Fed is the Villain in Krugman-Stockman Brawl
Comment of the Day

April 17 2013

Commentary by David Fuller

Fed is the Villain in Krugman-Stockman Brawl

Here is the opening from another article on this continuing debate, written by William D Cohen for Bloomberg
Because I don't have -- and have no prayer of ever having -- a Nobel Memorial Prize in economics, this statement is tantamount to blasphemy: Paul Krugman, the Nobel-winning economist and New York Times columnist, is wrong. At least when it comes to denigrating David Stockman's cogent argument that the U.S. Federal Reserve is fomenting economic trouble.

On the April 5 "Charlie Rose," Stockman, who also was a partner at the Blackstone Group LP (BX) and had his own (unsuccessful) private equity firm, succinctly posited one aspect of his argument.

"The Federal Reserve has basically become a bubble machine," he said. "There has been fabulous expansion of the Fed's balance sheet since the crisis of 2008. And almost all of that new money created -- $1.7 trillion -- is simply circulated through the banking system, through the fingers of Wall Street, so to speak, and is back on the Fed's balance sheet."

Why is this so bad? "What it does is allow people to speculate and hit home runs," he explained. "It doesn't go to Main Street. It's not helping the Main Street economy. And it's crushing savers. Remember, if you are saving, if you saved your whole life and you have $100,000, you're making $400 [a year] as a result of the Fed crushing short-term interest rates."

Stockman is exactly right. The Fed's "quantitative easing" policies -- which some Fed governors have begun to question, according to the minutes of the mid-March Fed meeting -- have been an unqualified boon to Wall Street. Not only has QE been a gift to traders -- they can trade freely on the Fed's promise to keep interest rates low for the foreseeable future, and who have found a willing buyer in the Fed, at market prices, for squirrelly mortgage-backed and other complex debt securities -- but the Fed's low short-term interest rate policy has allowed the money-center banks with access to the Fed's discount window to back up the truck and get as much short-term funding as they need at virtually no cost.

Then, as Stockman notes correctly, banks pay virtually nothing to depositors for the use of their money, and they turn around and lend out those deposits at wide spreads. It all adds up to an industry that pays close to nothing for its raw material -- cash -- and has the Fed's blessing to rake in the profits. In 2012, despite losing $6.2 billion in the London Whale debacle, JPMorgan Chase and Co. still earned $21.3 billion in profits, its best year ever.

David Fuller's view I have enjoyed the Krugman vs Stockman debate because it is entertaining for market types and helps me to think. Stockman may be ahead on PR points, despite frightening investors, because he actually has a sense of humour.

My own view remains that Austrian School policies would have been appropriate before the financial crises developed but that did not happen. Interestingly, Alan Greenspan, who was worshiped before he was vilified, uttered a mild Austrian School comment on 5th December 1996, when he spoke of "irrational exuberance" while still Chairman of the Federal Reserve:

"Clearly, sustained low inflation implies less certainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?"

The stock market swooned; enraging Wall Street types who castigated Greenspan as never before. He was too nice. Paul Volcker, I believe, would have raised margin rates significantly as an initial step to rein in the bubble. Instead, the intimidated Greenspan ruined his reputation by talking about the difficulties of recognising an asset bubble while it was forming, during the remainder of his term.

Ben Bernanke was nominated to succeed Greenspan on 1st February 2006, having gained a considerable following after his 2002 speech as a member of the Board of Governors at the Fed: "Deflation: Making Sure It Doesn't Happen Here". By that narrow definition, we can say that Bernanke has been successful and he is certainly loved by Wall Street. Several other countries and their central banks have followed versions of his quantitative easing (QE) policy in recent years, the most recent being Japan since Shinzo Abe became Prime Minister.

As equity investors, I think most of the Fullermoney Collective have benefited from Ben Bernanke's policies at the Fed. I doubt we would feel the same way if someone with David Stockman's views led the Central Bank. However, the big uncertainty concerns what happens when the Fed and other central banks engaged in QE wind down these policies, as I have mentioned before.

Meanwhile, this is not an immediate threat. Moreover, it will remain no more than a medium-term prospect while global GDP growth is subdued, Europe remains in the grip of deflation, commodity prices are declining and headline inflationary data remains mild.

We are probably in the second half of the global stock market pullback, in terms of time, which so far ranges from consolidations to corrections among equity markets. However, the latter stages of these setbacks can be more frightening for investors.

Nevertheless, they create buying opportunities and I regard this as a setback in a bull market rather than the beginning of a bear trend. Among individual stock markets, I would favour those where financial indices are at least matching the performance of broader indices. We continue to favour in form Autonomies and other performing shares with a history of dividend increases.

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