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Minyan Mailbag: The Fed & Liquidity


Minyans ask, Professors answer...



I have a lot going on these days and would rather spend more time hashing out some thoughts in the "Ville."

As I'm doing other things, (or attempting sleep), I'm preoccupied by your thesis that the Fed is still trying to inject liquidity. Maybe I'm splitting hairs here, but I think we're in different camps (which makes me uncomfortable of course). I think that the Fed is trying to reduce the amount of liquidity being injected. I think that Bernanke is possibly overconfident in his ability to handle any slowdown that results.

I am also chewing on the distinction between credit and currency. It seems fairly moot in a free market-priced universe. Although there are some nuances, I see its impact in our discussions largely like the difference between stock options and stock.

Also, it seems like some of the commentaries I read use a cause and effect logic that may not apply.

1) If the Fed lowers interest rates the dollar will fall.

*That cannot be confidently concluded on any near-term timetable. The dollar should have fallen long ago if free markets were pricing it, but central banks have and will continue to call the shots.

2) The dollar will strengthen as commodities fall.

*It seems to me that there is an assumption here that the markets have efficiently set prices on both commodities and the dollar. It also seems that the possibility of normally bullish fundamentals for the dollar may simply reduce the extent of its decline from artificially high levels.

3) Good economic reasoning suggests that excessive credit leads to excessive capacity, leading to deflation. Therefore the US is headed for deflation.

* The world has never experienced the kind of global connectivity that we are seeing now. Economics have played out predictably within their universe. Historically the US has been its own universe. I am suggesting that overcapacity has developed internationally and overconsumption has developed domestically which could resolve without violating economic principles via global deflation and domestic inflationary tendencies.

4) The Fed will be unable to stop a deflationary spiral.

* Here I tend to have confidence in Helicopter Ben. First, I think that the conclusion that the US's excessive credit has led to overcapacity misses the point. The US actually needs to rebuild productive capacity and destroy consumptive capacity. (Consumptive capacity just sounds wrong, doesn't it?) I think that the only way to get that kind of creative destruction is via a lower dollar which would inherently increase the cost of imports. I also think that the Fed has laid the groundwork to give themselves latitude to intervene in markets in unprecedented and unimaginable (for some) ways. A cascading collapse stemming from the massive leverage in our financial system could be met by a Fed that intervenes directly or by providing credit and encouragement to large financial institutions.

5) The break in the commodities uptrend line is the end of the commodities bull market and the beginning of deflation.

* I don't even know where to start. I think that this is more of looking for something to confirm what has already been concluded. I have not yet embraced the deflationary thesis. I still believe that it would be far more painful for the US to take the deflationary route. Foreigners would scoop up US assets hand-over-fist with the dollars they have accumulated. I am still finding it hard to fathom that the US will not choose to pay off foreign creditors with devalued dollars and devalue the debt problem of US consumers...

I think that some keys in thinking through the possibilities are:

  • All markets are NOT efficiently priced (particularly currencies).
  • Fiat currencies have potentially unlimited supply (and will not necessarily be efficiently priced).
  • US "could" be an anomaly in a global economic event.

If time permits - rip this apart unabashedly! (I feel guilty about just spewing this without giving it more thought, but don't have time for that. Perhaps you can interpret from my ramblings what I'm wrestling with and improve my grasp of your perspective.)

I really value the intellectual capital that you graciously extend to mere Minyans. (Truly, I feel privileged to access your critique and insight)

Minyan Jeff


There is a probability for every view and I attach a reasonable one to several of your thoughts. I am never in one camp, but always in several with varying probabilities. My portfolio reflects that. I try not to ever be the big winner or the big loser, but the one who muddles through all scenarios.

On your first thought, I look at it a little differently: the Fed is trying to keep liquidity high while reducing pressure on input prices (high money supply growth with higher interest rates). This is real hubris and walking a thin line.

I do not put as high a probability as you do on central bank's ability to control imbalances nor do I think globalization has somehow made the U.S. immune to consequence: the ability to maintain our level of public debt and the now inextricable trade deficit is dependent on foreign central banks and the ability to service high consumer debt inevitably falls on income generation, which is falling rapidly in relation. This is important: I think foreign central bank willingness to finance increasing trade deficits is directly linked to consumptive capacity in the U.S.: when foreign central banks deem the U.S. consumer to be "tapped" out, the dollar will fall and U.S. rates will rise rapidly. When they don't need us anymore, they will internalize growth.

Central banks can only do so much with traditional activity to inject liquidity. Their mechanisms are repo, coupon pass and margin requirement. The first two are meant to be monetization of risk-less assets. This provides credit, but the market can balk at taking it. Only if central banks begin to monetize risky assets like stocks can they affect the velocity of money. Imagine the government owning 50% of stock market? I agree with your assessment that they will fight deflation pressures with "new tools," but if they do so we might as well come out with declaring the U.S. a socialist system. That premise, as I am sure you agree, has its own set of problems. The cure is worse than the sickness. This gets to the heart of your statement: the U.S. needs to rebuild productive capacity and reduce consumptive capacity. I could not agree more. Everything I have seen so far says the opposite. And if we do somehow realize this to be true, do you think this will not be a painful process? Do you think it is one to be led by bureaucrats and not market forces? Believe me, bureaucrats will never agree to it, so it will be left to market forces to destroy this consumptive capacity.



Just to clarify a few points...

Perhaps we are closer than I thought on the Fed & liquidity. My view is that they do want a slowdown, but engineering a typical slowdown would probably spiral out of control. So they are hitting the brakes with interest rates and still keeping the accelerator depressed in keeping credit available. I do think that the Fed wants a slowdown; but is probably overconfident in their ability to gently slow the economy using the brakes and accelerator in unison. I believe that higher interest rates' impact on the housing slowdown is the "straw that broke the camel's back" here and is likely to result in recession.

Most importantly, (so I am clear), I do not think that the Fed or foreign central bankers will fix the imbalances or eliminate the consequences. What I was saying was that the central banks are much more comfortable with intervention and they could possibly forestall what the market would otherwise impose for an additional unknown period of time. I believe that is the only reason that the dollar has not already tanked and interest rates risen dramatically.

On the Fed specifically, what I have confidence in Helicopter Ben for is directing the serious consequences awaiting the U.S. in an inflationary manifestation. I do believe that he will make good on his "deflation can always be whipped" promise. But I am also pessimistic about the consequences that will have to be borne by the U.S. economy. I just believe that if the Fed finally has no choice but inflationary or deflationary consequences, they will choose inflation. And I believe that they will be capable of steering that choice.

Bottom line, I agree about the imbalances and the consequences that will ultimately come to bear. I am just making the inflationary consequences argument. (For the US within a global deflationary environment.)

Thanks for the discussion and have a great day!

Minyan Jeff


We are very close.

I still see a difference, but maybe not.

The Fed cannot stop deflation. They cannot force the market to take credit, unless...unless...

They monetize risky assets. I think in some form they already are by stepping in when stocks are down and buying to stem the tide.

If they keep doing that (a matter of degree) and continue to monetize risky assets than they are in effect extending credit and taking it themselves.

This is very dangerous. It in essence transforms our market economy into a form of communism.

God forbid they do this to any great extent.



You said:

"On the Fed specifically, what I have confidence in Helicopter Ben for is directing the serious consequences awaiting the US in an inflationary manifestation. I do believe that he will make good on his "deflation can always be whipped" promise. But I am also pessimistic about the consequences that will have to be borne by the US economy. I just believe that if the Fed finally has no choice but inflationary or deflationary consequences, they will choose inflation. And I believe that they will be capable of steering that choice."

One would have to be exceptionally blind to not come to the common-sense conclusion that government interventions in the private lives of citizens have been disastrous. In every case, government efforts have been a total loss: welfare, public schools, the war on drugs, housing affordability, the costs of secondary education, etc. Each "War," policy and intervention act to make whatever they are trying to "solve" far worse. There is more poverty now than when LBJ started the war on poverty; there are more drugs now than when Reagan did the same for illegal drugs, housing is far more unaffordable as a result of Fannie Mae (FNM) and Freddie Mac (FRE); secondary education, thanks to SLM, is far more unaffordable than ever; and of course public schools are a clear and utter failure on all levels.

Why then, when faced with such incontrovertible evidence in every OTHER sphere of public life, do ordinarily smart investors choose to believe the exact opposite when it comes to the Federal Reserve, themselves a bunch of politically appointed (and thus politically motivated) economists? When every other government bureacracy has a completely one sided losing record when it comes to solving crises of the body politic, why does anyone believe the Fed is able to "whip" deflation or able to do anything else it "sets its mind to?"

The Fed is a big player in the larger macroeconomic scheme; a statement so controversial that even hard-core Austrians themselves believe in the omnipotence of the Fed. But yet, the idea that the Fed can guide the economy and prevent secular forces like deflation and inflation is as deeply held a belief as exists in the financial firmament. And, naturally enough, it's wrong.

I, for one, am an aggressive seller of that deeply held belief.

-Scott Reamer

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