Jim Jubak on the Fed’s QE2
QE2 has touched off quite the furore lately, and from around the world, but among the most interesting comments are those from domestic investment professionals, who are charged with making money from madness. Throwing his hat into the ring today is Jim Jubak, from MSN Money. In an article entitled “Oops, has the Fed done it again?”, Jubak lays out the story behind QE2, and how it is just another step in a by-now-very-familiar cycle: pump up the money supply, watch the economy take off, the economy crashes terribly, so in response, pump up the money supply.
Happily, he also offers some investing advice. (Not that I endorse Jim Jubak or any professional stock picker, but if you choose to heed the advice, so much the better that you found it here.)
Let’s go through the article:
2000. 2007. 2011.
Is the Federal Reserve about to do it again? Is the Fed about to preside over the creation of another financial bubble?
Asset prices in the world’s emerging economies are climbing on the crest of a flood of dollars from the Federal Reserve. Central bankers in the world’s emerging economies have started to worry about what will happen if all the hot money flowing into their economies and markets suddenly starts flowing out.
“As long as the world exercises no restraint in issuing global currencies such as the dollar,” Xia Bin, an adviser to the People’s Bank of China, said, “then the occurrence of another crisis is inevitable.”
The only problem with this lead-in is the fact that it references only the past decade. In fact, the world is full of examples of monetary manipulation, asset bubbles, and currency crises. For a very good reference text (yep, it’s a whole book), I’d recommend Jesus Huerta de Soto’s Money, Bank Credit and Economic Cycles, published for free by the Mises Institute.
If you’re uncomfortable with a “hardline” Austrian viewpoint, I would also recommend the more “agnostic” financial history entitled “Devil Take the Hindmost,” by Edward Chancellor. For far more Keynesian take (but still mostly objective), I’d suggest the updated “Manias, Panics, and Crashes: A History of Financial Crises,” by Charles Kindleberger.
But 10 years after the bear market began in March 2000, the Nasdaq has barely recovered half its losses. From a high of 5,048.62, the market had clawed back to 2,578.98 at the close Nov. 5. That means the Nasdaq Composite Index is still down 49%.
True enough. Again, though we haven’t recovered from 2000, it seems the more important point is the fact that we haven’t learned our lesson from the late 17th century, when the first modern financial bubbles appeared in response to financial manipulation.
In the fourth quarter of 2002, when short-term interest rates were 1.23%, the real median price of a U.S. house was $197,219. (All these prices are corrected for inflation.) By the fourth quarter of 2005, the real median price was up to $262,634. That’s a 33% increase in the median price of a house in just three years — without inflation. That’s extraordinary appreciation for an asset like a family home in the United States.
And cheap money made it possible. It was possible to buy and flip for a quick profit. Possible to refinance and take money out to buy more stuff. Possible to buy more house than you could afford. Possible to find a lender who would lend you more than the house was worth. Possible to find a lender who wouldn’t ask questions about your income or credit record.
By 2006, this price appreciation had peaked. The median real price of a house that year ranged from $250,000 to $263,000. But by the second quarter of 2007, it had dropped below $250,000. And it kept on dropping. By the bottom, which nationally may have been the first quarter of 2010, the real median price of a house was down to $169,158.
That’s a drop of 36% from the 2005 quarterly peak to what may be the bottom in 2010. (And because the house they live in is by far the most valuable asset most families own, and because home ownership rates in the United States are much higher than stock ownership rates, that 36% drop in housing prices was more devastating for most families than a 77% drop in stock prices.)
There’s your housing crisis in a nutshell. This is why the 2008 downturn has been called the most devastating since the Great Depression, but it isn’t surprising that housing was affected. Capital investments, including hard assets and real estate are very prone to overinvestment (“malinvestment”) in the Austrian parlance when credit is artificially cheapened.
And now on to the present:
That track record suggests that “What, me worry?” isn’t a reasonable response to the Federal Reserve’s two rounds of quantitative easing, a strategy that pumps money into the economy to try to get it moving more quickly. The first round, which ended only this spring, saw the Fed buy $1.7 trillion in Treasurys and mortgage-backed securities. The new round announced last week would add $600 billion of Treasury buying to the total.
The dangers of these two programs to the U.S. economy are scary enough. The Federal Reserve is buying all these debt instruments on the cuff. The Fed doesn’t actually have the money to pay for these purchases. Instead, it is creating dollars out of thin air — printing them, figuratively at least — and at the same time creating a huge liability on the Fed’s own balance sheet. Of course, the Fed may be able to pay off that liability by selling the bonds back to the market someday, but you’re entitled to wonder where the buyers for $2.3 trillion in U.S. debt and mortgage-backed debt are going to come from.
If you’re the kind of person who worries when you see a big debt and no obvious way to pay it off, then the Federal Reserve’s current balance sheet undoubtedly worries you.
Why yes. Yes it does. In investment terms, the short-run questions are which assets will be pumped up, but the real long-term question is when will the next crash be, and how much worse will QE1 and QE2 make it? Unfortunately for the rest of the world, the fact that we’re dynamiting our own financial system is not something that other countries can sit on the sidelines and watch. Given the prominence of the United States and its dollar, we are affecting the entire world. And the results will not be pretty. Jubak again:
But those aren’t the possibilities that worry me most or that have overseas central bankers screaming in protest. The big problem is what will happen to that $2.3 trillion created by the Fed. The dollars certainly don’t all stay in the United States.
So far, China, India, Germany and Brazil have been very public in their disdain for our reckless wielding of this financial A-Bomb. I doubt it stops there, especially when the defaults begin. You’ll note that Brazil has been critical; they’ve also been a serial defaulter. Just as speculators plugged money into housing in 2004, watched it soar, and then lost their shirts when it came crashing to earth in 2008, so I fully expect at least one country to take off on the back of asset inflation, excite investors as the “next big thing,” and come crashing spectacularly down several years from now in one big default. It would not surprise me if Brazil falls into that category. Of course, we’d better hope China doesn’t – they have nukes.
And speaking of nukes, the inimitable Peter Schiff has an article today in the Business Insider entitled “Bernanke is Engaging in the Monetary Equivalent of Nuclear War.” An excerpt:
As the world awaits another $600 billion flood from Bernanke’s printing press, central bank governors from Brasília to Tokyo are preparing to respond in kind. This is the monetary equivalent of a nuclear war, except instead of radiation, bombs of inflation threaten to make the world economy uninhabitable for saving and productive enterprise.
…Chinese Commerce Minister Chen Deming said as much in an interview on October 26: “Uncontrolled” issuance of dollars is “bringing China the shock of imported inflation.” Most emerging markets are the same way. In order to prevent rapid economic dislocations, and often to appease their powerful export lobbies, these countries seek to maintain a status quo versus the dollar – whether through inflation as with China or capital controls as with Brazil and South Korea, or both.
In short, the currency war is really just the rest of the world trying to shield itself from a barrage of nuclear dollars.