Short Term Gain, Long Term Pain

The Federal Reserve announced last week its intention to purchase $300 Billion in U.S Treasury bonds. On the surface, this may seem to be positive, a vote of confidence of sorts. However, if you go below the surface you see that this is the Fed’s loudest and clearest statement to date about just how dire the economic outlook is. This was not a surprise move, the Fed had announced some time ago its intention to purchase treasuries. In the Fed’s eyes, being the buyer of last resort was inevitable and needed to underpin the economy. However, this move would not have been necessary if individual investors and governments were willing to continue buying and holding U.S. treasury bonds. Due to the U.S. economy, there has been a clear lack of interest to stay invested in low-yielding treasuries and the U.S. dollar. Recently, the main buyers of bonds have been speculators looking to unload when the Fed commenced buying. These are short-term traders, not long-term investors.

The Fed is in a tough spot. It has ballooned its balance sheet to encourage bank lending and consumer spending. But its efforts have not had a great affect on the economy. Since it cannot cut the Fed Funds Rate any further, it must now attack the problem from another angle. By purchasing bonds, it drives up demand, which in turn drives up the price of bonds. This in turn pushes bond interest rates down, taking mortgage rates with it. Mortgage rates will fall, and bond sellers will have an influx of cash to re-invest in the economy. Banks will lend again, and consumers will borrow at low rates. Sounds like a good plan, right? Not so Fast.

The Fed has displayed a willingness to continue printing money to grow the money supply and now to buy treasuries. Although this policy may succeed in halting the slide of assets like real estate and stocks, this feat comes with a huge price. Every dollar printed to buy bonds or increase the money supply results in more inflation and a continued debasing of the dollar, eventually sending our cost of living through the roof. In the future, this could be a more severe problem than the one we now face. Upon the Fed announcement, other currencies jumped against the dollar, as did gold. The Chinese Premier publicly expressed concern about China’s enormous investment in the U.S. China is the largest foreign creditor to the United States. Whether they will continue to buy low-yielding treasuries when they could earn better returns elsewhere is in question. Worse still, they could decide not to hold existing bonds to maturity, choosing instead to unload them.

To understand why Chairman Bernanke took these steps, consider this. He is well known as a student of the Great Depression. He knows that monetary policy on the part of the Federal Reserve in 1928-1929 played a great part in causing the stock market crash in October 1929, and subsequent depression. During those 2 years leading up to the crash, stocks shot up 90 percent. In recent years, from 2003-2007, the DJIA has had a similar rise. In both situations, the boom was largely artificial. Sensing the problem, in 1928 and 1929 the Fed started raising interest rates and selling government securities in an attempt to slow down spending. Those in the know then began selling stocks and buying gold. A similar pattern has been repeated in the last 2 years where gold is up nearly 50%. Bernanke, knowing very well what happened 80 years ago and seeing similar signs recently, is doing the exact opposite of what took place at the hands of the pre-Great Depression Fed in an attempt to avoid the same fate. Instead of raising interest rates, he has been aggressively lowering them. Instead of selling government securities, he has announced the largest purchase of long-term bonds since the 1960’s. Instead of constricting the money supply, he has been greatly expanding it.

At what point, however, does the cure become worse than the disease? While some great initiatives and important Acts came out of the Roosevelt’s New Deal, massive government intervention has never resulted in prosperity and growth. Even Roosevelt’s own Treasury Secretary six years into the New Deal, conceded that there was just as much unemployment as when that administration began, and in addition, enormous debt had been added. New Deal proponents argue that GDP increased 60% during those years, which is true. Omitted is the fact that the national debt nearly doubled in the same period. Unemployment remained in double digits throughout the New Deal and did not recede into single digits until we entered WWII. By the end of the war, it was 2%. The U.S. emerged from depression, but whether this was due to, or in spite of the New Deal is a matter that could be debated.

A recent Newsweek cover showed Uncle Sam with the words “I Want YOU to Start Spending!” Uncle, that’s how we got into this problem. We’ve become a nation of borrowers and over-consumers in an economy that has become largely service based. At some point we moved away from saving and producing in a manufacturing economy. Japan suffered through recession for years because they were unwilling to take the pain and correction, and instead prolonged an economic recovery. And Japan is a country with a high savings rate, trade surpluses, and a manufacturing based economy. The U.S. has none of the above.

I hope Chairman Bernanke is right. I hope the housing and stock markets find a bottom, unemployment peaks, and the credit markets start functioning again. Then, the real test will come. There is a tremendous amount of money on the sidelines, waiting. When individuals and businesses again have the confidence to open their wallets and start spending, Uncle Sam may get his wish, in spades. I hope then, that Chairman Bernanke has a great sense of timing regarding policy change. I also hope, for our sake, that he has the political gumption necessary to be as aggressive in stopping a runaway inflation train as he has been to throw everything he has at the recession. Otherwise, the cure may be worse than the disease.