No. of Recommendations: 29

Stabilization Won’t Save Us
New York Times, December 23, 2012


Stabilization, of course, has long been the economic playbook of the United States government; it has kept interest rates low, shored up banks, purchased bad debts and printed money. But the effect is akin to treating metastatic cancer with painkillers....

Overstabilization also corrects problems that ought not to be corrected and renders the economy more fragile; and in a fragile economy, even small errors can lead to crises and plunge the entire system into chaos. That’s what happened in 2008. More than four years after that financial crisis began, nothing has been done to address its root causes. ...
[end quote]

The rest of the editorial is a list of "shoulds." Whether or not you agree doesn't matter, since there's nothing we can do about what TPTB do. We can only influence our own investing.

The Federal Reserve and government have printed money and provided fiscal stimulus (debt) to a staggering degree. I discussed that in yesterday's Control Panel.

Assets - Securities Held Outright by the Federal Reserve is growing rapidly again and is now $2.67 Trillion (17% of GDP, which is $15.8 Trillion). This is monetary stimulus.

Federal Debt: Total Public Debt is $16.0 Trillion (100% of GDP) and growing rapidly. Net Government Saving (this quarter's Federal deficit) is -$1.23 Trillion (a deficit of 7.8% of GDP). This is fiscal stimulus.

Whether you love or hate the Federal Reserve, it's clear that the Fed served its primary function, lender of last resort, in late 2008-early 2009. For a terrifying description of the catastrophic effects of a liquidity collapse without a lender of last resort, read "Manias, Panics and Crashes," by Kindleberger.

I think most reasonable people would agree that the Fed prevented a systemic collapse during the 2008-9 crash with great flair, imagination and promptness. This stabilization was essential and historic.

However, the continuation of Federal Reserve buying of Treasury debt at all durations, especially Operation Twist (which uses the proceeds from maturing Treasuries to buy new long-duration Treasuries) has continued to pump monetary stimulus into the economy.

I would argue that the U.S. never recovered from the 2001 recession.

The story is told by the short and long term Treasury yields and is particularly clear from the Real Yields (inflation adjusted) that I have calculated in this spreadsheet.

Note the policies of the different Federal Reserve chairmen.

Paul Adolph Volcker, Jr. from August 1979 to August 1987.

Alan Greenspan served as Chairman of the Federal Reserve of the United States from 1987 to 2006.

Benjamin Bernanke was a member of the Board of Governors of the Federal Reserve System from 2002 until 2005 and has been Chairman of the Federal Reserve since February 1, 2006. Mr. Bernanke sat in the Federal Reserve committee meetings with Mr. Greenspan through the recovery from the 2001 recession (and dot-com stock bubble burst) and the sweet recovery from 2003-2007.

Until after the 2008 financial crisis, the Federal Reserve only manipulated short-term Treasuries, never long-term Treasuries, and used a light touch. The bond market determined both short and long-term T-Bond yields.

The shape of the Yield Curve (yields of bonds of different maturities) was an indicator of the health of the economy. Normally, short-term Treasuries yield less than long-term Treasuries because it's risky to tie up money in a bond for a long time. However, before a recession, investors become more reluctant to lend short-term, so the short end of the yield curve rises. Inversion of the yield curve (when short-term yields are higher than long-term yields) was an indicator of impending recession.

The Dynamic Yield Curve from 2005-present tells the story. Pay particular attention to the yield curve inversion in 2007.

Since the 2008 financial crisis, the Federal Reserve has tightly controlled both short and long Treasury yields. The Yield Curve no longer can signal a recession -- it can't signal anything because it's controlled.

Now look at the Real Yields (inflation-adjusted). Paul Volcker did the heavy lifting to squash inflation by raising Treasury yields.

The markets accepted that inflation was contained long-term by the time Alan Greenspan became Fed Chairman. Mr. Greenspan kept 10-Y T yields in a 3%-ish band throughout the 1990s. After the 2001 recession (which had slow job recovery), the U.S. trade deficit exploded. Trading partners (such as China) bought Treasury debt heavily.

High demand for T-Bonds lowered real yields until the 10Y T yield was negative in 2005. This fueled the housing bubble as mortgage rates dropped.

The Federal Reserve raised the 3-month Treasury bill yield to over 5% in 2007, which brought the Real Yield to its historic average of 2.5%. The Yield Curve inverted as long term bonds didn't immediately follow. However, 10 Year bond yields did rise in late 2006 and 2007 to the historically normal real yield.

Once the abnormally low yields reverted to normal, the economy entered a recession and the housing bubble popped. Due to the enormous derivatives market, the popping of the housing bubble and job losses among mortgage payers became a crisis, not just a normal recession.

Ben Bernanke learned his lesson in 2005. Negative real yields support a "healthy" (i.e. rising) asset market. Historically normal rates cause a recession. He won't let that happen again.

"Stabilization" -- that is, reversion to a normal, unmanipulated asset and financial market which is naturally decentralized until the entire market panics together -- ain't going to happen.

Where does that leave us as investors?

Don't fight the least as long as Ben Bernanke is chairman.

The biggest bubble in history -- the U.S. Treasury bond bubble -- is magnified by derivatives, just as the mortgage bond bubble was.

For now, it's stable. Will the giant and growing fiscal and monetary imbalances last our entire lifetimes? How Japan-like is the U.S. situation?

I would prefer to see a mild, corrective recession in 2012 but I don't know if that will happen.

This economy is like living in a working-class neighborhood over a giant tectonic fault.

The Control Panel looks slow but steady, no danger. The fault line hasn't gone away and won't go away gently.

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