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THE BEAR'S LAIR
How to disarm the liquidity bomb
By Martin Hutchinson
After its latest meeting, the policy-setting Federal Open Market Committee
(FOMC) announced on September 23 that it was considering ways to reverse the
unprecedented torrent of liquidity it has pumped into the US financial system,
but that interest rates will remain near zero for a prolonged period.
Apart from the question of when the United States Federal Reserve should move,
it has gotten the order wrong. Removing "quantitative easing" will be a
perilous process, which should be undertaken slowly and with great care.
Pushing up interest rates substantially is an urgent necessity, which should be
done today.
Neither raising interest rates nor removing quantitative easing is imminent,
yet a substantial policy move in the direction of monetary tightening should be
made. Zero interest rates remove
all incentive to save, so we see that the September US savings rate was back
down to 3%, closer to the zero at which it languished in 2004-07 than to the 8%
to 10% to which it needs to rise in order for the US economy to achieve
long-term stability.
It's not surprising people aren't saving; they have no incentive to do so. The
value of savings is currently eroded little by little by inflation, while the
modest returns available on debt instruments are taxable at up to 40% on
nominal income. An environment of very little saving, with all spare cash going
into short-term speculation, is the inevitable result of this.
As for inflation, it has been quiescent so far, as year-ago comparisons have
been flattered by the sky-high energy and commodity prices of summer 2008.
However, those comparisons are dropping out of price indices in the next few
months and commodity and energy prices have recently been strong, so inflation
should visibly accelerate. The price index for personal consumption
expenditures, Fed chairman Ben Bernanke's favorite because it's so well
behaved, rose 0.3% in August and has been rising at an annual rate of 3.7% over
the past three months.
According to the FOMC, quantitative easing will continue at least until the end
of the year. For one thing, the Fed has not yet bought all the US$1.2 trillion
of mortgage-backed debt it intends to buy - it is at $692 billion, according to
its latest report, so has more than $500 billion to go. With such a large
additional buyer artificially in the mortgage-backed bond market, and the
government guaranteeing $1 trillion of mortgages through the Federal Housing
Administration with down-payments as low as 3%, it is little wonder that house
prices have bounced and the construction sector's activity is up by 8% in the
last month.
This is not, however, a healthy housing market recovery; it is propped up by
artificially easy money, both in terms of rate and availability. Hence at some
point, when the money is withdrawn, the housing market is likely to fall back,
with damaging effect on the nation's banking system.
The difficulty of removing quantitative easing is illustrated by the fact that
the two worst depressions in US history were both caused by liquidity
shortages. In 1837, the de-chartering of the Second Bank of the United States
removed the primary instrument, Second Bank bills, by which inter-regional
trade had been financed. In 1836, a Mississippi merchant could pay for New
England textiles with a Second Bank bill, and give the seller full value. The
following year, unless he had gold (scarce then), he could give the seller only
Mississippi bank paper, which traded in Boston and New York at a 30% to 40%
discount.
In 1930-32 the closure of the Bank of United States, a major New York retail
bank, caused a withdrawal of deposits from the banking system and a cascade of
bank failures that similarly devastated systemic liquidity. In both cases,
depressions ensued, the two worst in US history.
In 1837-43, the problem was solved by a gradual expansion in soundly based
state banks, which had been suppressed by Second Bank's existence.
Nevertheless, it was not until the 1849 California gold discoveries that
liquidity was fully restored. In 1930-41, the Great Depression persisted for a
decade, being exacerbated by numerous other policy mistakes, before being
lifted by the beginnings of wartime economic expansion.
It should be noted that in both cases, interest rates were not the problem. In
1837, the speculation of 1836 had caused interest rates to rise. However, the
crash of May 1837 caused a sharp reversal, and thereafter throughout the period
of depression short-term and long-term interest rates remained relatively low.
In 1930-32, the Fed kept nominal short-term interest rates around 1% to 2%,
very low by historical standards, while long-term Treasury rates declined.
However, in both cases, the sudden drain of liquidity caused sharp price
deflation, with prices falling around 20% in 1837-41 and even more in 1930-33.
At present, there are two countervailing factors affecting liquidity. On the
one hand, the securitization market for home mortgages and other consumer
obligations is nowhere near back to normal, and may indeed never get back to
"normal". Furthermore, bank capital ratios are currently being increased to
meet the desires of newly conservative regulators. Both these factors tend to
drain liquidity from the market.
On the other hand, the high volume of liquidity available worldwide, caused by
excessively lax monetary policy in most countries, has caused sharp run-ups in
stock prices, commodity prices and especially long-dated US Treasury bond
prices, which are far above the level implied by the current 2% to 3% inflation
and budget deficit at 10% of gross domestic product. The 10-year US Treasury
bond yields only 3.25%, giving holders almost no real yield, at a time when the
US dollar is weak, inflation rising and the US government's financing demands
unprecedented.
In an ideal world, liquidity withdrawal would deflate stock, commodity and bond
markets, pushing real interest rates closer to a normal level, while leaving
the availability of finance through the banking system for small business
relatively relaxed, as befitting a deep recession. In reality, given the
gigantic budget deficits and eldritch incipient recovery in the housing market,
it is likely to do the opposite, squeezing small business before it corrects
stock, commodity and bond prices.
Hence the Fed should continue planning for liquidity withdrawal, but attempt it
only very cautiously.
On the one hand, raising interest rates sharply, perhaps to a 2% federal funds
target rate in the initial step (while maintaining high liquidity) but with the
announced intention of moving rapidly towards 5% or more if inflation takes
off, would appear to offer only benefits.
Since interest rates paid by small business borrowers are far above those paid
by the government, an increase in Fed funds rates and Treasury bond yields will
have minimal effect on small businesses, provided liquidity remains high. Small
business loans will still offer the highest interest margins to lenders, so if
liquidity remains available and lenders are not concerned about their own
funding, they will be made.
On the other hand, a sharp increase in interest rates would knee-cap stock,
bond and commodity markets, aborting the rapidly inflating bubble that is
threatening to produce yet another orgy of resource misallocation. In the stock
market, casinos would no longer be able to bail themselves out of bankruptcy
through initial public offerings (IPOs). Internationally, a drop in oil prices
would shove leaders like Venezuelan President Hugo Chavez, Iranian President
Mahmud Ahmadinejad and Russian Prime Minister Vladimir Putin at least partly
back in their boxes, while a fall in the gold price would short-circuit
inflationary psychology before it really takes off.
Higher short-term interest rates would give US savers at least a zero real
after-tax risk-free return on their money, thus ending the odious Keynesian
"euthanasia of the rentier" that Bernanke and his predecessor, Alan Greenspan,
have been undertaking since 1995.
Most important, a really frightening crisis in the Treasury bond market would
bang the heads of Congress and the Barack Obama administration against the
wall, and force them to start getting the budget deficit under control.
Once higher interest rates have deflated the various bubbles, pushed the
housing market down to a sustainable bottom and forced the government to rein
in the budget deficit, liquidity can be gradually removed from the market, as
the government's financing needs and the bubbles' demands on liquidity will no
longer be so excessive.
In that way, over a two- to three-year period, the Fed could return the US
financial system to a healthy state. It is, however, essential for it to remove
the market pressure from abnormally low interest rates and abnormally high
funding requirements BEFORE removing the liquidity. The other way around won't
work.
Knowing the Bernanke Fed, it will doubtless do precisely the reverse of what
this column recommends, beginning to withdraw liquidity vigorously at an early
date, while keeping interest rates at their present abominably low levels for
far too long. In that case, the Fed will deserve the hyperinflationary
depression it will almost certainly get.
It's only a pity that the rest of us, innocent of wrong-doing, should have to
live through it.
Martin Hutchinson is the author of Great Conservatives (Academical
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-2009 David W Tice & Associates.)
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