Opinion

The Great Debate

Fed is banking on phony wealth effect

By J Saft
October 7, 2010

The Federal Reserve is committed to enticing Americans into doing once again what worked out so badly in the last decade: spending the phony paper gains engineered by overly loose monetary policy.

That, at least, is the very strong impression given by a speech by Brian Sack, the markets chief of the New York Federal Reserve, a man whose job it will be to implement the second round of large-scale quantitative easing coming after the elections in November.

A round of speeches from key Fed officials has given the clear view that, faced with deteriorating conditions and trapped by the lower bound of zero in its monetary policy, the Fed is preparing to once again buy up large amounts of Treasuries, perhaps even more than the government is issuing on an ongoing basis, in an attempt to drive down market interest rates and stimulate the economy.

Will that do any good, given that people generally do not want to borrow and the banking system is impaired?

“Balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be,” Sack said in a speech in Newport Beach, California on Monday.

“It seems highly unlikely that the economy is completely insensitive to borrowing costs and wealth, or to other changes in broad financial conditions.”

So, there you have it: pump up asset prices and hope that people spend some of the ephemeral gains. The idea that people will spend more if their houses and other assets rise in value is called the wealth effect, but this policy creates only pretend wealth.

In fact, many people in the U.S. now face diminished retirements and generally straitened circumstances precisely because they mistook the rising prices of their house and Internet stocks for wealth and spent or borrowed against it. Is the U.S. actually so desperate for economic activity that this is the best it can do? Apparently so.

“When will these guys ever learn that maybe, just maybe, these Fed policies aimed at targeting asset prices at levels above their intrinsic values is probably not in the best interests of the nation?” Dave Rosenberg, chief economist and strategist at Gluskin, Sheff wrote in a note to clients.

CALLING DR RICARDO

So, now that the strategy is clear the question is will it work? So far, the promise of QE seems to be affecting the term premium in debt markets, reducing longer-term funding costs, and stock market traders also seem to think it will be good for equities.

The reality of QE when it arrives may be a bit different: debt markets are less dislocated than last time and so the value of the balm will be less, while stocks are far more richly priced.

A more interesting question is how households and businesses react to the paper wealth if the Fed is successful in creating it. Businesses may use their newly rich equity prices to go and buy other businesses, especially ones with actual resources attached, such as mining companies. They will be less interested in investing in new production unless they see strong signs from households that they are interested in buying more again.

For households, you have to wonder if there is a sort of Ricardian equivalence that applies to manufactured asset price inflation caused by QE or otherwise loose monetary policy. Ricardian equivalence is the controversial idea that consumers realise the fiscal constraints of their governments and will, for example, not spend a tax rebate if they know it means a tax rise down the road. Would they similarly not spend asset gains they see as false?

Clearly this idea did not apply to the interplay of policy, asset prices and consumption in the last decade. People spent some of the paper wealth that was created by loose policy under Alan Greenspan. That, however, was before they were burned by the housing crash, and Greenspan had the good sense to effectively conceal his experiment from his subjects. Now that the Federal Reserve has come out and said it is trying to ramp up asset markets, the feel-good factor from a rising stock market may be lacking.

If QE will work it will work as the big gun in the currency war, driving down the value of the dollar. In doing that,  though, the Federal Reserve takes considerable risks; that investors lose confidence in the dollar and in the U.S.’s commitment to its lasting value, and that they react by pulling back from dollar investments. This cannot be good for U.S. consumption, other than it might cause people to buy things now rather than later in diminished dollars.

Perhaps the real beneficiaries of QE will be commodities, or, whisper it not, gold.

Comments
24 comments so far | RSS Comments RSS

There are two components to our stagnent economy: commercial cash flow and private or consumer cash flow. By consumer cash flow, I mean consumer credit. The government took a swipe at fixing both markets with finance reform and fixing the consumer credit with the first-time homebuyer credit. But the banking system, once in a habit of handing money to almost anyone that asked, has done an about-face. Their heels are dug in for fear of government intervention or reprisals. And in the process of hunkering down, they have constricted consumer credit to new applicants and punished the very customers they recruited in the boom years with higher interest rates to help them cover the losses they are now incurring through their own careless lending. The consumer has been stung and now needs to know that he or she is not going to be stung again.

Posted by icfman | Report as abusive
 

Remarkable analysis.

Many people in America look at the reality around them, then they look at what’s going on in the stock market, and at the US deficit, and they smell a rat, or a trap.
Or both.

Posted by yr2009 | Report as abusive
 

Artificial wealth creation was a huge factor in the crisis. This is coming from Washington not Wall Street. But the banks fell for it like most individuals in assuming all houses can at the same time be worth full market value. The money is not yours until you sell the asset.

Posted by Har | Report as abusive
 

This whole mess is just insane….the common layman can see what is happening to our standard of living by these purely reckless acts. Please, stop this madness. Boot the Fed!

Posted by hunt | Report as abusive
 

A buck will be a buck in the end.Stay debt free… Gold can’t be eaten.. Save our water and our farms.

Posted by dr.bob | Report as abusive
 

These government “experts” should be held as personally accountable for their incompetence as the “expert” executives who have destroyed so many companies and financial institutions in the last couple of years. @yr2009 is correct in that many people in America smell a rat, which is why the stock market is also so lackluster. Trust in the system is ZERO.

Posted by cynicalme | Report as abusive
 

Quality article. Thanks for the insight.

Posted by AverageOne | Report as abusive
 

Excellent, a well thought out and written article.
All very true.

Posted by The1eyedman | Report as abusive
 

This article is so dead-on correct. Very insightful. Thank you.

You could explain this to a 6-year-old just by restating it as “You can’t make something out of nothing”.

For 15 years, that’s what the bookkeeping of the U.S. economy and our Gov’t has been doing – making something out of nothing. We claimed that real estate, future corporate earnings, future tax revenue, and the dollar were worth far more than they actually were. We convinced people of those lies, getting them to borrow and risk based on those lies.

That “we” was our political parties, our investment brokerages, our real estate companies and our corporations.

But now, “we” have to pay it all back.
And now “we” is you and me, the middle-class taxpayers.

Posted by redmerlot | Report as abusive
 

Good article.

For someone like me, it’s impossible to have any real faith in much of any expert, not because any given one is deliberately trying to lead us down the primrose path, but, in fact, quite the opposite. That is,this expert, with tons of qualifications, passionately and with all apparent sincerity argues for Option A or Interpretation Y — then I turn the page, and there is another expert, just as qualified, passionate, and sincere, arguing something different than Option A or Interpretation Y — sometimes arguing the precise opposite, in fact.

Take gold, for instance. In the past 24 hours alone, I’ve read recommendations to flee screaming as far away from gold and any gold-related products as fast as I can — and to buy it by the ton for a long-term investment, plus every variation of recommendation in between. Now, I may indeed buy a tiny bit of gold, in the form of personal jewelry, mostly, but that’s because I live in a country from which gold might allow me to exit in times of crises. A few ounces would suffice for that purpose. But that’s not a *financial* investment, per so, but, rather, an escape hatch. Beyond that purpose, I have no idea whether to not invest in gold, invest all I can, or something in between those two extremes.

About the only area that seems to be reasonably clear is in non-sexy commodities, such as coal (in which I have a small investment, despite my being somewhat green), potash, etc.

Applying all this to the point of this article, and I’m still left wondering, at least a little. It makes perfect sense . . . but is it possible that Americans, at least some in enough numbers to have an influence on future developments, have woke up and smelled the coffee?

Maybe the picture will be clearer once the dust settles from the election — though that won’t necessarily be November 3rd, as both parties are already lining up lawyers everywhere, set to challenge election results. It could be several months before we know everything (ie., who won a given election).

Posted by MekhongKurt | Report as abusive
 

Jim’s analysis is great, but a complete diagnosis would need the help of a psychoanalist. The West is a collective addict whose drug is the bubble. Bubbles are beautiful and fascinating beyond words. As soon as one burts, the addict desperatly scrambles to find another, and get a new high. All the trauma that follows the popping of the last bubble really is nothing to take so seriously, it is just a hangover that will last until the addict gets his new hit and gets over it. This is a cycle for the cynical businessman, a real predictible mechanism that can harnest much wealth.

Posted by Neander | Report as abusive
 

Yes, but the problem with gold is that it’s easy to buy and not so easy to sell (at least at the headline price). And yes, there’s a rat and a trap and the majority of hardworking people are stuck in a hole beneath both the rat and the trap. Is this the democracy America and the west stands for? The democratic “system” needs to get the balance between the public needs and corporate needs in balance. They BOTH need to be represented by democratic governments, it’s gone the corporations way too long, and most of them will have figured out how to minimise their tax, and every job “off-shored” is a tax payer’s contribution to society eliminated (not to mention the shopping power evaporated).

Posted by Tiu | Report as abusive
 

It’s simple for me. Any paper wealth generated by QE will be immediately converted to physical assets in a foreign country. If that country has a relatively stable currency then some of it may go to financial assets. This also serves to protect me from the eventual depreciation of the USD due to QE, vis-a-vis foreign currencies. When the depreciation has run its course I liquidate those foreign assets and re-purchase here in the US.

I believe this strategy is already being carried out by the big money investors. Which is one of the reasons QE is failing in the industrialized nations.

Posted by DeadRed | Report as abusive
 

Gold is a commodity. unlike cars, bicycles and TV sets etc.
Beware loading up on useless assets.

Posted by Willem1 | Report as abusive
 

Moss_GR in answer to your question: usually addicts loose the ability to do anything other than continue to consume the product their addicted to… until it kills them or they go cold turkey.

Posted by Tiu | Report as abusive
 

and yes, it should have said “they’re addicted to”.

Posted by Tiu | Report as abusive
 

Everybody knows what the problem is but nobody knows how to solve it, with any degree of certainty. Pointing the finger of blame at one person or one party is futile. We just have to hope that our Federal Reserve and our Government does its best to stimulate the economy without unleasing inflation and without burdening future generations with excessive debt. Can any one claim how to do this with any degree of certainty?

Posted by g11427 | Report as abusive
 

It appears that most comments have come from America and yet we have gone through the same thing in the UK and appear to be following the same path forward with QE also. It seems that fiscal and monetary policies have been designed to create the maximum incentive to go into debt and push up asset prices along the way that let you go even more into debt. Living life prudently seems to be a losing strategy as you simply end up (via massive tax increases or zero returns on your savings) bailing out all those who went along for the ride. With each bubble bursting our policy makers create a larger one to bail us out. Given how big the previous one was I dread to think about how large the next one will be – the one we are in the process of creating now.

Posted by jde10 | Report as abusive
 

Well, I guess that “free market-global economy” thingey they preached about for so many years isn’t so “free” after all. Seems it won’t work without the “not so invisible hand” (a.k.a the fed) doing a few slight of hand tricks behind the scenes.

How ironic that this so called “free market global economy” requires the micro-management services of a central planning agency such as the fed to prop it up. I thought that was a feature of communism. And what’s even worse, their chief objective is the continued bail out and protection of the interests and investments of our country’s elite.

I think we need to revisit and reconsider just who the characters of Orwell’s “Animal Farm” represented.

Posted by garrisongold | Report as abusive
 

The free market doesn’t need the Fed to prop it up.  What the Fed is doing is preventing the free market from working naturally, from going through its natural cycle of cleansing.  Fortunately, the Fed can only get in the way for so long; it cannot forestall the eventual and inevitable rise in interest rates.  The Fed is trapped by its lower bound of zero in its monetary policy, and soon it will be trapped by the lower bound of zero in market interest rates.  Interest rates, already at historic lows, can’t go much lower.  And what will happen to real estate values when interest rates begin to rise?  Yes, that’s right, there will be downward pressure on prices and a reduction in wealth.  There is no easy way out.  The sooner we accept the pain and work through the difficult market readjustments, the sooner we can return to natural free market growth.

Posted by cpv1022 | Report as abusive
 

The most significant effect of QE is the increase in the overall money supply, not the “wealth effect” if there even is one at this point. To increase the money supply, the FED could theoretically buy up anything, but it should be ready to withdraw this stimulus if/when inflation becomes a problem, so hard, fungible, liquid assets should be preferred over things like junk bonds, rare coins, or fresh vegetables. The author has a point that pumping all this stimulus into the bond market distorts it and could lead to a spectacular backlash if inflation gets out of hand and the FED tries to liquidate its position. I’ve been arguing that the FED should be stocking up on whatever hard commodities are not presently peaking, a special program to build up the strategic petroleum reserve would have been a great option 20 months ago and might still be worth doing now. Non-ferrous metals should also be considered as well as vacant land in distressed areas. On the former, some would argue that gold is at a peak, but it’s way below its record high; given the desperate fiscal state of most of the western world, I’m still bullish in the long term. The one thing the FED should avoid is foreign currency and bonds, such purchases could easily be canceled out with similar activity by foreign governments, not to mention the long term risk of inflation and default. The main aim should be to get dollars into the economy; even if they first land oversees, each one will eventually find its way back here in one form or another. Scary as all this sounds, it’s far saner than the alternative, following Japan down the bankruptcy hole with more fiscal stimulus, though both countries are probably headed there in the long run whatever the FED does.

Posted by PCL1 | Report as abusive
 

Moss_GR missed one important point: We, ehh, relieved ourselves of our WWII debt pretty much the same way. The dollar lost between 2/3 and 3/4 of its value (in real terms) between 1945 and 1980. PT Barnum was right; “sucker born every minute”.

Posted by PCL1 | Report as abusive
 

I have to agree with the MekhongKurt. The faith in the economy is weak and limited almost entirely to gold, silver, Mining Stocks, oil and commodities. The fact that people continue to scoop up gold in the face of these prices is revelatory of how little they believe in the dollar.

Posted by RogerLoomis | Report as abusive
 

Couple of things…

The only two people I trust to tell it like it is are David Rosenberg – and James Saft. Great job in cutting through the propaganda and lies James.

Let’s do more than whisper – I think we should be screaming Buy Gold!!!

Those who say you cant eat gold miss the point.

When the global economy unravels – and it will and soon – currencies wont even be good enough for toilet paper (not soft enough).

People will still need an easily transported store of wealth and throughout history – in times of strife – it has been gold.

Tell me. If you have a couple of hundred grand liquid or even 50 grand what are you going to do with that? Buy canned tuna?

What if you liquidate a one million dollar portfolio. Or 5 million. What are you going to do with the cash? Buy sacks of rice?

Of course not.

And that is why gold is going to be king. Because people of high nett worth need some way to store their wealth.

They will own gold.

Posted by Roadhouse | Report as abusive
 

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