Seth writes, While QEs 1 and 2 had no lasting impact, they did give a short-term boost to the stock market." My question: the stock market is up strongly from 2009 lows, why is it that the boost was "short-term" according to the author? ~ Ilene
On The Fullness And Boldness Of QE's Manipulation Of American's Behavior
Courtesy of ZeroHedge. View original post here.
With equity markets having reverted to pre-Draghi and pre-Bernanke levels, retail mortgage rates and MBS spreads now above pre-QEtc. levels, and the fundamental reality of the world's credit-driven growth peeking through into the new normal 'muddle-through'; it seems increasingly evident that central banks' actions (or the anticipation of such) are all that keeps advanced economies from crumbling back onto their non-vendor-financed rational valuations. The question is – who are the central banks really trying to help? Baupost's Seth Klarman provides the most clarifying and thought-provoking assessment of both the Fed's actions (quantitative easings specifically) and the moral hazard implicit in their deeds (as well as words).
Via Seth Klarman of Baupost's Q3 Letter:
Our Thoughts on QE3
On September 13 the Federal Reserve initiated QE3, a variation of the first two quantitative easings, involving the government buying back $40 billion per month of mortgage securities while maintaining the Fed's near-zero interest rate policy through mid-2015, nearly a full seven years after the financial market collapse of 2008. The goal of QE3 is to drive interest rates on 30-year mortgages lower (they reached an all-time record low of 3.36% in early October) while concurrently lifting housing prices (and inevitably the stock market), triggering a theoretical wealth effect that would potentially bolster consumer spending.
While QEs 1 and 2 had no lasting impact, they did give a short-term boost to the stock market. But because that effect was ephemeral, it's hard to comprehend why anyone would believe that QE3 will turn out better. QE3 is bold in its apparently unlimited duration, which may be intended more to demonstrate the Fed's determination rather than any actual conviction that it will work. Perhaps the oddest part of the ongoing QE scheme is that everyone can see in its fullness and boldness the attempted manipulation of Americans' behavior. (If people know they are being manipulated, do they behave exactly the same as if they don't know?)
While anyone would be glad to have a cheaper mortgage as a result of QE3, would they really believe this would make their home worth more? It's more of a credit holiday, whereby the government offers you better terms than previously available. In addition to making explicit the implicit U.S. government guarantee of more and more of the U.S. residential mortgage market, the rousing stock market approval of this measure is seen as a free lunch. But of course it is not free. For one thing, buying mortgage securities with newly printed money has the same inflationary risk that QEs 1 and 2 posed. This probably explains why gold rose strongly in response to this announcement.
Also, artificially low interest rates have a cost to the government. As we know from the recent U.S. housing price collapse, mortgage lenders can indeed lose money. The guarantor of the U.S. housing market has a huge contingent liability. Moreover, the U. S. housing market was clearly overbuilt (by five million homes, according to some estimates) as of 2007, yet cheap financing may attract temporary incremental demand which home-builders might interpret to be permanent and thus overbuild all over again. This highlights the deleterious second and third order effects of well-intended but ill-conceived government programs.
It is clear that someday the Fed will decide that the economy has strengthened sufficiently to end and then potentially reverse QE and zero-rate policies. Any possible sale of trillions of dollars of securities owned by the Fed, at such time would most likely be at a substantial loss given that interest rates would likely have risen and bond prices have fallen. Also, when people with a 30 year, 3.5% mortgage seek to move at a time when new mortgages now cost 5% to 6% or more, buyers will pause, reducing demand and driving house prices lower. QE3 may deliver a dose of helium to housing prices, but eventually helium leaks out of balloons, and gravity pulls them to earth.
What kind of policy is this: untested; inflationary; eroding free market signals; diverting more of the country's resources toward housing at the expense of priorities such as infrastructure, technology, or science and medical research; and inevitably only a temporary fix with no enduring benefit?
Finally, we must question the morality of Fed programs that trick people (as if they were Pavlov's dogs) into behaviors that are adverse to their own long-term best interest. What kind of government entity cajoles savers to spend, when years of under-saving and overspending have left the consumer in terrible shape? What kind of entity tricks its citizens into paying higher and higher prices to buy stocks? What kind of entity drives the return on retirees' savings to zero for seven years (2008-2015 and counting) in order to rescue poorly managed banks? Not the kind that should play this large a role in the economy.
Moral Hazard and Financial Risk
Recently, a financial columnist wrote: "Four years after the fall of Lehman Brothers, and with-a presidential campaign in full swing, everyone can surely agree on one thing: we shouldn't risk another financial crisis." While I'm sure he is well-intentioned in this sentiment, this highlights a flawed notion held by too many of our country's commentators and regulators. What does it even mean to risk or not risk a financial crisis? You don't intentionally risk financial crises; they just happen. In fact, there is no way to not "risk them". And they don't usually provide fair warning. Financial crises are awful: they affect the lives of individuals and families; they can damage the economy, weakening it to the point of tearing the social fabric they often take years to overcome. It would be great if we could outlaw them, but unfortunately we cannot. Ironically, attempts to limit short-term pain, such as those in the four years did counting since the collapse of 2008, almost certainly make a future crisis much more, not less, likely.
The seeds for financial crises typically grow undetected from a variety of excessive behaviors and assumptions, to where they become almost inevitable. Financial crises are rooted in over leverage and excessive levels of valuation. If society wants to prevent crisis, it must take measures well in advance, before the storm clouds gather, before excesses build in the system and before unbridled optimism dominates investor and business thinking. Efforts to constrain incipient crises in order to avoid feeling their full wrath, such as propping up bankrupt institutions and bankrupt countries, merely result in stagnation and a protracted period of subdued economic activity. Proper regulation might make some difference, if it had the effect of limiting leverage and containing speculative bubbles; but so much of regulation is naïve, ill-considered, and poorly enforced, thereby rendering it ineffective.
Anyone who believes that government control and intervention will prevent problems of all sorts is living in a fantasy world where what we wish will happen always does. Go back to 2007 where the world was seemingly in a perpetual period of prosperity with low volatility while stock markets were hitting record highs. Few sniffed the possibility of any crisis on the horizon. Virtually no one imagined the magnitude of the crisis that erupted only one year later. Financial crises, sadly, will be with us forever. The idea that we can avoid one at our will only suggests both a dangerous naivete regarding how the world works and also the likelihood that when a crisis does arise, years of built up excesses will ensure that it will be far worse than it would otherwise have been.
An environment where financial crises are seen to be a regular part of the landscape is one where people might actually take more precautions. People would maintain a margin of safety in all their decisions. investment and otherwise, regulations would be well thought out and diligently enforced, and the unscrupulous and the incompetent would quickly fail and disappear from the scene. Modern day attempts to abolish failure only serve to ensure it, as moral hazard– the likelihood that people's behavior changes in response to artificial supports or guarantees– surges. Attempts to prevent or wish away future crises only make them more likely. Only by allowing, even welcoming, episodic failure do we have a chance of reducing the likelihood and magnitude' of future financial crises.
We wrote on Friday of the frailty of central bank independence and merging of fiscal and monetray policy:
Globally, central banks are edging down monetary policy paths that can be viewed as increasingly backstopping budget deficits as lawmakers of respective governments continue to fail to make progress toward fiscal consolidation. A progression down this road could lead to many unsavoury outcomes, as fiscal and monetary policies entwine themselves in an increasingly negative dynamic.
It seems Mr. Klarman agrees…
