The drugs don’t work any more

September 29, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

On one point departing Kansas City Fed President Thomas Hoenig and the high-yield bond market agree: current monetary policy is not helping.

Bonds issued to highly indebted and riskier companies have suffered since the Federal Reserve last Wednesday introduced “Operation Twist,” its attempt to suppress longer-term rates and goose investment and speculation.

This should come as little surprise to Hoenig, who retires from the KC Fed on Oct. 1 after a long career as a central banker and banking supervisor, and who has decried the way monetary policy has encouraged the running up of debts.

“When you encourage consumption by inhibiting your interest rates from rising to their equilibrium level, you will in fact buy problems, and we have in fact bought problems,” Hoenig said on Wednesday in his farewell speech.
The cost of the debts, a drug that isn’t working any more, is becoming clear; from the utterly indifferent reaction in key markets to Fed policy initiatives and from the very poor performance of the economy since the bubble burst.

Hoenig predicts long-term U.S. GDP growth to average around 2.5 percent a year, down from the 3 percent plus the U.S. has enjoyed over the last quarter century. That may sound a slight difference, but if his prediction comes true it will have profound effects. For one thing the same low growth that has been caused by the amassing of debts will make those very debts harder to repay.

Considering that real wages for American workers have been essentially flat for the past 40 years, despite growth in the economy, it is hard to see strong gains in a more growth-starved environment. Something will have to give and neither will be good for risk assets; either the consumer economy suffers or workers will command a bigger slice of the corporate pie, thereby hitting profits and valuations.

The Fed’s new policy slate, under which it will sell shorter-dated Treasuries and buy longer ones as well as additional mortgage bonds, has so far had a decidedly mixed record. While 30-year mortgage rates are lower than they were a week ago, they’ve risen in recent days. That’s partly driven by bets that Europe will contain its financial crisis, but also a lesson in the limits of monetary policy.


The move higher in yields of bonds of sub-investment grade companies is striking. Investors are now getting 8.00 percentage points more than government debt to own high-yield bonds, according to a Bank of America Merrill Lynch index, up 0.40 percentage point since just before the policy was announced. That’s the highest they have been since October 2009.

That’s telling you that investors are worried about growth, worried about whether money will be there for debt refinancings and worried about market stability.

As analysts Bespoke Investment Group point out, high-yield spreads began to perform poorly in early August, just after the budget scare and Standard & Poor’s cut the U.S.’s long-term rating. This too fits in with Hoenig’s thesis, both about the impact of debt on growth and the inability of the Fed to wave a magic wand over things. Investors in corporate debt are recognizing that government spending will drop, which will hurt corporate profits. The further out on a limb a company is — and the high-yield borrowers are out there, the bigger the chance one will take a tumble.

The loss of the AAA rating, which is the result not just of the size of the debt but of the dysfunctional U.S. political system, has made debt investors very nervous. Now that we live in a world where nothing is truly safe or risk-free, investors are, ironically, buying newly downgraded Treasuries in preference to corporate debt. If nothing is safe, better to hold what is relatively safer. That is having, and will have, a far more profound impact on economic conditions than the Fed’s new $400 billion program of bond reallocation.

It may be that Hoenig’s critique of Fed policy is better than his suggested alternative of raising rates, at least if this is done in isolation.

Albert Einstein is supposed to have said “We can’t solve problems by using the same kind of thinking we used when we created them.”

That is exactly what the Fed has done, and largely what is being done in Europe; seeking to ease debts through time, low rates and inflation rather than seeking to destroy them.

That’s not the job of a central bank, it is the job of a government. Destroying debts can also be done by markets; we’re seeing it in Greece and we will see it again.

(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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Great article.

And there is something else wrong today: truth and facts no longer matter.

Many years ago when I studied the science of accounting, the principle of “conservatism” was a bedrock of the profession, taught in all the schools, and always on the CPA exam.

It basically says that accountants must represent the interests of shareholders and investors, and thus must value assets conservatively. If an asset has lost value subsequent to its acquisition, the accountant must “mark to market”.

If on the other hand the asset has gained market value since its acquisition, the accountant must continue to value the asset at its acquisition or “book” value, under the notion that unrealistic market gyrations shouldn’t enable the company to artificially generate accounting gains. Only when the company sells the asset can it claim the benefit of the market gain.

This principle of conservatism served American commerce well. But it is gone now. After the fall of Lehman Bros. in Sept 2008, America’s accountants have caved in big time.

The books of American companies and banks are full of dead, rotting wood. Assets carried at 100% of their cost, when they are only worth 20% of that.

Truth and facts no longer matter in American Republican commercial enterprise. It has now become a charade, with the Fed, SEC, and Treasury playing the make-believe game right along with them.

Mark-to-market is first necessary step toward economic recovery.

Posted by AdamSmith | Report as abusive

@AdamSmith: While I agree with your points, and I agree that mark-to-market is necessary, there will be no “economic recovery.” Recovery assumes that we’ll return to that chimerical market value of … when? 2007? 2006? No, a mark-to-market will erase the artificially inflated valuation built upon speculation, over-reliance upon a nearly depleted energy source, and the socialized hidden costs resulting therefrom. Mark-to-market means we get to learn how to ride horses again.

Posted by BowMtnSpirit | Report as abusive

Problem is that the destruction of ‘my debt’ is also the destruction of my creditors’ assets. How do you bridge this fundamental divide (chasm) between the interests of debtors and those of creditors?

Debt destruction is easy to say, hard to implement. Everyone’s in this global economy for himself. No one’s going to sacrifice his own wealth for the common good. So “debt destruction” will inevitably lead to war (economic or outright military) when it’s cross-border debt destruction. And debt destruction within national borders will inevitably lead to financial and economic collapse of entire sectors, if not the entire country – leading to catastrophic rips in the social fabric, civil disorder and martial law.

Debt destruction is one of those tools that works pretty good on paper – not in the real world of greedy, self-centered human beings, corporations and governments.

Posted by NukerDoggie | Report as abusive

Not being a person to whom people listen to, my view from the early ninety’s (far before the ‘irratrional exuberance’) that nothing good could come from Greenspans low-interest policy went unheard. Now I think of it in more philosophical terms, low interest was the amphetamine that made the economy run faster than it realistically could, making us richer than we could realistically expect to be, borrowing to increase even what we already had. Our present debts wouldn´t be the greater problem if we had robust growth, but that is more and more eluding us (hence the panic with central bankers and governments). The understandable fear that social unrest will tear the fabric of society may make us wish for immediate economical revival, but it might be wiser to prepare debtors and creditors, banks and governments for quite a few years of a becalmed world economy. That is a different mindset.

Posted by Lambick | Report as abusive