Thursday, June 26, 2014

What You Need to Know About the US Federal Reserve

The Instability of the Federal Reserve by Market Authority

Every economic transaction is an agreement between two motivated parties. It doesn’t matter what is being exchanged: cash for AAPL stock, airline miles for a first class upgrade, a used auto for bitcoin, or even a concert ticket for a little weed. For any transaction to occur, the buyer and the seller must believe that what they’re receiving will increase their utility (ie-happiness) and they won’t be ripped off. AAPL will not suddenly issue an earnings warning; the used auto must not be a “lemon”; and the concert ticket (and weed) must be real. There must always be an understanding that the other side is not withholding any secrets, and that the transaction is fully transparent.

An economy only grows if people believe that others aren’t holding onto secrets. Secrets cause fear, and this anxiety permeates every transaction. If people fear they will be “ripped off”, they will hoard assets that are safe from secrets. They may sell their stocks for cash or gold; or, they may choose to hold the used car rather than upgrade to the new one. This psychological fear becomes self-fulfilling, manifesting itself in slower economic growth. We fear the economy won’t grow to justify our purchases today, so those transactions don’t occur now. As a result, the economy doesn’t grow and reinforces those original fears.

The role of the Federal Reserve is to promote transparency and reduce secrets among economic agents. Before the creation of the Fed in 1914, secrets about banks (and subsequent bank runs) caused an overwhelming number of banks to fail. In our fractional reserve banking system, a bank keeps about 10% of depositors money and then lends out the rest.

This arrangement is satisfactory for banks and borrowers unless depositors attempt to extract their money at the same time. Due to the low reserve requirements (about 10% in the US), banks aren’t capable paying back every depositor’s cash simultaneously.

In the 19th century, there was no backstop for a bank run, so even the smallest concerns resulted in bank failures. With any negative secrets, people would immediately try to retrieve their cash, and the bank run would be self-fulfilling. Bank failures were crippling to the economy as it would take time for confidence to rise and people to transact again. In modern times, depositors don’t normally panic as the Fed (and the FDIC) will provide your local savings bank with the short-term financing necessary to allow access to your cash.

Imagine a friend posted on facebook that your local savings bank had made some terrible loans and was now facing bankruptcy. Even if it wasn’t true, the line to withdraw your cash would likely be around the block and the bank would be forced to liquidate. Obviously this can’t happen today as the Fed and FDIC provide ample liquidity.

Thus, the Fed provides stability for both the bank and the depositor. The bank can go about its business making loans; and the depositor can be confident that the money in the bank is safe. However, too much of anything is never a good thing. And, as we’ve seen, this stability eventually causes massive instability.

Let’s say I give you the choice to cross Niagara Falls via a high-wire or a five-foot wide steel bridge. Of course, you are going to choose the five-foot wide steel bridge. With the instability of the high-wire, each step you take will be very cautious. You will be acutely aware of your surroundings and the risk posed by a misstep. However, the five-foot wide steel bridge makes traversing the waterfall easy. And this ease brings about a complacency which enables risks not possible on the high-wire. Perhaps you move your family to other side of the river and build a house. Would you have attempted any of this on the high wire?

Assume this bridge can only be maintained if people continuously cross the bridge and pay a small fare. This revenue goes to general upkeep of the bridge, preventing it from cracks and collapse. Then one day, you are told a secret that the five-foot wide steel bridge has cracks and might collapse. Now, no one wants to use the bridge and the lack of revenues causes cracks to remain unrepaired. Everything you’ve brought to the other side of the seemingly stable bridge is in jeopardy. At the same time, everyone else who has been using the bridge is frantically trying to retrieve their belongings. The panic would be much less if only the high-wire was available and people didn’t rely on its stability.

The five-foot steel bridge is an analogy for the lower risk the Fed provides bank depositors. The stability and lower risk both allow economic agents to become complacent, which results in an appetite for more risk. While more risk-taking is correlated with economic growth, it eventually leads to a higher degree of instability when secrets are abundant. Thus, the over-reliance on the steel bridge has caused massive instability.

Next up, we’ll look at how the Fed has attempted to repair its five-foot wide steel bridge while everyone is trying to rescue their belongings from the other side of the river.

In 2002, economists James Stock and Mark Watson published a noteworthy paper titled, “Has the Business Cycle Changed and Why?”. In it, they discuss the macroeconomic phenomenon known as the “Great Moderation”: the significant reduction in economic volatility which started in the 1980s. This can be witnessed in lower volatility of major economic variables such as real GDP, industrial production, monthly payroll employment and the unemployment rate. For instance, take a look at this chart of GDP volatility:

Economists have cited four main reasons for the great moderation:

1. Central bank independence due to the Treasury-Fed Accord of 1951.

2. Counter-cyclical economic stabilization policies.

3. Improved economic stability from less reliance on manufacturing.

4. Good luck.

Now back to our bridge analogy…

The Great Moderation instilled the belief that the bridge is very stable, and the Fed is capable of managing business cycles with alacrity. This narrative of an omnipotent Fed provided necessary cover for the banks to extend unmanageable levels of credit, which lead to a sharper than expected contraction in 2008.

As we witnessed, Wall Street “innovations” were simply new products that added leverage and shuffled risk around. The investment community perceived the bridge as very wide and stable so they readily accepted these new-found products of controlling risk. As a result, the banking sector grew at double the pace of GDP. This is unstable, and a mark of adding leverage. Your local bank should not be growing faster than the businesses it services.

In 2008, the bridge displayed signs of extreme stress and was at risk of collapse. People were frantically trying to retrieve their assets at the same time, causing lower asset prices, and increasing the stress on the system (also known as a deleveraging). The Fed’s response was to make repairs to the bridge and purchase assets on the other side in the hopes that investors would stop trying to retrieve them.

The unprecedented actions of the Fed caused a shift in how investors priced assets. For the past 5 years, the main driver of stock, bond, and house valuations has been the seemingly endless monetary activity of the Fed. Economic data can only be viewed from the stance of “How will the Fed react?” Positive economic data means the Fed takes away the sugar earlier than expected, and the reverse is also true for negative economic data.

Bad news is good news; good news is bad news. Case in point: the -1% GDP in the 1st Quarter. This is bad news and, in normal times, we would expect the market to sell-off. However, everyone knows that bad news means more sugar and the market rallies. The mantra of “Don’t Fight the Fed” has never been more relevant.

And so the Great Moderation looks likely to resume where it left off in 2008. Volatility has once again drained from asset prices, and the shift in focus from the economy to the Fed’s moves means they have no intention of botching their repair work. When the economy heats up again (and the Fed ceases repairs), we will see how sturdy the bridge remains.

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