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The Other Side of the Mountain - John Hussman

April 07, 2014 | About:

The financial markets are at a transition that reflects tension between two realities. The first is that the Federal Reserve’s policy of quantitative easing has driven the stock market to valuations associated with the most extreme speculative peaks on record, coupled with a fresh boom in initial public offerings – with companies having zero or negative earnings accounting for three-quarters of new issuance – and record issuance of “covenant lite” leveraged loans (loans to already highly indebted borrowers, lacking normal protections that mitigate losses in the event of default). The other reality is that unconventional monetary policy has done little to push real economic activity or employment past the border that has historically distinguished expansions from recessions (about 1.8% year-over-year growth in both real final sales and non-farm payroll employment).

There is no question that quantitative easing has supported the mortgage market, and was almost wholly responsible for that role in late-2008 and 2009. But QE is not what ended the financial crisis (the March 2009 change in accounting rule FAS 157 is what removed the risk of widespread bank failures). Any economist familiar with the work of Nobel laureates like Milton Friedman or Franco Modigliani, or simply with decades of economic data, could have predicted even in 2010 that Bernanke’s efforts at creating a “wealth effect” would have weak effects on consumption, job creation and economic activity. In order to get any meaningful overall effect, it was clear that the Fed would have to create enormous but ultimately temporary distortions, inviting risk of longer-term financial instability. The Fed has now done exactly that.

The good news is that despite the long-term cost of diverting hundreds of billions to speculative pursuits instead of productive investment, a substantial retreat in the stock market and accompanying losses in illusory “wealth” is likely to compound this damage only weakly and temporarily – provided that the Fed is diligent in its oversight responsibilities and actively looks to minimize any systemic fallout from the portion of margin debt and leveraged loans that will inevitably go bad.

The best course for the Fed is to continue a gradual move toward a less discretionary, more rules-based policy. To the extent it feels the need to intervene, the FOMC should engage those policy tools where it actually has clear and measurable historical evidence of a cause-effect link between policy changes and intended outcomes. Unfortunately, it’s difficult to find such tools.

As Former Fed Chairman Paul Volcker observed last year, “I know that it is fashionable to talk about a ‘dual mandate’ – that policy should be directed toward the two objectives of price stability and full employment. Fashionable or not, I find that mandate both operationally confusing and ultimately illusory: operationally confusing in breeding incessant debate in the Fed and the markets about which way should policy lean month-to-month or quarter-to-quarter with minute inspection of every passing statistic; illusory in the sense it implies a trade-off between economic growth and price stability, a concept that I thought had long ago been refuted not just by Nobel prize winners but by experience.”

Though a substantial normalization in equity valuations and interest rates would certainly have short-run economic impacts, that sort of normalization would be the best way to ensure that scarce savings are allocated toward productive ends rather than repeated bouts of speculation. We don't believe that monetary policy should be used to deflate bubbles, but it should not be used to create or encourage them either, and that damage is already done. Moreover, the Fed also has a regulatoryrole in the financial markets, and in that role, it has a very real responsibility to provide oversight to reduce the likelihood and assess the potential consequences of reckless misallocation of capital, speculation, and practices that create systemic risk. This is a role that was clearly abdicated in the years prior to 2008, and is essential in the face of record margin debt and low grade leveraged loan issuance today.

Meanwhile, like any policy that creates risk and distortions without reliable effects, more QE isn’t the answer to anything – not even if economic growth were to weaken, not even if inflation was to slow further, and not even if the equity markets were to decline substantially. Among the many problems with quantitative easing, an important feature is that monetary velocity falls in almost exact inverse proportion as the monetary base expands. In other words, regardless of the quantity, the new monetary base simply sits idle. Regardless of effects on financial speculation, there is almost precisely zero effect on economic activity – not on prices, not on real GDP, not on nominal GDP.


Continue reading: http://www.hussmanfunds.com/wmc/wmc140407.htm

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