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An Open Letter To Stephen Roach




I read with great interest your open letter to Alan Greenspan published Friday February 26th; your decidedly non-consensus macro views since the popping of the asset bubble in 2000 have given you a singular gravitas among your peers on the sell-side. Bravo for employing that gravitas in the service of a long overdue discussion about the efficacy of the Fed's current monetary policy stance. Let us hope it sparks the necessary debate among investors, economists, public policy advocates, politicians, and Federal Reserve officials themselves to determine the costs of an excessively easy monetary policy.

In your letter, as well as the many missives you have written for Morgan Stanley over the last 2 years, you highlight the principal risks of a continued low interest rate policy by the Fed, specifically that such a policy (1) leaves them little stimulus "ammunition" in the case of some macroeconomic shock and (2) creates another opportunity for moral hazard to alter the risk-taking appetites of financial market participants, thus creating more asset bubbles like the one that most world equity markets witnessed in the late 1990s.

Your prescription for reducing these macro risks, namely raising the Fed Funds rate to 3% from its current 1% level, would undoubtedly alter the perception of and appetite for risk among financial market participants while allowing the Fed to "re-load" the monetary policy cannon. On this point there can be little debate.

Of little debate too would be the Fed's response (were they to ever offer one) to your missive: faced with declining inflation and still-massive slack in the economy, the Fed believes they have plenty of time to reverse current policy stimulus should inflationary forces start to appear in official aggregate measures of price inflation. In light of both that resource slack and the lack of inflationary pressures, the risk of asset bubbles and/or limited policy options remains small relative to a double dip recession or worse. After all, the "intellectual end-zone dance" that Chairman Greenspan made in his speech to the American Economic Association in January suggests he believes he could reflate his way out of any subsequent bubbles that might appear from a continued easy policy. And Gov. Bernanke's November 2002 "printing press" speech speaks directly to the Fed's willingness to use unconventional policy tools should they need them. It would seem that, to your very real risks, the Fed would reply: "We could still deal with them."

To your credit, you have been a vocal critic of Fed policy for the last several years; pointing out the perils of a loose monetary policy. However, your debate with the Fed ultimately revolves around the timing and size of monetary policy changes; you believe an excessively easy monetary policy should be reversed based on the risks. The Fed does not.

I believe that you are both wrong.

Your comment to Mr. Greenspan that " know better than anyone that a central banker's work is never done. There are always unexpected problems that require forceful policy responses..." suggests that you stand decidedly in favor an activist central bank. Yours would just be an activist bank that should be raising rates by now rather than keeping them low.

Suggesting that the Fed's job is to micromanage the US economy in this way furthers the classically illiberal idea that a central bank can and should attempt to control the economy; that a central economic authority can and should attempt to alter the nature of the business cycle to fit some preconceived ideal. And it furthers the notion that such efforts at economic central planning have only benefits and no costs to the economic and social fabric of the nation.

Such nostrums of course belie common sense: every public policy has costs and benefits, both of the short term variety and the long. Keeping interest rates excessively low incents consumption over production, favors debtors over savers, and decreases the cost of capital relative to labor. And raising interest rates, too, has benefits and costs. You have aptly laid out two of them in your suggestion for raising the Fed funds rate to 3%.

The larger point that manipulating interest rates - in either direction - has costs, both intended and unintended, can be brought into full relief by scratching the surface of the historically anemic job growth in the current US recovery. To your credit, you have made much of the curious lack of job growth in this particular cyclical recovery. Your suggestion that a new global labor "arbitrage" is underway - a combination of technology and the maturation of Chinese and Indian manufacturing and service platforms transferring jobs overseas - surely plays an important role in keeping job growth depressed.

But I would argue that at least as strong a force is a domestic labor arbitrage of sorts: that between capital and labor. The Fed's excessively easy monetary policy (combined with the administration's capex tax credit) has created substantial disincentives to employ labor and created substantial incentives to deploy capital equipment. After all, a Dell server, a Cisco router or some other piece of plant and equipment doesn't need a 401K plan or health insurance. Employees do. Businesses are simply taking advantage of capital that is, relatively speaking, far less expensive than labor; choosing instead to invest in capex instead of investing in employees.

But employment growth (or lack thereof) per se is not the thrust of my argument; it is that an activist central bank will always - always - manifest unintended economic consequences from the policies they pursue. And the more vigorously they pursue them, the greater the likelihood and intensity of those unintended consequences. The history of central banking is a catalog of unintended consequences. Almost all of them costly.

The root of the problem with current monetary policy, then, isn't that it is too loose, too tight, or even just right. Rather, the problem is that the Fed has become more activist than ever, opting to intervene in the economy at the slightest hint of financial distress, whether that distress be of a domestic (LTCM) or foreign (variously the Mexican, Asian, Russian crises) origin. That these serial interventions have taken the form of reflationary policies matters little from a philosophical perspective. An aggressively interventionist central bank creates distortions in the perception of and appetite for risk taking, both at the asset-market level and the entrepreneurial level. In short, an aggressive central bank can impair the equilibrium forces of the free market.

I think you can agree that the current Fed is defined by their appetite for monetary activism. Having pursued the most aggressive reflationary policies in its history, the Fed has shown itself to be reflexively interventionist. And worse still, their appetite seems to know no bounds nor no logical end.

The 2000 equity asset bubble may in fact be joined in the history books by the 2004 bubbles you describe: in housing, junk bonds, and equities. But not because the Fed didn't follow your advice and raise rates fast enough in 2004. The 2004 bubbles will join the greatest asset bubble in financial history because of a decades-long, increasingly aggressive desire by the Federal Reserve to manage the business cycle; to keep the booms going without ever having to suffer even the slightest of busts. One need not be a strict adherent to the Austrian school to understand the impossibility of such a policy. One need only have common sense.

When it comes to monetary policy, whether one takes the Paul Volcker approach to inflation, the Alan Greenspan approach to disinflation, or the Steve Roach approach to recovery, each of these policy prescriptions rests on the flawed assumption that a group of central bankers can better direct the economic cycle, better direct time preferences for consumption and saving, than each economic actor working for his own behalf. Economic history has proven this to be a false assumption. Time will ultimately tell if it turns out to be a tragic one.

Scott Reamer
Portfolio Manager
Union Tree Capital

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