Ultimately, the result of yesterday’s referendum makes no difference to the long term global economic outlook. Regardless of the fact that Britons have voted to leave the EU, the world will carry on much as it has for the past decade.
The global economy will still function on vast amounts of money creation, with each stimulus effort begetting an even bigger one.
The corner the central bankers have painted themselves into reminds me of the home spun wisdom often found in nursery rhymes.
There was an ‘Old Lady who swallowed a Fly’ is a children’s song about a lady who swallowed animals of ever increasing size in order to catch the previously swallowed, smaller animal.
The sequence and rhyme of the old lady’s animal degustation is (and feel free to sing along):
- Fly: ‘Perhaps she’ll die.’
- Spider: ‘It wiggled and jiggled and tickled inside her.’
- Bird: ‘How absurd.’
- Cat: ‘Imagine that.’
- Dog: ‘What a hog.’
- Goat: ‘She just opened her throat.’
- Snake: ‘For goodness sake!’
- Cow: ‘I don’t know how.’
- Horse: ‘She’s dead, of course.’
The moral of the story is, trying to solve a problem with an even bigger problem inevitably leads to a very sad and predictable ending.
We can apply this moral to the actions of the US Federal Reserve since the late 1980s.
The Fed’s mandate is twofold: Control inflation in the 2–3% range, and maintain full employment within the economy.
During the 1970s, inflation moved well outside the Fed’s comfort zone, soaring to 15%.
In 1980, the then Fed Chairman Paul Volker moved decisively to tame the inflation beast by ratcheting interest rates higher and higher — in spite of enormous political pressure to turn the interest rate dial down. The impact of this bold and deeply unpopular strategy was to plunge the US into a deep recession.
Volker’s courage was eventually rewarded — inflation fell back into the single figure range. Volker’s determination to stay the course did him no favours with the ruling class. He effectively signed his own ‘professional death warrant’. Volker’s tenure as Fed Chairman was not renewed. His replacement? Alan Greenspan, whose chairmanship at the Fed lasted 19 years.
The following chart shows Volker’s interest rate handiwork in the early 1980s — taking the US cash rate to nearly 20%.
To put Volker’s boldness into perspective, imagine (if the situation warranted such action) Glenn Stevens (RBA chief) doing that in Australia today. The political and public heat he’d incur would rival the fires of Hell.
[Click to enlarge]
Volker’s replacement, Alan Greenspan, took charge of the Fed in August 1987 — two months prior to the infamous Black Monday share market meltdown.
Greenspan was no Volker. Greenspan craved the populist power Wall Street and politicians bestowed upon him. Volker was a disciplinarian, whereas Greenspan gave the spoilt market and spineless politicians whatever they wanted.
In 1990 the US economy ‘swallowed a recessionary fly’. Greenspan obviously thought, ‘perhaps she’ll (the economy) die’. He need not have worried. Compared to the recession of 1982/83, the 1990 recession was rather tame. But Greenspan, not wanting to disappoint his political masters (he saw what happened to Volker), sent down a 3% interest rate spider to catch the fly.
The spider’s wiggling and tickling worked. The US economy recovered. Inflation rose.
Greenspan thought he’d found the formula to correct the ills within the economy. Turn the interest rate dial up or down and say the right things, with sufficient monotone gravitas, to keep the debt funded party going.
Greenspan’s response to the global economic wobbles caused by the 1998 Asian crisis was to send down an ‘interest rate bird’ to catch the spider. How absurd.
Again, the economy recovered. It powered ahead with the dotcom boom.
At the height of the boom, Greenspan was being hailed as a hero. He could do no wrong. Every boring word he spoke was analysed in great detail. At one stage, even his choice of tie was subjected to lengthy discussions on whether a subtle message was being sent to the markets. We were entering the realm of the truly absurd.
The dotcom bust gave Greenspan a ‘cat sized’ problem — imagine that, a problem of his very own making. What did Greenspan do? He went off to the animal shelter and found himself an interest rate ‘dog’.
Interest rates were quickly dialled down under 2%, and were kept there for over two years.
Phew, the dog ate the cat. Greenspan once again was the saviour.
The US housing market, fuelled by a toxic mix of low interest rates and liar’s loans, soared skywards. The share market shook itself off from the dotcom bust and responded positively to the housing market-inspired economic recovery.
In February 2006 Greenspan handed over the menagerie’s keys to Ben Bernanke.
What was Greenspan’s legacy? Here’s how Wikipedia describes Greenspan’s reign (emphasis mine):
‘During Greenspan’s chairmanship, when a crisis arose and the stock market fell more than about 20%, the Fed would lower the Fed Funds rate, often resulting in a negative real yield. In essence, the Fed added monetary liquidity and encouraged risk taking in the financial markets to avert further deterioration.’
Greenspan’s market friendly approach to monetary policy was termed the ‘Greenspan Put’.
Bernanke was also definitely not a Volker. Bernanke’s impeccable academic record (all theory and no practice) made him the perfect key holder of the animal farm.
The subprime crisis that began in early 2007 does not qualify as the ‘goat problem’.
However, Bernanke did make a goat of himself when he said in March 2007 that, ‘the subprime problem is contained.’
Bear Sterns, Lehman Brothers and the GFC gave Bernanke his ‘goat sized’ problem. The market ‘opened its throat’ and just swallowed asset prices — whole.
Bernanke sent in the interest rate and QE ‘snake’. Rates slithered down to near zero, and have remained pretty much in this zone ever since.
But something different was happening this time. The economy was not responding.
The ‘snake’ was not working.
Two decades of Fed manipulated interest rates had indeed produced outstanding economic results and stellar asset price improvements. But household balance sheets were awash in red ink. Even the most sustained period of the lowest interest rates in the history of money wasn’t enough to resume the debt funded consumption model spawned by Greenspan.
Over the past seven years, the ‘snake’ has worked a treat on asset prices. The US share market is within a whisker the record high it hit in May 2015. Investor confidence levels remain reasonably elevated, mirroring the market’s ‘success’.
However, the broad economy is not feeling the love on Wall Street. The real US unemployment rate (compared to the doctored official rates which are measured against falling workforce participation numbers) remains stubbornly high. Wages are stagnating. The Fed has — again — revised its growth outlook for 2016. Retailers are reporting softer trading numbers.
The top 10% of society have benefitted greatly from the Fed’s ‘snake’ solution, but the remaining 90% are sluggish from a massive case of indigestion.
Janet Yellen is also no Volker. Her academic pedigree is equally as impressive as Bernanke’s — another perfect key holder of the dwindling animal farm.
Yellen, by my count, has a ‘cow’ problem coming her way later this year, as a recession is looming in the US. All Yellen has left is a ‘horse’ solution.
Each problem the Fed has faced since 1990 has required an escalated level of response. Each of these responses has created an asset bubble of greater proportion than the one preceding it (more on this shortly).
The ‘cow’ is being fattened in a paddock rich with printed money and suppressed interest rates.
What sort of ‘horse’ Yellen is going to force down the economy’s throat is as yet unknown — even to her and her fellow stud masters. My guess is we should be prepared for a QE program that is likely to greater than all previous efforts combined. This is the pattern of previous ‘solutions’.
The conjecture on how many hands high the ‘horse’ will be is somewhat irrelevant because we know the ending, of course.
Sadly, Greenspan set the tone for his successors. Do whatever it takes to keep the markets afloat. This approach has convinced investors that any crisis or market downturn will be remedied by the Fed providing ample liquidity and the appropriate interest rate setting.
The problem is the Fed’s actions over the past 25 years have created a mindset of excessive risk taking — professionally termed ‘Moral Hazard’.
What investors do not seem to appreciate is that the Fed is fast running out of ‘bigger problem’ solutions.
What comes after the ‘horse’?
The economic glue factory awaits.
Editor, Markets and Money
Editor’s Note: This article was originally published in Money Morning.