Fed and the Treasury Department began weakening the greenback in the early 2000s, commodity prices took off. The price of oil, for example, went from around $25 a barrel to over $100. That head-spinning surge wasn’t a result of oil shortages but of the dollar losing value. In contrast, the price of wide-screen TVs has plummeted from $10,000 to a few hundred dollars today. That’s a result of productivity, not deflation.

The Greenspan Put

The Man Who Knew by Sebastian Mallaby is an excellent biography of Alan Greenspan, but it may have greater value in understanding the power and limitations of the Federal Reserve itself.

Greenspan has been accused of being an ideologue by some and a betrayer of free market economic ideology by others. He was a brilliant thinker and in his early career in his consulting firm, Townsend and Greenspan, consumed vast quantities of technical industry specific data long before econometrics was a word. He gathered unique insights facilitating valuable forecasts clients paid for dearly and willingly.

His close relationship with Ayn Rand fit with his market bias, but was tempered with pragmatic realities when he entered the political halls from Nixon to the second Bush. He served as Fed Chairman from 1987 to 2006.

With the analytical skills of a technocrat, he also possessed the depth of a philosopher. He understood the limitations of models. For example, in 1977 his firm realized that mortgage extraction was providing a spending source that was not included in the current models. Fueled by higher home prices it was also a vulnerable retardant if the home price boom ended.

Greenspan was one of the first to realize the value of financial assets in economic forecasting. As the financial sector grew in importance this moved to the center of many of his economic analysis and decisions. Yet while he knew that the financial sector was subject to excesses he was sharply criticized for failing to act in a way that would have prevented the calamity of the 2007-09 bust.

There were several reasons.

Volcker was considered a hero for staying with painful and politically unpopular actions to bring the inflation of the 1970’s under control. Following Volcker at the Fed, Greenspan remain stubbornly focused on managing inflation and protecting the difficult accomplishment of Volcker.

He became quite adept at digesting data and raising interest rates just enough to head off inflationary expectations while avoiding larger increases that would slow down the economy too much.

When his board viewed wages increasing and not matched by productivity they saw inflation on the horizon and recommended higher rates to avert the inevitable growth in inflation. Alan saw this did not fit with frequent stories about the productivity gains CEOs of industry spoke. Further diligent study saw that the industrial sector was reaping very strong productivity gains, but was offset by weak productivity gains in the service sector. This insight led him to a much smaller boost which proved correct.

Should the Fed act to prick financial asset bubbles? This was a frequent question as his tenure spanned a stock bubble in 1987 and 1999, a bond bubble in 1993 and of the course the mortgage bubble which burst painfully immediately after his term. Financial bubbles often occurred in a low inflation environment and this further complicated his work. The Fed had a mission to fight inflation and unemployment; bubbles seemed at best a peripheral issue.

Greenspan remained focused on inflation because it was easier to assess than market bubbles. He well understood that financial markets tended to excess but assumed self-discipline would generally yield better results than regulation. There was just too much information to process for most regulators to be able to assess effectively.

He assumed that the basics of the system were strong. When he learned of the accounting irregularities of Enron he was furious, understanding how the system depended on accurate accounting information. Still he understood that to supervise at this level would require a fivefold increase in the size of regulatory bodies, and weaknesses in the regulatory solution would remain.

He also assumed that in the event of a failure that would have serious economic consequences that the Fed would remain the lender of last result and could impose its power only when necessary.

For some this was a unacceptable inconsistency. The Fed would support failures, but not prick bubbles. The would protect firms on the downside, but not limit any risk on the upside. This would encourage excess risk.

He also recognized the risk of a long string of successes at the Fed though the 1990s. Success breeds confidence, confidence breeds complacency, and complacency breeds failure. The confidence in the Fed to act to reduce downside risk became known as the Greenspan Put. (A put is an option contract designed to profit from or protect from a market loss.)

Greenspan understood the risks of the insanely complicated financial and mortgage options. Even though he was warned about the unregulated derivatives by Brooksley Born in 1999, he understood how they helped availability and targeting of risks, and remained skeptical of regulatory solutions. He was alarmed at the massive size of the GSEs, Fannie Mae and Freddie Mac and the damage that would ensue from a housing bust.

He knew of the risks of bubbles but underestimated the size of the damage.

While he commanded interest rate and price stability quite well, this did not translate into financial stability. While we can see in hindsight the failures of reliance on self discipline, that does not mean that we understand the failures of excess regulation.

We have designed a fragile system that depends on regulation, rather than a robust system that requires less regulation. The regulatory system stifles competition rather than encouraging it. Fewer firms following the same rules may increase risk rather than mitigating it. We also suffer from a fractured regulatory system.

We need fewer rules more firmly enforced. Higher cap requirements for banks would reduce the need for bailouts, but Greenspan warned that this should vary greatly depending on the assets held. Low cap requirements for mortgages from the regulatory agencies led banks to prefer these instruments and made the mortgage collapse more painful.

The Fed firewall, the lender of last result, is necessary for ultimate stability, but such bailouts should come at a stiff price. Wage contracts and terms at the banks requiring such rescue should become null and void.

Misunderstanding Money

from Steve Forbes at Forbes Magazine, Reckoning for Biggest Wrecker of U.S. Economy:

Economies aren’t machines that can be calibrated, like automobiles. They are billions of people making decisions numerous times a day. The idea that central planners, whether they’re of the Soviet or Federal Reserve variety, can calibrate economic activity always founders because they can’t predict the future. Central planners assume that past patterns always repeat themselves. (This flaw isn’t confined to big government; more than a few smarty-pants hedge funds have blown up from this misconception.)

As for that seemingly mysterious decline in productivity, there’s no mystery to it at all. Productivity and innovation depend on investment. What the Fed and too many economists don’t grasp is that unstable money hurts productive investment, because businesspeople and investors can’t know what they’ll be paid back with–a 10-cent dollar, a 50-cent dollar, a 120-cent dollar. As a result, capital outlays have been awful for years.

All this points to the basic flaw in how the Fed and most central bankers and economists see money. Contrary to their core belief, money doesn’t control the economy. It reflects activity in the marketplace. Keynes and the monetarists had this exactly backward, but it’s been holy writ among economists and policymakers for decades.

Money simply makes the buying and selling of products and services easier. It has no intrinsic value, any more than a ticket to a concert does or a claim check for a coat at a restaurant. Money is a claim on products and services; it measures value the way a ruler measures space, a clock measures time and a scale measures weight.