We're in Good Hands (Bernanke's Hands)....

.....At least according to the investors who took a recent survey, as reported in this Bloomberg article.

Since Ben Bernanke took the helm of the Federal Reserve in 2006, the economy has been nothing but disaster. I will grant that it was the Federal Reserve policy under Alan Greenspan - easy money, cheap credit, stimulus and bailouts - that caused the current economic crisis.

Unfortunately, Bernanke is following the same policies of Greenspan times 10. How can he not understand that he is pursuing the same policies that caused the crisis? How can doing more of the same possibly fix the problem? One can only wonder.

Bad policy decisions aside, Bernanke is a PhD economist from MIT and former professor at Stanford, NYU and Princeton. He obviously knows what he's doing. Or does he?

Check out this video and see for yourself. My assessment? I'm working on raising an investment fund that makes investment decisions purely based on doing the exact opposite of what Bernanke says or recomends. This is in addition to the Anti-Jim Cramer fund I started a few years back...



On a final note, Bernanke addressed the House Finance Committe today on monetary policy, the Fed's exit strategy, etc. Ron Paul asked Bernanke to give his definition of inflation. Bernanke answered something to the effect that inflation was a rise in the level of consumer prices. I'm working on getting the clip/transcript to post this nonsense for all to see.

I'm going to address inflation in my next post, in Part 2 of the Inflation/Deflation debate.

Inflation or Deflation? The Debate - Part 1

Inflation or deflation?

This question is currently the hottest debate in the world of economics and financial markets. What are the arguments on both sides?

Inflation Argument: The combination of government bailouts, Fed money printing, stimulus, low-interest rates, massive government debt, record fiscal deficits and monetary expansion will lead to a devaluation of the dollar and rising prices in the near future.

Deflation Argument: High and lingering unemployment, excess economic capacity, the "output gap", continued demand destruction, falling wages and further credit contraction will stifle any inflationary pressures potentially caused by those in the inflation argument above. The argument is essentially that so much wealth and credit has and will continue to be destroyed, that no amount of money printing or government stimulus will possibly lead to inflation, because the "hole" that needs to be filled is so massive.

**Please note that the following are extremely brief arguments that I have heard and believe are acceptable on both sides. Feel free to comment on or question these arguments. This is an important debate that will continue until one side wins, whenever that is.

I am still personally researching this topic on a daily basis. This week was a "big" week in terms of economic data released by the government. One data point that I saw on economist Dr. Bob Murphy's blog is the Consumer Price Index of All Goods, not seasonally adjusted. The CPI you often hear about on CNBC does not include food and energy, an odd fact considering food and energy purchases constitute a major portion of consumer expenditures. The all inclusive CPI is the first link on the Fed webpage (graph below). This is one of many useful indicators to help guide the economic forecaster on this topic in the future.

Deflation or inflation*? Thoughts? Other good indicators?

*As Dr. Murphy pointed out on his blog, Gas prices and oil rose quite a bit in the 2nd quarter, which cannot be overlooked in its contribution to the increase.

I plan to examine other indicators and will continue to research and post on this debate in the future. Hopefully we can come to a definitive conclusion by Q4 2009 to guide future investment and business related decisions.

California IOUs

Housing Part 2

Regarding my last post, a friend asked:

"I do not understand how in the world this refinance at 125% makes any sense. We know the house isn't worth as much as they paid for it so we're going to say its worth even more? Am I getting that right?"

You are exactly correct. Again, that's saying here is a house that is worth $100,000. The owner would like to refinance his mortgage, so Fannie says great, here's $125,000.

The over-inflated loan-to-value ratio is not the real problem, but is an underlying symptom of it. The real problem is that because Fannie and Freddie are now government run entities, they can continue to provide mortgage loans with an interest rate and loan to value ratio that would never be allowed in a free market mortgage system. What we have to understand is that credit is currently scarce in the private market for a reason. Despite what the government would like for us all to believe, credit is not created out of thin air, but comes from the savings of businesses and individuals. Unfortunately, Americans are broke and we have a proportionately tiny savings pool from which to derive credit for our massively indebted economy. Lack of credit is the reason for the collapse in economic activity. As President Obama has stated on several occasions, credit is the "lifeblood" of our economy. What the President failed to mention is that when an economy is built on credit that is artificially created by the printing press of the Federal Reserve, the lifeblood can quickly turn into a cancer that will inevitably kill the patient when the bubble they created bursts.

The free market solution to the scarcity of credit is to make credit more expensive, so that only those individuals and businesses who need credit the most will be willing to pay the now much higher cost of capital. The result is that credit will be "scarce" for non-essential things like credit cards, car loans, and overpriced real estate. But this is a good thing. Because scarcity has made credit more expensive, Americans will be rewarded for savings with higher interest rates, and thus higher returns on their savings - a great incentive to save, especially when you consider the current 1-2% interest rates. As savings are built up, credit will become less scarce, interest rates will fall, and the economy will rebuild itself through simple market forces - in this case the supply and demand of credit. The imbalances in the U.S. economy are a major contributor to the current economic situation. Our economy is 70% consumer spending, while exports and investment makes up a tiny percentage of GDP compared to other economies like China and Japan. Personal consumption expenditure and housing growth were vital to the U.S. economy. But as mentioned in my previous post, this growth was largely artificial, driven by the Fed's cheap money and the inflation that resulted from it. Because the majority of our economy was driven by two sectors - consumer spending and housing - whose growth depends on ever increasing credit in the form of debt, when the debt stopped coming, and then contracted severely, the wheels came falling off.

For the past 20 years, the government has approached every recession in the same way. Interest rates are lowered for an extended period of time and some type of stimulus, whether a tax cut or direct injection, adds additional liquidity into the market, allowing the government to sustain unsustainable asset prices. The result is a temporary easing of economic hardship that masks the underlying problem. It is unfortunate that these past excesses continue to be swept under the rug because they always rear their ugly heads only a few years down the line. This is the explanation of our boom and bust economy. Government efforts to stimulate the economy never fix the underlying imbalances that caused the problem in the first place. In fact, the past stimulus's have only made the problems worse, resulting in the economy we find ourselves in today. The reason is because the artificial credit provided by the government distorts the self-correcting market mechanism. Imbalances continue on indefinitely, as the government's artificial supply of credit causes market actors to make poor decisions, based on credit that does not actually exist in the economy.

In conclusion, continual efforts by the government to stop the contraction in credit serve only to increase the imbalances in the U.S. economy and further weaken its foundation. My last post attacked the most recent attempt by the government to sustain artificial credit by increasing loan to value ratios to 125% for loans refinanced through Fannie and Freddie. This latest effort may seem unique or resourceful, but in reality it is simply another means for the government to keep our economy flooded with credit and debt that it doesn't need. In this case, supplying our economy with more artificial debt is like giving the drug addict in remission more drugs. The drugs may delay the pain for a while, but the artificial high will not last forever.

Rule Change

Today in an attempt to help stem home foreclosures and restore housing affordability, the government announced a new plan where homeowners who refinance mortgages through Fannie Mae and Freddie Mac can get a loan equal to 125% of the home's value. That means that if your home is worth $100,000, you can refinance for $125,000. Makes sense.....

Here is the article on CNBC.com.

The government has wrongfully concluded that falling home prices are the problem and the cause of the current economic crisis and recession. The government's solution is to prop up home prices through artificially low interest rates, rescue programs sponsored with taxpayer money and socialized housing schemes such as giving a 125% loan to value mortgage. What the government doesn't seem to understand is that it was exactly these same government schemes/scams in the past that caused the housing bubble that led to the economic collapse. While the government has passed around the blame for the crisis and pointed many fingers at greedy Wall Street bankers, speculators and hedge funds, ultimately Uncle Sam can point the finger right back at himself. Of all the misguided economic programs launched by the government in recent decades, the chief culprit and main cause of the crisis is the Federal Reserve, which has provided the economy with cheap credit and easy money for the past two decades in the form of artifically low interest rates.

After reaching an all-time high of 5132.52 on March 10th, 2000, the Nasdaq bubble burst and reached it's low of 1116.76 on Oct 10, 2002. When the Nasdaq bubble collapsed, the technology, communications and internet sectors of the economy were decimated. The result of every artificial credit boom is a bust that results in asset deflation and a credit crunch. The U.S. needed to experience a massive recession in 2001/2002 to "purge the system" and cleanse the economy of the malinvestment brought on by the internet stock bubble. Instead of allowing this natural market correction to take place and in order to stimulate the economy out of recession, the Fed aggressively cut interst rates down to 1% in June 2003 and left them at the then all-time low rate until June 2004. Notice how low interest rates remained even after the recession ended (recession highlighted in grey).


The result of all time low interst rates? Mortgage rates also fell to an all time low.


Not surprisingly, the low interest rate/low mortgage rate combination led to an explosion of borrowing and lending (and spending), specifically in the residential real estate sector. Commercial banks more than doubled the amount of real estate loans they made from 2002 to 2008.


Cheap money had to be loaned out in the frenzy as literally trillions poured into the mortgage market. "Home prices never fall" was the favorite saying in those days. Artificially low interest rates enabled the securitization market to thrive from 2005 - 2007, which further increased demand as investor appepetite for "riskless" U.S. housing investments shot through the roof.

How could these assets be riskless? The Government Sponsored Enterprises Fannie Mae and Freddie Mac contributed to the housing bubble by insuring mortgages and also buying mortgage securitities. Unlike the private mortgage market, the U.S. government's implicit backing of Fannie and Freddie guaranteed moral hazard and malinvestment, because if backed by the U.S. government, the securities purchased by Freddie and Fannie were rated AAA, meaning almost zero chance of default and essentially no credit risk. Alan Greenspan admitted the inherient moral hazard in this 2005 speech. Of course, with the collapse in the sub-prime housing market in 2007, the country quickly realized that these "riskless" assets owned by Fannie, Freddie and other commercial and investment banks were not AAA securities, but were actually worthless.

The problem today is not that home prices are falling. The problem is that artificially low interest rates triggered a massive credit and housing bubble, causing home prices to rise artificially above historic norms of growth. The housing boom was not real growth or wealth creation, but was simply an artificial boom created by credit growth injected by the Federal Reserve. As previously mentioned, the result of every artificial boom is the inevitable bust. Austrian Business Cycle Theory explains the boom and bust economy the U.S. has experienced over the past few decades. Not surprisingly, Austrian economists were some of the few who correctly predicted the housing collapse and the subsequent global recession. Regrettably, the terribly flawed Keynesian economic model that inspired the misguided thinking of our leaders in Washington continues to be followed as if it were gospel, apparently the only philosophy capable of rescuing the world from total collapse.

Of course Keynesian economics is total nonsense, and in order for our economic woes to come to an end, the government must come to its senses and realize that the solution to the problem is not to maintain housing prices at artificially high levels via Keynesian stimulus. As painful as it may be, the real solution is that we must let home prices fall to their natural level, or the historic trend-line. When homes become affordable again, due to lower prices, buyers will be enticed and will return to the market and in time, everything will be back to "normal". The housing experience from 1997 to 2007 was not normal, as the following inflation-adujsted U.S. home price graph demonstrates.

The problem with more government attempts to stimulate housing is that it was precisely these same government interventions and mistakes by the Federal Reserve and Congress that brought about the current crisis. More and stronger attempts by the government to prop up home prices and stimulate demand will have the exact opposite effect intended, and instead of stimulating, interventions will further distort the already fragile market, delaying the ultimate correction for another day.

Unfortunately, as with all the government stimulus' of the past, the effects of the current stimulus, which is the largest in the history of the world, will inevitably lead to worse economic consequences than those we have experienced in the past. Unlike the past however, when credit growth inflated assets like the Nasdaq and housing market, temporarily benefitting those who owned these assets, the current round of stimulus and credit creation will only destroy the value of the dollar. As a result, the cost of living for Americans will skyrocket and the average citizen will be most harmed by the stimulus that was championed by the government as the only possible way to save them.