Previously, it was Seth Klarman, one of the most respected value investors of all time warning against the hubris of economists, the complacency of investors and the stupidity of politicians. Now, it is the turn of that other, just as legendary hedge fund manager, Paul “Commodore” Singer, to take what is an increasingly contrarian position in a field of “experts” filled with momentum-chasers, Fed apologists, and those who are convinced the world owes them a free lunch, and once again tell the full truth about the Federal Reserve and its utterly clueless, real world reject, chairman.
The Fed, Lost In The Wilderness, by Paul Singer
[T]he financial system (including the institutions themselves, products traded, and risks taken) has “gotten away from” the Fed’s ability to comprehend. The Fed is primarily responsible for that state of affairs, and it is out of its depth. Former Chairman Greenspan created – and reveled in – a cult of personality centered on himself, and in the process created a tremendous and growing moral hazard. By successive bailouts and purporting to understand (to a higher and higher level of expressed confidence) a quickly changing financial system of growing complexity and leverage, he cultivated an ever-increasing (but unjustified) faith in the Fed’s apparent ability to fine-tune the American (and, by extension, the world’s) economy. Ironically, this development was occurring at the very time that financial innovations and leverage were making the system more brittle and less safe. He extolled the virtues of derivatives and minimized the danger of leverage and risky securities and dot-com stocks, all while he should have been putting on the brakes. It was not just the disappearance of vast swaths of the American financial system into unregulated subsidiaries of financial institutions, nor was it just government policies that encouraged the creation and syndication of “no-documentation” mortgages to people who could not afford them. It was also the low interest rates from 2002 to 2005, the failure to see the expanding real estate bubble caused by an unprecedented increase in leverage and risk, and the general failure to understand the financial conditions of the world’s major institutions. Under Chairman Bernanke, the combination of ZIRP and QE completed the passage of the Fed from sober protector of a fiat currency to ineffective collection of frantically-flailing, over-educated, posturing bureaucrats engaged in ever more-astounding experiments in monetary extremism.
If you look at the history of Fed policy from Greenspan to Bernanke, you see two broad and destructive paths quite clearly. One path is the cult of central banking, in which the central bank gradually acquired the mantle of all-knowing guru and maestro, capable of fine-tuning the global economy and financial system, despite their infinite complexity. On this path traveled arrogance, carelessness and a rigid and narrow orthodoxy substituting for an open-minded quest to understand exactly what the modern financial system actually is and how it really works. The second path is one of lower and lower discipline, less and less conservative stewardship of the precious confidence that is all that stands between fiat currency and monetary ruin. Monetary debasement in its chronic form erodes people’s savings. In its acute and later stages, it can destroy the social cohesion of a society as wealth is stolen and/or created not by ideas, effort and leadership, but rather by the wild swings of asset prices engendered by the loss of any anchor to enduring value. In that phase, wealth and credit assets (debt) are confiscated or devalued by various means, including inflation and taxation, or by changes to laws relating to the rights of asset holders. Speculators win, savers are destroyed, and the ties that bind either fray or rip. We see no signs that our leaders possess the understanding, courage or discipline to avoid this.
It is true that the CEOs of the world’s major financial institutions lost their bearings and were mostly oblivious to their own risks in the years leading up to the crash. However, as the 2007 minutes make clear, the Fed was clueless about how vulnerable, interconnected and subject to contagion the system was. It is not the case that the Fed completely ignored risk; indeed, several Fed folks made “fig leaf” statements about the risks of the mortgage securitization markets, as well as other indications that they appreciated the possibility of multiple outcomes. But nobody at the Fed understood the big picture or had the courage to shift into emergency mode and make hard decisions. In the run-up to the crisis the Fed was a group of highly educated folks who lacked an understanding of modern finance. After convincing the nation for decades of their exquisite grasp of complexities and their wise stewardship of the financial system, they didn’t understand what was actually going on when it really counted.
Ultimately, of course, as the system was collapsing and on the verge of freezing up completely, the Fed shifted into the (more comfortable and much less difficult) role of emergency provider of liquidity and guarantees.
All this background presents an interesting framework in which to think about what the Fed is doing now. QE is a very high-risk policy, seemingly devoid of immediate negative consequences but ripe with real chances of causing severe inflation, sharp drops in stock and bond prices, the collapse of financial institutions and/or abrupt changes in currency rates and economic conditions at some point in the unpredictable future. However, the lack of large increases in consumer price inflation so far, plus the demonstrable “benefits” of rising stock and bond markets, have reinforced the merits of money-printing, which is now in full swing across the world. In the absence of meaningful reforms to tax, labor, regulatory, trade, educational and other policies that could generate sustainable growth, “money-printing growth” is unsound. We believe that the global central bankers, led by the Fed as “thought leader,” have no idea how much pain the world’s economy may endure when they begin the still-undetermined and never-before attempted process of ending this gigantic experimental policy. If they follow the paths of the worst central banks in history, they will adopt the “tiger by the tail” approach (keep printing even as inflation accelerates) and ultimately destroy the value of money and savings while uprooting the basic stability of their societies. Read the 2007 Fed minutes and you will understand how disquieting is the possibility of such outcomes and how prosaic and limited are the people in whom we have all put our trust regarding the management of the financial system and the plumbing of the world’s economy.
Printing money by the trillions of dollars has had the predictable effect of raising the prices of stocks and bonds and thus reducing the cost of servicing government debt. It also has produced second-order effects, such as inflating the prices of commodities, art and other high-end assets purchased by financiers and investors. But it is like an addictive drug, and we have a hard time imagining the slowing or stopping of QE without large adverse impacts on the prices of stocks and bonds and the performance of the economy. If the economy does not shift into sustainable high-growth mode as a result of QE, then the exit from QE is somewhere on the continuum between problematic and impossible.
Central banks facing high inflation and/or sluggish growth after sustained money-printing frequently are paralyzed by the enormity of their mistake, or they are deranged by the thought that the difficult and complicated conditions in a more advanced stage of a period of monetary debasement are due to just not printing enough. At some stage, central banks inevitably realize, regardless of whether they admit the catastrophic nature of their own failings, that the cessation of money-printing will cause an instant depression. Even though at that point the cessation of money-printing may be the only action capable of saving society, that becomes a secondary consideration compared to the desire to avoid immediate pain and blame. The world’s central banks are in very deep with QE at present, and the risks continue to build with every new purchase of stocks and bonds with newly-printed money.
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And, as an added bonus, Singer’s thoughts on gold:
There are many current theories as to why the price of gold had been drifting down and then collapsed in mid-April. We are trying to sort out various possible explanations, but we urge investors to be cautious in their thinking about what circumstances would likely cause gold to rise or fall sharply. The correlations with other assets in various scenarios (risk on or off, economic normalization, inflation, the rise and fall of interest rates, euro collapse) may shift abruptly as the macro picture evolves. Many people think that if stock markets continue rising, and/or if the U.S. and Europe restore normal levels of growth and employment, then the rationale for owning gold is weakened or destroyed. This perception may be correct, and it is certainly a topic that is currently much discussed, but ultimately another set of considerations is likely to dominate.
The world is on a seemingly one-way trip to monetary debasement as the catchall economic policy, and there is only one store of value and medium of exchange that has stood the test of time as “real money”: gold. We expect this dynamic to assert itself in a large way at some point. In the meantime, it is quite frustrating to watch the price of gold fall as the conditions that should cause it to appreciate seem more and more prevalent. Gold may not exactly be a “safe haven” in the sense of an asset whose value is precisely known and stable. But it surely is an asset that, in a particular set of circumstances, becomes a unique and irreplaceable “must-have.” In those circumstances (loss of confidence in governments and paper money), there are no substitutes, and the price of gold may reflect that characteristic at some point.