After the fairly neutral/ bearish FOMC statement was issued yesterday, Ben Bernanke gave a press conference that helped the stock market regain its earlier vigor. In the Q&A following his prepared remarks, Bernanke inter alia indicated that 'QE3' in the form of additional mortgage backed securities purchases definitely remains on the table. This helped to outweigh the damage wrought on stock prices by the FOMC's increasingly pessimistic economic outlook, which suffered yet another downgrade. The markets of course love to see more inflation and this relationship between monetary policy and stock prices seems to confirm for Bernanke that his course is the correct one. He couldn't be more wrong. A complete recap of the press conference has been posted by the WSJ.
We want to look at a specific portion of the transcript that concerns a problem we have discussed at length back in late 2008 already. Interested readers should take a look at the article we wrote at the time, entitled 'The war on savers and how it damages the capital structure' which looks at the problems monetary pumping creates for the economy in some detail. We would note that what Bernanke said at yesterday's press conference indicates that he hasn't read it yet. :)
From the transcript:
“What effect is Operation Twist having on CDs and other savings?
Low interest rates "do have costs for a lot of people," he says, and the Fed recognizes that. "There is a greater good here, which is the health and recovery of the U.S. economy," Bernanke says. "After all, savers are not going to get very good returns in an economy" in recession.”
(emphasis added)
And this is precisely where Bernanke and his colleagues are wrong. Artificially lowering the return on savings to zero and pretending that the cost of capital should actually be zero does not produce a 'greater good' by 'keeping the economy out of recession'.
First of all, the recession is the market economy's attempt to heal itself by liquidating and transferring (where possible) malinvested capital and reorganizing the complex latticework of the production structure to reflect the actual demand patterns and demand schedules of consumers. This reorganization process takes time and requires initially less labor than was employed during the boom (capital maintenance is less labor intensive than all out production based on erroneous forecasts of consumer demand). Any attempt to interfere with this process will only delay the necessary adjustments, and lead to even more malinvestment and hence to an even bigger bust down the road.
Secondly, the boom was inter alia marked by overconsumption and the depletion of savings. It is therefore essential to rebuild the pool of savings. Unless this pool of real funding is rebuilt, it will not be possible to create additional wealth by adding new stages of production and engaging in more time consuming and 'roundabout' production processes. This can only be done if the pool of real funding is large enough to actually sustain investments in a lengthening of the production structure. By once again falsifying the interest rate signal, the Fed stands in the way of this process – it helps distort investment patterns due to a distortion of relative prices in the economy (the prices of higher order goods will increase relative to those of lower order ones) and it it creates a disincentive for capitalistic saving, this is to say saving for investment purposes.
Another noteworthy point from the transcript:
Can monetary policy really affect unemployment?
Well … yes. "Making financial conditions more accommodative should stimulate demand, should stimulate spending," he says.
And, well, no. Monetary policy can't deal with structural unemployment problems of people losing skills and falling out of the labor force.
And … back to yes. "Cyclical unemployment left untreated … can become structural unemployment," he says.
(emphasis added)
This idea rests on the erroneous Keynesian notion that what the economy needs is 'more aggregate spending'. It is erroneous because it gives no thought to production. In Bernanke's view, the economy is a system of circular flows – more spending (higher 'aggregate demand') will 'create more jobs', which in turn will 'create economic growth' by stimulating even more spending.
The reality is that the economy works exactly the other way around: more production creates economic growth, which creates more employment. More consumption is at the end of this chain, not at its beginning. One can not consume what one hasn't first produced. Bernanke seems to think that 'idle production facilities' are standing around and just waiting to spring into action if more consumption spending ensues due to his easy money policy. This view would only work if the economy really were a simple system of circular flows – but it is a far more complex animal. Capital is not a homogeneous blob 'K' that can simply be switched on and off by means of monetary pumping.
Lately it has been noted by several observers that US stock prices have outperformed stock prices in emerging markets and elsewhere over the past year. Isn't that a mark of the Fed's success? Bernanke himself seems to think so – when he patted himself on the back in April, he specifically mentioned that 'QE2' had managed to produce a rally in the 'Russell 2000 Index', while concurrently disavowing any responsibility for the concomitant increase in commodity prices.
However, it is erroneous to regard higher stock prices as a yardstick for measuring monetary policy success. After all, if this were a legitimate approach to interpreting the relationship between monetary policy and stock prices, then what did the all time high in the S&P 500 in 2007 signify? That the housing and mortgage credit bubble was a 'success'?
In reality, stock prices are in fact reflecting the economic distortions the easy money policy continues to produce. Stocks are titles to capital – and as such, their prices can be expected to rise relative to other prices in the economy when monetary policy is too loose and excess liquidity sloshes about in the system. However, this distortion of of prices is also ephemeral. Once the economy's pool of real funding is in grave enough trouble, no amount of monetary pumping short of hyper-inflation may suffice to keep stock prices at an artificially high level. Moreover, while current owners of stocks are of course happy if their stocks trade at high prices, those who wish to deploy capital wisely are frustrated by the impossibility to discover value in the market. Moreover, all those who buy at these inflated prices will suffer losses once the degree of capital malinvestment is unmasked again by the next bust.
Just as the 'economic recovery' achieved by monetary pumping is mirage – a Potemkin village if you will – so is the level of stock prices supported by the same policy.
