Dear Valued Clients and Friends,
The markets rallied dramatically on Wednesday when the chairman of the Federal Reserve, Jerome Powell, gave a speech at the Brookings Institute, essentially confirming the likelihood of a Fed “slowing” its plans for interest rate hikes. Other speeches this year have seen markets fall a thousand points. The direction of market impact is less important to my point than the impact itself: we have markets that are highly susceptible to speeches given by one person. And when I refer to “markets,” I do not merely mean the stock market but also the (much larger) bond market, the (similarly-sized) housing market, and the (gigantic) market for currencies.
Of course, the nature of market movement is not so much about a speech, per se, but rather policy expectations that are derived from a given speech. And the response in financial markets to the policy decisions of the Federal Reserve is hardly where it all stops; Fed decisions impact all aspects of the economy. No person lives a life free of impact from the decisions of the Federal Reserve.
Today I want to unpack this a bit more, at least as much as a commentary of this size will let me. I doubt all of this information and perspective will be new to consistent readers of the Dividend Cafe, but I do believe you will find it relevant to your investing life, and, more importantly, relevant to how you think about the economic affairs in which we live.
I teach high schoolers at Pacifica Christian High School in Newport Economics 101 two mornings per week, and I made the course available as a free online offering geared towards teaching people the “first principles” needed to properly understand economics. There are a lot of “takeaways” I properly identify as “the key thing I am going to say this semester,” yet one of those things is definitely this: Much of the divide in 21st-century economics, as it was in 20th-century economics, is the division between those who favor “risk-taking” as a matter of emphasis in an economy and those who favor “central planning.” There is a lot more that can be said to unpack all of this, but essentially some antithesis around “risk-taking” and “central planning” is usually at the heart of economic theory.
Now, I would add because I sort of have to, even that divide is usually about some disagreement around human anthropology – one’s understanding or belief about the human person, human nature, and the purpose of mankind. But I digress …
The 20th-century economic giant, Friedrich Hayek, taught us that the “fatal conceit” of central planning was the idea that mankind can shape the world around him according to his wishes. It flowed out of Hayek’s “knowledge problem” – that is, that the wide dispersion of knowledge in a society renders it impossible for a central planner to ever have the knowledge necessary to effectively plan the affairs of an economy. He advocated for the principles of private property and free exchange to be left alone to create something called “price discovery,” – whereby the subjective valuations of actors in an economy would lead to objective information that would lead to a more efficient (and free) market economy. He found it to be a “fatal conceit” that economists believed central planning could design a superior result. He offered us this gem as a summation of this concept:
“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”
I have said this many times in the Dividend Cafe, but it bears repeating now. I do not agree with Fed critics who believe that the intentions of current central bankers are evil or conspiratorial. I do not agree with critics of the Fed who believe it was created as a secret pact to empower and enrich key banking executives. I do not believe the entire concept of central banking is evil. I do not believe that all of the results of the Fed have been an unmitigated disaster. I find most of those assertions really unhelpful in trying to actually constructively criticize what is wrong with the Fed, and generally revealing of some deeper sociological inclination – not a thoughtful economic argument.
But with that said, I am certainly convinced that what plagues modern central banking is very much the “fatal conceit.” It can be well-intentioned, it can be temporarily effective, and it can be innocuous over certain periods of time – but at the heart of what plagues modern central banking is the conceit that a small number of powerful men and women can have the knowledge needed to do what they have set out to do.
Lender of last resort
The late 19th century and early 20th century saw several substantial periods of economic distress created from a so-called “liquidity trap” – that is, many stops flowing through the economy, not because of insolvency (liabilities greater than assets) but rather money being “sidelined” as actors (for any number of reasons) hold on to cash. In periods where money is not properly flowing, a “lender of last resort” could help keep the financial system liquid
The great 19th-century economist gave us the dictum that ought to govern (and limit!) central banking always and forever:
“To avert panic, central banks should lend early and freely to solvent firms, against good collateral, and at high rates.”
In this vision of a central bank, there is a real limiting principle at play. It is liquidity-oriented, it is also emergency-oriented, and it still requires solvency, collateral, and trade-offs (high rates). It solves for liquidity traps but doesn’t invite discretion, experimentation, and a sort of unlimited idea of what the Fed would be doing.
What interest rates are
I understand that we view interest rates as a nuisance when we are paying them, and a blessing when we are receiving them. When we borrow money to buy a house, we want a low mortgage rate, and when we lend to someone else as an investor, we want a high yield. Fair enough.
This is actually so incredibly easy of a concept to understand that I thought of an analogy I would share to help people relate this concept to other things: Interest rates being different for the payer vs. the receiver is similar to, wait for it …
Every single other thing ever in the entire economy always.
When you sell a house, you want a high price. When you buy a house, you want a low price. When you buy a car, you want a low price. When you sell a car, you want a high price.
If this is confusing for you, you may be eligible for a government position. Now, when it comes to interest rates, there is no real profundity in my point that high vs. low rates have a different impact on borrower vs. lender. But the profundity is that we already know how to get rates set; we let prices get discovered between the borrower and the lender just like we do with a buyer/seller of a home or an automobile.
Why would the cost of money be different? We are allowing the central bank to set rates for no other reason than to alter price discovery, not to find it. We are asking them to distort the signal of prices (the most important price in an economy – the cost of capital that reflects the price of time one is away from their money) – and we are asking them to do it to somehow centrally plan economic affairs better than risk takers and those who proximate knowledge of a given transaction can do.
One of these things is not like the other
Serving as a liquidity provider to financial institutions to keep a liquidity crisis from turning into a solvency crisis is a very, very different thing than seeking to govern the price of time – to govern the signals that are embedded in interest rates across an economy. Setting the price of capital accelerates the burden on the central bank light speed past the initial vision of a “lender of last resort.”
And then, we ask them to do this for the purpose of creating stable prices and maximum employment. We congressionally chartered the idea that a few Ph. D.s around a conference table could drive the policy paradigm that optimally employs people and governs the prices of things we buy and sell. We literally did this.
Fatal conceit, indeed.
All’s well that ends well?
One of the problems with being a critic is that other critics are not content with being reasonable and it can poison the well for the reasonable critics. Here is a caveat that may not sit well with all, but has to be made for the sake of intellectual credibility and integrity … One can believe that the Fed has been empowered in a way they ought not be empowered, and that much of that empowerment has led to negative things, without believing that it all turns of negative. In fact, it would take a rather distorted view of reality to say that all that has happened economically in the last several decades has been negative. There have been ample negatives, and I’ll highlight which one I believe to be the most obvious by-product of the Fed in a moment, but I certainly can see that through those negatives and co-existing with the negatives, has been a functional, growing, albeit inadequate and distorted, impressive economy.
I believe our economy is growing below its organic potential, and that the fruits of the economy would be more “fruitful,” if you will, had there not been these various monetary interventions. But I do not believe that is the same thing as preaching inevitable doom and gloom. The criticism that we are facilitating distorted and sub-optimal results is not the same as sweating an apocalypse.
And this is the point I want to bring the fatal Fed conceit to – that in asking for the central planning wisdom of a few handpicked academic and credentialed folks to set the price of time and cost of capital, we have, essentially, created a boom/bust cycle that goes on and on and on.
The Fed did not create the asininity of non-fungible tokens or worthless dotcom stocks, or NINJA loan purchases of Vegas condos in 2005. No, those things are a by-product of human nature. Human beings desire easy money, free money, and the allure of “getting rich quick.” They do not naturally crave safety but rather the illusion of safety. Humanity possesses cognitive and behavioral tendencies that, uncoupled from disciplines, virtues, and a variety of checks and balances, can make for a truly failed investor (quick aside – “to that end we work”).
But, the Fed’s interventions have poured gasoline on human nature, if you will. The easy money, incentive to reach for yield, embedded confidence in taking irrational risk, low cost of leverage, and distortion of capital allocation feed the bad behavior. It is an enabler to the first degree.
Capital seeks an optimal use and return in the future. This is the natural order of things. Fed interventions
Think of it like a human being
What is the ideal amount of savings you want to have? Is it so much that your current spending needs are threatened? I doubt it. Is it so little that your future needs are in jeopardy? I doubt that, too. Of course, achieving the savings needed to find equilibrium between current needs and future capacity is a different story, but the point is that these two objectives are at the heart of optimal savings. We intuitively know this.
The Fed worries that people will save too much (so rates need to be lower to incentivize less savings?) or will save too little (so rates to be high enough to save more? – but I suppose it has been a while since they actually acted like they cared about low savings). By taking the load off of human beings and on to the fatal conceit of central planners, we have subjected people’s behavior to incentives that distort healthy savings habits. Low rates incentivize spending, but they disincentivize saving. And savings is the sine qua non of productive investment.
At the end of the day, there is a certain arrogance in believing one can find this equilibrium across a society of 330 million people, that the cost of capital, the price of time, the equilibrium between savings and spending, and the exposure to booms and busts (and aftermath of those same boosts and busts) can all be governed by one person or one dozen people.
I don’t fault the Fed for not having the tools to manage all these things perfectly. I fault all of us for daring them to try.
Using monetary policy to manipulate economic outcomes can create good economic outcomes at times. But it creates an embedded instability because of the natural order of things – we have asked them to do much.
Where are we now?
In Japan their central bank bought more bonds last month than they actually issued. Yep. Their confidence in their own use of policy tools to create outcomes caused them to lend bonds to banks who then sold them into the marketplace where short-sellers went to work, causing the Japanese central bank to have to buy more bonds than existed to keep their rate control policy in line.
Does anyone else think this is insane?
I think it is the fatal conceit – the by-product of an imperial and deified vision for central banking (applied central planning) that seeks to do what it cannot do.
And here is where we are now. When something breaks, we will have no choice but to ask the person who broke it to fix it. Is this wrong? Should we let a lot of innocent people suffer because of what someone else did? I’ll save a discussion on the prescription for unwinding for another day. My point here is descriptive. We will turn to the central bank to fix what they broke when it breaks. Mark my words.
Investors are living in an increasingly unstable dynamic that possesses an increasingly symmetrical potential for upside and downside. Booms and busts both pacify and frighten people, depending on where one is in the cycle.
But from the vantage point of an investor with decades of decisions to make (or the financial people guiding them), it behooves one to recognize this for what it is. To think poorly of the fatal conceit, to think highly of a free society, and to de-couple their investment strategy from a boom-bust cycle that is endemic to the hubris of modern central banking.
Chart of the Week
Energy and the S&P against each other after years of ESG influence – the result may be different than some expected.
*YCharts, Wealth of Common Sense, Nov. 2022
Quote of the Week
“Arrogance and hubris destroys everything, every time.”
~ Rich Handler
* * *
I am hitting send on this from John Wayne airport, getting ready to fly to San Francisco for a speaking engagement and client meetings. And no, I will not be missing tonight’s USC game. I can only say that you may be hearing more from me on that subject come Monday. FIGHT ON!
And enjoy your weekends. Fed or no Fed, the future is bright. You’ll see.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet