Driving in Reverse - The Fed’s Economic Model
August 5, 2003
Guest Commentary, by Richard Benson
[Richard Benson is president of Specialty Finance Group, LLC , offering diversified investment banking services.]
It used to be that the economy drove the markets. Now, the markets drive the economy, and the Fed is behind the wheel!
The new market driven economy is based on managing expectations always upward and manipulating markets to keep asset prices up, and the appearance of wealth high. This is designed to keep businesses and households spending. This economic model, however, has an air of desperation about it. At present, corporate cash flows, and the rate of capacity utilization does not justify any meaningful pick-up in corporate investment or hiring. The household sector continues to spend beyond its means and is sustained only by the extraordinary increase in annual mortgage debt.
It is clear that if consumers began to pay down their debts and actually save, the US economy would have a massive recession that would shatter the overgrown financial system – the current $32 Trillion of debt could not be serviced, and the $160 Trillion of financial derivatives insure that the financial system is one large Long Term Capital. The Fed is desperate because it knows that a dollar saved is a dollar not spent.
The Fed drives markets by force-feeding liquidity into markets and asset classes. There is no question that they, and other foreign central banks, buy their own governments and each other’s government securities, with a view to increasing liquidity and spending, and to manipulate the value of their currencies.
Example: Treasury Secretary Snow’s recent statement on Japan. He stated that the US would not pressure Japan to stop buying US Treasuries to hold down the value of the Yen.
Isn’t it more likely that Japan stopped buying Treasuries for a short time and the Administration and Fed had a heart attack watching the yield on the 10-year Treasury note go from 3.09% to 4%?
Fact: If Japan stopped buying US Treasuries, it would be the end of the mortgage refinancing boom and likely the end of the financial world as we know it today.
Under the Clinton Administration, the dollar was made to look strong by manipulating the price of gold down. The world’s central banks lent their gold to bullion banks that could then lease it out to institutions that, in turn, would sell the gold for cash and invest in financial instruments earning a large arbitrage. Currently, the arbitrage is gone and some market players have hedges that need to be unwound.
Market footprints left everywhere indicate that at key times major financial institutions place orders for the Fed/Treasury in index stock futures markets to “stabilize the markets”. A crash could hurt confidence and might cause investors to pull back and save. The Fed has declared saving “public enemy number one” and manipulating markets is a small thing compared to the evil of saving.
Greenspan’s congressional testimony showed that he is being forced to slowly “lift the magical curtain” to reveal the Fed Wizard of Oz at work. He stresses the economy is driven by spending. He speaks eloquently about the increase in wealth because of rising stock and housing prices. He is even more eloquent about how equity (wealth) can be extracted from housing and spent!
Wealth is created by asset price inflation, and spending is driven by borrowing against the inflating assets. By providing unlimited access to credit at virtually no cost, the Fed can levitate the stock market. With the stock market going up to key psychological levels, people “feel good” and expectations are “kept up”. With housing prices rising, consumers can “extract” wealth from their homes and keep on spending.
Greenspan honestly believes that not only is saving unnecessary for our economy, but saving is unwanted or outright “dangerous” (a dollar saved is a dollar not spent). Behind the magical curtain, money and credit can be created at will to sustain spending. Easy money can be used to lure individuals and institutions into buying stocks at laughable prices, and the threat of creating money even faster can be used to scare short sellers in the market to run for cover. A negative return on cash in a bank or money market fund makes running with the stock market bulls look safe (if you don’t think it’s safe, just ask Larry Kudlow).
Keeping the stock market up is critical because it is one of the pillars holding up expectations. Indeed, the hope is that the stock market will rally enough to push wealth high enough to get consumers to spend enough to achieve the current economic growth forecast of 4.5%. Unfortunately, the only way to get spending to rise that much is by getting consumers, corporations, and the government to borrow an extraordinary amount of money. However, the Fed could care less if it ever gets paid back. Besides, paying back debt causes savings, and savings are evil. It’s the Fed’s moral duty to punish savers!
Moreover, keeping money flowing in the corporate sector has been key to the success of this economic model. In the old days, banks and insurance companies made credit decisions based on a company’s ability to repay. In the new market driven economic model, the decision to extend credit is based not on any logical views of a company’s ability to repay, but on its ability to borrow more.
With interest rates approaching zero, individuals and institutions will throw their cash at bond funds. In the High Yield bond arena, money is flowing in and bond issuance is soaring.
Example: The internet stock bubble. When individual investors sent cash to the tech fund manager, he bought more tech stocks, regardless of what the stock price was.
Now, people are throwing cash at High Yield fund managers, and their job is to find bonds to buy. Indeed, buying a new issue and helping a company makes the bond “good for now”. It doesn’t matter that the company may have taken on more debt and will most likely never pay the debt back. Since the company borrowed more, it is perceived “liquid” and can make the next few interest payments. And, with liquidity flowing into the sector, someone else will always have to “buy the bond”.
The reality for the risk markets of stocks and bonds is that liquidity can help levitate prices, raise expectations, and “juice animal spirits” in the short run. However, as long as corporate solvency is related to cash flow, and corporate value is related to free cash flow, liquidity driven markets can not be self-sustaining. Liquidity has a habit of not making bad loans good, but making bad loans bigger! Liquidity has a habit of making stock prices higher in the short run through momentum investing, but has a record of being unable to hold stock prices up in the stratosphere as revenue growth, and earnings growth, fail to catch up.
The most interesting component of this “Driving in Reverse” model is being played out in the housing market. The wave of mortgage refinancing and mortgage creation is running at over $3.5 Trillion a year in mortgages written, with over $800 billion of spending supported by the $800 billion of new outstanding mortgage debt. The mortgage debt can be extended because of rising housing prices. However, the rising house prices are the result of the unlimited availability of mortgage credit. Behind the magical curtain at the Fed, Greenspan smiles because of all the spending and wealth created. The Fed lets the system “create the credit” and then through the market driven credit system, “automatically creates the money”. Since the Fed is accommodative, any mortgage created will be financed.
This economic model is actually not new. Running a monetary policy on accommodating all requests for credit, and force-feeding cash into markets has been tried many times over the past hundred years. Look at Weimer Republic and the past Latin American inflations. Running an economy on no savings, with all new spending driven by credit creation, always breaks down, and the breakdown can come swiftly!
The Fed has been able to get away with running its “Driving in Reverse” economic model (which is really a very old inflation model) because the US dollar has remained the World Reserve Currency, and the Japanese, Chinese, and the rest of Asia seem willing to buy every US Treasury Bond, FNMA and Freddie Mac security we send them in return for building factories and employing their workers (apparently, the dollars will have some value some day as they are still accepted by the Arab oil producing countries in return for real oil). Otherwise, at some future date, we may wake up and discover that Asia may have so many dollars claims, that it actually owns America.
The Dollar remains the World Reserve Currency because the countries that buy our debt want American jobs. If we play rough and they stop sending the money, who is going to finance the $500 billion Treasury Deficit, the $500 billion trade deficit, and provide the cash to write $800 billion a year in new mortgages? Either interest rates would have to rise to high levels to create the needed savings, or the Fed would have to start buying debt and printing money like crazy.
In summary, As summer comes to an end and fall approaches, it will become evident that this economic model is going to be harder to sustain. Just about every homeowner has already refinanced. The Fed has pushed stock prices to levels that can only be sustained by revenues and earnings rising sharply now and forever. We have liquidity driven credit spreads (how else could GM borrow a quick $16 billion to fund its pension fund even though it makes no money selling cars? The only money GM makes is on financing mortgages, and that can’t go on forever). Corporations are borrowing to be liquid; however, their profits are rising because they are being paid huge amounts of money to send jobs to China and India.
More people are beginning to look behind the magical curtain created by the Fed. Because the United States has no savings, we are at the total mercy of our trading partners to fund our Treasury and trade deficits. If not, the Fed will have to monetize Treasury debt like there is no tomorrow. With $160 Trillion of financial derivatives and the financial system rigged like Long Term Capital, that could mean “there would be no tomorrow.”
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