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Monday, June 5, 2017

About that growth

  4% growth may be difficult because of what Obama’s Fed has done.  A little history. 

In the 1900 to WW I era, there were 3 very hard recessions.  JP Morgan had to be called upon to be the lender of last resort.  That would be equivalent to the President calling Warren Buffet and saying , “Hey get some of your friends together and we need all your money right now!”  Without such a lender of last resort a major credit collapse would plunge the country into a long, dire recession.  Why the need for LOLR?  Well, you and few of your drilling buddies couldn’t pay their oil patch notes to a local bank in OKC.  Because of this, the OKC bank couldn’t pay a larger note they owed to a big Chicago bank.  The Chicago bank in turn couldn’t pay other mega banks in NYC and the country’s entire credit structure and ability to loan was brought down.  I’m telling the story of the failure of Penn Square Bank of OKC in 1984 that led to the failure of Continental Illinois. But CI was seized by FDIC which gave rise to the expression, “Too big to fail”.  And the Fed, our LOLR gives patch-up loans to that bank you couldn’t pay which went into default itself.  Otherwise, default/bankruptcy brings distrust and no one lends for years--Peru, Poland, Argentina give recent examples.

In the Panic of 1907, Morgan was barely able to be the LOLR.  Panic of 07 still ranks as nearly equal to the Great Depression.  In the wake of this near collapse of our economy for years, Congress established a Federal Reserve as LOLR.  It not only has the power to lend but to manipulate interest rates so that the little guy doesn’t face astronomical “payday loans” rates after a crash.  Recently, Ron Paul and a few others have politicized the issue of the Fed saying we don’t need it.  Auggh! Are you going to call Buffet? However, Trump’s notion of an audit of the Fed is good transparency idea.

The politicians of the 1930s were in the era of Progressivism’s bloom and wanted to do big gov’t things.  John Maynard Keynes, 1936 came along with reasoning that justified their power grab.  Keynes said economically shocked people were too tight, wouldn’t spend and that is why the market wouldn’t restart.  So Government should be the stimulator with big spending that would save us all.  Deficits don’t count.  Gleeful advocates of big gov’t said, “Just stimulate continuously and utopia will occur.”  It did not.  When gov’t piles up debt, it can pay it only with turn-on-the-printing-press money, worthless money, and inflation occurs.  Happened in Weimar Germany, Argentina, Brazil and everywhere else it was tried.  But the dream of jiggering some monetary measures and insuring eternal bliss, lives on among central bankers. 

The Fed has 3 tools to control short term rates—overnight bank loans, discount rates, and Fed Funds rates.  They can make the short term interest rise or fall.  If they make it go way, way down, the economy temporarily blooms as businesses can borrow easily.  But long term rates, like 30 year loans remain high and this yields or reflects inflation.  Plot this.   Plot bonds on a graph of “years to maturity” versus rate, you see short term bonds as low rates and long term loans at the other end of the graph as higher. (Lenders want more return if they lend for a long time versus a short duration when they can get their money back.) If the Fed upsets this normal curve by forcing short term rates way down, the economy booms with inflation but the easy money may go into some asset mania, followed by recession.  On the other hand, if the Fed raises short term rates, so they actually exceed long term rates,( “inverted yield curve”) then money is tight, borrowers can’t borrow and we usually get a recession or slowdown.  So central banks like the Fed, have always been held back from extreme behavior by reality of what investors and businesses see and how they react.  Alas, for the Keynesians, there’s No free lunch.  Inflation occurred during the seventies when the Fed tried to stimulate around the oil shock but then Carter wanted to decrease the value of the dollar to help US trade. The Fed complied.  Then came a bad recession.  Millions of investors (Wall Street) react  when they perceive that a credit crunch is coming if the Fed raises interest. 

In the recession of 2007, housing/real estate was the commodity that collapsed.  Since this is most of the nation’s wealth, it was a bad credit collapse.  Obama and the Keynesians wanted to stimulate colossally.  So they tried something new.  The Fed would buy bonds in the open market, in particular, long-term gov’t bonds. Those who held the bonds would have sudden cash and would have to spend it somewhere else.  Many bought stocks and the stock market soared.  By buying long-term bonds the Fed could now lower long-term interest as well as short.  And the yield curve could be held ‘normal’ by lowering short-term interest as well. For the first time, Fed could control interest entirely, thus the lowest interest rates in history have occurred.

No free lunch--it didn’t stimulate much.   And government debt doubled.  Many held their breath that hyperinflation would occur but it didn’t.  To explain this consider: if government (the Fed) owns a bunch of gov’t (its own) bonds, is it really a debt?   The Fed could just say, “Debt is forgiven. That was just money we owed ourselves.” True, but if this debt has no inflationary effect it won’t stimulate either. Result was pitiful growth.  Thus the economy grew at 1.6% for 8 years.  Now comes Trump who might get tax reform, will surely get regulatory reform, will likely get health care reform.  This will help the economy.  But will it last?  With a huge $4.5T gov’t bonds in the Fed’s account, these have to be either forgiven or sold back into the market. Selling bonds means higher interest implies economic slowdown. That may or may not happen. We don’t have much experience with this.  Often raising rates when rates are under 5% works out without a credit crunch. But not always.  Getting 3% long term growth may be hard for Trump and Fed as they try to undo the damage. 

There’s no such thing as a free lunch.  And central bankers the world over have the foolish prejudice that they can create nirvana by jiggering a few indicators.  In Europe the latest rage is bonds that pay negative interest. Why would you invest in something that takes your money rather than putting the cash in a sock? Like the mortgages in 2006 which were “zero down, interest only” (borrowers didn’t create any equity,) unsustainable things can’t go on for long. The mortgage people just abandoned the houses when they lost jobs.  It was in effect a rental owned by the sucker banker. We enter unknown territory.

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