John Hussman on QE2, Bernanke’s Recklessness, and the Fed’s Constitution-Abusing Quasi-Fiscal Role

John Hussman is always worth reading, and his current missive is a hum-dinger. I’m extracting some key bits below, and urge you to read it in full.

Note that Hussman is far from alone in chiding the Fed for encroaching on Constitutionally-mandated budget processes, including former central bankers. From Willem Buiter:

As regards democratic accountability for the use of public funds, even if the central bank has sufficient capital to weather the capital losses it suffers on its holdings of private securities, the central bank should never put itself into the position of becoming an active quasi-fiscal player, nor a debt collector. The ex-post transfers or subsidies involved in writing down or writing off private assets are (quasi-) fiscal actions that ought to be decided by and accounted for by the fiscal authorities. The central bank can act as a fiscal agent for the government. It should not act as a fiscal principal, outside the normal accountability framework.

The Fed can deny and has denied information to the Congress and to the public that US government departments like the Treasury cannot withold . The Fed has been stonewalling requests for information about the terms and conditions on which it makes its myriad facilities available to banks and other financial institutions. It even at first refused to reveal which counterparties of AIG had benefited from the rescue packages (now around$170 bn with more to come) granted this rogue investment bank masquerading as an insurance company. The toxic waste from Bear Stearns balance sheet has been hidden in some SPV in Delaware.

The opaqueness of the financial operations of the Fed in support of the financial sector (which are expanding in scale and scope at an unprecedented rate) and the lack of accountability for the use of tax payers’ resources that it entails, threaten democratic accountability. Even if it enhances financial stability, which I doubt, democratic legitimacy and accountability are damaged by it, and that is too high a price to pay.

From Hussman (hat tip reader Scott):

Given that interest rates are already quite depressed, Bernanke seems to be grasping at straws in justifying QE2 on the basis further slight reductions in yields. As for Bernanke’s case for creating wealth effects via the stock market, one might look at this logic and conclude that while it may or may not be valid, the argument is at least the subject of reasonable debate. But that would not be true. Rather, these are undoubtedly among the most ignorant remarks ever made by a central banker.

Let’s do the math.

Historically, a 1% increase in the S&P 500 has been associated with a corresponding change in GDP of 0.042% in the same year, 0.035% the next year, and has negative correlations with GDP growth thereafter (sufficient to eliminate any effect on the long-run level of GDP). Now, even if one assumes – counter to reasonable analysis – that the GDP changes are caused by the stock market changes (rather than stocks responding to the economy), the potential benefit to the economy of even a 10% market advance would be to increment GDP growth by less than half of one percent for a two year period.

Now, as of last week, the total capitalization of the U.S. stock market was at about the same as the level as nominal GDP ($14.7 trillion). So a market advance of say, 10% – again, even assuming that stock prices cause GDP – would result in $1.47 trillion of market value, and a cumulative but temporary increment to GDP that works out to $11.3 billion dollars divided over two years. Moreover, even if profits as a share of GDP were to hold at a record high of 8%, and these profits were entirely deliverable to shareholders, the resulting one-time benefit to corporate shareholders would amount to a lump sum of $904 million dollars. In effect, Ben Bernanke is arguing that investors should value a one-time payout of $904 million dollars at $1.47 trillion. Virtuous circle indeed.

One of the main reasons that stock market fluctuations have such a limited impact on real output is because investors correctly perceive these fluctuations as impermanent – particularly when they are detached from proportional changes in long-term fundamentals. Recall that the primary source of the recent financial crisis was excessive debt expansion, consumption, and speculative housing investment. Consumers observed persistently rising home prices, and inferred that they were “wealthy” enough to shift their consumption forward by borrowing against that perceived “wealth.” A key to this dynamic was the fact that U.S. home prices had never experienced a sustained decline during the post-war period, so the increases in housing wealth were indeed viewed as permanent. As Milton Friedman and Franco Modigliani demonstrated decades ago, consumers consider their “permanent income” – not transitory year-to-year fluctuations – when they make their consumption decisions.

Rising home prices were further promoted by a combination of lax credit standards, perverse incentives for loan origination, a weak regulatory environment, and a Federal Reserve that sat so firmly on short-term interest rates that investors felt forced to reach for yield by purchasing whatever form of slice-and-dice mortgage obligation the financial engineers could dream up. Rising home values provoked more debt origination, and even higher prices. What seemed like a “virtuous circle” was ultimately nothing but an overpriced speculative bubble with devastating consequences….

It is difficult to interpret Bernanke’s defense of QE2 as anything else but an attempt to replace the recent bubble with yet another – to drive already overvalued risky assets to further overvaluation in hopes that consumers will view the “wealth” as permanent. The problem here is that unlike housing, which consumers had viewed as immune from major price declines, investors have observed two separate stock market plunges of over 50% each, within the past decade alone. While investors have obviously demonstrated an aptitude for ignoring risk over short periods of time, it is a simple fact that raising the price of a risky asset comes at the sacrifice of lower long-term returns, except when there is a proportional increase in the long-term stream cash flows that can be expected from the security.

As a result of Bernanke’s actions, investors now own higher priced securities that can be expected to deliver commensurately lower long-term returns, leaving their lifetime “wealth” unaffected, but exposing them to enormous risk of price declines over the intermediate (2-5 year) horizon. This is not a basis on which consumers are likely to shift their spending patterns….

To a large extent, the Fed has assumed the role of creating financial bubbles because we have allowed it. The proper role of the Federal Reserve, and where its actions can be clearly effective, is to provide liquidity to the banking system in periods of financial stress or constraint, by replacing Treasury bonds held by the public with currency and bank reserves. But to expect the Fed to somehow bring about full employment is misguided. To believe that changing the mix of government liabilities in the economy (monetary policy) is a more important determinant of inflation than the total quantity of those liabilities (fiscal policy) is equally misguided…

We are betting on the wrong horse. When the Fed acts outside of the role of liquidity provision, it does more harm than good. Worse, we have somehow accepted a situation where the Fed’s actions are increasingly independent of our democratically elected government. Bernanke’s unsound leadership has placed the nation’s economic stability on two pillars: inflated asset prices, and actions that – in Bernanke’s own words – should be “correctly viewed as an end run around the authority of the legislature” (see below).

The right horse is ourselves, and the ability of our elected representatives to create an economic environment that encourages productive investment, research, development, infrastructure, and education, while avoiding policies that promote speculation, discourage work, or defend reckless lenders from experiencing losses on bad investments.

There is a great deal more thoughtful material in Hussman’s newsletter, which you can read here.

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  1. F. Beard

    Why should any thing the Fed does be surprising? We have an insane and unstable money system and the Fed is in charge of it.

    Rather than directly address the injustice of the system and bailout the victims (and BTW, fix the banks), which only the Federal Government can do, the Fed does all it can do which is only to save the banks.

    So now we will all pay higher prices for food because the Federal Government is morally clueless and yet the debt will still remain.

    Shall we next have WW III to cap off GD II?

  2. Tao Jonesing

    “It is difficult to interpret Bernanke’s defense of QE2 as anything else but an attempt to replace the recent bubble with yet another – to drive already overvalued risky assets to further overvaluation in hopes that consumers will view the “wealth” as permanent. ”

    Bernanke’s defense of QE2 is nothing but kabuki theater. There’s nothing to be gleaned from it. Indeed, Bernanke’s defense of QE2 is nothing more than an invitation to engage in “anchoring and adjustment” (Ben is supplying the anchor, which is very far away from the truth, hoping that we will incrementally adjust around that anchor; i.e., he’s limited our ability to see the true motive of QE2).

    What is the true motive? To help prevent the continuing collapse of the last bubble from crushing the banks that caused it by putting more reserves on their balance sheets to guard against the comnig writedowns. QE2 is all about the last bubble, not the next one. (Yes, we’re going to see a lot of speculation in commodities that are consumer staples, but that won’t arise to the level of a bubble before it starts creating new rounds of layoffs.)

    1. Doug Terpstra

      Love the cutback on Christmas shopping, down to necessities—including more ammo.

      Good stuff: “Ben Bernanke has, despite a promise not to do so, has monetized the debt. make no mistake, it is a “Hail Mary” pass of epic proportions and of massive desperation. That was the last play in the Book. There is nothing more Ben Bernanke can do, except RAISE interest rates when inflation comes calling and/or when the economy comes crumbling down. That’s it.”

      Only exception is to: “…the loony left that has capture[d] the heart and soul of the Democrat party.” It’s 180-degrees off. Obama is a decidedly bankster-friendly, warmongering DLC Neocon—a fascist, yes, a socialist, NOT.

      1. Patriot

        You can see how 2 generations of Cold War propaganda has left people completely ignorant.

        I talk to Tea Party folks pretty regularly– when I say, oh, no Obama’s not a socialist, that might be a good change, it’s fun to watch their mouths fall open. They’re defenseless at that point.

  3. Jason Tisler

    As long as Ben & Co insists on crashing the dollar, I’ll be holding my nose and staying in stuff like GLD and EEM, even though they have run up so much. Recently also went to NAFAX as wall street journal and Time have been singing the praises of africa investments. Anything else out there worth putting my money into? I just don’t like how the dollar is looking worse and worse everyday.

  4. Paul Reptock

    Did Mr. Hussman air the same critisism of Greenspan? Much as I despise the actions of the Fed in general and QE I in specific, Mr. Bernake is consistent. He is by default continuing Greenspan’s program with the only tool he has left. After all, it is difficult to make people understand the mechanics of a negative interest rate, so the only thing he could do is give money away. If the government had not been doing this the banks and foreign investors would have pulled the plug on the American economy some time ago.

  5. Doug Terpstra

    Hussman is brutal with Greenspan: “by irresponsibly promoting reckless speculation, misallocation of capital, moral hazard (careless lending without repercussions), and illusory ‘wealth effects,’ the Fed has become the disease.”

    “Alan Greenspan contributed to the late-1990’s market bubble by his embrace of the notion that 100 million lemmings leaping off of a cliff into the ocean can’t be wrong. Beyond a single bit of rhetorical lip service to the effect of “how do we know when irrational exuberance has unduly escalated asset values,” Greenspan aggressively accommodated that bubble. Once it crashed, the Fed sat on short-term interest rates in a way that directly contributed to the housing bubble.”

    Greenspan and Bernanke follow Rothschild’s maxim, “Give me control of a nation’s money and I care not who makes it’s laws”. Thus, they have privatized our nation’s money creation as a counterfeiting racket —turned the country into a casino, where the house always wins in the long run; but most of the players are ruined unless or until they wise up.

    “The first truth is that the liberty of a democracy is not safe if the people tolerate the growth of private power to a point where it becomes stronger than their democratic State itself. That, in its essence, is fascism – ownership of government by an individual, by a group or by any other controlling private power.” – Franklin D. Roosevelt

  6. Rick Halsen

    At the rate things are going, I’m now thinking that WWIII will ultimately be against the Fed. They’re doing a very, very, fine job of major-league pissing off not only our enemies but the few friends we have left.

    It’s as if they have suicidal tendencies hence not caring a whit what happens to everyone after they’re gone or the aftermath of their damage.

    IOW, we have an institution that’s for all intents and purposes clinically insane, aggressively anti-social, and in effect an extreme danger to society in general.

    So what do our elected leaders do against them? Apparently nothing worse than double-secret probation.


  7. FX

    John Hussman’s weekly commentaries are superb and I never miss them. We need him involved with the Fed.

  8. Paul Repstock person I can and will avoid ever reading again is “Bloggy Bayou”. He sounds like Glen Beck in a white sheet and pointy hat.

    How can anyone (other than for racist reasons), demean Mr. Obama, in favour of Mr. Bush and company.

    When as seems to have happened, one jumps out of the fire into the frypan, it makes no logical sense to jump back into the fire.

    The scrabbling vested interest partisanship seem to make it impossible for these people to understand that the alternative is not to be found in choosing between “The lesser of two weavils”. The National pride of the American people seems to have been sacrificed on the altar of greed and expediency.

  9. razzz

    It is a Congressional problem.

    Elected leaders screw their own people.

    Congress has control over the Federal Reverse and the US Treasury.

    They are all complicit.

  10. ds

    I agree with a lot of points Hussman makes. Monetary policy is not as effective as fiscal policy. Bernanke and others who believe in the new-consensus macroeconomics religiously pushed the opposite idea. During the boom years, they took credit for the ‘Great Moderation’, and actively subjugated the role of fiscal policy while blithely ignoring the unsustainable growth in both trade balances and in our financial infrastructure. And now when everything has collapsed and monetary policy is out of bullets, they wonder why there is no political motivation whatsoever for fiscal policy.

    That said, I still don’t understand what Hussman’s problems with QE are specifically. The alternative to QE is higher interest rates and higher yield-spreads, both of which are worse for the real economy. If QE is the incorrect call, what then should the Fed do? Raise rates? If so by how much?

    Bernanke & co. have certainly erred in many ways, but QE and QE2 are the correct calls, especially in light of the fact that fiscal policy is completely off the table.

    1. Paul Repstock

      It may possibly be that raising rates is the logical step. Certainly until they do that, banks will not be icentivised to lend. At zero percent we all know they cannot fall further except by more QE??

      My fear is that the banks will not lend anything till the rates are near 10%. This will put the really disgusting icing on the cake. The banks being so obscenely rewarded for the damage they have done. Sadly a charter from the Fed is just a licence to steal.

      IDK about Mr. Hussman’s problems with QE; Mine is that it is a means of raping the other half of the population. The people on fixed incomes and those who still had savings. If it contimues then nobody but banks and large corporations will have any money.

      The only way out of that moral box would be for the government to impose a rate cap…LOL. I won’t hold my breath.

  11. Bill

    It seems to me the Fed is just giving lip service to their “mandate”?!? , to keep employment high and inflation low . Its almost a mantra of meaningless drivel , soaked up by the populace , and our uber governors in Washington . Just more propaganda . To keep it simple . Its easy to tell if Bernanke & Co are lying . Their lips are moving . The middle class has no purpose anymore here in America , no purpose to those we have elected , nor to those in power unelected . Our last visages of wealth and income are about to be snuffed out. Through Inflation , Taxes , Income theivery from the highest levels . We are likely to never see a wealth effect again . Whats left to have the effect from . Stocks are no good as value unless one sells them – then the cash value is realized – they too are only worth what the next greater fool is willing to pay . May we not be that next greater fool . End the Fed !!!

  12. Brick

    Various voices including those from PIMCO have derided QEII, but pointed out that they will make money from it. What was interesting was Goss’s argument that the FED acted because government will not. They will not review spending and cut back where it can and they will not provide stimulus where it is needed. Perhaps the message the FED is sending out is that the government is too slow, too conflicted, too into intrigue, too influenced by lobbying, too focused on their own interests to do anything to help the economy and general population. Perhaps the message from the FED is that the underlying data devoid of manipulation is so bad that the economy is ready to implode and a gamble on QEII is worth a try. What does it mean if the FED and other agencies are starting to imply US government does not work.
    This statement by Ben quoted in the Hussman report suggests he probably knows that things are desperate.

    “Nonstandard open-market operations with a fiscal component, even if legal, would be correctly viewed as an end run around the authority of the legislature, and so are better left in the realm of theoretical curiosities.”

    This second quote though is what really worries me about the Fed Actions.

    “The general argument that the monetary authorities can increase aggregate demand and prices, even if the nominal interest rate is zero, is as follows: Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero.”

    There is an assumption here that higher prices are good and wages will immediately follow prices. If wages are sticky for too long then high prices damage the economy in the short run, perhaps enough to offset the longer term gains. There is also a bit of an assumption that the rest of the world and the investment community will stand for this. I am also concerned that any attempt would be front run such that aggregate demand and prices get way out of step with each other. In essence there are too many assumptions that some things will not change in the mean time and assumptions that some things will. Either way the Hussman Report is right to point out that the cost eventually comes in further down the line.

    1. ds

      I agree with you to an extent. It does seem to me that the Fed is doing QE because Congress is doing nothing. Given how the target maturities of QE match the duration of government debt, it appears Bernanke is almost screaming at government to deploy further fiscal measures. Ultimately though, there is no chance of new stimulus and Bernanke’s power is limited. On balance, views of the other Fed governors are pretty hawkish, so its kind of a coup that any QE got done.

  13. Just a thought...

    I found the Hussman piece interesting until…

    “The right horse is ourselves, and the ability of our elected representatives…”

    “Ourselves,” yes. “Elected Representatives,” no. The Federal government, headed up by your elected representatives, was wholly complicit in causing the crisis and is currently making no credible moves to address the problems they created. For recent evidence, look no further than Bachus telling regulators not to enforce regulations.

    Our elected representatives will not represent the people until such time that the endorsements and money of corporate interests are removed from the political process. The sad joke is that the ‘change’ from last Tuesday’s vote will ultimately be a rehash of failed policies from before the crisis versus the failed policies from the last two years. Isn’t change great.

    Hussman talks about treating the disease and the symptoms in his piece, but if he can’t recognize that corporate corruption of our current political system is the disease and everything else is a symptom, including the Fed, which stopped operating independent of Federal/Treasury policy a long time ago, there is little reason to assume any value in Hussman’s opinions.

    I’m almost amused by people who direct their anger at the Fed given the complete lack of independence of the U.S. central bank. Maybe it is time to shut down the Fed and see what changes. By the way, the answer is nothing. Policy implementation will merely get shifted from a large board room in D.C. to a much smaller office in D.C.

  14. Ray L Phenicie

    I’m plowing through Viral V. Acharya and Matthew Richardson’s analysis of the ongoing financial crisis (it has a somewhat wishful title of “Restoring Financial Stability”) and found this bit which is directed at Treasury’s original bailout. This can be applied to the Fed’s actions as well. . .’the plan appears to be providing a large transfer of wealth from the taxpayers to the financial sector without significant returns and without resolution of the credit crunch at hand.’

    So let me see if I have the essentials of QE II.
    1. Fed buys back long term government bonds from the banks.
    2. Banks now have even more reserves of cash.

    Then what will be done with these reserves?

    I can guess I won’t see any of it nor will many of the readers of this blog. What will happen is that some garment factories in Bangladesh and China will be getting more funds to upgrade the computers for their pattern cutting machinery. Then we can purchase those garments at steep discounts from retailers like Target and Walmart.
    ‘ Hey Joe, my handy dandy broker, got any deals for me floating around? I’s short $2 mil for that new yacht I was eying and the yachting season is only six months away.’
    ‘ Sure thing Mr. Doaks, I have this deal floating up from some overseas garment makers.’

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