Government Intervention and Market Volatility
Amid the volatility in recent months, investors big and small have struggled mightily to gain a grasp of where the markets are going — in the process a number of them have lost their shirts. So why has the VIX reached levels unseen in its history? The answer is very simple: uncertainty. To understand why this uncertainty permeates the market, we must first look at the system from which it sprang.
Markets are supposed to serve as discounting mechanisms, and to reflect in a sense a forecast of the future. Even in good times, it is very difficult for knowledgeable and sophisticated investors to get it right — see Warren Buffet over the last year, among others. Not only does one’s thesis have to be right, but one’s timing is also crucial, and to combine these two things is very difficult; there is always an element of chance involved with success. No economic model can factor in everything that affects the economy, including human emotions such as fear and greed. But the market, when unhampered, is the most effective and unbiased mechanism to provide direction on the future.
Right now we see fear among market participants as reflected in the widespread liquidation in which investments across all asset classes (with the exception of US treasuries) are getting crushed, regardless of fundamentals. Perhaps this is so shocking to people because we were in a 25-year bull market, in which we forgot that values do not always rise. Some of the growth during this period was real due to technological advancements, liberalization of markets, and financial innovation. A significant amount of it was artificial — false prosperity generated by unnaturally low interest rates which led to a preponderance of investments across all asset classes. The euphoria that went along with this easy money served to amplify the size of the false wealth creation.
This is nothing new; it is in fact a recurring theme in economic history. Artificially low interest rates generate a boom in which there are malinvestments that need to be wiped out in the subsequent bust. There have been booms in tulips, booms in railroad companies, booms in real estate, and booms in entire nations. The constant is that easy money incentivizes people to take on more risk than they normally would, causing money to flush into the sector or nation of choice. It is only when the poorer investments are liquidated that the markets can return to equilibrium and reflect the true value of assets, laying the ground for new real growth.
This is the way our country functioned for a very long time. Throughout the 1800s and early 1900s, the United States experienced immense growth due to many factors, most notably unprecedented advances in technology. By the early 20th century, because of a relatively free market, the poorest people were able to live better than kings of the past. However, there was not uninterrupted growth; the country saw a variety of crises and panics. While they were sharp and painful, the government for the most part allowed the inevitable liquidations to run their course.
The Great Depression however set a precedent in which the government would no longer stand by when times got hard. Two of the voices on the opposite sides of this argument were Andrew Mellon, secretary of the Treasury, and President Herbert Hoover. Mellon, a fiscal conservative and laissez-faire advocate, argued (unpopularly) that liquidation should be encouraged by the government. Hoover framed the argument as follows:
The “leave-it-alone liquidationists” headed by Secretary of the Treasury Mellon felt that government must keep its hands off and let the slump liquidate itself. Mr. Mellon had only one formula: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate.” He held that even panic was not altogether a bad thing. He said: “It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.”
We might have done nothing. That would have been utter ruin. Instead we met the situation with proposals to private business and to Congress of the most gigantic program of economic defense and counterattack ever evolved in the history of the Republic. We put it into action…. No government in Washington has hitherto considered that it held so broad a responsibility for leadership in such times…. For the first time in the history of depression, dividends, profits, and the cost of living, have been reduced before wages have suffered…. They were maintained until the cost of living had decreased and the profits had practically vanished. They are now the highest real wages in the world.
Creating new jobs and giving to the whole system a new breath of life; nothing has ever been devised in our history which has done more for … “the common run of men and women.”
It would take the Dow until 1954 to reach its all-time high from 1929.
Yet in the wake of the 25 years lost in the markets, the lesson of the prolonged downturn was lost. The legacy of the regulations, agencies, and overarching philosophy from this period remained, albeit with a variety of other controls removed during the presidency of Truman. Over the years, the government has consistently intervened during recessions, generally by (artificially) lowering interest rates to reflate the economy. In this respect, the central bankers have been successful in that we have so far avoided anything reminiscent of the Depression.
In more recent times however, besides just starting up the printing presses after pricking the bubbles with higher rates, the government has also encouraged the propping up of failed enterprises. While there are numerous other examples such as with Chrysler a few decades ago and the Mexican peso in 1994, in recent memory the bailout of the Long Term Capital Management hedge fund was deemed “too big to fail” and was bailed out directly by the government. This set a highly dangerous precedent because it signaled to businesses that, if their balance sheets were big enough and if they were intertwined enough in the financial markets, they could reasonably expect to be bailed out if something went wrong. This moral hazard had begun in the Depression era when large sums of money (as today) were injected into financial firms, various industries gained protection and subsidization, and the FDIC was created.
Recently, the government has decided to bail out Bear Stearns, AIG, and Fannie and Freddie, but refused to bail out Lehman Brothers, Wachovia, or Washington Mutual. The government injected capital into some of its favored remaining megabanks as well. But once the government gets into the business of deciding winners and losers, this undoubtedly causes uncertainty in the market. Right now, the government is effectively doing this in requesting that struggling companies (mainly financial institutions) fill out applications to receive cash from the $700 billion bailout appropriation — and make no mistake about it: “cash from the appropriation” means our cash: our wealth is taxed, and this money is redistributed to different companies at the whim of a handful of politicians in Washington. If we had always propped up failing industries, how would we ever have advanced to where we are today? When people started driving cars, there were certainly a lot of upset horse-drawn-carriage operators put out of work. Was the cost of their loss of business greater than the benefit of the introduction of the automobile? But alas, this is for another essay.
In addition to determining winners and losers, the government has further led the market astray with its TARP, which is apparently now getting scrapped to some extent. One of the most telling things to come out of this is the fact that John Paulson, famed fund manager who made a fortune off of the subprime debacle swooped in and bought the very securities he had shorted after the announcement that the purchasing and eventual auctioning off of toxic mortgages by the government was no longer going to be implemented. When prices drop to certain levels, prudent investors will buy. This is the silver lining in recessions — overvalued assets become affordable.
One of the government’s other major adventures in the marketplace has been their temporary bans on short selling. The premise is that institutions were losing significant market capitalizations for reasons beyond fundamentals. This brought more artificial protection especially to the finance sector. The short sellers, already scapegoated now had injury to go along with insult as they were squeezed. Short sellers provide just as valuable a function to the market as permabulls. And if the short sellers really were wrong about the companies they cannibalized, then the people on the other sides of their trades would profit when prices rose. It is a zero-sum game. And of course, while those who shorted financial institutions were socked by the government, what of the people that brought the price of oil down in recent months? Were these people not evil short-selling speculators? The government again picks who wins and loses.
Fundamentally, all of these measures taken by the government have served to lead the markets down a perilous and volatile path. Deciding whom to bail out makes it very tough for market participants to determine what they should buy and sell, largely because fundamental valuation and analysis is less important than the swift pen stroke of a politician.
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Creating programs outside of the markets to try to support illiquid assets undermines the objective signals of markets in which value is measured by the market price. If assets are mispriced, then in the long run the market will make the necessary correction. If the government attacks people who make bets one direction or another, the result is a far less orderly and efficient deleveraging and liquidation.
If the bull run of the past quarter century is over, then the best thing that we can do is to urge Washington to keep its hands off of the market and let it function as it should. Any efforts to resist liquidation will ultimately lead to prolonged pain. We can’t have capitalism without profit and loss, without success and failure. Prices determined by markets show us the winners and losers. Capitalism without the rough edges is not capitalism at all.
Ben Bernanke’s Pretense of Knowledge
In response to the meltdown of financial institutions, unprecedented power has been unleashed by the federal government. Between actions by the Federal Reserve, the TARP, guarantees made by the FDIC, and other direct bailouts, the total comes to nearly $8 trillion. That’s over 30 times the inflation-adjusted cost of the S&L bailout, according to Bianco Research.
But the mainstream financial press is urging the Fed to do much, much more. “Look, this is no time for the Fed to act like a bashful virgin,” ex-Fed operative Vincent Reinhart told Barron’s. Reinhart used to be the director of monetary affairs under Greenspan and now toils for the American Enterprise Institute. Ironically, Mr. Reinhart says that because we are now in a “dangerous period,” the central bank “needs to be aggressively buying all sorts of paper, including toxic assets like collateralized debt obligations, non-agency mortgage-backeds and non-investment-grade corporate bonds in order to bring liquidity to the markets and raise security prices.” That would be the paper much of which was created during the monetary expansion ramped up by Reinhart and his former boss.
Of course Fed chair Ben Bernanke is doing all he can to disabuse any and all that he is a bashful virgin. “Although conventional interest rate policy is constrained by the fact that nominal interest rates cannot fall below zero, the second arrow in the Federal Reserve’s quiver — the provision of liquidity — remains effective,” he told the Greater Austin (Texas) Chamber of Commerce. Bernanke told the Chamber audience that the Fed could buy long-term Treasuries and other agency securities on the open market to raise prices and lower yields. Indeed, Bernanke’s employer purchased $5 billion worth of debt from Fannie, Freddie, and the Federal Home Loan Banks just a few days after he spoke.
All of this monetary pumping hasn’t put anyone to work. The labor department reports that 533,000 jobs were lost last month. And if part-time workers wanting full-time work and anyone who has looked for work in the last year unsuccessfully are added to those who are included in the official unemployment rate, the total amounts to a 12.5 percent unemployment rate, according to the New York Times, “the highest level since the government began calculating the measure in 1994.”
But the argument is that we must be patient with our wise men at the Fed and the Treasury. Monetary policy takes time to work, but, rest assured, the mistakes of the 1930s will not be made again. After all, Ben Bernanke is an expert on the Great Depression, we’re told over and over. He knows what to do to make sure it doesn’t happen again.
But as F.A. Hayek explained in his 1974 Nobel Prize acceptance speech, entitled “The Pretense of Knowledge,” monetary and fiscal policies are the product of what he called the “scientistic” attitude, which is in fact unscientific in that it “involves a mechanical and uncritical application of habits of thought to fields different from those in which they have been formed.”
Just as it was 34 years ago, when Hayek delivered this seminal speech, which is included in the soon-to-be published book A Free-Market Monetary System, there is the belief that there “exists a simple positive correlation between total employment and the size of the aggregate demand for goods and services; it leads to the belief that we can permanently assure full employment by maintaining total money expenditure at an appropriate level.”
So while Bernanke, Treasury Secretary Hank Paulson, and soon-to-be Treasury Secretary Tim Geithner think they can crunch the data, make a diagnosis, concoct the right monetary witch’s brew, and inject lots of it to make us all employed and living happily ever after, the fact is that’s impossible. In the physical sciences, that may work; but, as Hayek explains, “such complex phenomena as the market, which depends on the actions of many individuals, all the circumstances which will determine the outcome of a process … will hardly ever be fully known or measurable.”
The wise ones at the Fed and Treasury are only looking at factors that can be quantitatively measured and disregard any factors that can’t. Thus, “they thereupon happily proceed on the fiction that the factors which they can measure are the only ones that are relevant.”
No single observer could know all the factors determining prices and wages in a well-functioning marketplace. But because policy makers think they know, “an almost exclusive concentration on quantitative measurable surface phenomena has produced a policy which has made matters worse,” said Hayek back in 1974. Nothing has changed.
Bernanke and company are making matters worse by endlessly inflating and bailing out dysfunctional firms. The result will be more unemployment, not less. But not-so-bashful Ben is arrogant enough to believe that he can step on the monetary gas, make things all better, and then return the Fed balance sheet to normal (whatever that is). Perhaps Chamber members believed him when he said, “To avoid inflation in the long run and to allow short-term interest rates ultimately to return to normal levels, the Fed’s balance sheet will eventually have to be brought back to a more sustainable level. The FOMC will ensure that that is done in a timely way.”
The government’s money men are engaging in what Hayek referred to as “the fatal conceit,” thinking they have the knowledge to fix and plan the economy. They can and will only make matters worse.
Going the Way of France (1790)
First printed in 1896 and as unfortunately pertinent today as it was then, Dr. Andrew Dickson White’s Fiat Money Inflation in France chronicles the national suicide of an imposing empire that choked to death on one of mankind’s more foolish delusions — the stubborn belief that money does grow on trees. Dr. White’s style makes the book an easy read, even during the frightening parts that sound as if lifted directly from today’s newspapers.
Weighing in at a light sixty-eight pages, the book nonetheless packs a wallop. It is well-researched and — most surprising for a history book — full of laugh-out-loud moments. One-hundred-plus years have done nothing to diminish the effect of Dr. White’s prose.[1] Only in the author’s method of referring to the numbers involved — numbers that then seemed so fantastic yet are commonplace today — does the book show any signs of dating. This leads you to read, for example, “twenty eight hundred millions” instead of $2.8 billion — billions likely being beyond the thought process of the people of his time.
Not beyond ours, though; we’re up to a trillion.
File Under “Idea, Not a Good One”
The issue of paper will show that gold is not necessary.
Wisdom comes and goes; lessons are learned hard then hardly remembered. Mankind’s endless stupidity on the subject of paper money surely ranks up there in the realm of the sublime. We are forever like Charlie Brown, trying and trying to kick Lucy’s football. Generation follows generation, each refusing to learn one of life’s more important lessons — nobody must be allowed license to counterfeit. Fiat Money Inflation in France uses as its lesson plan the tragedy of France in the 1790s and Dr. White moves the tale along at a steady clip.
His prose is pointed but polite, and makes no bones about giving credit where credit is due. On the plus side of the ledger, he notes that France was not plunged into a decade-long economic pit by wild-eyed fools, but rather by calm, well-educated ones. The smartest guys in the room whose ideas brought about the tragedy “were universally recognized as among the most skillful and honest financiers in Europe” (p. 47).
Because France in 1789 was in an economic downturn, the idea that the difficulties were due to a lack of money — and that more of it would be nice — caught the imagination of many people. France boasted its own Bernankes, Paulsons, and Greenspans, and when not misthinking, they were off making the rounds of Parisian salons, talking peoples’ ears off about how fiat money, despite its disastrous history, could work if only done better — and better is what they intended.
Fiat money, declared the experts, was a means of “securing resources without paying interest” (p. 2). The idea promised that from nothing there would be something — or, as Keynes would later put it, from stone there shall be bread. Nobody was thinking this one through.
Soon the doctrine wormed into the ears of the French politicians who, upon having it explained to them that the plan called for them to print money whenever they wanted, were quickly convinced the whole thing was a splendid idea.
France in 1790 was on a gold standard, with the livre being the unit of measure, but the government would now issue paper money, too. It was to be backed not by gold but by church land stolen specifically for the purpose, and under the authority of The Will of the People. While France had just experienced a harsh lesson in paper money not too long before the coming madness — with John Law’s 1720 paper-money schemes — members of the French central government insisted that John Law’s paper notes did in fact bring prosperity, “and the ruin they caused resulted from their over-issue, and that such an over-issue is possible only under a despotism” (p. 4).
“We don’t live under a despotism!” everyone agreed, and promptly voted to issue $400 million livres’ worth of paper money, backed by the stolen church land and paying interest to the holder at three percent annually. Not five months later, $800 million more were printed, the notes not bearing any interest at all. With the currency now nice and elastic (before it all collapsed in 1796), the French politicians were madly printing money in secret, running the printing-press workers at a very un-French-like fourteen hours per day.[2] In less than six years, the French politicians printed over $45 billion in irredeemable paper — and that was when $45 billion was a lot of money.
It is where Dr. White outlines the effects of all this inflation on France that the book reads like today’s paper. Prices rose as the value of the currency endlessly fell; savings dwindled while debt loads rose; a spirit of gambling took hold, and bribery flourished. I just Googled those terms plus “America,” and we’re four for four.
Dr. White created the book from a series of lectures given during his time at Cornell University and the University of Michigan. Judging by how the book reads, he must have been quite the speaker. Describing Mirabeau’s impassioned 1790 speech in support of paper, he writes of its oratorical beauty, of how it was frequently interrupted by applause, yet how listening to the opinion of a man who never studied the subject he’s yammering about (Mirabeau knew nothing of economics) “was like summoning a prize fighter to mend a watch” (p. 18).
And that went for the rest of the French Assembly, too, bursting with plans to “fix” the economy but full of “men who had never shown any ability to make or increase fortunes for themselves (yet) abounded in brilliant plans for creating and increasing wealth for the country at large” (p. 17). They soon would fall back to the politician’s more natural road to wealth, as their newly found power to dispense endlessly available money made them obvious candidates to bribe for legislative favors. Dr. White tries to see the bright side by writing “it is some comfort to know that nearly all concerned were guillotined for it” (p. 30).
What is best about the book is that it is, at its base, a plea for the poor — an appeal to grant them the protection afforded by gold. Dr. White shows a progressive mind in his concern for the less fortunate, always the ultimate victim of inflation, which “creates on the ruins of the prosperity of all men of meager means a class of debauched speculators, the most injurious class that a nation can harbor” (p. 5).
Don’t we know it.
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