View Full Version : Fed's Mistakes Beget Greater Mistakes

March 26th 09, 09:34 PM
Mistakes Beget Greater Mistakes:

March 18 – Bloomberg (Kathleen Hays and Dakin Campbell): “Bill Gross,
co-chief investment officer of Pacific Investment Management Co., said
the Federal Reserve’s purchases of Treasuries and mortgage securities
won’t be enough to awaken the economy. ‘We need more than that,’
Gross said… The Fed’s balance sheet ‘will probably have to grow to
about $5 trillion or $6 trillion,’ he said.”

“The problem with discretionary central banking is that it virtually
ensures that policy mistakes will be followed by only greater
mistakes.” Here, I’m paraphrasing insight garnered from my study of
central banking history. Naturally, debating the proper role of
central bank interventions - in both the financial sector and real
economy – becomes a much more passionate exercise following boom and
bust cycles. The “Rules vs. Discretion” debate became especially
heated during the Great Depression. It was understood at the time
that our fledgling central bank had played an activist role in fueling
and prolonging the twenties boom - that presaged The Great Unwind.
Along the way, this critical analysis was killed and buried without a

I believe the Bernanke Fed committed a historic mistake this week –
compounding ongoing errors made by the Activist Greenspan/Bernanke
Federal Reserve for more than 20 years now. I find it rather
incredible that Discretionary Activist Central Banking is not held
accountable – and that it is, instead, viewed as critical for a
solution. Apparently, the inflation of Federal Reserve Credit to $2.0
TN was judged to have had too short of a half-life. So the Fed is now
to balloon its liabilities to $3.0 TN, as it implements unprecedented
market purchases of Treasuries, mortgage-backed securities, and agency
and corporate debt securities. And what if $3.0 TN doesn’t go the
trick? Well, why not the $5 or $6 TN Bill Gross is advocating? What’s
the holdup?

Washington fiscal and monetary policies are completely out of control.
Apparently, the overarching objective has evolved to one of
rejuvenating the securities and asset markets and inciting quick
economic recovery. I believe the principal objective should be to
avoid bankrupting the country. It is also my view that our
policymakers and pundits are operating from flawed analytical
frameworks and are, thus, completely oblivious to the risks associated
with the current course of policymaking.

Today’s consensus view holds that inflation is the primary risk
emanating from aggressive fiscal and monetary stimulation. It is
believed that this risk is minimal in our newfound deflationary
backdrop. Moreover, if inflation does at some point rear its ugly
head the Fed will simply extract “money” from the system and guide the
economy back to “the promised land of price stability.” Wording this
flawed view somewhat differently, inflation is not an issue - and our
astute central bankers are well-placed to deal with inflation if it
ever unexpectedly does become a problem.

Our federal government has set a course to issue Trillions of Treasury
securities and guarantee multi-Trillions more of private-sector debt.
The Federal Reserve has set its own course to balloon its liabilities
as it acquires Trillions of securities. After witnessing the
disastrous financial and economic distortions wrought from Trillions
of Wall Street Credit inflation (securities issuance), it is difficult
for me to accept the shallowness of today’s analysis. In reality, the
paramount risk today has very little to do with prospective rates of
consumer price inflation. Instead, the critical issue is whether the
Treasury and Federal Reserve have set a mutual course that will
destroy their creditworthiness - just as Wall Street finance destroyed
theirs. Additionally, what are the economic ramifications for ongoing
market price distortions?

The counterargument would be that Treasury and Fed stimulus are
short-term in nature – necessary to revive the private-sector Credit
system, asset markets and the real economy. That, once the economy is
revived, fiscal deficits and Fed Credit will recede. I will try to
briefly explain why I believe this is flawed and incredibly dangerous

First of all, for some time now global financial markets and economies
have operated alongside an unrestrained and rudderless global monetary
“system” (note: not much talk these days of “Bretton Woods II”).
There is no gold standard - no dollar standard – no standards. I have
in the past referred to “Global Wildcat Finance,” and such language
remains just as appropriate today. Finance has been created in
tremendous overabundance – where the capacity for this “system” to
expand finance/Credit in unlimited supplies has completely distorted
the pricing for borrowings. As an example, while Total US Mortgage
Credit growth jumped from $314bn in 1997 to about $1.4 TN by 2005, the
cost of mortgage borrowings actually dropped. It didn’t seem to
matter to anyone that supply and demand dynamics no longer impacted
the price of finance. Yet such a dysfunctional marketplace (spurred
by unrestrained Credit expansion) was fundamental in accommodating
Wall Street’s self-destruction.

Today, the markets will lend to the Treasury for three months at 21
bps, 2 years at 84 bps and 30 years at 371 bps. I would argue that
this is a prime example of a dysfunctional market’s latest pricing
distortion. As it did with the Mortgage Finance Bubble, the
marketplace today readily accommodates the Government Finance Bubble.
And while on the topic of mortgage finance, the Fed’s prodding has
borrowing costs back below 5%. This cost of finance also grossly
under-prices Credit and other risks.

I would argue that market pricing for government and mortgage finance
remains highly distorted – a pricing system maligned by government
intervention on top of layers of previous government interventions.
These contortions become only more egregious, and I warn that our
system will not actually commence its adjustment and repair phase
until some semblance of true market pricing returns to the
marketplace. Yet policymaking has placed peddle to the metal in the
exact opposite direction.

The real economy must shift away from a finance and “services”
structure – the system of “trading financial claims for things” – to a
more balanced system where predominantly “things are traded for other
things.” Such a transition is fundamental, as our system commences
the unavoidable shift to an economy that operates on much less Credit
of much greater quality. But for now, today’s Washington-induced
distorted marketplace fosters government and mortgage Credit expansion
– an ongoing massive inflation of non-productive Credit. I would
argue this is tantamount to a continuation of Bubble Dynamics that
have for years misallocated financial and real resources. In short,
today’s flagrant market distortions will not spur the type of true
economic wealth creation necessary to service and extinguish previous
debts – not to mention the Trillions and Trillions more in the

Market confidence in the vast majority of private-sector Credit has
been lost. This Bubble has burst, and the mania in “Wall Street
finance” has run its course. The private sector’s capacity to issue
trusted (“money-like”) liabilities has been greatly diminished. The
hope is that Treasury stimulus and Federal Reserve monetization will
resuscitate private Credit creation; that confidence in these types of
instruments will return. I would counter that once government
interventions come to severely distort a marketplace it is a very
arduous process to get the government out and private Credit back in
(just look at the markets for mortgage and student loan finance!).
This is a major, major issue.

The marketplace today wants to buy what the government has issued or
guaranteed (explicitly and implicitly). Market operators also want to
buy what our government is going to buy. In particular, the market
absolutely adores Treasuries, agency MBS, and GSE debt. There is no
chance that such a system will effectively allocate resources. There
is today no prospect that such a financial structure will spur the
necessary economic overhaul. None.

There is indeed great hope policymakers will succeed in preserving the
current economic structure. On the back of massive stimulus and
monetization, the expectation is that the financial system and asset
prices will stabilize. The economy will be, it is anticipated, not
far behind. And the seductive part of this view is that unprecedented
policy measures may actually be able to somewhat rekindle an
artificial boom – perhaps enough even to appear to stabilize the
system. But seeming “stabilization” will be in response to massive
Washington stimulus and market intervention – and will be dependent
upon ongoing massive government stimulus and intervention. It’s
called a debt trap. The Great Hyman Minsky would view it as the
ultimate “Ponzi Finance.”

As I’ve argued on these pages, our highly inflated and distorted
system requires $2.0 TN or so of Credit creation to hold implosion at
bay. It is my belief that this will ONLY be possible with
Trillion-plus annual growth in both Treasury debt and Federal Reserves
liabilities. Private sector Credit creation simply will not bounce
back sufficiently to play much of a role. Mortgage, consumer, and
business Credit – in this post-Bubble environment - will not re-emerge
as much of a force for getting total system Credit near this $2 TN
bogey. In this post-Bubble backdrop, only government finance has a
sufficient inflationary bias to get Trillion-plus issuance. But the
day that policymakers try to extract themselves from massive stimulus
and monetization will be the day they risk an immediate erosion of
confidence and a run on both government and private Credit
instruments. Also as I’ve written, once the government "printing
press" gets revved up it’s very difficult to slow it down. This week
currency markets finally took this threat seriously.