Employment Really Counts

I don’t know of anyone who thinks that the employment crisis is not at the top of the list of government priorities.  And yet, despite the combination of massive stimulus packages and financial bailouts, little success has been achieved to date.  As I write, unemployment is at generational highs; and it is going to get worse.  I have a suggestion that I think would really help.  Whenever the government decides to throw a financial lifeline to a company (bank, insurance company, automobile manufacturer, or anyone else), it should come with two mandatory strings attached.  First, the recipient must agree that it will not reduce headcount for an extended period (say 18 months).  Second, it must also agree to reduce compensation and benefits for everyone (not just the senior executives, and this should also include retirees receiving benefits too) by a minuimum percentage, say 5-10 percent over that period (and, perhaps longer).  Now I know that this will not be a popular suggestion to people working for these institutions (and, if unionized, the unions either).  However, lets face it, companies in need of these rescue packages will probably not survive without the assistance, so all employees are receiving a pretty big benefit from these government rescue packages.  In most cases, compensation and benefit programs are the predominant expense. So cutting this expense raises the likelihood that the company will survive and pay back the taxpayers.  However, beyond this, there are other important benefits.  First, by interrupting the lay-off cycle, we may actually stabilize the economy faster and help us return to growth.  This should have a less disruptive impact on the economy than large headcount reductions.  It will help alleviate the uncertainty that all employees at struggling companies have, so they will be more inclined to spend and make other financial commitments.  Furthermore, it will help alleviate strains on government resources.  Unemployment insurance payments are a tremendous drain on state and local economies.  Keeping people at work will allow such resources to be used for other purposes.  Other sources of assistance will also be freed up.  Finally, it will raise the likelihood that the taxpayer will be repaid, which means that the future of this economy is brighter for everyone.

Good Bank, Bad Bank, Naive Public

Well, here’s the newest plan…Good Bank, Bad Bank.  Take all of these bumbling institutions and split them into two pieces.  One piece will contain the residual part of the bank that ostensibly works; i.e. the assets that have value including the management teams (not that they are necessarily assets) and employees of the near failing institutions.  The non-performing assets will be unloaded into a separate institution (i.e., the US government and its taxpaying public). The general idea is that the restructured institution, well-capitalized and free of the noose of non-performing assets, will be able to begin lending again.  This may be true, although it is not clear how many of the retained assets will default.  Also, based on past experience, you have to wonder how many new loans will go sour too.

Well, maybe this new iteration of government financial innovation will work.  Although, past performance being a guidepost, I must admit I am skeptical. More importantly, I have a few more general concerns.  The first comes from the repeated promises made by our representatives in Congress that they are going to protect the American taxpayer.  Please stop insulting our intelligence.  That is exactly what this type of plan is unlikely to do.   The government will eat all of the losses which, unless years of experience has gone by the wayside, means that we the taxpayer will be footing the whole bill for the losses.  And let us not forget the Billions and Trillions that have alread been forked over with little recompense and nasty surprises like large bonuses and corporate jets.

Worse, most of the upside will be left for the Good Bank.  Let me translate this into English.  An awful lot of future profits will be paid to senior management of the Good Bank, ostensibly for the wonderful job they will be doing without all of those nasty problem loans that they originally put on the books.  I know we will receive promises to the contrary, but they will be as hollow as all the prior promises.  Does anyone really think the CEO’s and other senior management have gone or will go uncompensated.  I doubt it.  There are lots of ways to dupe a legislator or regulator.  Let’s try a simple one.  Most senior executives are loaded with option grants (I would not be surprised if many new options were granted at year end: yes that would really be a form of bonus).  In the aftermath of the separation, I think you can be pretty sure that management equity, including options, will be conveniently restructured in such a way to eliminate performance drag from the old institution.  Yep, in a few years time, these financial honchos could well be swimming in beautiful new swimming pools, tooling around in new Ferrari’s and, maybe, flying around in their own Gulfstreams all due to Congressional (oops, taxpayer) largesse.

I trust many of you are as angry and disappointed as I am about the course of events surrounding the financial bailout.  We may disagree on some of the issues, but very few of us (outside of the protected bankers) are happy to see a past and future generation of our hard work simply handed over to institutions that are responsible for their own demise.  Worse, we should not be happy that we have been conned into going along for the ride by the empty promises and assurances of our political establishment.  If the government has to bail out these institutions, make sure the taxpayer is really protected.  Leave future asset appreciation in our hands and make sure management does not reap windfalls.  I know we are also told taxation is a bad thing. But I see no reason why we should not really protect the taxpayer by making sure the financial institutions help pay for the mess they have left us.  Congress should institute a special financial institution tax that will continue until any and all losses are recovered; and it should be structured in a way that banks and bank management can’t make an end run around their responsibility.

The Law of Unintended and Unanticipated Consequences

Our Government does not handle dissent or opposition very well.  The Bush Administration has refined this to a science.  But the Congressional hearings on the Paulson bailout package hammer home the point, and should raise a red flag as high and as poignantly as the flag the Marines hoisted at Iwo Jima.

We are facing the gravest economic crisis in generations.  Warren Buffett’s description of this as an “Economic Pearl Harbor” probably understates this by multiples.  In magnitude it is probably more like the tsunami that destroyed the Pacific a few years ago; maybe something far worse.  And yet, facing a cataclysm, our legislature has hastily arranged a party for two.  We have heard from Hank Paulson and Ben Bernanke, the crafters and proponents of the bailout ackage.  Their message, boldly stated, is do this or else.  They state they have considered alternatives.  In their opinion, this is the best alternative.  Unfortunately, no one else has been asked to testify, opine and answer questions about this plan or other alternatives.  The media really does not help.  They parade on people who are part of the marketing team; often people with a vested interest in the outcome.

Quick passage of this package may feel good.  But the rush to judgment and the unwillingness to consider alternatives means that the analysis has probably been relatively simple, relatively linear.  It means they have probably missed a lot or ignored a lot.  That carries big risks.

First of all, the plan focuses on saving financial institutions by taking assets off of their balance sheets.  How long will it take to get the program up and running?  More importantly, how long will it take before these institutions start lending again?  As I read the plan, it will be a while.  This economy needs financial intermediaries to extend credit for growth to occur.  While we wait, what happens to the economy, to employment, to consumption?  In addition, even if banks can start lending again, it is not clear that borrowers will want the money.  Japan experienced this problem.

How about other risks?  We are printing money.  What does this mean for our currency?  For inflation?  The Government’s financial condition is deteriorating at a staggering rate.  This could pose significant risk to growth trajectories for a generation.  Further, the current financial crisis is not the only major problem that we are facing.  The cost of this bailout may limit our ability to address other problems.  As is well known, the Social Security/Medicare/Medicaid System is in trouble.  Now, there is talk that the FDIC is in a $400 billion bind.  The PBGC, guarantor of many pension plans, is deeply in debt.  As became apparent last year when a bridge collapsed in Minnesota, we have under-invested in plant and equipment for a generation.  At the time, Senator Dodd estimated the rebuilding cost to be $1 trillion to $2 trillion.  Can we afford this?  The longer we delay, the higher the cost. 

In many ways, this country has been under-investing in technology.  Energy is a great example.  Often, Government is a necessary participant.  Without investment, we become less competitive, less productive.  In general, the private sector needs capital to grow and thrive.  The Government’s demand for money may crowd out the private sector.  At the very least, it will make the cost of money more expensive for years to come.  This has negative effects on growth, income, prices, deficits.  Private savings become more vulnerable.  The real value of assets will rise far more slowly.

In essence, by focusing our resources on the financial crisis, we are focusing our resources on all of these problems, and probably many others.  Unfortunately we are not focusing our attention.  We ought to consider this now.  If not, the Law of Unanticipated Consequences will surely apply. Unfortunately, so will the Law of Unintended Consequences.  Let us hope, that it does not bring Murphy’ Law into play.

The Buck Stops Anywhere But Here

When I was young, I was taught that people were expected to assume responsibility for their actions.  The idea was encapsulated in a quote that appeared on President Truman’s desk.  Remarkable in its succinctness, the quote read “The Buck Stops Here”.  Unfortunately, as the years have passed, that simple concept seems to have been turned upside down.  In this hour of national crisis, it has become “de rigueur” to point fingers at eveyone else.  From the President down, someone else is always to blame.  And maybe that is why we find ourselves mired in quicksand.  Nowadays, the “Buck Stops Anywhere But Here.”

In the spirit of the moment, I have decided to hand out some awards to people who bear some responsibility for this economic and political morass.  I would like to call them the Truman Awards, but they already exist and I do not want to enter a legal minefield.  So I think I will be simple and call a rose a rose.  I give you the “Pass the Buck” Awards.  Hopefully, when I get through handing out these well earned awards, we can stop blaming each other and focus on getting this country back on a sound economic footing.  It will not be easy; it will not be fast; it will probably be painful (even more than has already been felt); and it will require contributions from everyone.   Anyway, here goes.

Pass the Buck Award 1.  The American People.  Yes you; and you; and you; etc.  Oh, and me.  Why?  Simple.  This crisis is, in part, political in nature.  The American people are responsible in the end for our political representatives and processes.  And, although it may not have felt that way before, they have let us down for a very long time.  We have tolerated mediocre electoral choices to be presented to us and, in most instances, we have chosen a relatively mediocre (maybe that is too polite) group of representatives who have become ensconced in our nations’ political establishment.

Pass the Buck Award 2.  The American Taxpayer.  Will the recipients of Award 1, please come back to the stage to accept their second Award.  This has been one of the most contentious areas in this year’s nominations.  The middle class says they pay too much tax, and the wealthy don’t pay enough.  Congress tends to come out and vocally support this view, although who knows what they really think or do.  The wealthier amongst us (and that can be a relative term), obviously think the opposite.  And to be fair, each position has its merits.  For instance, although there is a lot of anger at Wall Street, they did actually pay a lot of taxes: at the local, state and national level.  Maybe the percentage was not enough, but New York State just woke up and found that 20 percent of its’ revenue is seriously impaired.  Washington will feel these effects too.

The truth of the matter, however, is that none of us have paid enough taxes for a long time.  Over time, the books of this country have been presented in a way that masks the true extent of the financial mess that awaits us.  In part, that is why the current crisis is so bad.  However, be aware that this is Act One.  Unless we do something comprehensive, and do it now, the Second and Third Acts will make the current crisis look mild.  And this burden rests on all of our shoulders.

Pass the Buck Award 3.  The President and the Executive Branch.  We have created an Executive Office where it is more important to protect the President from the consequences of his decisions, or those of the people around him, than it is to insist they stand behind their actions.  Well, President Truman is turning over in his grave and would never tolerate such behavior.  Few if any of our great statesman would either.  In this day and age, we bandy about the word “Patriotism” more as a sword than a badge of honor. Unfortunately, in many ways, we have forgotten what it means.  Real patriotism means being willing to take a side, state a view, admit you are wrong and take responsibility.  And that is the type of leader this country needs, crisis or not.

Pass the Buck Award 4. Congress and State Legislatures.  Okay, I don’t really need to say much here.  These guys are really pros.  They have done so much to cause so many problems.  Yet, they refuse to accept any recognition.  Nevertheless, they do point fingers so often I am surprised they can still lift them.

Pass the Buck Award 5.  Chairman Greenspan.  I can’t help myself here.  Under his leadership, the Federal Reserve sowed the seeds of the current crisis.  Free money created bubble after bubble.  Economic distortions became the norm.   Expectations became detached from reality.  Inflation, at least for most Americans, became oppressive.  (Although it is not discussed, I will go so far as saying that inflation was a major, if not the major, cause of the sub-prime crisis). Leverage exploded.  Risk management was relegated to the minor leagues.  In the end, well, you see the damage.  Perhaps this goes a bit far, but remember that “Sir Alan” willingly assumed the mantle of an oracle.  Every economic policy or act needed his imprimatur.

Pass the Buck Award 6.  Wall Street, the Banks, the Rating Agencies, the Mortgage Lenders and the Housing Agencies.  Yes.  They too bear their share of responsibility.  Lots can be said here, but too much has been said everywhere.  However, lets note that there was encouragement from many other sectors.  “Home Ownership” was the “American Dream”.  That is a major reason why all of these institutions exist.  Combine the Dream with a political agenda, an aversion for oversight and meddling, lots of money to be made by everyone (including the politicians), and you have the recipe for a disaster.

By the way, as people may now be learning, there are other financial risks that have been swept under the rug.  Do you have exposure to equities?  Important safety tip, equities can go down; and they can go down further.   How about our pension system?  It also has a lot of exposure to equities.

Pass the Buck Award 7.  The Homeowner.  I know everyone in trouble thinks they have been conned.  I am sure some were.  Our political leaders certainly want to reinforce this point of view.  However, at the end of the day, there is only one John Hancock on each mortgage, and I don’t know of many people who were forced to ink their name with a gun to their head.  Everyone dreamed of owning a home.  Money was cheap.  Down payments (a risk cushion) became a distant memory.  Prices only went one way.  Buy now.  There was no downside.  Except there was.

Unfortunately, everything went wrong at the same time.  Rates went up (on resets and new loans).  So home prices started to drop.   The exit door slammed shut.  On the other side, living costs exploded.  Oil for heating the home and gasoline for travel exploded in price; so too did the cost of food and other necessities such as education and health care.  Families were squeezed from both sides.  And many people could not afford the double whammy.  It was a lethal combination and the rest is history.

Now that the awards are out of the way, and blame has been adequately meted out to everyone involved, can we please stop pointing fingers and start to address the problems we are confronted with.

Our political system has stopped working.  Perhaps the system is outdated.  Our politicians want power, but they do not want accountability.   We are unwilling to take them to task.  But our future really depends on sending talented people to Washington who are there for the long term health of this nation, not the long term health of their own careers.

The financial system has been shredded and is on life support.  This economy can not grow fast, or fast enough, without a strong financial sector.  Improving balance sheets is not enough.  A lot more capital is an imperative.  While the financial sector has been in cardiac arrest for a while, Main Street recently was admitted to the ER too.  Business is grinding to a halt.  Jobs are at risk.  Income, savings and consumption are falling.  Wealth and capital has been decimated.  The economic landscape needs more than cosmetic help.  However, decisions need to be carefully thought out for the long term and band-aids are not enough.

Many now stand with their hands out, begging for assistance.  And assistance is necessary.  However, it should not be too much to ask those who receive assistance to return the help in kind, if and when they are able.  Financial firms need better regulation, more transparency and more oversight.  They should welcome a guiding hand, not resist it.  They should also understand they are being treated in an extraordinary manner and should return the favor.  Where possible, protecting jobs is important.  And standing up as a taxpayer should not be too much to ask either.  The same can be said for distressed homeowners who receive assistance.

The balance sheet of this country is also in tatters.  At every political level, we are in trouble.  Liabilities are exploding.  The pension and benefit programs are insolvent.  Public sector demands will crowd out the private sector.  Again it is a problem that will not easily go away.  The longer we wait, the more intractable the problem becomes.

It is a difficult time.   No one needs to be told or reminded.  As a country we have to make difficult and painful decisions.  In periods of crisis, great leaders have stood up and asked us as a nation to come together, share the pain and overcome great challenges.  This is one of those rare moments.  Let’s stop blaming each other.  Let’s all assume responsibility.  And let’s rise to the occasion as the great nation we are.

The Beggar’s Banquet

Chairman Ben Bernanke

Chairman

Board of Governors of the Federal Reserve System

Washington, D.C. 20551

 

Dear Ben: 

  

I hope you don’t mind the informality, but I feel like you should always be able to call your banker by his first name.

 

I noticed this morning that one of the factors in deciding to “rescue” Bear Stearns” was the possibility that they might file Chapter 11.  I am thinking of filing Chapter 11 too (I have less net worth than most of the people you bailed out over there, and I did not act with the stupidity and reckless abandon of Bear’s management).  Any chance you are willing to send $30 Billion my way too.

 

Thank you for your willingness to make sure I am as well taken care of as the deserving folks at Bear Stearns.

 

Respectfully yours,

 

John Q. Public

Where’s the Fire?

If you have read this Blog (or talked with me over time), you would know that I have been critical of policy and policy response from the Federal Reserve (as well as the Treasury).  I often refer to the Fed’s approach as ostrich economics.  Their short-sighted policies have dug us into a fine mess.  Across the entire spectrum, people have been suckered in hook, line and sinker.  This includes the average Joe who over-extended himself to buy the over-sized, over-priced home of his dreams.  Somewhat surprisingly, the list also includes sophisticated investment firms and major financial institutions, several of which have been brought to their knees.

The Federal Reserve, which is given the dual mandate of full employment and price stability, has found itself facing an economic landscape with more craters than the surface of the moon.  Let me list a few: Credit (Check. And not the type lenders do); Leverage (Too much); Liquidity (Not enough); Growth (Hard to find); Jobs (Even more scarce).  It sounds like a bad infomercial.  But wait, there’s more.  How about skyrocketing commodity prices, a collapsing currency and fiscal fissures at all levels of government.

Unable to confront both a deteriorating economy and rising inflation at the same time, the Fed has thrown everything it can think of (including the kitchen sink) to try and prop up the economy and protect our financial institutions.  Inflation is tomorrow’s problem.  Unfortunately, the policy equivalent of the firepower of the U.S. Navy has “barely” put a dent in the surface of the problem.  Only last week, one of our storied investment banks, Bear Stearns, was forced onto life support and then, in historic and questionable fashion, into the arms of JP Morgan.  I have much to say on this latest development, but I will leave it for another time and place.  I do not believe in bail-outs, but it is becoming abundantly clear at this point that there will be virtually no innocent bystanders if this vortex is not stopped.

Although I admit it begrudgingly, the Fed is directing its attention to the core of the problem: The deteriorating condition of our financial institutions.  The Fed, which has aggressively lowered rates and provided innovative financing facilities to financial intermediaries, is concerned with liquidity.  Their solution is reminiscent of the Japanese response to the problems that destroyed that economy twenty years ago.  It is more a “rearguard” action designed to allow time to do the healing.  But if Japan is any example, the healing process is glacial and time is the one thing we do not have.

As is suggested by Bear Stearns, I believe the problem faced by financial institutions is capital, or lack thereof.  Illiquidity and leverage are manifestations of this problem.  It is apparent that these struggling institutions need capital to survive.  Unfortunately, that is not enough.  Mere “survival” leaves our financial institutions in a state of suspended animation.  The economy will probably find itself in the same boat.  If the economy is to regain its’ footing, banks have to be part of the solution.  They will have to provide fresh funding to a wide array of end users, and this requires much stronger balance sheets.

If I were in the Fed’s shoes, I would insist that our major banks and financial institutions raise capital, a lot of capital.  I would also press lender’s to pass on to creditworthy borrowers some of the cost savings being provided by Federal Reserve policy.  Finally, I would try to persuade financial institutions to retain employees, even at the expense of reducing earnings.  To the extent that institutions balk at these suggestions, I would gently remind them that Fed initiatives have helped bottom lines significantly over the last nine months and will do so for the foreseeable future; and these initiatives are being done for the good of the economy as a whole, and not just for bank management, shareholders and debtholders.

One final thought.  In the last three decades, a number of crises have been resolved by Federal bailouts.  I would suggest that when general taxpayer dollars are used to prop up private institutions, taxpayers should also reap the benefits.

Robin Hood and the Friar’s Tax Rebate

If you should ever decide to go to the website of the IRS ( www.irs.gov/taxstats/index.html  ), you will find a wealth of statistics on the U.S. taxpaying population.  The last year listed is 2005.  Now you may question the sanity of anyone voluntarily glancing at these numbers, but you do get some interesting results.  To begin with, there were a tad more than 90 million individual returns filed that year.  Of these filers, roughly 68 million had taxable income (after credits) of $75,000 or less.  On this income, this taxpaying group paid cumulatively $179.6 Billion in taxes.  If it sounds like a lot to you, consider this.  In the current rush to provide aid to the economy, our wonderful legislators decided to return over $150 Billion to taxpayers; most of this going to lower income earners.  Assuming that 2007 is similar (and there is no reason assume otherwise), this means that net of this tax rebate, roughly 2/3rds of all taxpayers will not owe any taxes.

I find it hard to understand why so many people think the tax system unfairly favors the wealthy, or the near wealthy.  Robin Hood and Friar Tuck could not do better if they tried.  

Fool Me Once, Shame On You; Fool Me Twice…

Most of those who ask my opinion on the maelstrom in the capital markets know that I believe (rather too strongly) that the prior Chairman of the Federal Reserve bears a significant part of the responsibility for the financial distress many are now encountering.  I won’t repeat the litany of errors here.  But I do have a new mistake to add to the list…Behavioral Economics.  A more popular description is the “Greenspan Put”.

Over the years, we were treated to Greenspan Alchemy in any number of variations.  There was, however, always a similar plot.  Something good would happen in the economy.  Something too good.  The stock market would appreciate in an unprecedented fashion.  Housing prices would soar, spurring record construction.  Everyone could get a mortgage, irrespective of financial condition or income.  Commodity prices exploded.  In sophisticated jargon, we experienced bubbles.  One after the other.  Even Bazooka Joe couldn’t have made the Final Four.  In each instance, this financial wizard would demur if called upon to intercede at an early stage.  In his own mind, it was not this bartender’s responsibility to take away the punchbowl.  In fact, he did not want to stop refilling everyone’s cup.  According to the Chairman, the Fed was not positioned to anticipate bubbles, nor was it positioned to prevent or moderate them (even if easy credit was at the heart of the problem).  However, the Central Bank would be happy to provide the Alka Seltzer for the guaranteed hangover.

Over the years, we were taught, collectively, that financial exagerration was, at worst, an inconvenience and, at best, a “buying opportunity”.  Time and again, like a perfect Pavlovian experiment, we were taught to wag our tongues and tails when in pain.  The “Greenspan Put” was the perfect Milkbone Dog Biscuit.

Unfortunately, it was a bad lesson.  And a lesson learned that may be responsible for this mess.  Leaks in the Sub-Prime balloon started showing up several years ago.  In the early stages, it prompted little concern at any level.  Most importantly, financial institutions saw no reason to react.  As the problems grew, the same behavior continued.  In fact, I would not be surprised if the first few bumps were not viewed as buying opportunities.  As things progressed, problems grew.  But, hey, the Fed was there and they would get aggressive.  Almost nothing was done to prepare for the coming tsunami.  Assets were not sold, debt and leverage was not reduced, duration was not shed.  The system’s response function was broken.  It was a perfect Pavlovian response.  Most of us did what we were taught to…Ignore reality.  We are drowning in it now.

Hopefully it is not too late and we learn our lesson.  Maybe Ben Franklin put it best…”An ounce of prevention is worth a pound of cure.”

Zero For Too Many

We are not terribly tolerant of failure.  A CEO who disappoints investors and the markets often finds plenty of time to read by the fireside. A coach or manager who can’t win finds his ears ringing from boos and is soon nothing more than a spectator.  Yet, when it comes to something of real significance, like the overall performance and management of our economy, we seem quick to ignore poor performance.  Surprisingly, we also seem comfortable believing that the captain who ran this ship aground is capable of once again making her seaworthy.  I must admit, I don’t understand why.

Let me first start with our Central Bank.  Under the stewardship of its former Chairman, we were treated to a number of asset bubbles that, cumulatively, eroded the foundation of our economic systemic.  The last bubble, the Housing and Sub-Prime Mortgage crisis, is perhaps emblematic of how we should remember his long tenure.  His successor, a former Fed Governor and Chairman of the Council of Economic Advisors, admittedly walked into this buzz saw.  However, he has not distinguished himself by performance either.

Let’s take a look at the Fed’s current batting average. The housing industry is in shambles; losses in home equity are staggering; foreclosures are occurring at the fastest pace in a generation; the entire debt capital market system is in disarray; enormous writedowns are threatening the stability and viability of many financial institutions; from the peak, equities have lost approximately 15% of their value; the industrial economy is now slowing; jobless claims are exploding; the cost of goods, including many of our basic necessities, is rising rapidly; and, the US Dollar, long the reserve currency of the world, continues to depreciate.  So, as best I can tell, the Federal Reserve’s batting average is zero.  And it is not because they have been to the plate only once or twice.  They have had plenty of opportunities to swing at the ball.  They are basically Zero For Too Many.  I do not want to walk away hoisting all the blame on the Federal Reserve.  Other members of the team have not managed to get a hit either.  The Treasury Secretary, who has oversight of much of the financial and economic system, has a hand in this mess.  So does Congress and a number of other regulatory oversight bodies.

Given the breadth and depth of the problems confronting us, we must recognize that we will not be able to get out of the cellar without making wholesale changes.  The manager needs to go.  The players need to go.  The playbook needs to go.  It is time to clean house.  It will take time and patience, but it can be done.  However, we need to turn to someone who inspires confidence; basically, we have to find a manager with a winning record.  If this were a baseball team, Mr. Steinbrenner would know what to do.

It’s Official, Fed Banishes Inflation from the Vernacular

In his appearance before Congress yesterday, the Chairman of the Federal Reserve made clear that the only concern of the Central Bank at this point in time is the abysmal state of the economy.  Inflation, which over the last five years has been an annoyance requiring lip-service, has had its’ status further degraded.  It is officially irrelevant.

That is unfortunate. First, one of the reasons we are having economic problems to this degree is inflation.  Skyrocketing prices of fuel, energy, food and other items are forcing Americans to reallocate expenditures, lowering real growth.  Debt burdens have risen commensurately, and are reflected in skyrocketing default rates on mortgages and other consumer debt.  Of course, the Federal Reserve has essentially eliminated such “non-core” items from their policy deliberations.  This is laughable.  Next time you fill your gas tank, try telling your gas station attendant that he can only charge $1.99 per gallon because the Fed Chairman says the cost of a non-core item like gasoline does not count.

Furthermore, in speeches before Congress over the last few years, Mr. Bernanke has repeatedly hewn to model-based prognostications that slower growth would reduce price pressures.  These models have been wrong.  Reported GDP in 6 of the last 12 quarters has been under 2.5%; 8 have seen GDP under 3.1%.  During this same period, commodity prices have exploded. As measured by the CRB, commodity prices have risen at a 10% compounded rate over this period.  Using the overall CPI, prices have increased at a compounded rate of 3.5%.  (I do not know anyone who actually believes this is an accurate measure of personal cost increases).  The Fed has tried to assure us that current price increases are tolerable so long as inflation expectations remain “contained”.  When sentiment and reality are in conflict, following sentiment can be a dangerous game.  In any event, these forward indicators are also in the red-zone.

Perhaps most importantly, inflationary pressures are offsetting the impact of monetary easing.  Commodity prices have been exploding raising the cost of basic necessities.  The depreciating value of the dollar is likely to further hurt consumers by raising the cost of imported goods.

It is clear that the Central Bank has taken its eye off the ball and we are paying for this dearly.  Inflation is not the only effect we are feeling.  In large part, the disaster in the real estate and financial industries, including the sub-prime disaster, can be tied to overly-accommodative monetary policy.  This includes the process of normalizing rates employed by Mr. Greenspan.  (I refer to his approach as infinitesimal incrementalism).

What is perhaps most unfortunate is that the Fed has actually drifted from its mandate.  Section 2A of the Federal Reserve Act, as amended, provides that: “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”  There is no GDP target granted to the Fed by statute.  They are mandated to achieve “maximum employment”.  While there is obviously linkage, GDP growth and employment are not always coincident.  This has been clear in recent years, as the unemployment rate has stayed near multi-year lows even with sub-par GDP growth.  In the last year, this rate has drifted up only modestly to 5%.

This shift in emphasis, implemented by former Fed Chairman Greenspan, has given the Fed more flexibility to identify and react to growth risks and ignore inflation issues.  There are obviously periods when the markets, economists and consumers (politicians and voters too) have believed this to be the right approach.  (The relatively small number of market participants who have voiced opposition to this approach (generally referred to as “bond vigilantes”, a group in which I include myself) have generally been marginalized.)  We are paying the price.  The Fed was given independence and a prescribed mandate to stay above the fray.  They were given the rare privilege of focusing on longer term economic trends and trajectories.  This was embedded in the dual objectives maximal employment and stable prices.  Unfortunately, the Fed has allowed “mandate creep” to subvert these objectives.  Because of this we are facing an unstable economic environment with, being polite, sub-optimal policy prescriptions.  The sad thing is that there is no accountability.