As Never Before, The Federal Reserve is the Engine of Malinvestment

The Federal Reserve has largely acted as the safety net for the financial system. Fed rates historically tracked market interest rates. That was true in 2008 as well, until the launch of quantitative easing. Since it started "normalizing" policy, the Federal Reserve is again reacting to market forces. Fed officials are turning dovish here in June 2019 because the speculative market went from pricing in one rate hike in 2019 to two cuts.

Separating the idea of central banking with implementation of policy, I think the Fed gets too much blame for prior bubbles and busts. The creation of central banking itself devalued the money supply by allowing incredible money creation, particularly after the gold link was cleanly severed. All of these errors fall on politicians. That speculators and the herd behavior of investors created various bubbles during the Fed's tenure is on the Fed's head to the degree you believe the Fed should have, and also could have, burst these bubbles early by ramping up interest rates or taking away credit. in short, I'm no defender of the Fed or central banking, but the Fed's role has largely been one of going along to get along with Wall Street and Washington, D.C.

There's an exception though, a time when they intervened far beyond their mandate. In the lead-up to the Great Depression, the Federal Reserve kept interest rates artificially low because it was helping to prop up the British pound. The British set their exchange rate with gold too high after World War I (their misguided version of a return to normalcy) and the market naturally wanted to bring the pound lower and lift currencies with capital inflows, such as the United States. Instead, the Fed policy of a lower interest rates created a U.S. dam in the global capital flows. Capital (gold) accumulated in the United States and credit paper flowed out. Needless to say, when the adjustment came, it was a doozy. This policy rhymes with the expansion of China in the 2000s and 2010s. China artificially suppressed the yuan to protect its export industries and U.S. dollars pooled there, while it became a net creditor.

The past 10 years of extraordinary monetary policy is far worse than 1920s market distortions and the Fed's recent dovish turn shows it will not voluntarily give up its control over economic life in America.

Bill Blain explains: "In 35 Years Of Markets, This Is The Stupidest Moment I’ve Ever Seen"
Dear Chairman

The Stock Market is not a driver of growth – it is the price investors are willing to pay for their perceptions of future value of stock market assets, a price which is relative to other assets, including factories, property, intellectual capital and infrastructure. Do not confuse the stock market with the economy. “Trade war” weakness may worry investors about the value of their stocks, but, should equally cause investors to finance and build new economic assets (ie factories, farms, infrastructure, schools, etc) to benefit from the opportunities “trade war” opens long term to the US economy.

While reducing rates to near zero levels to finance a Trade War with China may seem a logical decision, experience shows the unintended consequences of zero rates will achieve sub-optimal results. Since 2009 “lower for longer” rates have not caused a regeneration of manufacturing, infrastructure or other productive assets. Instead, low rates have encouraged corporates to buy back their own stock, pay their owners larger bonuses and dividends, and fooled investors to buy these same stocks as the most attractive relative asset – which is distortion.

A second unintended consequence is burdening the economy with unproductive assets and obsolete capital assets. Corporate borrowing to convert equity into debt raises systemic weakness across the economy. The Darwinian Selection process which drives growth and causes firms rise and fall according to their ability to manage themselves becomes distorted and lose momentum, leading to too many weak zombie indebted going-nowhere companies to block market niches more nimble new firms could more profitably fill. The long-term consequences are long-term rentier behaviour by owners, and declining real wages (and rising income inequality) as productivity across the nation slides as capital assets are not replaced and upgraded.

Long term, investment in replacing obsolete infrastructure, and the normalisation of interest rates to levels that create real returns to encourage real investments (into productive capital projects) rather than unproductive financial investments (such as already distorted stocks), would benefit the economy.

There is, however, a strong argument that 10-years of financial distortion through low interest rates, and the deliberate transfer of risk assets from the now heavily regulated banking sector into the more diverse investment management sector, now leaves the pension savings of millions of American’s vulnerable in the case of a stock market downturn.

This is an issue for the committee to determine…
The U.S. economy tried to rebalance away from financialization in 2008. The market wanted mass bankruptcies and a clean balance sheet for the U.S. (and global) economy. Instead, the Federal Reserve froze the economy in amber. The technology sector kept advancing and energy extraction financed by cheap capital exploded, but the rest of the economy was locked into slow growth. Unemployment remains stubbornly high. Students and farmers are burdened with debt and a suppressed price for the labor/goods because of Federal Reserve policies (and government policies such as mass migration). Corporations took on cheap debt to retire equity instead of reinvesting in capital and equipment. Individuals bought and flipped houses instead of starting companies. The overall economy looks like a giant LBO as equities disappear. As of June 2018, the Wilshire 5000 index was down to 3,486 stocks.

How do cheap interest rates work over the long-term? Hopefully for stock market investors, it doesn't work like it has in the energy market. Here's iShares US Oil Equipment & Services (IEZ). A 0 percent return since the 2008 low.
The Fed will not allow a credit default event, but the policy to prevent it also eliminates default via inflation. To some extent, the election of President Trump and the subsequent trade wars are America's attempt to free itself from Federal Reserve policy (and the Washington/Wall Street axis). The Fed's intervention again is another declaration of war upon the American worker and the non-FIRE sectors of the economy.

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