Bank failures another sign of the evil of monetary manipulation

Recently, banks have failed, and the Federal Reserve has raised interest rates another 25 basis points, or 0.25%. Some analysts say banks are safe while others cry that the sky is falling. Who is right? Christians need to discern the financial signs of the times. 

Jesus warned his disciples to get out of Jerusalem when they saw a sign: “When you see Jerusalem being surrounded by armies, you will know that its desolation is near. Then let those who are in Judea flee to the mountains, let those in the city get out, and let those in the country not enter the city,” (Luke 21:20,21). The early church followed Jesus’ advice and fled to Pella in modern Jordan, thus saving the small group from a similar fate. 

Solomon wrote, “A prudent person foresees danger and takes precautions. The simpleton goes blindly on and suffers the consequences,” (Proverbs 27:12).

When The Fed Creates Money, Who Gets It?

Source: AP Photo/Jacquelyn Martin

The stock market rocketed recently on news that the Federal Reserve may cut interest rates. People speculated that it may do so because of tanking economies in the rest of the world, President Trump’s trade wars, the slowing US economy, and other ideas.

Central banks have used the tools of interest rate changes and open market operations (buying and selling treasuries) for over a century in misguided efforts to boost their economies out of recessions. They get by with it because the process is complicated enough that most people don’t understand it. The general idea is to force feed the economy more money through the tube of the banking system.

Show me the money

Most business cycle models include the money supply as a leading indicator of the economy, meaning that changes in the money supply tend to precede and signal changes in the economy in the near future. The money supply year-to-year change spiked late last year, giving some money watchers goose bumps.

According to Ryan McMaken at the Mises Institute, the money supply jumped 11.3 percent on the Austrian money supply (AMS) index late last year. Murray Rothbard and Joseph Salerno created the Austrian money supply index to provide a better measure than the Fed’s M2. That spurt in money occurred after a several years of sedate money growth. 

McMaken wrote that since 2014, money supply growth has ranged from about 7 percent to 8.5 percent. In October of last year, money supply growth hit a seven-year low of 6.8 percent. The AMS spiked to 11.3 percent in the fourth quarter, then in February it collapsed back to a year-to-year growth rate of 7.7 percent.

Interest rates have fallen and can’t get up!

Some of us suffer from Fed head: we have allowed anger at the Fed to infect our brains to the point that we blame it for everything from flat tires to broken bed springs. George Selgin, an Austrian friendly economist at the Cato Institute, says take two aspirin and read his blog in the morning:

The view that the Fed might have raised interest rates long ago, had it only wanted to, became notorious during the presidential campaign, when Donald Trump publicly accused Janet Yellen’s Fed of keeping rates low for political reasons. But Trump was merely embroidering a belief common among many (mostly conservative) Fed critics...

The unvarnished truth, I hope to persuade you, is that interest rates have been low since the last months of 2008, not because the Fed has deliberately kept them so, but in large part owing to its misguided attempt, back in 2008, to keep them from falling in the first place.

Stop dancing to the Fed's fiddle

For the first time in almost a decade the market shrugged off a significant move by the Fed when it increased its rate by 0.25%. Of course, the market had anticipated the increase for a year and so priced it in earlier. And euphoria over the president elect trumped Fed policy. This is a good time to reassess the logic of dancing to the Fed’s fiddle.

Mainstream economists used to dance to the tune of Keynes and fiscal policy until the disaster of stagflation in the 1970s. Fiscal policy, they cried, suffered from too many lags to be effective, as if the lags were the only reason it couldn’t be effective. There were no problems with lags during the 1930s under FDR and it still wasn’t effective.

Fickle as teenage groupies, mainstream economists switched their adoration to the Fed. The Fed could save us all when Uncle Sam failed. Adulation for the Fed climaxed with the financial media’s crowning of Fed chairman Alan Greenspan as the “Maestro” who could orchestrate the economy as he wished with a wave of his wand.

Then housing landed on the economy and caused the Great Recession (GR). Ben Bernanke waved his wand but the economy wouldn’t perform. It couldn’t get out from under the house. Eight years later, confidence in the Fed has evaporated and mainstream groupies are bailing out on the Fed and returning to their first love, fiscal policy.

How the Fed creates bulls and bears

If you grasp this you will be light years ahead of most economists. Bull and bear markets can't exist without the Fed manipulating the money supply. Here's why.

Assume the stock of money is fixed. For example, say there exists only $1 trillion in gold and banks have lent out nine times that amount so that the total money supply of gold plus credit equals $10 trillion because the required bank reserves are 10%. Also assume the population remains constant. If nothing changed, prices would remain the same and the economy would be in a state that economists call equilibrium. Profits would equal the cost of credit, say 5%.

Now we have to look at how many times the $10 trillion is turned over, or changes hands, in order to figure out the total sales for the year. We’ll assume that the turnover, or velocity, of money is five. Then total sales for the year would come to $50 trillion. A profit of 5% would mean $2.5 trillion. Now let’s assume the PE ratio, the measure of risk tolerance, is 15. The market cap would be $37.5 trillion.

With a fixed stock of money, productivity increases at zero and the population remaining constant, the stock market would show the same values every day. Planned investment equals real savings.

Japan, Europe and mainstream monetary theory are out of gas

When a sailor hits a dead spot where the wind refuses to blow he cays he is “in irons.” Japan’s economy sailed into the irons this past quarter when its GDP declined for the second quarter in a row and officially signaled a recession. GDP fell 0.8% in the third quarter after shrinking 0.7% in the second on an annualized basis. This marks the fourth recession Japan has endured since the global crisis hit in 2008.

Following so soon on the heels of massive stimulus, the recession should strike a death blow to mainstream monetary theory. Abenomics, the economic recovery plan that Prime Minister Shinzo Abe launched in 2012, was the poster child for mainstream monetary theory. Japan would wash away deflation and decline with a torrent of new money.

Central banks as vestigial organs

In his early years Hayek anticipated that the monetary theory of trade cycles, now known as the Austrian business-cycle theory (ABCT) would become widely known by business people who would refuse to borrow when the central bank reduced interest rates to an artificially low level. That would dampen booms caused by money created ex nihilo and reduce the severity of recessions.

Hayek was wrong because the Keynesian tsunami pushed the ABCT into a tiny corner so that few business people learned it. However, we may have reached a similar dampening of economic cycles by another route, that is, by central bankers making central banking irrelevant. Glimpses of this can be seen in Japan, as I wrote in this posting.

Fed loses its mojo

The Dow hit another record high and the Japanese stock market rung the bell for a 15-year high this week following statements by Fed Chairman Janet Yellen before Congress that the she was losing patience. (Actually, she said the Fed would remove the word from its policy statement.) 

Both markets have been helped by the Big EZ's firing up its money presses. Much of the new issue of euros will swim the pond and dry out in the US stock market. Also, margin debt and debt by corps to buy back their own stocks are at record levels. 

No Rate Increase in 2015

Mainstream economists and financial experts warned us early in 2014 to stay way from bonds because the Fed would raise interest rates and as everyone knows rising interest rates shoot buckshot-sized holes in bond portfolios. So most people avoided bonds and piled into stocks. Now we can look back and see that conventional wisdom was wrong; the Fed did not raise interest rates; inflation remained tame; and bonds returned about twice the money as stocks.

Now the mainstream has dusted off its forecast of rising rates and is trying again. Surely this is the year the Fed will raise rates and kill bonds. After all, the Fed has always raised rates at some point in an expansion. How can it not raise them in this one?

Plucked Chickens, MMT and Investing

Plato once defined man to his followers as a featherless biped. Diogenes heard it, caught a chicken and plucked it then brought it to Plato saying, “Here is your man.”  I got that story from Jack Sparrow at the Mercenary Trader.

Was Plato wrong? No. Most men walk on two legs and most of us don’t have feathers, but that is a very simplistic model of what constitutes mankind and as a result has very limited application. The humor in the story comes from Diogenes stretching the model beyond its ability to describe the real world and drawing wrong conclusions.

Plucked chicken modeling happens in economics on a regular basis. Economics is about modeling complex events. If the model is too complex it becomes unwieldy and few can understand it. The trend in economics over the past century has been to create extremely simple models. The assumption of equilibrium that forms the foundation of mainstream economics is the most egregious example.

ECB Goes Negative

Spontaneous Finance has a good post on why negative interest rates on bank deposits at the European Central bank will not encourage bank lending to businesses, especially lending to small businesses that represent greater risks. As Julien shows, the move by the ECB does little more than squeeze bank profits at a time when low interest rates have already reduced profits. The analysis covers Europe, but the same principles apply to the US because the European Basel accords regulate banking on both banks of the pond.

Fed Inflates Capital Markets!

In an email newsletter sent out by the Wall Street Journal called Macro Horizons, Michael J. Casey appears to grasp a point about monetary policy that few other mainstream economists can get a grip on, while Austrian economists have taught it for decades: inflationary monetary policy benefits the rich. He wrote,

Easy money translates into gains for those who are rich in assets, especially financial assets, and that excludes a large swath of the population [italics in the original].

I assume Casey is a mainstream economist because the main point of his post was the need for central banks to maintain monetary “stimulus.” The quote above follows this:

The subject of disinflation is the focal point of Wednesday’s data, where we are being reminded of its nonexistence in the industrialized world and of the risk that it could morph into outright deflation. This is most evident in Wednesday’s CPI data out of Europe, which is why the notoriously stimulus-shy Deutsche Bundesbank insiders even came around to telling the Journal Tuesday that they were considering backing actions at the European Central Bank’s June meeting to attack the disinflationary trend. But we’re likely to see the same later in the U.S. producer price data and in the U.K., whose economy is otherwise growing strongly, the Bank of England indicated that it still sees no great impetus for inflation to breakout. There was a time when this scenario of growth, coupled with low inflation, was seen as a “Goldilocks” scenario, a perfect not-to-hot, not-too-cold combination where policy would stay accommodative but gains could be had in the economy and markets. But the longer we flirt with deflation – which translates most directly into near-zero wage growth – the more that the adoption of hyper-accommodative policies tends to exacerbate the other great scourge of our age: inequality. 

Led by the Fed Investing Advice

If you have followed this blog, or read Financial Bull Riding, you’ll know that the stock market tends to follow the business cycle and Fed monetary policy determines the business cycle for the most part. So I was very interested to read this title: "Voices: SteveKrawick, on Asset Allocation Guided by Fed Policy." Krawick wrote

 “There are four phases in a Fed cycle. Today we're in the fourth and final phase of the cycle that began around 2008. This phase is marked by an accommodating Fed, which means low interest rates. Historically, in this environment, consumer discretionary stocks and financials have outperformed S&P benchmarks and their peer sectors. So, during this cycle, we have our clients overweight in that sector and underweight in others like industrials, materials, and technologies, which tend to underperform under current conditions.”

The View from Vienna on Interest Rates and the Stock Market

Interest rates have some impact on the stock market because if investors can earn a better return in bonds than in the stock market and with less volatility they will sell stocks and invest in bonds. A large part of the recent record highs in the stock market reflect the Fed’s squashing of interest rates. The Fed wants to punish savers and reward debtors.

Interest rates have been falling since the early 1980’s to near zero today. According to the Financial Times columnist, Gavyn Davies, my main source for what central bankers are thinking, the International Monetary Fund identified three main reasons for the decline depending on the period:

1. In the 1980’s and 1990’s Fed inflationary policies caused the drop.
2. Since 2008, businesses have quit investing.
3. 2002 – 2007, the savings glut from emerging markets kept rates low.
4. Since 2000, portfolio shifted to bonds because of two stock market crashes.

QE to Infinity and Beyond and Cantillon

Mainstream economics denies that Cantillon Effects exist. Cantillon Effects are one of those insights that Austrian economics offers followers that help us avoid nasty surprises like the Great Recession. Recently, McKinsey and Company provided research that supports the Austrian view of Cantillon effects from QE. Here is one of their charts:

Financial Education Fails

 Many people share a strong pessimism about the future of Social Security while secure pensions from a lifetime of working for the same company have followed the path of buggy whips. So in spite of decades in which the nanny state tried to protect people from life, people feel  less secure than ever. 

As usual and when all else fails, the experts turned to education. Teaching people about the miracle of compound interest and providing GPS guides to navigate the forest of investment alternatives and complex securities would empower consumers to make wise investment decisions. But as usual it failed according to a paper by three academics who analyzed 168 papers covering 201 prior studies. The paper, “Financial Literacy, Financial Educationand Downstream Financial Behaviors” was made available online in January and will appear in a forthcoming journal, Management Science. The authors concluded that

These interventions cost billions of dollars in real spending and larger opportunity costs when these interventions supplant other valuable activities. Our meta-analysis revealed that financial education interventions studied explained only about 0.1% of the variance in the financial behaviors studied, with even weaker average effects of interventions directed at low-income rather than general population samples.

ABCT Extends to Emerging Markets

Trouble in emerging markets has provided the rationale for at least part of the recent correction in the stock market. Emerging markets, such as, Brazil, Russia, India, Turkey, Thailand and China, are suffering largely because of the withdrawal of US dollar investments from them and this confirms the effects of monetary policy as described by the ABCT, the Austrian business cycle theory. Here is a chart showing the performance of emerging market stocks relative to the rest of the world:

To refresh your memory, the ABCT states that inflationary monetary policies such as those of the Fed for the past five years will cause an unsustainable boom as new money pours into the economy and stimulates demand for consumer goods and for investment. Usually we think of the ABCT in terms of a single nation, but the EM problems demonstrate that it has international implications, especially in a world of increasing trade integration and a currency that other countries use for trade and their banks for reserves.

Bubble Detectives

“One important conclusion is that the probability that the S&P 500 index is currently in a bubble is only 20-33 per cent,” according to Gavyn Davies in his recent article for the Financial Times, “How to detect amarket bubble.” “But that could change fairly quickly during 2014 if the recent pace of advance in equity prices continues.”

Davies approves of the New Palgrave definition of a financial bubble:

Bubbles are typically associated with dramatic asset price increases followed by a collapse. Bubbles arise if the price exceeds the asset’s fundamental value. This can occur if investors hold the asset because they believe that they can sell it at a higher price to some other investor even though the asset’s price exceeds its fundamental value.

Davies then mentions two other bubble detectors:

Based on the Shiller cyclically adjusted p/e (CAPE), the probability of a bubble is estimated at 33 per cent in December 2013, while the price/dividend model produces a bubble probability of 20 per cent.

The Fed's Zombie Apocalypse

Economists are trying to figure out why the Fed hasn't generated higher inflation. According to Gavin Davies, "In most countries, headline CPI inflation has been falling significantly since the end of 2011, and it has now dropped to less than 1 per cent in both the US and the euro area." Here's a graph of inflation in the US and UK from Davis: