Excerpted from his presentation to the Ira Sohn Investment Research Conference on May 26, 2010
We should have learned by now that every credit – no matter how unthinkable its failure would be – has risk and requires capital. Just as trivial capital charges encouraged lenders and borrowers to overdo it with AAA rated CDOs, the same flawed structure in the government debt market encourages and therefore practically ensures a repeat of this behavior – leading to an even larger crisis. (Greenlight continues to hold short positions in the common stock of the rating agencies, Moody’s and McGraw Hill [owners of S&P]).
I remember hearing that the rating agencies would never downgrade MBIA or Fannie Mae…I don’t believe a US debt default is inevitable. On the other hand, I don’t see the political will to make voluntary efforts to steer the country away from crisis. If we wait until the markets force action, as they have in Greece, we might find ourselves negotiating austerity programs with foreign creditors.
Some believe this could be avoided by printing money. Despite Mr. Bernanke’s promises not to print money or “monetize” the debt, when push comes to shove, there is a good chance the Fed will do so, at least to the point where significant inflation shows up even in government statistics. That the recent round of money printing has not led to headline inflation may give central bankers confidence additional quantitative easing can be put in place without inflationary consequences. However, printing money can only go so far without creating inflation.
Now, government statistics are about the last place one should look to find inflation, as they are designed to not show much. Over the last 35 years the government has changed the way it calculates inflation several times. For example, under the current method, when the price of chocolate bars goes up, the government assumes people substitute peanut bars. So chocolate gets a lower weighting in the index when its price rises. Even though some of the changes may be justifiable, the overall effect has been a dramatic reduction in calculated inflation. According to Shadowstats.com, using the pre-1980 method CPI would be over 9%, today compared to about 2% in the official statistics. While the truth probably lies somewhere in the middle, this doesn’t even take into account inflation we ignore by using a basket of goods that does not match the real world cost of living.
For example, we all now know that healthcare, which is certainly a consumer good, is about one-sixth of our economy and its cost has been growing at a rapid pace. So what is the weighting of healthcare in the CPI? About 6%. The government doesn’t count the part which the consumer doesn’t pay out of pocket. So, if your employer has to pay more for your health insurance, it doesn’t count, even if it means you have to accept lower wages. Similarly, Medicare cost increases don’t count, even though everyone has to pay higher taxes to fund them. Income and payroll taxes, which are part of the cost of living, are not counted in the CPI either.
On the other hand, one-fourth of the index is comprised of something called owners’-equivalent-rent. This isn’t something that anyone actually pays for. If you own your house, the government assumes you are foregoing rental income. The amount that you could receive from a hypothetical renter – the government implicitly assumes you rent it to yourself – is counted in the basket. So, rising taxes, which you do pay, don’t count; the fast rising cost of healthcare, which someone else pays on your behalf, doesn’t count; but hypothetical rents which you don’t pay, and conveniently don’t rise very quickly, have a huge weighting.
The simple fact is that if your goal is to never see inflation, you won’t see it until it is rampant.
Low official inflation benefits the government by reducing inflation- indexed payments including Social Security and Treasury Inflation- Protected Securities. Lower official inflation means higher reported real GDP, higher reported real income and higher reported productivity.
Subdued reported inflation also enables the Fed to rationalize easy money. The Fed wants to have an accommodative monetary policy to fight unemployment, which in a new trickle-down theory it believes can be addressed through higher stock prices. The Fed hopes that by keeping rates low, it will deny savers an adequate return in risk-free assets like savings deposits and force them to speculate in stocks and other “risky assets” to generate sufficient income to meet their retirement needs. This speculation drives stock prices higher, which creates a “wealth effect” where the lucky speculators decide to spend some of the gains on goods and services. The purchases increase aggregate demand and lead to job creation.
Easy money also aids the banks. Arguably, we still have many inadequately capitalized or insolvent banks. There has been so much accounting forbearance and extend-and-pretend loan collection that it is difficult to get an accurate gauge on the health of the system. However, each week the FDIC seizes more failed banks and when it does so, there are very large losses to the deposit insurance fund. In most cases, the failed banks’ most recent financial statements claim that they were solvent which implies that the banks’ balance sheets are not stated conservatively. It probably isn’t just the banks that fail that are taking advantage of accounting forbearance.
As a result, the Fed prefers to keep rates extraordinarily low in an effort to help banks earn back their unacknowledged losses. However, this discourages banks from making new loans. If banks can lend to the government, with no capital charge and no perceived risk and earn an adequate spread walking down the yield curve, then they have little incentive to lend to small businesses or consumers. Higher short-term rates could very well stimulate additional lending to the private sector. Given the enormous gains in the prices of bank stocks, it might be quicker to have banks deal with their questionable assets through additional equity offerings and more aggressive loss reserving than waiting for years for profits from an easy money policy to repair the balance sheets.
Easy money also helps the fiscal position of the government. Lower borrowing costs mean lower deficits. In effect, negative real interest rates are indirect debt monetization. Allowing borrowers including the government to get addicted to unsustainably low rates creates enormous solvency risks when rates eventually rise. I believe that the Japanese government has already reached the point where a normalization of rates would create a fiscal crisis.
While one can debate where we are in the recovery, one thing is clear – the worst of the last crisis has passed. Nominal GDP growth is running in the mid-single digits. The emergency has passed and, yet, the Fed continues with an emergency zero-interest rate policy. Perhaps, an accommodative policy is still appropriate, but zero-rate policy creates enormous distortions in incentives and increases the likelihood of a significant crisis later. Further, it was not lost on the market that during this month’s sell-off, with rates around zero, there is no room for further cuts should the economy roll over.
Easy money policy has negative consequences in addition to the obvious inflation of goods and services and currency debasement risks. It can feed asset bubbles, such as the internet bubble and the housing bubble. We know that when such bubbles collapse, there are terrible consequences.
Nonetheless, the Fed has a preference to inflate bubbles. Sometimes Fed officials tell us that there is no bubble or that bubbles are hard to identify. Afterwards, they tell us that monetary policy was not to blame. Earlier this year, Mr. Bernanke said that the housing bubble was not caused by monetary policy. Essentially, he did a statistical analysis which found that there are many times when extraordinarily easy monetary policy has not led to a housing bubble. As a result, he argued that one can’t generalize that easy monetary policy causes housing bubbles in all circumstances. From this, he reached the dubious conclusion that easy monetary policy was not responsible for the housing bubble he presided over. He must feel it is important to disclaim responsibility for the last bubble at a time where the Fed appears to have a desire to foment a fresh asset bubble.
In recent years, we have gone from one bubble and bailout to the next. Each bailout reinforces moral hazard, by rewarding those that acted imprudently. This encourages additional risky behavior feeding the creation of a succession of new, larger bubbles, which then collapse. The Fed bailed out the equity markets after the crash of 1987, which fed a boom ending with the Mexican crisis and bailout. That Treasury financed bailout seeded a bubble in emerging market debt, which ended with the Asian currency crisis and Russian default. The resulting organized rescue of LTCM’s counterparties spurred the internet bubble. After that popped, the rescue led to the housing and credit bubble. The deflationary aspects of that bubble popping created a bubble in sovereign debt despite the fiscal strains created by the bailouts. The Greek crisis may be the first sign of the sovereign debt bubble popping.
Our gold position reflects our concern that our fiscal and monetary policies are not sufficiently geared toward heading off a possible crisis…We own gold and some gold stocks for our investors and ourselves. We will worry about the grandchildren later.
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