Don Coxe is chairman of Coxe Adivsors LLP and is an advisor to several commodity funds. He has been consistently ranked as a top portfolio strategist and received a lifetime achievement award from Brendan Wood in 2011. He will be sharing more insight with Inside the Market readers next month.
It was so easy for so long… For almost five years, the Fed and the Treasury, and the Bank of China and the Politburo, have been printing and lending money at a rate that might have drawn approbation from the Bank of Weimar.
Once the shadow banks – hedge funds here, and state and local enterprises there – understood that they had no interest rate or volumetric risks to constrain their borrowing, they became the premier users – and abusers – of “financial heroin.” (In 2009, in our discussion of The Power of Zero , we coined the term “financial heroin” for the seemingly limitless liquidity being injected into the veins of the economy; the biggest and baddest banks were mainlining, and we deemed this a habit that would be hard to break.)
Money supplies exploded in both of the world’s biggest and most influential economies. Interest rates dove and stayed stuck at levels that central bankers believed would lead to sustained growth.
Across the industrial economies, five years of unprecedented monetary expansion were accompanied by deficits at levels that Keynes would have deemed guarantors of strong growth.
So why haven’t these drastic policies worked? Why, for example, are companies sitting on cash with near-zero returns or using it to buy back stock rather than investing for future earnings growth?
First, we must understand why the hectic monetary policies and zero interest rates have lasted for so long.
Dr. Bernanke gave a series of lectures last year at Princeton explaining the Fed’s interest rate policies. A student asked why he wasn’t concerned about the impact of his policies on seniors accustomed to saving through insured bank deposits, and on pension funds that cannot meet their goals because of the minimal interest rates.
He responded that the Fed was aware of these collateral effects, but explained that the Fed had just two mandates: controlling inflation and maintaining economic growth at acceptable levels. Nothing in those mandates referred to the externalities that so concerned the questioner. But he made it clear that the unconventional policies would not be continued once the economy showed signs that the Fed’s therapies were finally curing the patient’s recession disease.
With that assurance Bernanke had placed “Chekhov’s Gun” on the Fed’s Wall. A century ago, that renowned Russian playwright noted that if a theatre set included a gun on the wall or the mantel piece in the First Act, it would be surely be fired in a later act. And, once the gun was used by one character against another, the situation of all the players was irretrievably transformed.
The Gun has not yet been fired...yet.
But in June Dr. Bernanke made it clear he believed that he – or his successors – would reach for it soon. That pledge immediately roiled financial markets long addicted to the Fed’s heroin. In particular, hedge funds responded in horror, unwinding positions across much of the financial spectrum. In the ensuing turmoil, many observers recalled Warren Buffett’s dictum: “When the tide goes out, you find who’s been swimming naked.”
Simultaneously, the Bank of China began imposing a tourniquet on the reckless speculation in the shadow banking systems in all too many of its provinces. That dangerous process had forced spectacular money supply growth, and spawned corruption and insta-billionaires who aroused widespread resentment about the privileges of a new class of new rich. Its sudden termination unleashed a wave of bankruptcies.
The simultaneous challenges to financial liquidity in the two biggest economies stunned stock and bond markets worldwide. From Paul Krugman on the American Far Left to the economics departments on Wall Street, this turmoil triggered rage against the Fed and the Bank of China.
The supply of financial heroin was suddenly being constrained by the markets themselves, and the addicts continued to react in pain and fury.
Heroin was the battlefield anesthetic of choice for severely wounded soldiers in World War II. The key for doctors was to monitor the recoveries of the grievously wounded soldiers: once they showed signs of survival, and as soon as possible, the heroin had to be reduced and then withdrawn, because the patients would otherwise become addicts. They would then be unfit not only for the risks of the battlefield, but for the demands they would face when they returned home.