Like a puppeteer trying to control his puppet without realizing the strings have been cut, the Federal Reserve has been taking extraordinary measures to affect the economy without understanding its policy levers cannot reach their targets.
That, in essence, is the message of an unusual letter from John Hussman to shareholders — part economic treatise and part cri de coeur, but not the usual discussion of the stock market per se.
The portfolio manager of Hussman Funds, a former academic, went to unusual length — 13 pages — to explain what he suggests is a profound disconnect between Wall Street and Main Street as indicated by several factors.
Among them are the fact that the stock market is at record highs, yet the economy has but modestly improved; or that 40% of Americans say they are “just getting by,” and 60% don’t even have savings sufficient for three months’ expenses despite years of massive Federal Reserve intervention in the economy.
“Something remains terribly wrong, and [Americans] can’t quite put their finger on it,” Hussman writes, and he answers that “much of this perplexity reflects the application of incorrect models of the world.”
Hussman covers a number of links between policy and outcome with a view toward showing that some but not all of these links are supported by the data.
Even a well-founded link — such as that between the monetary base and short-term interest rates — is problematic for Fed policy. That is because the monetary base now stands at 24% of GDP, yet a chart he includes shows that “less than 16% was already enough to ensure zero interest rates.”
That means “the past trillion and a half dollars of QE” merely promoted speculation, and that “the Fed would have to contract its balance sheet by about $1 trillion just to raise Treasury bill yields up to a fraction of one percent.”
A weak relationship that Hussman argues the Fed and many economists rely on is the supposed link between low interest rates and stronger economic activity.
Hussman says that strong economic activity is actually quite compatible with high rates, which can serve to discourage nonproductive investment.
But by keeping rates low in order to stimulate loan demand, the Fed is not only lowering the cost, but also the quality of loans. That, Hussman says, is what triggered the global financial crisis to start with. So Fed policy is punishing savers, increasing interest-rate speculation and encouraging the indebted to take on more debt.
Despite these hazards, Hussman’s charts show there is no clear relationship between low rates and subsequent economic growth.
Yet, paradoxically, higher real rates do generate faster, subsequent economic growth as economic actors choose highly productive investments targeting high expected rates of return.
As he sees it, the fallacy in Fed policymaking — the disconnect between Wall Street and Main Street — is in not appreciating that companies will borrow only if they expect future output to profitably cover their expenses, which include but are not limited to interest rates.
By suppressing interest rates, the Fed is favoring business for whom the cost of funds are the primary cost of doing business, i.e. the financial sector.
The Fed seems to think that distorting the economy in this way will create a “wealth effect” that will kickstart the rest of the economy.
But Hussman argues that the data (for which Milton Friedman won a Nobel Prize) shows that “individuals consume off of what they conceive as their ‘permanent income,’ not based on fluctuations in volatile securities.”
So the Fed is thus fueling investor speculation for which there will be “economic payback” without achieving its ambition of lowering unemployment and increasing GDP growth.
“Pushing harder on the accelerator pedal has simply caused a speculative bubble across nearly every class of risky assets, pulled consumption forward from the future, encouraged massive issuance of low-grade debt, and continues to starve the elderly, the disabled, and others who rely on interest income of any source of safe return,” he writes.
Hussman sees as madness the abuse of the Philips Curve, a classic economic doctrine establishing a link between labor and wages: when the former is scarce, wages rise and vice versa.
Economists today, however, seem to have “dropp[ed] the words ‘real wage;’ thusly looking at data not adjusted in real dollar terms has led to bizarre policy ideas such as the thought that “one can obtain more jobs by ‘allowing’ more inflation.’”
Perhaps Hussman’s biggest lament is what he sees as a Fed policy course that has created a “winner-take-all economy.”
“In recent years, the U.S. has experienced a collapse in labor participation and weak growth in labor compensation, coupled with an increasingly lopsided distribution of whatever benefits the recent economic recovery has generated,” he writes.
That is because the Fed’s two decades of low rates have resulted in malinvestment that has enriched those with skilled labor and capital at the expense of those with low skills, effectively hollowing out the middle class. This, he says, will not end well:
“Transfer payments like welfare and unemployment compensation allow many households to maintain consumption despite being out of those jobs, and given the ability of households to take on debt, even if they are actually living paycheck to paycheck, the produced goods get purchased, companies make a profit, government runs a deficit, the Fed keeps interest rates low which allows all the debt to be serviced, and everyone is pleasantly, if unsustainably, happy,” he writes.
The fund manager ends his long lament with a call on the Fed to, first, stop the harm. Trying to lower unemployment with easy money doesn’t work but has many unsalutary side effects.
Besides a growing income gap, those include preserving and enhancing “too-big-to-fail banks, financial engineering, and speculative international capital flows at the expense of local lending, small and medium-size banks and enterprises, and ultimately, economic diversity.”
“The issue is not whether the U.S. economy does or does not need ‘life support.’ The issue is that QE is not life support in the first place.”
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