That was quite a binge, quantitative easing was. A bender that went on for years.
Now comes the hangover.
Just like the Austrian school economists said.
In fact, the reason the Austrian Business Cycle Theory is sometimes called the Austrian “hangover” theory is becoming all too clear.
Interest rates are said to coordinate production across time. Normally in a free market when people choose to save more money, the lower rates that result incentivize businesses to carry out longer-term capital goods expenditures for future production.
On the other hand when rates rise, businesses, factoring in the higher borrowing costs, are less likely to engage in long-term expansion. That’s a good thing because the high rates mean that consumers — the final objective of all economic activity — don’t have the liquidity to afford all the new production of the expansion.
It is a natural and wholesome dynamic. High rates encourage the savings that the economy needs for longer-term production to eventually take place, while low rates normally reveal that consumers are not in a hurry to consume today.
|The stock market is the most visible part of this biggest of all bubbles.|
Businesses read the buildup of savings reflected by low rates as evidence that their longer-term production will be met by consumers whose saving will enable them to afford the new production.
But sometimes the central bank bartender steps in and spikes the punch bowl. It prints money electronically so that it can buy bonds and artificially drive rates lower.
Having drunk from the Fed’s spiked punch bowl, people become intoxicated. It affects their vision and their judgment. The party gets lively and businesses start wearing lampshades on their heads. In the raucous environment, homebuilders, high on cheap money, are likely to start building homes in the suburbs of desert cities like Las Vegas and Phoenix, far beyond the sustainable growth of the market or the means of people to pay for them all.
And that is exactly what happened.
If businesses, intoxicated by low rates, start wearing lampshades, markets can be described as swinging from the chandeliers. In the general inebriation the markets race higher, setting new records. But then the punch runs out and the hangover starts with the inevitable correction in prices.
And that is exactly what has happened over and over again with quantitative easing.
When QE I ended, the market sold off. After a 14 percent drop in the stock markets, the Fed bought drinks all around. A lot of drinks.
QE II was much bigger than QE I. But when it ended, the market sold off. Again.
QE III was the biggest bacchanalia of all. It has blown the Fed’s balance sheet up past $4 trillion.
One day in June 2013, Ben Bernanke threatened, not to take away the punch bowl all at once, but to just slowly begin watering down the QE III drinks. The Dow Industrials fell more than 200 points that day alone, while the S&P 500 fell even more as a percentage. Altogether that summer the Dow fell almost 1,000 points from its May high to its June low.
In December last year the Fed met again. This time it announced that it would reduce its liquidity operation by $10 billion a month beginning in January 2014.
The stock market threw a fit and the Dow fell more than 1,200 points from Dec. 31 to the beginning of February.
Now QE III is ending and the early signs of the hangover began appearing in the market selloff last week.
But hope springs eternal and it only took a comment from one Fed official to convince the market that the liquor would not stop flowing. It was “hair of the dog” time! Another drink and all will be well!
It is not pleasant, but it’s time to face reality. The economy and markets have been intoxicated. In fact they are chronically drunk and the Fed is their enabler. They must get into detox. Unsustainable projects must stop. Malinvestments must be liquidated. Markets must return to normal — it’s called a “correction” for a reason.
The monetary manipulation must end, and the malinvestments must be confronted so that resources again move to sustainable economic activities.
This is why the economy has never really recovered, despite the unprecedented creation of trillions of dollars and zero interest rate policies. The Fed’s activity interferes with crucial price signals so that investors are misled and capital is misallocated. It interferes with long-term economic planning, encourages speculative activity at the expense of productive investment even as it penalizes the risk-averse investor, typically the elderly.
Will the Fed break open the liquor cabinets again? Bank of America/Merrill Lynch speculates that a ten percent sell-off would be sufficiently painful for the Fed to turn to the bottle again. Others disagree.
I have spelled out my own view in the Freedom and Prosperity Letter. For reasons having to do with criticism from both the Bank for International Settlements and the International Monetary Fund, as well as having to do with the Fed’s credibility and the credibility of the dollar itself, I suspect the Fed will not be so quick to start up another round.
It is an interesting debate, but we cannot know the answer for sure. Fed officials are divided among themselves and they don’t know what to do. They are making it all up as they go along.
But there are some things we can know. And that brings us back to capital goods: Machinery, buildings, raw materials used in production, plants and equipment.
Consumer spending can turn on a dime. A decision to spend a week at an expensive new luxury resort or to buy a new car can be made on a weekend. But expanding that resort to accommodate all the new guests, or expanding the new car plant to keep up with the added demand created by artificially low rates, those things require longer term planning and commitments. Then, if consumer spending patterns change — too bad!
The intoxicant of loose money since 2009 has been spiking capital goods orders. This is an indication to many that a real recovery may at long last finally be at hand.
But Austrian school economist Frank Shostak, writing recently in Mises Daily, warns that even bubble activities, “like any non-bubble activity, also require tools and machinery (i.e., capital goods).”
Shostak’s analysis is that “a down-trend in the growth momentum of the money supply since October 2011 is currently on the verge of asserting its dominance. This means that various bubble activities are likely to come under pressure. Slower monetary growth is going to slow down the diversion of real wealth to them from wealth generating activities.
“Consequently capital goods orders are going to come under pressure in the months ahead. The build-up of a wrong infrastructure is going to slow down — and fewer pyramids will be built.”
If Shostak is right, it means that the United States will soon join in the economic slowdown that is taking place in China and the recessions that are growing in Europe and Japan.
That means that just as the prior dot com and housing bubbles eventually popped, the air is beginning to come out of the QE bubble. When this process begins, no amount of money printing and not even a few good stiff drinks from Janet Yellen will be able to stop it or to re-inflate the bubble.
The stock market is the most visible part of this biggest of all bubbles.
It could prove to be the biggest of all hangovers.