Stephen Roach is without a doubt the most iconoclastic of Wall Street Economists. He has been alone among major investment house economists in calling attention to the stock bubble, the bond bubble, the housing bubble, and in questioning the sustainability of the recovery. He has arrived at some of the same conclusions as many Austrians without an explicit formulation of the Austrian Theory of the Business Cycle. He is one of the few mainstream thinkers to correctly identify the Fed’s inflationist policies as the source of asset bubbles and mal-investment.
In an economic commentary The World’s Biggest Hedge Fund, Roach explains how the Fed’s low interest policies have created asset bubbles by funding speculation at low rates, and how the US financial system has become increasingly dependent on the expansion of debt.
Unfortunately, the role of the US central bank goes beyond benign neglect. Over the past several years, the Fed actually has been quite aggressive in arguing why excesses are not bad. That was the case when it repeatedly justified the equity bubble on the basis of the so-called productivity renaissance of the New Economy. It has also been the case when the Fed has argued that America is not suffering from a debt problem, nor a twin deficit financing constraint. By serving as a cheerleader when financial markets are going to excess, the Fed is losing its credibility as an objective observer. It is no longer the tough guy that relishes the role of “taking away the punchbowl just when the party gets going” — to paraphrase the legendary mantra of former Fed Chairman William McChesney Martin. By condoning excesses, the Fed, in effect, has become a stakeholder in the carry trades it spawns.
Writing on the Financial Times subscriber site ($) The Asset Economy is a House of Cards he writes:
There have been two distinct phases of the asset economy, the first being the equity bubble in the late 1990s and the second a by-product of frothy property markets in the current decade. The impact of property wealth far exceeds the impetus provided by equity wealth. This differential is the key to what is perhaps the biggest risk of the asset economy: the property wealth effect is a far more debt-intensive phenomenon than the equity wealth effect. ...
US policymakers have joined in celebrating the miracles of the asset economy. The Federal Reserve has provided the rock-bottom interest rates that have pushed asset markets into uncharted territory. But this has led to the ultimate moral hazard: overly indebted consumers and overly exposed financial institutions, both of which are vulnerable to an overdue normalisation of monetary policy. That takes us to the weakest link in this daisy-chain: the juxtaposition of the imbalances of the income-based US economy and the purported soundness of the asset-based alternative. In a rush to embrace the new, America has pushed the concept of income-based imbalances, such as saving rates and current account deficits, into the danger zone. This could not have happened were it not for the high-octane fuel of extraordinary monetary and fiscal stimulus. As those policies are now normalised, the asset economy should be subjected to its toughest test.
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Contrary Investor’s July column, Enough Rope? analyzes the July flow of funds report from the Fed to produce a series of charts and graphs emphasizing the serious imbalances that exist in today’s currency markets. The US is accumulating debt to foreigners at an alarming rate. CI does not cover this part of the story...the current financial system is the residue of the Bretton Woods currency system that placed the entire world on a dollar standard and left the dollar alone on a gold standard. The US soon inflated its way beyond any possibilty of gold redemption and then defaulted on its obligation to redeem dollars for gold. We are left with a system in which vast amounts of dollars are held as “reserve assets”.
The rest of the world needs dollars to conducti international trade, while we, here, on the other hand, can just print more of them and buy imports without having to produce much in return. Back to CI, contrary to the optimists who say that this is a sign of the strength of our economy and how great a place the US is to invest, CI notes that foreign investments are increasingly in paper assets rather than direct investment in factories, plants, etc.
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Jim Puplava has penned a lengthy and thoughtful essay on problems in the financial system on, The Carry Trade Economy. The story, in summary, is that the Fed has pursued an inflationary policy through lowering the interest rates available to banks and financial institutions. This has made profitable a massive amount of borrowing by financial institutions at low rates, ultimately supported by Fed money printing, These financial institutions, banks and funds have invested (or more properly speculated) in various types of financial instruments with borrowed money. Because these positions have grown so large, there is no possible counter-party to purchase them should the Fed raise rates.
Puplava forecasts that the only way out of this is hyper-inflation, which will result if the Fed buys the leveraged assets from financial institutions to prevent them from defaulting in nominal terms. He provides some interesting comparisons to the Weimar period hyperinflation. Also of interest is a piece from last year, The Zero-Interest-Rate Economy.
