“Smarts versus Wisdom at the Fed”

March 6, 2012

Thought of the Day

“Smarts versus Wisdom at the Fed”

March 6, 2012

Nobody will argue that Federal Reserve Chairman Ben Bernanke is not a very smart man. Before the age of thirty-two he had graduated Summa Cum Laude from Harvard, had earned a PhD in economics from M.I.T. and had become a full professor at Stanford. However, (and hoping I am wrong) I question his wisdom. It was debt that got us in trouble in 2008 – years of expanding debt, especially consumer debt and government entitlement programs. So, now buckets of “hair-of-the-dog” are the answer?

Certainly, liquidity was necessary in the fall of 2008, for what could have been a solvency crisis. The efforts of the Federal Reserve and the Treasury prevented what would (or could) have been a total collapse of the financial system. And for that, we owe a debt of gratitude to Mr. Bernanke, Treasury Secretary Henry Paulson and Tim Geithner, then head of the New York Federal reserve.

But once the ship was righted, which credit markets indicated happened pretty quickly – by the end of December, 2008 – was it still necessary to print money at the rate they did? Was it really necessary to borrow, and then spend, $850 billion for a stimulus plan? Did we have to pass what will turn out to be the biggest and most unaffordable entitlement program ever – the Affordable Care Act? The Fed’s balance sheet, for the week ending February 22 was $2.935 trillion, versus $877 billion in December 2007. Last year, the Fed bought 40% of the U.S. Treasury’s issuance. (China was a net seller of U.S. Treasuries in 2011.) We all know that the Fed has been artificially depressing interest rates. The concern that everyone has is: How high will rates go when the Fed begins the process of normalizing its balance sheet? A normal yield curve environment would have Ten-Year rates three or four hundred basis points higher than Fed Funds, suggesting that interest costs would be approximately $400 to $600 billion higher than the estimate for 2012 of $225 billion – a meaningful change to a $3.8 trillion budget, especially when receipts are only expected to be $2.6 trillion!

Obviously, no one knows when rates will rise. A year ago, Bill Gross of PIMCO, the dean of bond fund managers, made a famously bad bet in selling Treasuries – obviously, too early. Nevertheless, we know that at some point the thirty-year bull market in bonds will come to an end. Warren Buffett recently wrote in his annual report that “…bonds should come with a warning label.” David Stockman, the former White House budget director under President Reagan, and who resigned in protest over deficit spending (and went on to make a fortune investing in debt-inspired leveraged buy-outs), in a recent interview with Associated Press suggested that Fed Funds ought to be 3% or 4%, instead of the current quarter of one percent.

The problem of too-low interest rates is not the sole purview of the U.S. The combined balance sheets of the U.S., England the ECB and Japan now total $8.76 trillion, suggesting that a back-up in interest rates, when it happens, will prove a headwind to global growth. As well, China has been easing its reserve requirements to stimulate more bank lending.

The Fed is making the bet that they will be smart enough to know when to start gradually reducing their balance sheet, without negatively impacting growth that is likely to still be anemic. As Hamlet might say: “‘Tis a consummation, devoutly to be wished.” We are already 33 months into a very mediocre expansion, with the average post-war expansion lasting 59 months. Additional pressure on economic growth comes from demographic trends. Robert Arnott, chairman and founder of Research Affiliates LLC, points out in a Wall Street Journal interview on Monday: “This very year, for the first time in U.S. history, the population of senior citizens rises faster than the working-age population.” Does anyone believe that economic growth will accelerate in the next couple of years?

Policy initiatives should be encouraging investment, not consumption. Yet, the Fed and the Administration are doing the opposite. Artificially low rates encourage speculation and consumption, not investment in plant and equipment, which are based on their expectations (not governments) for economic growth. And plans to treat dividend income the same as earned income will discourage investment; and it certainly hurts seniors, as they receive more than half of all dividend income. They are the group that already has been most affected by low interest rates on savings. In the meantime, the longer the Fed persists with abnormally low interest rates, the more difficult will be the process of detoxification. The Fed has placed itself – and by proxy, us the taxpayers – in a difficult position.

The good news is that non-financial corporations entered the downturn with good balance sheets and they now hold almost $2 trillion in cash. Consumers have been addressing their debt. The fourth quarter report on household debt and credit from the Federal Reserve Bank of New York showed that total household debt continued to fall in the fourth quarter, down $126 billion to $11.53 trillion. Household mortgage debt and home equity lines of credit are now, respectively, 11% and 11.7% below their peaks. However, consumers are not out of the woods. The Case-Shiller Index suggests that national housing prices, which as of December 2011 were down 34%, have not yet bottomed.

But federal debt continues to increase at alarming rates. Other than Representative Paul Ryan, no one in Congress, and certainly not the President, has seriously addressed the problem of entitlement spending. Given the propensity of Congress to spend, it is little wonder that fiscal conservatives do not trust Congress to use increased taxes to voluntarily pay down debt. If they did, they would have no problem paying higher rates. Even today, the top 10% of income earners pay 70% of federal taxes. Spending must be curtailed and entitlements must be subject to means’ tests. A federal government that provides net support to more than half its citizens becomes a government very difficult to dislodge.

No one can foresee how we will extricate ourselves from the trap that has been set, the web that has been woven, but we all better hope that our leaders are endowed with more wisdom than they have shown so far, to go along with their academic degrees.

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I will be out the balance of the week, skiing in New Hampshire with a number of my siblings, an annual ritual at a place, Mt. Sunapee, where I first skied almost sixty years ago.