Beware the Ides of Summer (and the mindless printing of money)

Wednesday, June 12, 2013

By Farrokh Langdana, Director, Executive MBA Program & Professor of
Finance and Economics

Faculty Blog:

Ides of March

The Death of Caesar, after being warned of the Ides of March, (1798) by Vincenzo Camuccini.

Optimism abounds.  It is everywhere and at all levels. The Bulls have stormed Wall Street and are now pouring down the side-roads.  Total strangers exchange nods in subways and at airports and mutter things like, "Well, it’s high time!  That Bernanke knew what he was doing after all!"  And others in places like Princeton smile smugly with, "We Keynesians rule, after all." 

And why should optimism not abound?  Hey, the stock market is impressively up (Dow closed at 15,070 on 6/14/13), the budget deficit as a percentage of GDP is actually going down, the unemployment rate is down, and housing is on the rebound.  Joy is everywhere, right?

The Bulls stress that this is not just some idiosyncratic outburst of irrational optimism on their part—the whole economy, in fact, the global economy, seems to be buying into this rosy sentiment.  The Swiss Franc has been hammered down to its lowest level in two years and gold has been savaged week after week. This is surely an indication of money fleeing boring safe haven "caves" and rushing into the exciting stock market and back into housing.  Right?  One could almost be tempted to intone Churchillian phrases like, "Maybe this is the End of the Beginning…" 


But wait! Then came Wednesday, the 22nd of May, 2013.

That day began with shares starting higher thanks to comments by Bernanke suggesting that "the Fed would continue its course of pumping money into the financial system." (From: "Stocks Change their Mind on Bernanke," by Alexandra Scaggs, Wall Street Journal, 5/23)

But then, by afternoon, "the market reversed as Mr. Bernanke hedged those comments by saying the Fed could decide to pull back on its easy money efforts in coming months."  The selloff intensified during the afternoon when it became clear from the minutes of the Fed’s last policy meeting that some members have had enough of the $85 billion per month bond buy-back program (read: unrestricted and madly irresponsible monetization).

Clearly, the Fed will have to stop the unprecedented printing of money some time soon.  Thanks to the demolition of the once-existing firewall between the Treasury and the Fed, we have financed our way out of our fiscal and monetary messes by overt collusion between the Fed and the Treasury.  Spending since 2008 has simply been financed by "borrowing" freshly printed money at artificially managed zero interest rates both at the short end and at the long end of the yield curve (the latter thanks to Operation Twist).  No nation, not even the United States, can indulge in fiscal/monetary profligacy forever.  This is beyond economics, this is now in the realm of Physics as in you can’t get something from nothing forever; the Fed understands that.

The easy money policy will eventually have to stop, immediately followed by a long-overdue correction in equity prices.  Events of May 22 are a perfect microcosm—the "smoking gun" if you will—that tie the knee-jerk whipsaw in stock prices directly to the Fed's printing of money.  In addition, with the culmination of the Fed’s manipulation of the long-end of the yield curve, long term rates (mortgage rates) will jump quickly.  In fact, there is already discernible activity here.  Beware the Ides of Summer.

Quantitative Easing


But what about all that good macro news in paragraph 2 above?  Is there a recovery in progress or not?  What’s with all this annoying gloom and doom?

Let’s examine the "falling deficit."  Under President Obama, the national debt has increased by nearly $6.2 trillion, about $78,000 per family of four.  Yes, the annual deficit has dropped, but this has been due to an increase of almost 28% in tax filings in late 2012 as incomes were reported before the higher taxes kicked-in for 2013.  In addition, the second biggest "decrease" in the deficit was due to a one-time adjustment for Fannie Mae.

The "falling" unemployment rate does not mean that more Americans are finding jobs. The participation rate has fallen as more discouraged Americans have dropped out of the civilian labor force.   As we know, the unemployment rate is a percentage of the civilian labor force that is unemployed and actively searching for jobs.  The "falling percentage" is a lower percentage of a smaller slice of the pie.

Finally, one must really look at private consumption (C) which is 70% of our economy.  As long as C lies dormant, there can be no real recovery.  Period.  Over the 21 quarters since the beginning of 2008, C has increased only an anemic 0.8-1.0 percent.  In contrast, from 1996 to 2007, it increased by 8.6 percent.  Typically recessions are followed by an explosion in C due to pent-up consumer demand; this is simply not happening yet.  And without a significant rebound in C, there can be no real rebound in output.


But then what about the housing market?

There is definite traction here. Low home prices and long term rates on the verge of going up, make for a delicious buyers market.  But sellers are not coming forward.  It will be almost two years before most sellers' homes come back above water as home prices gradually rise.  At present, the massive excess demand is snapping up homes typically within a week of being listed.  There is indeed pent-up demand from new buyers and from retirees looking to downsize, but sellers are still waiting on the sidelines.  Consequently, while the housing market is on fire, the number of closings are historically still very low.


So are we in a recovery or not?

We are enjoying a newfound wealth effect thanks to housing and the recently surging stock market.  But these wealth effects are unfounded, and not proportional to the real facts.  To be sure, there is traction in our economy. As EMBA director, I interview a large number of executives every year, and I constantly pick-up signals on real economic activity. Recently, the evidence has all been pointing in the same direction.  For example, an EMBA applicant who owns a trucking company tells me that they cannot find enough trucks or drivers due to the high demand for moving goods.  And another, whose company does soil testing for remediation prior to companies indulging in new construction, reports that he is working 24/7.

Yes, there are signs of growth and they are healthy, but not enough to warrant the recent surge in stock prices.  After the correction, one expects a saner stock market to reflect the gradual re-emergence of our nation, with sustainable growth in stock prices tied to real growth, and not reflexively to the mindless printing of money.

But until then, beware the Ides of Summer.

TAGS: Business Insights Executive MBA Farrokh Langdana MBA Thought Leadership