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Posted 6/13/2005
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Straight talk on what the Fed has wrought
Finally, the mainstream press is taking a look at the problems the Fed created with its cheap-money ways. The consequences will be very serious for all of us.
By Bill Fleckenstein
For once, there was a somewhat intelligent (though incomplete) discussion in the mainstream press about how the Federal Reserve bailed out the stock bubble with a real-estate bubble.
I am referring to a page-one story in Thursday's Wall Street Journal headlined "In Treating U.S. After Bubble, Fed Helped Create New Threats." To quote its author, Greg Ip, who is thought to be plugged into the Fed:
"Five years after the stock market's peak, the economy faces other threatening imbalances: a potential housing bubble, rock-bottom personal saving rates and a gargantuan trade deficit. And the Fed's post-bubble prescription bears some responsibility for all three."
Fed officials acknowledged as much to Ip, but they insisted the alternatives were worse, including a deeper recession and the risk of deflation.
The Fed's response is both true and false. True: The alternatives will be worse, because all the Fed did was to postpone them, guaranteeing that they will be more severe than they would have been then. False: We would have been far better off accepting the harsh medicine from the biggest stock mania in the history of the world, rather than creating gargantuan amounts of debt at the consumer level -- and in the financial system -- in the form of real-estate loans.
A gazette gets it wrong
The article and the Fed argued from a false premise to a false conclusion, by blaming the American bust of the 1930s and the one in Tokyo in the 1990s on monetary tightening: "Faced with an asset bubble, a central bank has two choices: Prick it early or wait for it to burst and try to contain the damage. The Fed in 1929 and the Bank of Japan in 1989 tried the first route, raising interest rates in response to rapidly rising asset prices. The result in the U.S. in the 1930s was depression and deflation. In Japan it was stagnation and deflation that continues today."
That is completely untrue. The aftermaths of both were caused by the preceding asset bubbles, precipitated by reckless monetary policies. It is asset bubbles that create the damage, not the small amount of tightening that comes at the end. In fact, I would argue that the tightening didn't end those bubbles. Exhaustion ended them, and the tightening was coincident with the exhaustion phase.
Policymaking is the perpetrator
The trouble that ensues from a bubble is historical fact, but part of what makes the aftermath better or worse than you might expect are policy decisions. Part of what put "Great" into the phrase "Great Depression" were events that came after the bubble, such as 1930's Hawley-Smoot Tariff Act and the policies of the Hoover administration. I would also note that the inflexibility of the gold standard made "printing" our way out impossible.
Related news and commentary on MSN Money
Similarly, Japan's problems were exacerbated by the failure of its brand of "semisocialist" capitalism to allow markets to clear. Japan tried to prop up zombie companies for far too long, which, in part, has made its recovery process so slow. Bad debt in the banking system, emanating primarily from the Japanese real-estate bust, also exacerbated the country's problems.
We don't know what policy mistakes we're going to make next. I would argue that we've made a policy mistake by bailing one bubble out with another, debt-inspired, bubble. And, when the fallout from these two hit, it will be made better or worse by subsequent government actions. Of course, once you know it's a government action, it's almost certain that it will make matters worse.
Federal Reserve Bank of Frankenstein
The Fed only postponed the pain, ensuring that it will be dramatically worse. Easy Al and the other apparatchiks at the Fed embarked on a grand experiment with the American economy and everyone's lives. Historian Edward Chancellor, author of the terrific history of financial speculation "Devil Take the Hindmost," makes the same point to Ip:
"The Fed is conducting a 'crucial experiment' in post-bubble monetary policy. We don't know what the outcome is yet."
I would say that we can speculate on how ugly it's liable to be.
The Fed chose not to address the stock bubble, choosing instead to bail it out with a real-estate bubble. When the stock bubble was in full bloom, as I have noted many times, rather than even hint that there might be a problem or raise margin requirements, Greenspan got behind the bubble and cheered it on with all his "new era" cooing and "productivity" pompoms. His behavior led many to suggest that the market, in fact, had a Greenspan "put" underneath it.
One of the incorrect points of Ip's article is that, gee, this housing bubble is great because it bailed out the stock bubble. Though he raises the specter of our problems, he doesn't connect the dots as to how catastrophic the consequences are liable to be.
Fed complicity gets publicity
Although I have just criticized Ip and the Journal for not coming to the conclusions I would have liked, I think that getting the discussion into the mainstream press is useful. So is Ip's ability to illuminate the "thinking" behind the Fed's bubble-management practices: "Fed officials expect home prices to stagnate while incomes advance, bringing affordability back to historic ranges."
You can see that they're still delusional. They think that what they've done has worked; that somehow, job creation and incomes will be able to grow enough to support this tremendous increase in home prices. It isn't going to happen that way.
The housing market is in a bubble. Housing prices have gone up because housing prices have been going up, i.e., rising prices create more demand from speculators. At some point, however, the market will exhaust itself. Time magazine's recent cover, "Home $weet Home: Why We're Going Gaga Over Real Estate," means to me that the moment of exhaustion is circa now. And we should be on red alert for signs of trouble in the housing market.
Incompetence outed
I believe that the more the present situation is understood, the more it's liable to foment angst and panic when, as I noted in "GM's woes one more blow to housing bubble," the next time down eventually unfolds. Lastly, in my personal-pet-peeve department, recognition of where we are will also hasten recognition of the irresponsible, incompetent record of the Greenspan era.
Bill Fleckenstein is president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column on his Fleckensteincapital.com web site. His investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of MSN Money.
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