The Global Curse of the Federal Reserve

How Investors Can Survive and Profit From Monetary Chaos

B. Brown

• Publisher: Palgrave Macmillan
• Year: 2013
• ISBN:
  9781137297402
• Edition: 2
• Topic: Economics
• Subtopic: Economic History
• Index: Economics

This revised edition offers the most up-to-date advice for investors who wish to defend themselves, or even make a profit from, the blighted policies of the Federal Reserve. Dr. Brown demonstrates how disordered US monetary policy causes waves of economic destruction around the globe.

1

How Monetary Chaos Powers Irrational Exuberance

What is the global curse of the Federal Reserve?

At first blush many readers might think the answer is the collapse in the purchasing power of the US dollar during the hundred years of the Federal Reserve’s history. In 2012 a dollar could buy only the equivalent of around 4 per cent of what it could in 1913. In the pursuit of alternative dubious aims the Federal Reserve has deprived mankind of an ideal stable store of value.

There is no denying the loss. Many apologists for the Federal Reserve would remonstrate that in several key episodes of inflation this institution was obeying political orders and did not bear the responsibility for its actions. Others would cite economic advantages that the Federal Reserve, through its monetary activism, has at times obtained for the USA and also for some other parts of the globe. It was too bad that these advantages have been at the cost of sacrificing stability in the long-run purchasing power of the dollar.

US monetary activism, however, has been the source of periodic bubbles and busts, both domestically and around the globe. The Federal Reserve has obtained vast discretionary power to determine monetary growth, to manipulate interest rates and to wage currency warfare. In exercising this power, albeit subject to shifting Congressional mandates, the Federal Reserve has created tremendous waves of irrational exuberance which have swept through the global financial marketplace. These waves have wrought much economic destruction.

Two forms of economic destruction

That destruction has taken two main forms. First, there has been huge malinvestment (a concept treated especially in the writings of Ludwig Lachman; see, e.g., Lachman 1977) – capital ploughed into particular types of industries, enterprises and buildings and into training or education, on the basis of price signals in the capital market which were seriously distorted by monetary chaos, including related irrational exuberance. By the same token other more economically worthwhile end destinations were deprived of capital. The extent of malinvestment is discovered (if at all) only when the wave of irrational exuberance has dissipated.

For example, in the USA at the end of the 2000s a wide range of automobile factories, shopping malls and houses (especially those aimed at satisfying the ‘dream of home ownership’), all built on the assumption of permanent high demand from an unsustainable credit bubble, had fallen sharply in value to reflect the sobered expectations of their income potential. They should not have been built in the first place. Finance-sector professionals and construction workers who had accumulated their human capital (training and skills) in false anticipation of the financial, real estate and mortgage boom conditions continuing found themselves part of the ‘structurally’ unemployed.

Second, waves of irrational exuberance, especially the rare giant ones, leave in their aftermath (after boom gives way to bust) a shrunken willingness amongst investors to assume equity risk. This shrinking does not take the form of a swift, painless decrease in the voracious appetite of the bubble period back to a ‘normal healthy’ appetite. Rather, the adjustment is, first, from voracious to anorexic. Alongside there might well be irrational depression. And the ‘healthy norm’ is likely to diminish in overall capacity where there has been a history of irrational exuberance and depression, unless radical treatment of the underlying malaise occurs.

Investors come to realize that in the monetary environment which allows such waves to develop, equity risk is greater than they previously assumed. They may also become alarmed by a series of scandals revealing huge failures of corporate governance which occurred during (and were aggravated by) the monetary boom and thus overestimate the likelihood of these recurring – an example of ‘irrational depression’ (see Munk, 2013). In the economic and financial bust which follows the wave of irrational exuberance, political forces hostile to capitalism might well become stronger and indeed triumph, justifying the perception of heightened equity risk. The pain of recent large losses (far beyond what would be normal under a stable monetary regime) explains at least part of the increase in equity risk aversion.

This perception of heightened equity risk and the inflamed aversion to bearing equity risk, if they persist, cause the motor of economic progress in the capitalist economy to slow down. A slower, shallower journey into the forest of investment opportunity – the consequence of a shrunken appetite for equity risk – means less growth in living standards over the long run. The good news is that the slowdown does not have to be long lived. In a new context of monetary stability accompanied by economic liberalism (in its classical sense), the appetite for equity risk should recover well, meaning that appetites are still smaller than during the sickness of irrational exuberance but greater than during the sickness of anorexia accompanied by irrational depression. Without such monetary reform the appetite for equity risk would remain less robust, even when having recovered as far as possible under the revealed conditions of infernal monetary instability, than would be the case if the violent waves of irrational exuberance had become a dead phenomenon.

When equity risk appetites are voracious (during the period of irrational exuberance), investors may both underestimate the actual amount of risk they are bearing, looking at the world of investment opportunity through rose-coloured spectacles, and also be more willing than usual to assume the risks they perceive. When the equity risk appetites return to healthy condition, they estimate the risks in sober, rational fashion and exhibit normal caution about possible danger. The passage of an economy from voracious equity risk appetites back to healthy appetites, most likely through a period of anorexic appetites accompanied by depression, is costly. However, investment opportunity can blossom amidst the economic destruction left behind by the previous wave of irrational exuberance, with much of the existing capital stock now worthless. As we shall see later in this volume, such blossoming depends in particular on a combination of entrepreneurship, flexibility of prices, labour market flexibility and technological progress.

How a monetary virus can attack software controlling the invisible hands

So far the theorists who write about irrational exuberance in the burgeoning literature of behavioural finance have not laid emphasis on the role of the Federal Reserve or, more broadly, of monetary disorder in generating the phenomenon. When they read the famous lines of J. S. Mill that ‘most of the time the machinery of money is unimportant, but when it gets out of control it becomes the monkey wrench in all the other machinery of the economy’, they do not interpret them to mean that irrational exuberance stems chiefly from the work of that monkey.

In fact we could put the J. S. Mill quote in modern idiom by re-expressing it as ‘most of the time the software of money is unimportant, but when it mutates it spreads a virus which attacks all the other software behind the price signals (including in particular those in the capital market) which guide the invisible hands of the capitalist economy’. The virus attack results in malinvestment and ultimately in an impairment of equity risk appetite so crucial to prosperity in the capitalist economy. One element in that impairment of appetite is the extra reward which investors require for assuming equity risk due to their realization that again in the future a virus attack might get underway and yet remain long undetected, meaning that present market signals could become seriously distorted away from underlying economic reality.

A more recent factor in the impairment of equity risk appetite by the Federal Reserve’s monetary activism has been the growing efforts by that institution to manipulate long-term interest rates. The brandishing of ‘non-conventional’ tools designed to force long-term rates down in response to any apparent setback to economic recovery or to any serious pullback in equity markets can set off its own cycle of irrational feedback loops. Market participants believe the tools are effective though they have hardly been tested. The resulting speculative lurch-downs in long-term rates appear to signal that indeed an economic depression could be looming.

Indeed, amidst the ‘success’ of the Federal Reserve in manipulating long-term interest rates down to record low levels during summer 2012, there was a string of commentaries in the marketplace to the effect that these hinted at investors now putting a significant probability on various economic disaster scenarios. Hence, far from the manipulations promoting economic expansion, the feedback loops which they trigger (the fanning of irrational expectations of great depression) may well have had the opposite effect.

Moreover, many investors have likely concluded that under such circumstances of pervasive manipulation by the Federal Reserve, long-term market interest rates are no longer a reliable market-generated best estimate of the so-called neutral level. The fact that a reliable best estimate is unavailable means the investor in appraising the size of the equity risk premium would sensibly substitute his or her own view as to where the neutral level of the long-term interest rate is most likely now situated. The calculation of the equity risk premium (on the basis of that view about neutral) should include a bonus item to reflect the investor’s estimate about the present extent and likely duration of the manipulation by the central bank of long-term interest rates below neutral – all very hazy! Amidst such ambiguity in the calculation as to what extra returns are available for assuming risk, it would not be strange for investors to require a higher return on equity than if there were greater clarity, as under a regime of monetary stability.

Robert Shiller, the pioneer of behavioural finance, chooses to minimize the role of monetary disorder in explaining market irrationalities. He lists many factors responsible for the periodic emergence of irrational exuberance during the last two decades but puts monetary disorder fairly low down (see Shiller 2005). He makes the underwhelming charge that the Greenspan Fed convinced market participants that it would always take action to prevent a market rout (the so-called Greenspan put) and thereby stimulated excess optimism. Shiller agrees with the Fed apologists that monetary policy is too blunt an instrument to moderate swings of speculative temperature, repeating their point that if a central bank seeks to prevent bubbles, it risks triggering unnecessary recession.

This volume asserts, in contrast, that money’s role in stimulating irrational exuberance is absolutely fundamental, towering above other factors, which may nonetheless play a subsidiary role. The process of stimulation occurs over long periods of time. By the time the central bank (or any other more or less expert analyst) can diagnose fairly confidently the presence of irrational exuberance, money will have been seriously out of control (or equivalently, a ‘monetary virus will have been attacking the software behind market price signals’) already for some considerable time with much economic damage already predetermined. Most likely a monetary tightening at that late point in time would make the damage even greater. One is reminded of Milton Friedman’s observation about the long and variable lags between monetary disequilibrium and the emergence of goods inflation. And so it is with irrational exuberance.

In order to describe the process of monetary fuelling of irrational exuberance, it is essential to step back and define some terms and concepts. In particular there is no one standard definition of irrational exuberance. One insight into that concept comes from viewing the future as a combination of different possible scenarios, each with a probability weighting. The phenomenon of irrational exuberance would be present if market prices were based on a widespread tendency of investors (actual and would-be) to overweight (relative to a sober estimation) the probability of highly optimistic scenarios whilst underweighting (relative to any sober assessment) the probability of other scenarios, especially pessimistic ones. (Conversely, irrational depression, such as emerges sometimes in consequence of the monetary contraction which accompanies the bursting of the monetary-fuelled credit and asset bubble, would feature a preponderance of investors overweighting highly pessimistic scenarios).

In less technical language, Shiller describes the phenomenon of irrational exuberance as follows (2005):

Irrational exuberance is not that crazy. It is more like the kind of bad judgement we all remember having made at some points in our lives when our enthusiasm got the better of us. Irrational exuberance is a very descriptive term for what happens in markets when they get out of line. It is a kind of social phenomenon.

As a social phenomenon irrational exuberance, according to Shiller, lies behind those patterns of irrational behaviour which become growingly evident as a market journeys from ‘normal state’ to ‘bubble state’ (or equivalently, as the speculative temperature in marketplaces under consideration rises above normal level).

One such pattern of irrational behaviour is what psychologists describe as ‘magical thinking’. If a given set of actions – including a type of news or data – precedes a big success, even though there is no causal link, people believe that a repeat of the same set of actions will produce a repeat success. For example, the first time the FOMC pointed to a probable early use of ‘non-conventional monetary tools’, the equity market may have jumped and the US dollar plunged. So every time afterwards speculation that Professor Bernanke is about to make a similar new announcement could have the same market effect – even though it is unclear that there is any rationale for this. In fact, one theme to be developed in this volume is that the use of these non-conventional tools, by adding to actual and feared future monetary instability, causes the equity markets to follow a lower-than-otherwise path over the medium and long run.

A second pattern is ‘mental compartmentalization’ – a human tendency to place particular events into mental compartments based on superficial attributes and then to be influenced by these. For example, investors might think of interest or dividend income and how they spend out of it as distinct from capital gain; and so, for example, during the interest income famine of growing severity created by the Bernanke Fed in the aftermath of the panic of 2007/8 and the subsequent ‘great recession’, there was an endless sales pitch by the security houses that investors should favour ‘dividend-paying stocks’ and ‘high-yield bonds’. Yet no rational investor would focus just on one subdivision of overall income (dividends or high yield) rather than considering these jointly with the probability distribution of possible capital gains or losses. The rational investor would not be fooled by the prospect of high dividends paid at the expense of capital gain.

A third pattern of irrationality is ‘positive feedback loops’: news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors who, despite doubts about the real value of the investment, are drawn to it partly through envy and partly through a gambler’s excitement.

A rise in speculative temperature (meaning the growing presence of irrational exuberance, as described in the examples above and more broadly), when evident over a wide (but not total) range of asset and credit markets, driven by monetary disequilibrium as shortly to be described, is sometimes described in the economics literature (especially that drawing on the Austrian School) as ‘asset price inflation’. The idea behind this term is that speculative fever drives prices above fundamental value, where this reflects a sober, rational appraisal of the present and future.

How does monetary disorder fuel a rise in speculative temperature?

The hypothesis here is that three key elements (not always present simultaneously) in monetary disorder lie behind the emergence of irrational exuberance and asset price inflation.

The first possible element is the pegging and forward guidance of short-term interest rates by the central bank causing medium- and even long-term interest rates to be below their neutral level. In monetary economics the neutral level defined, say, for medium and long maturities, respectively, is that which would be consistent with overall equilibrium – long-run stability of the price level and no asset price inflation. (The modern Federal Reserve equates long-run price level stability to an annual average inflation rate of around 2 per cent per annum – a practice which is deeply flawed, as explained in Chapter 4 – and correspondingly in this world the ‘neutral level’ is defined with reference to the price level rising by, say, 20 per cent every ten years and a set of inflation expectations to match.) No one knows for sure what the neutral level is at any time, and ideally market forces drive actual market rates close to the neutral level if the monetary system is well designed and not subject to hijacking by ‘policy activists’; this would be the case if the monetary base were at its pivot and its expansion subject to strict rules (see Chapter 4).

The second possible element is investor fatigue from an abnormally low real level of neutral interest rates (medium- and long-maturity) where there are no reserves (in the sense of the camel’s hump) against this fatigue from an earlier period of ‘good deflation’, during which the real value of monetary assets would have risen.

The third possible element is a deep anxiety about a possible emergence, some years from now, of a high inflation – where the source of this anxiety is an ambiguity in the present stance of monetary policy making.

Let’s explain these three elements in greater detail and in the context of both the US and the global economy.

In the case of the first element of monetary disorder, the manipulation of interest rates below the neutral level means that asset prices across a broad range of markets (not all!) are likely to be frothy, with a low discount rate relative to profitability driving the price to an abnormally high level. These gains in prices are likely to excite gambling excitement and trend following – especially if there is a floating theme out there about how the world has changed, meaning a prolonged period of supernormal returns (such a theme has been described as a ‘speculative displacement’ by students of bubbles, including Minsky, Kindleberger and Aliber; see Aliber, 2011). A positive feedback can develop in the form of the theme gaining credibility exactly because the price has been frothy. Asset classes where there is a credible theme enjoy the full heat of the monetary disorder. Others might find themselves in the cold.

Investors and analysts attribute their success in mak...

Table of contents

• Cover
• Title
• 1  How Monetary Chaos Powers Irrational Exuberance
• 2  A 100-Year-Old Monetary Disorder
• 3  Phobia of Deflation
• 4  Manifesto for a Second Monetarist Revolution
• 5  US Currency War Machine
• 6  Bernanke-ism Equals Monetary Lawlessness
• 7  The Fed Believes Japans Great Deflation Myth
• 8  How to Survive and Profit from the Feds Curse
• Bibliography
• Index