Thinking Things Over September 16, 2012
Volume II, Number 31: Bernanke Casts a Vote for Obama John L. Chapman, Ph.D. Washington, D.C.
“Reason…teaches all Mankind, who would but consult it, that being all equal and independent, no one ought to harm another in his Life, Health, Liberty, or Possessions. [And what best promotes this?] …[A] standing Rule to live by, common to every one of that Society, and made by the Legislative Power erected in it; A Liberty to follow my own Will in all things…and not to be subject to the inconstant, uncertain, unknown, Arbitrary Will of another Man. …. Every Man has a Property in his own Person. This no Body has any Right to but himself. The Labour of his Body, and the Work of his Hands, we may say, are properly his. The great and chief end, therefore, of Men uniting into Commonwealths, and putting themselves under Government, is the Preservation of their Property.” — John Locke
More than 320 years ago, when the world-historical figure and progenitor of American liberty was working out the details of his philosophy of political economy, a body of thought which profoundly influenced both the Scottish Enlightenment writers and the American Founding Fathers in the ensuing 18th century, John Locke could not have been directly anticipating the machinations of central bankers in their monopoly oversight of politically managed money. To be sure, with the founding of the Bank of England in 1694 just a few years after publication of his Two Treatises, Locke was in the camp of the wary, given his discernment of the axiomatic linkage between economic liberty and prosperity. The Bank’s royal charter, connections, and vast new powers in its favored position would, therefore, surely have been a cause for his concern at the time.
But even the great Locke, genius and eternal friend of liberty and human progress that he was, could not have foreseen what has taken place in recent years, right through this past week, at the ultimate seat of economic power in the United States: the white Georgia marble building at the corner of 20th Street and Constitution Avenue in Washington, D.C. For it is here, at the headquarters of the Federal Reserve System, that Fed Chairman Ben Bernanke stands astride the U.S. economy today. Locke’s all-too-prescient warning about “the arbitrary will of another man” imposing negative externalities on a free citizenry came to mind this past week, as the Fed announced a new round of bond-buying (“QE3”), an extension of zero interest rates three years hence, and an open-ended commitment to do whatever Mr. Bernanke deems necessary to promote job creation in the U.S. (all while assuring maintenance of “price stability”).
Additionally what has transpired of late with the Fed would have bothered Locke in a moral sense as much as concern for long-run attenuation of the economic efficiency that best ensues in a laissez-faire policy regime. For he knew in a visceral sense how important the protection of property was to what we now call “economic growth,” and how the sovereign manipulation of property, which by definition occurs in the manipulation of money and credit, can harm the exercise of man’s individual will, that is to say, the entrepreneurial risk-taking energies each of us employs whenever we move into an uncertain future.
And so it’s worth remembering Locke’s warnings as we analyze what the Fed’s latest moves mean for investors and the economy moving forward. The Federal Reserve’s announcements on Thursday were greeted with cheer in U.S. equity markets, and indeed, by the end of the week the S&P 500 closed at 1460, up more than 16% on the year. But the Fed’s own press release scripted a different tune, that justified a new round of open-ended – itself extraordinary – action:
Growth in employment has been slow, and the unemployment rate remains elevated. Household spending has continued to advance, but growth in business fixed investment appears to have slowed…..
The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook….. To support a stronger economic recovery, and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate (emphasis ours), the Committee agreed today to increase policy accommodation by purchasing additional agency mortgage-backed securities at a pace of $40 billion per month. …. [This and Operation Twist] will increase the Committee’s holdings of longer-term securities by about $85 billion each month….. [and] should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.
….If the outlook for the labor market does not improve substantially (emphasis ours), the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.
Parsing this statement as well as the follow-up commentary from Chairman Bernanke in his press conference, what we see is that the newly-announced version of “QE”, while seemingly less than the first two rounds in total dollar volumes, is now open-ended, and entirely discretionary. Further, future inflation may be pro-actively pursued, with the 2% limit noticeably absent in the statement. While the entire Open Market Committee votes on policy, the fact is that this week’s call went 11-1 for the Chairman, with only the stalwart sound money President of the Richmond Fed, Jeffrey Lacker, protesting. The rest are now, frankly, mere lapdogs in a one-man stage-play, and as a result a minimum addition of $40 billion to the Fed’s balance sheet, per month, in the form of mortgage agency debt, is now official policy indefinitely. With other yield curve manipulations doubling that in the short run, and no announced restraints on any form of balance sheet changes, the Fed Chairman is in de facto control of a wide swath of the U.S. economy.
Indeed, we not long ago joked that direct purchases of U.S. equities by the Fed must be on the table in the ante-rooms of the Fed Chairman’s offices: can anyone now seriously say that such a thing could never happen in the 21st century United States?
Further, the Fed has lowered its medium term estimates of GDP growth and improvements in domestic employment (to, for example, 1.7-2% growth for 2012, and unemployment still hovering above 8%; marginal improvements are still forecast in the next five years to a long run steady state economy of 2.3-2.5% GDP growth, which is well below the 1850-2000 average of 3.4% growth in the U.S. per annum). For the Keynesians who dominate the Fed’s policy research apparatus – up to and including the Chairman – this prospective lackluster future is less the result of a specific policy mix, and entirely due to the vagaries and whims of the mentalities of private capitalists. By using the Fed’s own communications and outreach as a “policy tool”, Mr. Bernanke believes he can influence and improve the desultory spirits of business decision-makers, thus engendering economic activity.
Indeed, as a direct result of his research on the Depression, and his belief that the Fed tightened in error in 1936 to bring on another downturn in 1937-38 (itself a highly questionable interpretation of the period’s history; Roosevelt’s undistributed profits tax, Supreme Court packing, Supreme Court acquiescence in his second term, etc. also mattered), Mr. Bernanke has determined that “expectations” must be managed in a long-forward manner. Thus, policy “guidance” with respect to zero interest rates has been extended, and is now in place for at least three more years:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
There is therefore a “stake in the ground” of 2015 for rate hikes – though this is in a de facto sense meaningless, as it has been often moved in the last three years. But with respect to “highly accommodative” policy, the future is open-ended and the policies undefined.
What does all this add up to? First, we concede, the policy effects and their likely degree of success are controversial. There are, for example, economists who are generally committed to laissez faire and strong growth, and prefer, ceteris paribus, sound money, too, who are nonetheless applauding QE3 and even its open-ended nature (David Beckworth, Scott Sumner, Bill Woolsey, and Michael Woodford come to mind). While each of these analysts has his own policy prescriptions, all are, at least implicitly, fans of Nominal GDP (NGDP) targeting by the Fed (NGDP targeting would commit the Fed to maintain a steady growth in nominal GDP, thought to be optimized in recent years in the 5% range; this implies expansionary policy during a negative GDP growth period, and monetary tightening when real GDP growth – thought by Keynesians to lead to inflation – exceeds the nominal target. The “smoothing” of nominal GDP would, in theory, be countercyclical in effect, lessening and shortening any real downturn, and promoting recovery and then stable growth).
While this is off the subject at hand here, and will be analyzed by us in the near future, we will only say now that we agree with these writers that NGDP targeting could, again in theory, be effective, and a better form of rules-based policy-making than the era of de facto unbridled Fed discretion through which we are now living. But ultimately we remain in the camp of Ludwig von Mises and F.A. Hayek, both of whom warned that central planner bureaucrats of any type lack both the proper incentives and right sources of information to make correct decisions on a timely basis, in a complex economy involving hundreds of millions of economic agents. That is to say, we have a permanent fear of unintended consequences being worse than any disease, ultimately, regardless of the well-intended aims of the policy.
But what we do know, and feel strongly about, is what the Fed’s exploding balance sheet means in the long run for investors, even if this quasi-NGDP targeting works in the very short run. In short:
(1) As we have stated before, our colleague at Alhambra Partners, Joe Calhoun, likes to enunciate what we have come to refer to internally as ”Calhoun’s Golden Rule” for sustainable growth. It is in short that long-term sustainable growth in the U.S. will be guaranteed when we see three simultaneous conditions met and maintained: (a) a rising dollar, (b) rising equities, and (c) a falling gold price (and indeed, much is subsumed in the simultaneous attainment of the three: viz., a strong dollar encourages forward-looking investment that takes the air out of gold, even as it creates jobs that stoke profit growth and increasing wealth via rising equity prices). Any one or two of the three conditions being met in isolation (which often, in fact, occurs) is by definition not stable or sustainable with respect to achieving and maintaining prosperity.
And indeed, if we go back to the end of 1994, when the bond market bottomed out the very day the Republicans won huge Congressional majorities, having promised to pursue fiscal restraint and check President Clinton’s grandiose ambitions, we had a period just like Mr. Calhoun’s axiom for the better part of six years, as Chart I shows:
Chart I. Trade-Weighted U.S. Dollar Value, Gold Price, and U.S. Equities (January 1995-Current)
In our lifetime study of the venerable fields of finance and economics, a pursuit grounded in relentless passion, we can state categorically that never have we found a better way to capture the health of an economy through the triangulation of disparate data. Indeed, this tripartite summary of an economy is “bullet-proof” in its accuracy when the three variables, each influenced by a different, albeit over-lapping, set of factors, are all trending the optimal way. This was the case in the six years after 1994, a time when the national debt actually decreased through four budget surpluses (1997-2000), 4% GDP growth was achieved four times, and averaged 3.8%, 13 million new jobs were created, etc.
Whether by coincidence or not, beginning with the Presidency of George W. Bush, we have had more than 11 years of an economy growing at less than 1.8% per annum on average, zero growth in jobs, long term stagnation in wages (now back to 1995 median levels) and net worth, higher joblessness, and all-round greater angst in the U.S. economy. Not coincidentally, the global economy has also greatly faltered.
The Fed’s new zealotry in committing to active dollar creation (read, debasement), and the open-ended nature of it, combined with an expressly avowed promise of the creation of inflation, make it hard for us to see how years of stagnation can be avoided.
(2) Accordingly, we think the outlook for dollar-denominated assets has now worsened, gold likely has more of a run in it in the years ahead, and equity markets will be highly volatile in nominal terms, and flat to down in real terms. Our view is that U.S. equities are at or near a secular top, right now: the line-up of potential bad news in the months ahead seems too preponderant, in spite of Mr. Bernanke’s best intentions.
Near term, the U.S. economy is dependent upon the election outcome on November 6. Mr. Romney, who is favored by investors and business owners by at least 3:2, has proven to be an extraordinarily poor candidate, vague and even unctuous by turns, and inept at laying out a counter-thesis to a Beltway press bent on at least implicit ridicule. But a Romney victory is the only seeming real chance at a forestalling of very damaging tax increases in January, along with more bust-out spending and perhaps a Moody’s downgrade of the U.S. sovereign credit rating next spring in the midst of more debt limit turmoil. And indeed, now, even if Mr. Romney wins, the numbers may not be there in Congress to support a mandate to promote economic growth policies of the kind that produce the positive side of Chart I, above, after 1995. For only with [a] a commitment to fiscal restraint; [b] promotion of investment in a policy regime where (Lockean) property rights, in terms of after tax return certainty, are guaranteed and indeed defended (rather than damned) by the political class; and [c] a concomitant pronouncement by both Treasury and Fed officials to defend the soundness of a dependably-valued U.S. dollar, can the Calhoun Golden Rule described above be maintained on a sustained basis.
(3) The probability of an Obama victory on Intrade has soared in recent days back to 66%. The more likely this looks to happen, the worse, in our view, for equities, short term. Our friend David Malpass of the excellent economic research firm, Encima Global, outlines why this is so:
- Income tax rates for all brackets up via with-holding on January 1
- AMT tax, for middle and upper income taxpayers, rises
- Employee portion of payroll tax (up from 4.2% to 6.2% on the first $113,700 of income)
- Estate and gift taxes rise
- Long term capital gains from 15% to 23.8%
- Dividend rate explodes to 43.4% from current 15%
- Tax on interest income up by increase in underlying income plus 3.8 percentage points for ObamaCare surtax on passive income
- Numerous expiring provisions, such as Medicare “docfix”, will lower incomes and inducement to output
- Several state taxes rise pari passu with rise in federal rates (e.g., New York charges 6.9% (or 8.8% for incomes over $2 million) and disallows or lessens some charitable deductions; the combined marginal rate for New York City will approach 50%, not counting the mass transit payroll tax and unincorporated business tax.
This veritable “Taxmageddon,” as some call it, could total up to $467 billion next year, seriously increasing the risk of recession.
(4) Worries about Europe, China, Japan, and the supplier countries to them all have hardly abated. China has announced further stimulus moves and may increase its money supply, temporarily floating “growth” via activity, however unproductive. And the European monetary authorities, in concert with the taxpayers of Germany, seem prepared to continue to backstop the profligacy of the GIPSI countries, particularly Greece and Spain at the moment. But the continued lack of understanding there, especially in Brussels, that a suffocated private sector cannot come to the rescue of a public sector which, across the continent, refuses to pursue some level of rationalization, can only mean torment and decline for years. As we have long posited, the one external prod that could turn Europe toward better policies, a resurgent United States, as per the 1980s, does not seem likely at the moment.
(5) Lastly, returning to the Fed’s folly this week, we cannot help but wonder, in the vein of Carnegie-Mellon’s great historian of the Fed, Allan Meltzer, whether or not Mr. Bernanke’s moves now tend to become self-fulfilling. The Fed has told the world it expects economic languor for at least another three years in the United States, and it is prepared to vastly expand the Fed’s balance sheet and range of activities now, to promote growth in employment. Clearly, in fact, unemployment is now more of a “bad” for the Fed than monetary instability and its attendant consequences, and the trade-off between the two now sits in the lap of one human being: Chairman Bernanke.
Indeed, any “lessening” of Fed activity in asset purchases may come with, from the Fed’s viewpoint, deleterious moves on the part of economic actors: Fed refusal to buy mortgage backed debt would surely see those asset values decline, perhaps precipitously. To say this differently, the market’s option to exercise the “Bernanke put” has now been “intensified,” in form and effect. For an economy in need of lessening moral hazard and “too-big-too-fail-itis”, the world got riskier this week.
In sum, the equity markets that hit 4+-year highs this past week are, in our view, at or near their top. Continued turmoil and political uncertainty in the United States may lead to very different feelings by market participants by next spring – and the 1280 on the S&P Index that could come with that. An Obama electoral victory, which is suddenly looking more likely than a few weeks ago, will likely ensure big tax increases and a new wave of regulatory oversight, and provide a new spike of fear in markets (it would also ensure, not coincidentally, the re-appointment of Chairman Bernanke in 2014). Therefore, now may be a good time to lessen weightings in U.S. equities, and moving forward in coming months concentrate on the “reliables” of commodities, natural resources, utilities/energy, and special situation ex-USA opportunities. The downside risk in the U.S. is, in our view, now higher.
As for Mr. Romney, little may, in fact, be any different from President Obama with his election, for reasons stated above. But the current moment does provide him with an opportunity. He is already on record as saying he would remove Mr. Bernanke from the Fed if elected, and it is well-known in Washington that Paul Ryan strongly disagrees with Fed policy going back several years. Indeed, the Wisconsin Congressman is one of a handful of Members on Capitol Hill in favor of fundamental monetary reform. There is thus an opportunity here to engender a discussion about monetary policy in the context of the broader economic challenges facing the United States. And, how an integration of the pursuit of sound money with pro-growth fiscal policies, defense of liberal trade arrangements, and regulatory reform, could all work to return the United States to a path of prosperity and fiscal stability. Sadly, this seems unlikely given the Romney campaign’s tone-deafness on the urgency of explaining our economic challenges to the broader electorate.
And what now, for the Fed Chairman? His unprecedented moves on the eve of a Presidential election cannot be ascribed to politics: Mr. Bernanke is sincere in his worries about the stability of the U.S. recovery, and he has unbridled confidence that efficacious monetary manipulation designed and led by him can induce salutary behavioral change on the part of investors and job-creators. It’s not a belief we share, and indeed, for us, it violates the Hippocratic Oath every Fed Board member implicitly takes, to do no harm to the macro-economy. Regardless of this, anyone who does not understand how personal things get in Washington, or how much Mr. Bernanke relishes the thought of keeping his job, does not understand how such back-stories can affect policy in a very real way.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@4kb.d43.myftpupload.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.
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