In This Edition
A quick look at history demonstrates that new Federal Reserve chairmen are invariably confronted with a financial crisis within months of taking up the single most powerful economic policy role in the world. A coincidence perhaps? Or is there an explanation for this pattern? Could it be that financial markets are wont to test the resolve of Fed chairmen at the earliest available opportunity? To see under just what crisis conditions they are willing to ease policy in response? In another, perhaps more intriguing coincidence, this pattern of ‘Baptism by Crisis’ began with Arthur Burns, under who’s chairmanship the gold-backed Bretton-Woods system broke down and the fiat dollar regime emerged. Now why should that be? Could it be that, absent the solid monetary foundation of gold, US money and financial markets have become inherently unstable? Let’s investigate…
A Brief Honeymoon
It is often said that new jobs, or new responsibilities, tend to begin with a ‘honeymoon period’, however brief, in which the true challenges remain either unknown, hidden from view, or just lie so far out in the future as to not require any meaningful present thought, planning or action. As it happens, this appears to be the case with the biggest job in the world of economic policy: Chairman of the Board of Governors of the US Federal Reserve System.
Ben Bernanke’s honeymoon lasted longer than most, but just over a year after he assumed the chairmanship in February 2006, there arrived the first foreshock of the global financial crisis, namely, the sudden illiquidity of numerous subprime Collaterized Debt Obligations (CDOs). Although Treasury Secretary Paulson and others subsequently spoke of the subprime crisis being ‘contained’, we know now that it was anything but; rather, as we learned in the ensuing year and a half, it permeated most of the developed economies’ financial systems.
As it happens, around the time that Bernanke assumed the chairmanship, I attended a dinner event for about fifteen hedge fund executives in London’s Belgravia neighborhood. The venue was a well-known Italian restaurant, which had a large private dining room downstairs in the wine cellar, surrounded by racks and racks of fine Italian vintages, purportedly the largest such cellar in London.
The primary topic of the evening was macro credit strategy, in particular, whether the various ‘carry trades’ in subprime and other structured credit instruments remained attractive, or whether these securities were dangerously overvalued and subject to a sharp correction, say, in the event that the US housing market began to slow down.
Well, unbeknownst to the attendees at the time, the US housing market had, in fact, already begun to slow. Yet the market for subprime debt securities kept chugging along as if everything was fine. Why?
As we now know, the major banks that were the primary originators of subprime securities had their own dedicated mortgage origination conduits and also their own investment funds that in turn invested in such paper. These vertically-integrated structures impeded price discovery and created the illusion of market liquidity where, in fact there was relatively little. In some cases, a degree of fraud also appears to have been present, with subprime traders deliberately mismarking books, rather than merely ‘marking to model’ or to ‘make-believe’, as some were suggesting at the time.
By June 2007, however, the deterioration of subprime collateral values became plain for all to see. The ratings agencies began to downgrade risky CDOs and Bear Stearns suspended redemptions from its structured credit funds. (It would subsequently liquidate these funds. Their holdings would be assumed by the Federal Reserve as part of the deal negotiated for JP Morgan to take over Bear Stearns.)
Returning now to the dinner, in my prepared remarks I made several observations that provoked an active debate. First, with reference to some inventory and sales data, I suggested that the housing market was slowing down, although I was unaware just how sharply. Second, I pointed out how the subprime housing market had all the classic characteristics of a market with ‘directional liquidity’, that is, the appearance of a liquid market as long as prices were stable or rising, but the rapid disappearance of liquidity on the downside.
Third, I pointed out that Greenspan was about to retire and that the financial markets might be concerned about how his successor would deal with a housing market slowdown and subprime crisis.
It was at this point that one of the executives interjected. As I recall, he said something along the lines of “Here you are talking about all these big macro risks, of housing, of subprime, of leverage, of financial market structure, and yet now you suggest, amidst all that, that just ONE GUY, ONE GUY somehow makes a difference! Bernanke is just ONE GUY! How does he change anything? If it is all going to blow up, it is all going to blow up. If things are fine, things are fine. ONE GUY doesn’t matter!”
He had a point. I responded by mentioning that not only Greenspan, but an unusually large number of other Fed governors and regional bank presidents were also retiring over the coming months; that there was a general ‘changing of the Fed guard’ about to take place. But his point remained valid. Why should just one guy, or a handful of guys, make such a difference? If there is something amiss in the economy, the financial markets will eventually sniff it out and react accordingly, regardless of who is in charge at the time at the Fed, at the Treasury, or in the White House for that matter.
As mentioned above, by June 2007 the financial markets had indeed sniffed something out, and it didn’t smell particularly nice. All of a sudden everyone was aware that the price (and risk) discovery in the subprime securities market was not only suboptimal, it was essentially non-existent, and so the subprime market seized up.
In the following months, US economic officials worked to reassure financial market participants that the subprime meltdown was ‘contained’. What they didn’t realize, however, was that banks now didn’t trust one another. This was because they were well aware that their counterparties were holding as much or more now-illiquid subprime junk as they themselves were and that, as a result, one or more of their counterparties might be insolvent. So eventually the interbank lending market in general seized up, restricting banks’ access to funds and increasing rollover risk. The first casualty was Bear Stearns but, as we know, Lehman Brothers, Merrill Lynch, Wachovia, Countrywide and WaMu all followed.
Chairman Bernanke may have enjoyed an unusually long honeymoon but he has spent the bulk of his tenure in crisis-fighting mode. Initially, he oversaw the creation of various emergency lending facilities, most of which have now been wound down. Subsequently, he stonewalled repeated requests by journalists and the US Congress to provide some transparency into those facilities. (At one point the Fed even invoked ‘national security’!) The courts eventually forced the Fed to provide a degree of disclosure, but Bernanke still managed to keep things under wraps for a prolonged period of time.
Throughout, Bernanke has overseen the greatest expansion of the US money supply in history. This is primarily through the creation of so-called excess reserves, which do not flow through the economy, at least not directly. They do provide the basis for financial speculation, however, including in the prices of shares and other risky assets, for example. It is no coincidence that the correlation between the size of the Fed’s balance sheet and the level of the stock market has been unusually high since 2009. The Fed has thus artificially engineered a generally higher level of asset prices, although it is unclear to what extent this is in fact stimulating economic activity.
What is clear is that artificially-engineered asset price bubbles can do extensive economic damage. US household real income and jobs growth have been anemic for years. Income inequality has risen sharply. The US economy has been piling on debt at a historically unprecedented rate (outside of wartime) and yet this is getting little traction. The trade balance remains sharply negative, implying chronic uncompetitiveness vis-à-vis trading partners.
So yes, perhaps one guy doesn’t make an iota of difference. Perhaps it is the system itself that is deeply flawed. For whatever reason, however, the system seems to suffer crises disproportionately around the time that the Fed’s changing of the guard takes place, as the historical record makes clear.
Mr Burns’ Honeymoon
Arthur Burns was an economist’s economist. Prior to assuming the Fed chairmanship in 1970, he had served as the chairman of President Eisenhower’s Council of Economic Advisers and as the head of the National Bureau of Economic Research. He mentored Milton Friedman, among other prominent economists.
His professional gravitas was no match for the international money markets, however, including that for gold reserves. On arrival at the Fed in 1970, the US gold reserve was already draining rapidly as foreign central banks sought to divest their accumulated dollar reserves for gold instead. France was leading the charge but others followed close behind. By August 1971 the gold reserve was nearing depletion and president Nixon decided to ‘close the gold window’, thereby defaulting on the Bretton Woods obligation to redeem dollars for gold.1
Burns is on the historical record having opposed this decision, although he was powerless to prevent it. In any case, the crisis of Bretton Woods came to a head during his first year at the Fed. In his subsequent years he witnessed a large decline in the value of the dollar, the first ‘oil shock’ and the onset of what would become known as ‘stagflation’.
Mr Miller’s Year
Bill Miller was appointed by president Carter to succeed Arthur Burns. On arrival at the Fed, he expressed his opinion that the trend toward higher price inflation was temporary and would ‘self-correct’ as the economy weakened. He thus chose to keep interest rates low to support growth. The international money markets pounced on these dovish policies and the dollar plummeted by nearly 40% within a year. Price inflation began to surge. In the words of Fed historian Steven Beckner, “Miller poured gasoline” on the fire that had been lit when the dollar was de-linked from gold in 1971.2
No Honeymoon for ‘Darth’ Volcker
A desperate president Carter enacted a range of emergency measures in 1979 to try and shore up confidence in the dollar, including replacing Miller with Paul Volcker, who wasted no time in getting to work. In his first meeting as Fed chairman, he completely changed focus away from interpreting economic data to listening instead to what the financial markets were saying or, in this case, shouting: The dollar’s continuing plunge showed that they demanded higher interest rates. Volcker delivered, with rates rising to 20% by 1981.
The dollar’s decline began to reverse. Volcker succeeded in restoring some credibility to US monetary policy. Indeed, he was perhaps too successful. By 1985 US economic officials were of the opinion that the dollar had become too strong. This led to the negotiation of the Plaza Accords that year, in which it was agreed to weaken the dollar in controlled fashion through public and coordinated foreign exchange intervention by the G7 countries.3
Notwithstanding his obvious success in carrying out his mandate, Volcker was not reappointed by Reagan to serve a third term as chairman. He rode off into the sunset, perhaps unaware of the fresh crisis that was already brewing.
Greenspan’s ‘Black Monday’
In August 1987, Alan Greenspan inherited what appeared to be a healthy economy. Yet it was an increasingly unbalanced one. The US had gone from being a net creditor to being a net debtor in the early Reagan years. The budget and trade deficits had become chronic. The dollar had weakened again—albeit as a matter of policy—and the outlook was deteriorating as the German Bundesbank indicated it was prepared to raise interest rates, sharply if necessary, to contain what it perceived to be rising inflationary pressure. By implication, markets began to speculate that the US Fed would need to reciprocate with higher interest rates of its own.
Financial markets were on edge in the following weeks and, early one October Monday morning in Asia, there was sudden, high-volume selling of equities. The selling accelerated when London opened later that day. Finally, it was New York’s turn, and by the end of the trading session, the US stock market had lost over 20% of its value, to this day the largest one-day decline in US stocks in history.
Greenspan was perhaps as surprised as anyone by this development. While the imbalances were no doubt an issue and the weak dollar had traders spooked that a repeat of 1979-81 might be in the works, a sudden 20%+ stock market crash seemed a disproportionate response.
In any case, Greenspan got to work, enacting a handful of emergency policies to stabilize the market and prevent a cascading decline. Sure enough, within months the market had clawed back all of its Black Monday losses and then it kept right on going.
Nearly a decade later, with stock market valuations an order of magnitude higher, Greenspan would speak of the dangers of ‘irrational exuberance’. He would also, however, be largely ignored: Actions speak louder than words, and Greenspan had already demonstrated through his actions that the Fed stood ready to support asset prices.
It would take far more than a warning from Greenspan to tip the markets into another crash, including a rash of Asian balance of payments crises; a Russian default; and the collapse of hedge fund Long Term Capital Management (LTCM). When that happened, however, Greenspan remained true to form, lowered interest rates, and sent asset prices higher yet again, this time into the spectacular NASDAQ rally of 1999-2000.4
All Just a Coincidence Perhaps?
Could it be that this history of brief or even non-existent honeymoon periods for Fed chairmen is all just a coincidence? Or could there be something more going on here?
Let’s step back and look at the entire pattern: Each new Fed chairman arrives and a financial crisis is either already underway or brewing. There is always a fundamental backdrop, however, usually some combination of a weakening dollar and the threat of sharply higher interest rates. Bernanke is perhaps the exception to the rule here, as asset prices were falling under their own weight in 2007 and 2008, rather than responding to dollar weakness and the threat of a Volcker-like interest-rate response.
Consider now what to expect in the transition to the Fed QEeen, Janet Yellen, as she is now colloquially known. The fundamental backdrop is one of a chronically weak economy. The dollar is stable and interest rates are zero. Aggressive QE is proceeding apace and has few opponents of consequence. Stock prices are soaring, however, to multiples associated with a robust, healthy economy, presumably the result of the Fed’s actions. What sort of crisis, if any, is Yellen thus likely to face?
My money is on a crisis not unlike that faced by Bernanke. The fundamental backdrop today is eerily similar to 2007. Sure, housing may not be anywhere near as strong at present, but the roaring stock and leveraged loan markets largely compensate for that. There is also the explosion in financial leverage in the emerging economies, which to some extent rode to the developed economies’ rescue in 2008-09 with various stimulus measures of their own. The effects of these have since worn off and some of those economies, including China, India and Indonesia, are now facing some combination of rising price inflation and slowing growth.
There is of course the possibility that Yellen is not going to face a crisis at all, that is, other than the one that has never really gone away since 2008 and which is why zero rates and QE are very much still in place in the US and elsewhere. But history strongly suggests otherwise. In time, perhaps in a short time, she is likely to be tested in some way.
This entire discussion about recurring financial crises begs the question of why the pattern should exist in the first place. As I asked above, should we believe that this is all just some unfortunate coincidence? Well, as it happens, the pattern began in the late 1960s, with the first crises being those that culminated in the end of dollar-gold convertibility in 1971. That is, the crises began when the US government began to run chronic budget deficits and Fed monetary policy accommodated those deficits, rather than allowing them to place natural upward pressure on interest rates.
The US, in other words, has been living beyond its means. Periodically, the financial markets get nervous and place downward pressure on the dollar and/or US assets. This pressure occasionally results in a financial crisis. The Fed then fights the crisis with lower interest rates, and the cycle begins anew.
It is also no coincidence that each of the crises is larger than that which came before. The resource misallocations that are not allowed to work themselves out due to Fed intervention remain in place, only to be exposed as even greater misallocations when the next crisis strikes, requiring even greater intervention, until one day the mother of all crises hits, and the insidious dynamic ends.
Some believed this is what was playing out in 2008, as one Wall Street firm after another succumbed to the crisis. But the Fed intervened aggressively, in ways that were arguably illegal according to a strict reading of the Federal Reserve Act. The US government also threw unprecedented fiscal stimulus at the economy in the form of huge deficits. Other central banks and governments followed suit, in their various ways. The proverbial can was kicked, harder than ever, although as Yellen may well soon discover, not very far.
Market Update
As mentioned above, the stock markets have been on a tear in recent months, notwithstanding US and global economic data that do not paint a particularly healthy picture. Commodities markets are telling a much different story, with, oil, copper and other metals prices having declined significantly of late.
I have been cautious with respect to the equity markets all year and so have missed this impressive rally, but when it comes to equities and other long-duration assets, I tend to think longer term and, where I don’t see value, I don’t chase trends. Sometimes I even fight them. I nearly bought the S&P options volatility index (VIX) last week as its price nearly dropped below 12. It subsequently spiked a bit higher, but I continue to watch it, as anything below 12 represents excellent risk/reward in light of the overvalued stock market, in my opinion.
Commodities are a different matter, however, and there have been some excellent trading opportunities of late, in particular in industrial metals and certain agricultural products. For example, there was recently a sharp reversal in coffee prices, which have been in a multi-year bear market. I built a position in coffee earlier in the fall and have only just now begun to take some initial profit, believing as I do that this bounce has much further to run.
Corn, now also depressed in both absolute terms and relative to other agricultural products, is due a bounce and, should one occur, it could be rather dramatic. I’ve now built a substantial long position, offsetting the directional risk with a short position in cattle futures. Cattle prices have recently soared to levels that simply leave beef uneconomic as a protein source for many American households, or other global consumers for that matter. Substitution effects (eg pork, poultry) are likely to kick in during 2014 unless cattle prices correct sharply in the interim.
Finally, a word on gold, which has sunk below $1,300/tr oz yet again. I continue to believe that we have already seen the floor in the gold price for this correction.5 Demand out of Asia and elsewhere remains solid. In India it would probably be stronger if not for the punitive gold import tax now in place. That only slows demand, rather than stopping it, however, so the net effect is to create ‘pent-up’ demand that will be released in future instead.
Thinking bigger picture, the remonetization of gold continues to take place in the dark background of international monetary relations, out of sight of most financial market participants. But much as astronomers can observe black holes indirectly, by the distortions they create in nearby space, so the remonetization of gold can be inferred from keen observation of gold flows and economic policy shifts taking place around the world. The strongest such signals may be emanating from China at present, but there are others. (For a more thorough update on this topic, please see Cognitive Dollar Dissonance: Why a Global Rebalancing and Deleveraging Requires the De-Rating of the Dollar and Remonetization of Gold, The Gold Standard Journal, issue 34, October 2013. The link is here.)
To my American friends, Happy Thanksgiving!
Resources:
1 For a more extensive discussion of these events, please see “The Window Closes,” chapter 1 of my book, The Golden Revolution (Wiley, 2012), available on Amazon here.
2 Steven Beckner, “Back from the Brink: The Greenspan Years” (Wiley, 1996), p. 5.
3 The Volcker years are the subject of chapter 2 of The Golden Revolution, “Stagnation, Stagflation and the Rise of ‘Darth’ Volcker.”
4 The Greenspan years are covered in chapter 3 of The Golden Revolution, “Of Bubbles and Bailouts.”
5 Please see “Will the Fed Re-Arm the Bond Market Vigilantes?” Amphora Report, vol 4 (1 July 2013). Link here.
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