Institutional failure week

November 2, 2010

-The opinions are the author’s own-

By the end of this week, the U.S. will face a government that is unable to act to aid the economy and a Federal Reserve that is unable to stop.

The stock market may well rise on this dysfunctional combination, only serving to prove that the economy and market are becoming fundamentally disconnected.

Tuesday’s election may well deliver a split Congress with the Republicans in control of the House of Representatives and the Democrats clinging to a narrow majority in the Senate. This means that there is no chance of further meaningful stimulus and that Democratic timidity will likely harden into an intransigence to match that of the Republicans.

Rather than building bridges, the next two years will be spent dickering over tax codes, and, as the 2012 election nears, fighting trade and currency wars.

Many will argue that this is right, that the election will freeze stimulative spending that is wasteful and unpopular.

Perhaps, but economic growth is extremely weak. The initial reading of third-quarter gross domestic product, released on Friday, showed the economy expanding at a faster 2.0 percent rate. Most of the growth, however, was from inventory rebuilding, a process that is very likely to slow. Actual growth in real final sales was an anemic 0.6 percent, making this the weakest such recovery on record, according to economist David Rosenberg of Gluskin, Sheff.

Rosenberg estimates that a 20 percent slowing in the rate of inventory building — and remember that inventories can grow faster than demand for only so long — in the current quarter would take the economy into contraction. Combine this with the fact that the reduced government spending in 2011 as the stimulus is burned through will remove 1.5 percentage points from the trend in GDP growth and you have the recipe for a double dip.

Here is where the Federal Reserve will, unfortunately, step in. Despite the risks to its independence this involves, the Fed seems likely to react to the interplay of a hobbled economy and recumbent government by starting another round of quantitative easing. The Fed will probably confine itself to buying Treasuries and perhaps may buy enough to in effect monetize all of the government’s borrowing needs with freshly created money.

The Fed will engineer lower interest rates in order to transfer risk to itself, to entice investment, to raise asset prices and to lower the value of the dollar, all forms of stimulus it hopes will help the economy to escape deflation and reenter vigorous, job-creating growth.

There are a lot of problems with this. The Fed, by weighing in when there is not consensus to stimulate through the fiscal process, opens itself up to further political interference, especially if it monetizes the debt. This is not to say that the political gridlock left to itself will bring on the best results, but that proper process and division of powers in a democracy matter.

Even putting that to one side, the resumption of quantitative easing is nothing more than the continuation of the policy the Fed has followed through the Greenspan years and into the reign of Bernanke. When faced with weakness, the Fed stimulates, when faced with bubbles, the Fed fails to act.

During the past decade globalization meant that something quite fundamental was changing in the U.S. economy, raising the natural rate of unemployment as jobs and industries moved overseas to cheaper places of production. Rather than allowing the U.S. to come to grips with this, to cut its cloth or its pie differently, or even to develop new strategies and industries, the Fed eased. This brought on a wasteful and false housing bubble. Labor and capital flooded into housing and homeowners spent as if the money were real.

That leaves the U.S. with a huge cohort of people in real estate and construction whose skills are no longer needed. What’s worse is the lost opportunity: a decade to grow export industries. Think of all the start-ups that never got funded or started because money was flowing to marble counter tops and construction.
On the flip side, think of all the companies that should have failed but didn’t, kept alive by low rates and easy money.

“More disturbingly for investment professionals, (asset price manipulation) changes the normal workings of capitalism and the market,” Jeremy Grantham of fund manager GMO wrote in a note to clients. “Weaker companies need more debt. Artificially low rates that are engineered by the Fed mean that leverage is less of a burden and survival is easier. Similarly, the Great Bailout allowed many companies that normally would have failed and been absorbed by the stronger or more prudent ones to survive.”

Rather than a great moderation, the past 15 years have been a great misallocation, and one which the Fed seems determined to extend and politicians unable to end.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.


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Good Night America. Institutional failure ‘week’??? I hope this failure doesn’t last 20 years like ole Rip V.W’s slumber…. And when we finally awake, I hope our head has been cleared, and we’re not just suffering another hangover.

In the immortal words of Edward R. Murrow; Good Night, and Good Luck…

Posted by edgyinchina | Report as abusive

James Saft wrote: “the economy and market are becoming fundamentally disconnected.”

It is comments like this that make Saft my favorite Reuters columnist. He gets it. Wall Street and Main Street used to be joined at the hip, but outsourcing and Wall Street bailouts changed all that. Now the Dow can climb to the stratosphere, while unemployment remains high.

James Saft wrote: “the next two years will be spent dickering over tax codes”

Neither party is willing to curtail outsourcing. The Democrats are only marginally better at limiting Wall Street’s drunken orgy of greed. So gridlock might be a good thing, as few laws will be passed.

James Saft wrote: “Think of all the start-ups that never got funded or started because money was flowing to marble counter tops and construction”

And think of all the start-ups that never got funded because all of our money was being shoveled into Wall Street.

Posted by saucymugwump | Report as abusive

[…] Markets will be disappointed this week as the false optimism created around QE2 finally vanishes. The retreat will come when the market realises that QE2 even if pursued will be a failure. With interest rates already around historic lows, any further cut in interest rates will have an insignificant effect on the investment decision making process. Please read on: 10/11/02/institutional-failure-week/ […]

Posted by Institutional Failure week: The Dawn of Realism | | Report as abusive

Ron Paul is trying to downgrade power of FED and in yesterdays interview said: ‘If we succeed in Congress/Senate to challenge the power of FED significantly (what he suspect is not possible right now) ANY president would veto such decision’. Scary conclusion about real FED power. People and their representative including president cannot stop harmful actions of private cartel in any ways? Good morning America.

Posted by Pred | Report as abusive