We are living through the largest broad-based financial bubbles in history – stocks, bonds, real estate and bitcoin. Bubbles by nature grow through self-reinforcing feedback loops. Bubbles mostly grow, not pop. Eventually they pop, but some of the strongest growth occurs in the terminal phase.
It is not just the US that is in bubbleland, the entire developed world is along for the ride. In the chart below we see the prices of the same houses over time, not new larger homes. And the index is adjusted (lowered) for “inflation”. Ever since the Swede’s eliminated housing from their “inflation” measures, it has stayed near 2% – sound familiar?
What makes this bubble larger and broader than any before it, is that it is supported by central banks who can simply create money out-of-thin-air to backstop any attempt by the free market to correct – so far. This has led to the largest credit bubble in human history. And it is the credit cycle that causes booms and busts. The only way to stop a bust is to not allow a boom – too late.
Extreme Monetary Policy
The global central banks have been simply monetizing financial assets and sterilizing that debt onto their balance sheets. In other words, the central banks have been injecting the financial markets with cash created out-of-thin-air which has the effect of driving real estate, stocks and bond prices higher.
Global bond prices hit a 5000-year peak when the central bank’s efforts resulted in the insane negative interest rates in much of Europe and Japan. The US stock market by many measures exceeds the valuation levels of 1929 and 2000. Commercial real estate today and the debt that backs it are in in real trouble. The *combined* valuations of stocks, bonds and real estate have surpassed 1929 and 2000.
Monetizing means the central banks buy government & corporate bonds, mortgages and even stocks with money created out-of-thin-air. Their purchases are removed from the supply of financial assets available for others to buy. Since demand does not change, the prices of financial assets go up. And speculation drives the markets to bubble levels while this is going on.
Underlying economic, profit and wage growth have not mattered. Only how much the central banks are monetizing and how their policies encourage others to reinforce the bubble dynamics have mattered. One example are corporations taking on debt with low interest rates to buy back their own corporation’s stock.
Initially, the central banks wanted to re-inflate the prices of everything back to previous bubble levels to repair the balance sheets of banks, households, etc. When home prices and other financial asset prices crash the debt does not just go away. Many banks were insolvent in 2008 since they were required to mark their asset prices to market value – that rule was suspended and this is when the “crisis” ended (on paper).
Most of the de-leveraging of households since the financial crisis was through foreclosures. The banks of course got bailouts and historically low interest rates to transfer wealth from savers to re-capitalize the banks. Today, one of the new monetary tools is to pay banks interest on their required not just excess reserves. This means when the Fed raises interest rates the banks income goes up – a nice little monetary tool if you are a bank.
The problem with the solutions to the last crisis is that most of the monetary “stimulus” simply went into driving financial asset prices higher and very little transmitted to the working economy. Studies have shown that the economy did not grow any faster than it would have otherwise. Stimulus certainly did not transmit into higher wages or higher consumer prices which the Federal Reserve pretends to be targeting.
The US economy has matured and demographically our population and working population are growing at a slower rate. But the question of the day is did lowering interest rates to zero and buying over 4 trillion dollars in multiple rounds of QE help the economy grow faster than it would have otherwise. I would say no.
And what about the Fed’s arbitrary 2% CPI inflation target: why does main street need 2% inflation to go along with low wage growth? and why hasn’t the fact we have been within 1% of this target since 1990 been good enough?
The answer is a 1% inflation target would have been a fine target unless you want an excuse to keep monetizing the financial system. Some respected analyst have asked this same question, but they come from outside of the current monetary regime. So I was shocked to read lucid quotes coming from one of the front-runners for Chairperson of the Federal Reserve – Kevin Warsh.
In a Wall Street Journal op-ed earlier this year, Warsh suggested lowering the Fed’s inflation target to 1 to 2 percent, from its current 2 percent. The current pace of about 1.4 percent would fall within that range and encourage Fed officials to raise interest rates.
Jerome Powell who was selected will continue to push for arbitrary 2% inflation target and has stated it is somewhat of a mystery why inflation has remained below 2%. Many economist find low inflation today a mystery so they suggest more of the same – which has not worked.
QE redirected capital to the financial economy
And what did Warsh think of current monetary policy’s effect on the economy…
“We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose ‘shareholder friendly’ share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.
In other words, QE has negatively impacted the main street economy. Oh boy, do I like this guy, he is the right man for the job…
“The conduct of monetary policy in recent years has been deeply flawed… A robust reform agenda requires more rigorous review of recent policy choices and significant changes in the Fed’s tools, strategies, communications and governance. Two major obstacles must be overcome: groupthink within the academic economics guild, and the reluctance of central bankers to cede their new power.
First, the economics guild pushed ill-considered new dogmas into the mainstream of monetary policy. The Fed’s mantra of data-dependence causes erratic policy lurches in response to noisy data. Its medium-term policy objectives areat odds with its compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its output-gap economic models are troublingly unreliable.
My Fall Summary Predictions
…so he [Warsh] probably will not be nominated.
Before I get my hopes of that Trump will nominate him, I remind myself that wall street bankers are whispering in Trump’s ear that he will be the new Jimmy Carter if he selects Mr. Warsh.
President Carter nominated Paul Volcker to head the Fed and he saved the dollar from high inflation. He pushed the Fed funds rate to over 20% and induced back-to-back recessions to save the dollar. He is one of the most respected Federal Reserve Chairpersons in history, but President Carter got blamed for the recessions and was not re-elected.
If Mr. Warsh is allowed to go on the attack against insane monetary policy, the financial system will begin to reset to free-market determined prices. No more monetary back-stopping of every little market correction. A bear market perhaps. And that will not make the sitting President look good. So I will be surprised if Mr. Warsh is nominated by the President.
I expect Powell to get nominated.
What does all of this mean to our investments?
See our Fall Summary Report for my answer.