Fed Folly and its Practical Effects
“The… task of economics is to demonstrate to men how little they really know about what they imagine they can design.” –Friedrich von Hayek
Adam Smith was the first to name the “the invisible hand” so felicitously, but he was hardly the first to notice the existence of such a phenomenon.
The idea of an unseen agent working in the background to produce positive outcomes is as old as the human species. The concept of gods or of a God is an example—we often speak of “the hand of Providence” profoundly affecting human lives. Or consider Darwin’s concept of natural selection which, operating invisibly in the background, eventually produced home sapiens.
The capital markets are also governed by a kind of “invisible hand.” When investors invest they aren’t intending to make the markets more efficient. Far from it—as investors we would like the markets to be less efficient, so that we could take advantage of that inefficiency.
Yet, the more we invest, the more efficient markets become. Eventually they became so efficient that Eugene Fama postulated the Efficient Market Hypothesis (EMH), according to which no one can beat the market because all significant information is instantly incorporated into stock prices.
Today, of course, few of us believe in the EMH, at least in its strong form, not least of all because markets are made up mainly of individuals who don’t always behave rationally. But notice that this doesn’t invalidate the “invisible hand” concept. It merely suggests that less rational investors will always be bested (eventually) by more rational investors, and that in the meantime the markets will become ever more efficient and fair.
Historically, when the U.S. government has legislated or regulated or otherwise intervened in the capital markets it has been to make them more efficient and honest. Shady practices were outlawed and the SEC got better and better at ferreting out such abuses as insider trading, front-running, pumping-and-dumping, naked shorting and so on.
But all this changed shortly after the turn of the century. In 2001, Japan became the first country to experiment with quantitative easing, as the Bank of Japan bought huge quantities of government bonds, asset-backed securities and even equities. Although the BOJ expanded its balance sheet by a factor of seven (from ¥5 trillion to ¥35 trillion), nothing happened to Japanese inflation or economic growth. QE was a complete bust.
You might suppose that this would have served as an object lesson in the foolishness of weird, “unconventional” central bank policies designed to manipulate a country’s capital markets. But that’s because you are a thoughtful person who is unimpressed by flimflam initiatives that prove to be wholesale failures. If you were a central banker, on the other hand—that is, a person for whom the quality of humility is unknown—you would merely say that Japan failed because it didn’t do enough QE.
Sure enough, in November of 2008 the U.S. Fed launched QE1. When that failed, they launched QE2 in November 2010, and when that failed they launched QE-Infinity in September 2012. What could possibly have been going through the Fed’s mind? Even if the example of Japan didn’t impress them, shouldn’t they have given some thought to the damage market manipulation causes? After all, if you or I attempted to manipulate the markets we would go to jail.
Consider the example of the Hunt brothers, Nelson and Bunker. In the late 1970s and early 1980s the Hunts bought massive amounts of silver on margin, eventually cornering the market and driving silver prices up more than 700%. I was, at the time, in charge of a silver mine on the Arizona-Utah border, and observing that the price of silver was heading for the stars I invested much more capital in the mine.
My investment turned out to be a big mistake—the U.S. government intervened in the Hunt project, changing the margin rules and driving the price of silver down to about $600/troy ounce. The Hunts were forced into bankruptcy, along with my silver mine, and the brokerage firms that had loaned the Hunts the money would also have collapsed but were saved by a consortium of banks formed for the purpose. The Hunts were later convicted of conspiracy.
And that was in an obscure corner of the market—silver futures—that hardly affected most people. The Fed, by contrast, was manipulating the largest capital markets in the world: the U.S. bond and equity markets. By buying up huge quantities of bonds the Fed drove bond yields down to preposterously low levels. Since investors couldn’t earn a return on bonds they were forced to buy stocks (and real estate and similar assets) sending the prices of risk assets soaring.
As in Japan, none of this had the slightest positive effect on the underlying economy, but it made a lot of already-affluent people a lot richer. And by arbitrarily mispricing risk assets, disguising the true cost of money, and favoring speculators over prudent investors, the Fed managed to place the American capital markets in disrepute. Once the fairest markets in the world—indeed, in the history of the world—the U.S. stock and bond markets were now subject to manipulation at the whim of a few dimwitted economists in Washington, DC.
Bad as all this was, the worst impact was felt in the U.S. economy itself. Business people had no idea what the real cost of money was, or what true underlying interest rates might be. They no longer trusted the capital markets. As a result, no one could possibly undertake the major capital projects that might jumpstart the economy but that might also blow back on them.
What the Fed claimed it was fighting—secular stagnation—was in fact caused solely by the Fed’s own staggering arrogance. It wasn’t until the Fed began unwinding QE that U.S. growth finally took off, almost quadrupling growth rates elsewhere in the developed world and beating many emerging economies. Alas, it came eight years and, depending on your politics, one Presidential election too late.
Gregory Curtis is the founder and Chairman of Greycourt & Co., Inc., a wealth management firm. He is the author of three investment books, including his most recent, Family Capital. He can be reached at gcurtis@greycourt.com. Please note that this post is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.
