Vigilant Investor

This from Nouriel Roubini at NYU yesterday:

“Certainly yesterday’s (Wednesday’s) equities rally was totally driven by Fed governor Kohn signaling the obvious, i.e. that given that the liquidity and credit crunch is now worse than at its August peak the Fed will cut rates in December, January and for as long as needed. In this game of chicken between the Fed and the bond market (with the latter signaling already for a while that the Fed will keep on cutting) the Fed was obviously the one to blink: this was no surprise to anyone who had noticed the meltdown in financial markets (a ugly liquidity and credit crunch) in the last few weeks. But for some reason the stock market on Wednesday discovered what analysts, the bond market and credit markets knew all along, i.e. that the Fed will have to keep on cutting rates as we are headed towards an ugly recession that is now inevitable regardless of how much the Fed cuts rates.”

Call it a Bernanke Put if you believe that the Fed is trying to avoid a financial meltdwon; call it a need to bail out the economy rather than bailing out the markets if you believe - as I do - that the Fed actions are more driven by its concerns about the economy rather than an attempt to rescue investors; call it a moral hazard play if you believe that the Fed is trying to rescue investors and risks to create down the line another asset bubble. You can call it whatever you like but one thing is obvious: the Fed easing is perceived by the stock market as an action aimed to prevent a recession from occurring and stock prices rally - in spite of worsening macro news that are signaling recession ahead - because of the hope - that I will show is only wishful thinking - that the Fed will be able to avoid such a hard landing. Thus, what has been mostly driving up the stock market in the cycles since last summers is Fed policy expectations of easing.

Dr. Roubini raises some great issues. Just the same, we should not forget that all this policy action is engineered with the money printing press. The fed’s lower interest rate encourages more borrowing, which otherwise would normally dry up the naturally occurring pool of savings, which in turn would force interest rates back up. Instead the Fed provides the liquidity necessary to keep interest rates below the natural rate that the existing pool of savings would demand. Consequently, all these dollars that are freshly minted are suddenly bestowed with purchasing power. Of course, that’s not magic — It is simply inflation, which in turn comes out of the hide of all those who are storing their wealth in pre-existing dollars. Any wonders why gold, oil, and a host of other hard assets are up so dramatically since the gargantuan liquidity injections of Bernanke and his anointed predecessor, Alan Greenspan?

This has two obvious effects on the economy. One is that the dollar will continue to decline in its unit of exchange per unit of other things that can’t be so wantonly manufactured. In plain terms, prices will rise. The other problem is that this freshly created money will deliver to the credit markets a support of asset values that have been exposed in recent months as naturally unjustifiable, while many business and investment projects were similarly exposed as unwanted dislocations of wealth and savings, and unsupportable by the economy. (Think of the housing bubble and all those empty condos sitting in Miami.) So this flood of liquidity from Bennie and the Liquidity Jets is merely dislocating good wealth and throwing more good money into the black hole of bubble dislocation.

This begs the questions of, how is wealth created and how do we become wealthier?

Clearly printing money from nothing creates nothing, otherwise the poor victims of such stupidity in Zimbabwe would be rich instead of finding their shelves emptying of goods as they scramble to bundle dozens of pounds (in weight terms) of bank notes to purchase a loaf of bread.

No, wealth is created by savings and sacrifice among market participants. A baker who produces bread must first sacrifice present consumption to save to purchase ovens and ingredients and other start up capital. Of course, someone else could do the sacrifice for him in order to loan him the start-up cash, for which our baker must then be obligated to pay interest in return. Either way, the baker is then must contribute time and energy into his bakery in order then produce bread.

As such, each dollar he earns from consumers exchanging dollars for bread really represents the loaves of bread he has sold, and as such, each dollar represents his effort, sacrifice and savings. Consider, he could just as easily opted to sit on his couch and drink beer and watch television, and the economy would have been many loaves of bread less wealthy. Instead, the baker produced something that had not existed before. His dollars earned really represent production sold.

That, friends, is a legitimate economy. Compare that to the fiat banking system that simply prints money out of thin air. What has Ben Bernanke contributed to the wealth of the economy to back up the $8 billion he injected into the economy just last week? Certainly, Wall Street big wigs who get to play with the process of injecting that money into the economy will get some fat fees for packaging it into the liquidity that other players are desperate for in order to delay being forced to put their overpriced assets to market, or prevent others from declaring their ill-conceived and unmerited investment projects insolvent. What is Bernanke really enabling? He’s converting the functioning economy’s finite wealth into economic malignancies dependent on ever-more life support.

It should also be noted that such policy also slowly strangles the incentive to save in an economy by the legitimate business class. Real savings is disincentivized as real producers are penalized and movers and shakers are rewarded for creating horrible dislocations. Conservative savers are given below market interest rates on their hard earned savings to subsidize the same movers and shakers. Those on fixed income watch their purchasing power decline, while those first to use the fresh money create mega deal fees for packaging subprime debt deals that are now blowing up.

Sure, a few big Wall Street CEOs have been given the ax, but the parachutes are very golden. Indeed the mortgage industry is now paying the price for overextending so dramatically, as is any sector related to housing — having all been suckered into believing all that profitable consumption actually represented growth in wealth instead of a simple, inflationary bubble. But others are being flatly bailed out, and especially at the highest levels on Wall Street. While saddling shareholders with over $70 billion in losses and the economy with unprecedented turmoil, these players still have the hubris of doling out some $35 billion in bonuses. Hey, when your playing with someone else’s’ wealth, why not?!?

Indeed, to believe central banks degrading the value of their currencies somehow contribute to growth in an economy is as naive as believing a counterfeiter is creating growth for the economy. There is an old New Yorker cartoon where some counterfeiters are printing away, and one says, “Boy! Retail spending in the neighborhood is sure in for a shot in the arm.” It may give the illusion, no doubt, but illusions are just that — and as we’ve seen with the housing bubble and credit bubble collapse, when the curtain is pulled aside, the reality is quite grotesque.

That said, navigating this environment requires understanding the nature of the system as it is. It means understanding the players involved and their historic tendencies, their bias to protect the power structure of the status quo, and the inherent “follow the money” priorities. In other words, don’t be sheep or a fall guy. Their are plenty of opportunities for those not on auto-pilot!

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