Thoughts about 2008
What’s going on in the world? I’d characterize 2008 as “A Year of Change…But What Year Isn’t?” The current crisis is always the most severe crisis because we tend to lack a historical perspective. Part of the reason this year has been so devastating to portfolios and injurious to the economy is that public policy has been so bad. For example, the target federal funds rate was 1% back in June 2004. Beginning June 30, 2004, the Federal Reserve began raising that rate in 25 basis point increments to 5.25 by June 29, 2006. Ben Bernanke took over the Chairmanship of the Federal Reserve Board on February 1, 2006. So, my take on the situation is that Greenspan’s easy money policy caused a broad asset class price bubble. His sudden about-face in 2004 led to the popping of the bubble; but, since monetary policy operates with a lag, the bubble popped under Bernanke’s watch instead of Greenspan’s. In short, “The Maestro” was really “The Misfit.” But that’s my opinion.
Former Fed Governor Fred Mishkin said that industry is the body of the economy while the financial system is the brain. Since October 2007, we have seen what happens when “the brain” gets confused. When the brain goes, the body begins to falter. The popping of the housing bubble could have been nicely contained, but The Brain got confused because Hank “The Crank” Paulson decided that he should be Emperor and decide who lives and dies in the arena. When he decided to bail out Bear Stearns but to let Lehman die, that was the first thumbs down for the financial system. Then, he wanted to expand his power with a three page piece of legislation that would give him not only arbitrary authority, but capricious power as well. He wanted to buy what he wanted, when he wanted, at whatever price he wanted. That seized up the credit market because why would anyone holding an asset sell it to someone else when they thought there was a high probability they could off-load it to the Greater Fool that is the Treasury? In short, the Treasury thought the credit markets were seizing up and their poor policy decision made it seize up further. That created a macro-level sell-off of the equity markets and a massive flight to safety to Treasury Bills.
When The Brain suffers, the Body suffers. That’s why we had a dramatic decline in consumer confidence, retail sales, and overall output. The economic doldrums are somewhat misleading though. A lot of the statistics that are focused on are year-on-year changes in the variables. One good question that nobody is asking is whether the base year of comparison was at the appropriate level? For example, retail sales for November came in at $355.7 billion. That was a 1.8% decrease from the previous month and a 7.4% decline from a year prior. Are we to conclude that current retail sales were too low, or that previous sales were too high? Considering the practically non-existent savings rate from previous years, I would suggest that maybe retail sales numbers were too high.
Now, it looks like the big concerns are: (1) what’s with all the money the Fed is pumping into the economy and (2) what’s on the horizon with the Obama administration?
For the Fed, considering the Federal Reserve has expanded its balance sheet from assets of $943 billion (Jan. 2, 2008) to $2.3 trillion (December 24, 2008), there is good reason to be concerned about whether this will be inflationary. The Fed’s balance sheet is not the same thing as money. Most of the increase has been in the form of bank reserves, which are not being passed on in a one-for-one manner into increased availability of credit in the economy. Even though bank reserves have increased by 143%, MZM (Money of Zero Maturity) has increased by a mere 8% over the same time frame. What that means is that the Fed’s pumping of reserves into the banks is not being pushed into the economy with an increase in transactions for goods and services. Banks are using those reserves to bolster their capital since investors are paying premium prices for banks that have strong capital positions compared to those that are have less equity. Inflation would be a problem if banks and non-bank lenders suddenly decided to revert to the lax lending practices of the past few years. Just as quickly as the Fed can push reserves into the system, so too can they pull it out.
The Federal Reserve just announced on December 30th their MBS program where they will purchase mortgage backed securities from their primary dealers. This has the possibility of putting the added liquidity into the non-bank private sector instead of just into the banks. This could be a problem for inflation since this type of policy is not as easily reversed. However, one nice thing about the Fed’s new program is that their intention is to hold the purchased securities to maturity. That’s what the Treasury program should have done! The Fed is now trying to bailout the Treasury.
Now that Fannie Mae and Freddie Mac are under the conservatorship of OFHEO, their debt is fully backed by the U.S. government. As a result, the Federal Reserve can now purchase as many of their securities as they want without regard to the maturity of the debt. Previously, they were limited to purchases with a maturity of 6 months, but now they can start manipulating long-term mortgage rates through the purchase of longer-term Freddie and Fannie debt. This is a dramatic policy move that I don’t think the markets will fully appreciate for a while. Effectively, this allows the Federal Reserve to indirectly get involved in the making of home mortgage loans through Fannie and Freddie. This power is limited to $500 billion, but basically the Fed is now a mortgage lender and mortgage rates will continue to descend. Couple this with the Treasury’s new $6 billion program for the auto-industry to promote free money for the purchase of cars and you have a belated Christmas present for the housing and auto industry.
Cheap money being thrown after assets that nobody really wants/needs at market prices is NOT a good solution. Housing was overbuilt. A few years ago, the US auto-industry made a good bet on SUVs, but a bad bet on making their production facilities inflexible to adapt to the changing tastes of consumers. Painting over the problem does not get rid of the problem. Economic recessions are caused by businesses producing goods or services that people no longer want. The old Keynesian paradigm was to increase deficient demand through expansive government spending. That’s the backward way of dealing with this problem. The better solution is to focus on the supply side to get businesses to switch their production to what’s demanded, not to have the government step in to buy what the private sector doesn’t demand.
So, 2009 will likely be either really good for the markets or really bad. I do not suspect it will be somewhere in between. The most recent consumer confidence number was disgustingly low, yet the markets bounced up. That shows that the market is primed for a rally. If the government steps in with some old demand management policies, there may be a broad-based rally in the equity markets but it will be short lived. If the government cuts taxes and rewards investment in capital goods, there may be hope that a rally could be sustained. Otherwise, I’m in cash. But that’s just my opinion.
Brian J. Jacobsen, Ph.D., CFA, CFP®