The Second Stupidest Argument

In yesterday's installment, the explanation for why there is no housing bubble was identified as being the stupidest argument of recent times. Today, we discuss the second stupidest argument - that the Fed should not and will not "target" asset prices when formulating monetary policy.

The second stupidest argument works in combination with the first stupidest argument and the truism of the "wealth effect" to go a long way in explaining how the crazed American consumer, and hence the U.S. economy, both seemingly continue to prosper.

This argument goes back almost ten years, originating around the time that "irrational exuberance" morphed into "productivity miracle". The Fed's position on asset prices and monetary policy since that time has been consistent and has always been framed by the use of the word "target", allowing them to answer a different question than they are asked - subtle misdirection at its best.

When queried with something like "Shouldn't you think about raising interest rates when it is obvious that easy money is causing asset prices to rise dramatically?" The reply is a sharp "the Fed does not make asset prices the targets of policy" or "the Fed can not target a particular level of asset prices". What this (by now reflexive) response does is answer a different question - instead of answering "Shouldn't you do something about the alarming rise in asset prices?" or "Shouldn't the alarming rise in asset prices be important in policy decisions?" they answer the question "Why aren't rising asset prices the sole driver of monetary policy".


Very clever - a good offense is always better than a good defense.

So, let's look at a specific case. In this 2004 speech, Easy Al discusses the relationship between asset prices and monetary policy:

In addition to the narrower issue of product price stability, asset prices will remain high on the research agenda of central banks for years to come... There is little dispute that the prices of stocks, bonds, homes, real estate, and exchange rates affect GDP. But most central banks have chosen, at least to date, not to view asset prices as targets of policy, but as economic variables to be considered through the prism of the policy's ultimate objective.

Yes, asset prices are high on the list of things that will be looked at - more research will be done. Well, at least they're doing something. But, what's this part about "most central banks have not chosen to view asset prices as targets of policy"? You're the head of the biggest central bank on the planet, and you're saying "Well these other guys aren't doing it, so I'm not going to do it". What kind of lame excuse is that?

So asset prices will be studied, but until then, they will not be targeted - they will be considered, along with myriad other factors, in pursuit of the ultimate goal of price stability and full employment. Product price stability that is, not asset price stability - that's a different kind of price, a kind of price that exhibits very little stability, actually.

Well the neat trick here, obvious to anyone doing any thinking at all, is that if you don't consider stock/housing prices, you can fuel a stock/housing boom with cheap money and create all kinds of stock/housing jobs, and as long as you exclude stock/housing prices from whatever it is that you do "target" when it comes to prices, then you've gone a long way toward accomplishing the goal of price stability and full employment.

Hey, they've been doing this since 1995! How long can this g

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The Stupidest Argument

Every time I read Kudlow, I feel like I just got a lobotomy.

In yesterday's furball at the National Review, he prattles on about the Fed and interest rates:

Does anyone really know what Alan Greenspan is up to? Does the Maestro himself know why the Fed’s target interest rate has been robotically raised eight consecutive times, with no end in sight?

OK, anyone who still calls Greenspan the Maestro is a moron. It's that simple. Someday, when they write the history books, we'll see pictures of Alan Greenspan and George W. Bush next to a description of what happened to the U.S. economy in the early 21st century - it won't be good ... and they won't call him the Maestro, unless it's in a mocking sort of way.

On the subject of how the moderate growth in money supply does not warrant further interest rate increases:

Take, for example, the latest monetary data from the Federal Reserve Bank of St. Louis. The data show a marked slowdown in key money-supply measures. The adjusted monetary base, over the past six months, is growing at a meager 2.6 percent annually. A broader money measure known as M2 has slipped to a below-normal 3.5 percent.

Even I know that the traditional measures of money supply have lost much of their significance recently - ever since the world's monetary system became so grotesquely distorted, where money is now created in manners and in quantities never imagined just a few decade ago when money supply measures could be used to make policy decisions.
In fact, one of the Fed Governors sat next to Larry during the April 1st jobs report on Squawk Box and said as much (well, he didn't use the word grotesque, but he did say that these measures are not nearly as important as they once were ).

And then he goes on to make the stupidest argument of the last two years - the argument about why there is not a real estate bubble. This argument is heard over and over again, coming out of the mouths of realtors, Federal Reserve officials, loopy authors of "get rich in real estate" books which were published this year, and most disturbingly, from the mouths of purchasers of "get rich in real estate" books which were published this year:

So what is he targeting? Maybe he has the so-called housing bubble in his sights, or the mortgage credit-expansion behind it. If he is watching housing, he’s looking the wrong way. The key reason behind the surge in housing investment is the shower of tax advantages that have fallen on this sector since the 1997 tax bill. On a tax basis, it’s much better to invest in homes than in stocks as home-sale profits are tax-free up to $500,000.

One Wall Street investment manager asked me when the Fed is going to “fix” housing. I asked him, “Do you mean that Greenspan should get a ladder and a paint bucket and actually begin work on a house?” “No, no,” he said. “When will the Fed stop the bubble?” To which I responded, “That’s not the Fed’s job.”

There is a bubble in Naples, Florida. But there are no bubbles in Syracuse or Hartford. Or do the central planners at the Fed think their mandate extends to controlling the local economies of each and every American city?

That's right. Rampant speculation in real estate has not infested every burgh in the country, and therefore there is not a problem. Or, as some Fed officials like to say - there is no national housing bubble, and therefore there is no bubble, and therefore there is nothing to be concerned about - prices may level out for a while and some areas may experience slight declines.

Real estate is local, and until all localities simultaneously experience 20% year over year increases, there's not a problem.

Truly, the stupidest argument of the last two years.

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Nine Thousand Hedge Funds

Now would be an excellent time for all the credit rating agencies to overhaul their procedures to be more compatible with the new business models developed during the last ten years of parabolic credit creation - if they don't, they just might spoil the party.

Look what happened today - rumors swirled on Wall Street that a couple hedge funds were overexposed to GM and Ford debt, which was downgraded to junk last week by the Standard and Poors credit rating agency. U.S. stocks fell and then people started talking about the price of oil again, and how it's supposed to go back down below $50 a barrel and stay there, but it just won't, and then stocks fell some more - it ended up being a bad day.

We can't control the price of oil, and we can't control the hedge funds, but you would think that we should be able to control the credit rating agencies.

Can't they do some kind of hedonic indexing or calculate some kind of an adjustment that they can apply to credit ratings, so that all companies stay above junk status - permanently? Then, when a company has a problem, it can just borrow more money, and keep borrowing more money, whenever it's necessary ... forever.

That has obviously been the plan at GM for the last three years - why does it have to stop now?


Downgrading to junk causes investors to view companies differently - it's as if they turn into lepers. Hey GM! Hey Ford! You can't stay here anymore - you must leave! There are some caves just outside of town - you have to go there now. All the people there, they're just like you - and don't come back.

Well, maybe leprosy isn't the best analogy, and I really don't know if all lepers live in caves - that was from one of those old Charlton Heston Bible movies. The point is, lots of people can't carry GM and Ford debt anymore because it is now junk, and it's going to cost much more for them to borrow more money to sustain their businesses.

Someone needs to do something about this before it's too late - it is time to reform the credit rating agencies.

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Gold and the Scientific Method

As an engineer, the role that gold has played in monetary systems throughout history is fascinating to me. If you are an engineer or scientist by profession, you were taught the Scientific Method - observe, postulate a theory, then test the theory. If the theory survived the testing, it would be accepted as being true, or as being an accurate model, or as being a viable system - something that could then be used to reliably predict future outcomes.

Sounds like a pretty good method. So, why isn't the Scientific Method used to create and control monetary systems?

It seems that throughout history, over long periods of time, the same mistake is made again and again - although intentions are initially noble, governments and their banks always end up creating too much money. At first things seem to go well - everyone prospers for a while, but it always ends badly. More money relative to things that the money can purchase causes the money to lose value, people lose faith, and disasters occur - a moral hazard.

Surely, these can't be the results of using a system developed using the Scientific Method, where the outcome can be reliably predicted.

Now, these problems only occur when a monetary system uses fiat money - money that is not backed by anything other than faith in the government and the economy of the country that issues it. The same government that, in recent centuries, in most of the western world, offers themselves for re-election every few years - their aim is to please their constituents, while at the same time controlling the money supply - maybe this is part of the problem.

Another type of monetary system, one which uses commodity money, for example gold coins and paper money backed by gold, doesn't seem to suffer the same fate as fiat money systems - this must be because in a commodity backed system, money can not be "created" - it has to be dug out of the ground. Digging is harder than printing or making entries in an account.

In fact, you might guess that the commodity backed monetary system is the result of the Scientific Method first used thousands of years ago - a system which has stood the test of time - continually tested over millennia ... and surviving. Maybe the real problem with government and money over the centuries is that there has been a proven monetary system available, but governments just don't use it enough, or they stop using it from time to time - and then problems arise.

Today, we find ourselves thirty some years removed from any linkage to gold, and look around - debt, credit, stocks, bonds, hedge funds, real estate.

Hmmm...

If we are not going to use the monetary system that we know has worked successfully throughout history, maybe someone should run some tests to see if the system we are using can really endure. Maybe we should conduct some experiments, somehow, instead of just continuing to create more money - money creation as a cure for all the world's economic problems - we know how that will probably turn out.

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This Explains a Lot

Paul Volcker has been praised on this blog on a few occasions before, most recently in Past, Present and Future. This, without knowing much about him other than that he wasn't afraid to take away the punch bowl back in the 1980s, and that he has been critical of recent monetary policy.

This interview from 2000 sheds new light on why he may have said some of the things he has said in recent years. First of all, it turns out he isn't that crazy about Keynesian Economics:

INTERVIEWER: When did you begin to have doubts? How early did you begin to become skeptical about things?

PAUL VOLCKER: I was already skeptical. I guess I'm skeptical about everything. I've gotten worse in my old age, but I was a little bit turned off by the precision and certainty that these people attached to the doctrine. The analytic framework was very convincing, but this feeling they had, that they could press the right buttons and manage the economy pretty exactly, for some reason it turned me off. I was very skeptical that they were not overselling the precision of this theory and the precision [with] which they could run policy.

INTERVIEWER: Was that a gut instinct, or was that something you picked up?

PAUL VOLCKER: It must have been a gut instinct. I don't know why, but I was just a little bit turned off by the sense of certainty that they had.

You gotta like that! A little skepticism is a healthy thing - we haven't had too much skepticism in the last ten years. Even when the Nasdaq bubble popped, after six months of blank stares, interest rates dropped like a rock, which begat the carry trade, the bond bubble, the mortgage bubble, hedge funds multiplying like rabbits, then finally, the mother of all bubbles - the world-wide real estate bubble. After a brief lull, everyone was too busy either making money from low interest rates or borrowing money at absurdly low rates to improve their lifestyle - there was no time to be skeptical.

On inflation (back in the days when there were no cheap imports from Asia, and the inflation calculation included house prices, food prices, and energy prices, but did not include quality adjustments):

INTERVIEWER: Can you in general terms explain what you did?

PAUL VOLCKER: That's a complicated story, but what we did, against a background of increasing unease about inflation and increasing unease about the performance of the economy, was to face up to the need and [take charge of] monetary policy and control of the money supply, to accept the proposition that at the end of the day inflation is dependent upon inflationary monetary growth, too much money growth, too much credit growth, and we set out to make that point and say that we've just got to stop this and draw some kind of a line in the sand about how much money and credit growth was appropriate. In doing so, the effect was to push interest rates up in the short run, because people were expecting inflation; they were perfectly willing to borrow. It was a good thing to borrow when you expect inflation, and the borrowing came up against a limited supply of money and credit. Interest rates were way up, and sooner or later that was bound to have an effect on the economy. It did, and we had a severe recession, but we came out of that recession with a very strong movement called price stability and also with strong economic growth.

A novel approach - "a line in the sand about how much money and credit growth was appropriate". Well "appropriate" is a subjective term - to many, the money and credit growth of the last ten years may be entirely appropriate. That is if your intention is to create a series of asset bubbles in America while generating unprecedented economic growth and a job boom in Asia.

Now, this is the part that, given today's real estate madness, you have to stop and think - how could this have really happened? A Fed Chairman who reduced liquidity to the point that it hurt homebuilders? Surely he is joking - two-by-fours?

INTERVIEWER: Did you feel any sort of personal pressure? People were really hurting, weren't they? You were getting letters?

PAUL VOLCKER: Builders are always most affected by tight money, and they said, "We're not getting any use for these two-by-fours," so they sawed them all up and we used to get hundreds of two-by-fours delivered to the office making a plea to do something about this situation. Some of them were given as [a way to say] stop this recession and stop this inflation, reduce the money supply, which of course is what we were trying to do. The message had gotten through, but I remember quite clearly -- you remember these things, or you see these things through your own eyes. But even though the homebuilders were the most singularly, strongly affected industry, [there] was a clear sympathy, even there among their leaders, as for what we were trying to do. They would come in and see me frequently and understandably be disturbed, but their plea was, "Can we get this over with as soon as possible?"

Now it's been a long time since anyone's heard talk like this, from anyone working for anything with the word "Federal" in it - maintain the value of the currency?

INTERVIEWER: You saw inflation as a moral issue, to a certain extent?

PAUL VOLCKER: To some extent I think it is. Inflation is related to monetary policy. It's related to the issue of money. The issue of money is a governmental responsibility predominantly, and to use that authority in a way that leads to inflation is a system that fools a lot of people, and to keep fooling them you have to do it more and more; [that] is a moral issue. I put myself in that camp.

INTERVIEWER: But why a moral issue? What does it actually corrode?

PAUL VOLCKER: It corrodes trust, particularly trust in government. It is a governmental responsibility to maintain the value of the currency that they issue. And when they fail to do that, it is something that undermines an essential trust in government.

Makes me want to go get some platform shoes, put on a leisure suit, and fire up the disco ball.

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