Mark Twain once said, “To a man with a hammer, everything looks like a nail.” To the Federal Reserve — an institution employing an army of economists and academics — everything looks like an economic problem that needs to be quantitatively eased. As a result, the Fed is killing the economy.
Sir Alan Greenspan, who after he left the Fed suddenly turned into a rational and comprehensible person, said during a recent appearance on The Charlie Rose Show that businesses don’t want to invest because they are concerned about the future. I agree.
Ironically, by intervening in the free market and arbitrarily setting short- and long-term interest rates at insanely low levels, the Fed is responsible for this uncertainty, enabling and propagating speculation — not investing — and eroding confidence about the future. Usually, in investing, liquid capital turns illiquid when it is committed to a higher, more productive long-term use. The ability to forecast aftertax cash flows and discount rates is key here. Speculators, however, are indifferent to what asset they hold (junk or quality). Their time horizon is much shorter, and they are just looking for a greater fool on whom they can unload their stuff. The next tick in price is the only variable that matters to them.
Speculators are the ones driving stock prices up (and down) in the short run, but they leave as quickly as they arrive. It is the investors who stick around, but because of Fed chairman Ben Bernanke, they are choosing not to come.
The Fed and others are measuring the health of our economy by the wrong statistic: unemployment. It’s a political number that everyone pays very close attention to, but it’s not as important to the economy as it appears to be. Although 9 percent unemployment is high statistically, most of the inability to find work is in low-paying sectors. Unemployment among people with bachelor’s degrees was just 5.4 percent last year, according to the Bureau of Labor Statistics, while unemployment among those who don’t have a high school diploma was almost 15 percent. Workers with a bachelor’s degree make almost three times more than those who don’t graduate from high school. Thus the economic impact of unemployment is a lot less pronounced than the headline number may indicate.
Don’t get me wrong: I feel for all the people who don’t have jobs. But the Fed and the government are trying to fix a problem that only time can solve. The bulk of current unemployment is structural; it is not caused by too little money in the economy or interest rates being too high — the Fed took care of that, and it didn’t make a difference.
Focusing on the wrong statistic and using the government’s balance sheet (that is, debt) to cure the incurable is dangerous. The statistic that the Fed should focus on is the one it worries about the least, as it feels it can control it — yes, interest rates. They are more important for our economy than unemployment. As our debt grows, interest payments are becoming a greater portion of the federal budget; thus our budget deficits will become more interest-rate-sensitive, which in turn will impact tax rates. The housing market is tethered to interest rates as well. Having taken short- and long-term interest rates to all-time lows, the Fed has not been able to lift the housing market — we simply got too addicted to low interest rates. However, if interest rates go up to levels we have not seen in a few decades, they will tank the housing market.
The Fed is desperately trying to mess with interest rates through quantitative easing, but at some point it may lose control over them. Recently, we saw yields of Italian bonds jump to 6 percent — and Italy is a first-world nation. The market is more powerful than the Fed and not stupid. It will not let the U.S. government borrow at first-world rates while behaving as a third-world country (like the ones we used to preach to about how to run their government finances). ?Also, China and Japan, the largest foreign holders of ?U.S. Treasuries, have their own sets of problems and may have a lot less demand for our less-than-excellent debt in the future.
Until the U.S. hits the wall, we are not willing to take the needed pain: significant budget cuts across the board (we simply cannot afford the government we have) and some higher taxes. Unfortunately, we are so impressed with the Ivy League vocabulary the Fed heads use, and so scared that our economy will cease to exist without the Fed’s help, that we play along. But our economy really needs to get off Fed (and government) steroids and start functioning on its own. However, judging from Bernanke’s latest testimony to Congress, that is not likely to happen, as the Fed will use the U.S. economy as a laboratory for untested measures, which will go down in history as QE3. Prepare for higher interest rates and higher inflation. • •
Vitaliy Katsenelson (vk@imausa.com) is CIO at Investment Management Associates in Denver and author of The Little Book of Sideways Markets.
