Responsible Versus Irresponsible Central Banking

Good Afternoon: After surging for four straight sessions this week, U.S. stocks spent most of today consolidating those gains. The quiet, sideways action we had today is fairly typical of summer Fridays, but, as always, there are longer term issues to consider. What, for example, will happen to the myriad middle market businesses that depend upon CIT if the lender slips under the waves of leveraged finance? As the Q2 earnings season progresses, will tech company earnings releases bring more of the happiness seen at Intel and IBM, or the disappointments presented by Dell, Nokia, and Google? Likewise, will financial companies start to print money like Goldman Sachs, or be weighed down by the credit losses seen at Bank of America? What do GE’s struggles indicate?

The major averages have run up in part because investors have a sense of optimism after seeing the early earnings releases, but it will be quite interesting to see what the back half of the earnings season brings, not to mention what the economy serves up in the second half of 2009. It won’t take much upside follow through to push the S&P 500 above the June highs, setting up a test of the 1000 level. Similarly, it may not take much in the way of more earnings disappointments like GE’s to cause a retracement of this week’s booming rally. Since what the Fed decides to do from here on out will influence the outcome, we’ll later examine two wildly different approaches to central banking.

The economic data released yesterday and today were mixed, and I can think of no better example than housing starts. Market participants were puzzled to see both starts and permits jump in June (in addition, May figures saw an upside revision). The numbers, while still but a fraction of peak levels, are good news in that some construction workers are finally going back to job sites. Maybe the President’s economic stimulus package is starting to take effect, but more houses aren’t exactly what are needed right now. We used to make fun of Japan ‘s 1990’s era fiscal stimulus packages, saying all the construction amounted to “building bridges to nowhere”. With millions of homes for sale in the U.S. , many of them already vacant, it’s hard to quarrel with those who claim the U.S. is now “building homes for no one”. Capping off an exuberant week, stocks finished mixed; bonds again took on water; the dollar rose; and the CRB index tacked on another 1.7%.

Some folks tried to credit Nouriel Roubini with yesterday’s late move higher in equities. This frequently quoted bear was said to have thrown in the towel on his previously negative outlook for the U.S. economy, and this news quickly circulated through the markets via CNBC. Mr. Roubini issued a clarification of his views after yesterday’s closing bell, but I think it’s a stretch to give so much weight to the opinions of one economics professor who became famous after the 2007-2009 credit crisis proved him right. I prefer the views of those who’ve seen more than one cycle, and especially the views of those who predicted our current malaise years ago — when policy changes could have been enacted to avert much of the distress we’ve been forced to endure.

You can read about one such man in the second to last article below. William White was the chief economist at the Bank for International Settlements during the period of time when Alan Greenspan’s star power was at its zenith. The article offers some unique insights into the BIS (which is the central bank of all other central banks — including our Federal Reserve) and how Greenspan always managed to foil Mr. White’s warnings that the Fed’s easy money policies were leading to unsustainable global imbalances that would one day threaten the global economy. Mr. White directly challenged Mr. Greenspan on the subject of bubbles, saying central banks should prevent them. The invincible Maestro though otherwise, preferring instead to let them blow and clean up afterwards. Mr. White started issuing his warnings to Mr. Greenspan and the other central bankers more than 8 years ago, and kept right on serving them up in spite of Greenspan’s ego and opposition. Mr. White was right, and Greenspan did indeed lead the world off a cliff.

If William White’s views represent “responsible central banking”, then we should all be on the lookout for those who wish to continue “irresponsible” central banking. Even with the printing presses humming, there are those who feel the Fed needs to go further. The Japanese tried to escape the perils of twin broken bubbles (stocks and real estate) first with fiscal stimulus and then with quantitative easing, but they didn’t intervene enough for PIMCO’s Paul McCulley. The Japanese should have adopted the unorthodox policies espoused by, among others, Paul Krugman and Ben Bernanke, in Mr. McCulley’s opinion. In his latest piece, “What If?”, McCulley argues that the Bernanke Fed should consider any and all ways to reflate — even if they have to “credibly promise to be irresponsible”. Mr. McCulley thinks no intervention is too much until policy makers can create negative interest rates and revive lending and borrowing (and thus spending).

You’ve read the above correctly; do not adjust your computer settings. But since I don’t want to misrepresent Mr. McCulley’s views, please read his piece before reaching your own conclusions. Aside from having a visceral reaction to “irresponsible” policies — including those with good intentions — I take issue with Mr. McCulley’s prescription for some of the same reasons he raises in the article. Any attempt by the Fed to communicate an intent to buy up as much Treasury paper as is needed to lower long term interest rates (while printing the money with which to do so) would backfire, in my opinion. China and our other foreign creditors would bolt, the dollar would be eviscerated, and long term rates would be much more likely to skyrocket than fall.

The U.S. in 2009 is not facing the same circumstances Japan faced during its lost two decades. As a nation of savers, Japan could call upon a vast pool of domestic savings to finance government bond issuance. The U.S. , to put it kindly, is not exactly a nation of savers. Furthermore, Japan endured its troubles while the rest of the world was growing and while global sovereign debt issuance was actually receding. Today the opposite conditions are in place; government bond issuance is in a rip-snorting bull market of its own. And finally, the yen is not exactly the world’s reserve currency. It’s important, but goods the world over are denominated in dollars, not yen. Watching the Fed push the hyper-drive button on our nation’s printing presses will make global investors feel nervous in the same way high school kids do when they see a classmate mixing an unauthorized concoction during chemistry class.

Mr. McCulley claims that a promise by the Fed to be irresponsible is in fact the responsible thing to do. We otherwise risk debt-induced deflation and a long period of stagnation, a la Japan . Perhaps, but where have I heard before this call for an aggressive monetary policy intervention to ward off the demons of deflation? That’s right — from Greenspan and Bernanke during 2002/2003. It was that intervention to forestall an imaginary deflation that brought us the housing bubble, among other credit-related distortions. It was the very stuff that caused William White to issue his warnings back then. I don’t know which policies our central bankers will try next, but I hope Mr. White keeps pestering them about the dangers involved. “If at first you don’t succeed…” is good advice for most of life’s challenges. But if Mr. White doesn’t succeed this time, then I’ll feel more comfortable than ever owning precious metals and their related equities.

— Jack McHugh

Most U.S. Stocks Fall as GE, Google Results Offset Housing Data

Housing Starts in U.S. Climb to Seven-Month High

Treasury Bets U.S. Financial System Can Weather CIT Collapse

Global Banking Economist Warned of Coming Crisis

What If? by Paul McCulley, PIMCO

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