Notes From Underground: The Tail That Wags the Dog

The global financial system is in a difficult state as the world’s central banks react to equity markets as a guide to economic policy. Ben Bernanke has to assume some responsibility for this because of his August 2010 Jackson Hole speech about the importance of PORTFOLIO BALANCE CHANNELS. In an effort to get the “animal spirits” of investors flowing Bernanke pushed for a second round of QE to make interest rates so low that investors, insurance companies and pension funds would choose to buy equities and high yield corporate debt, taking on more risk so as to arouse the capitalist’s desire for higher returns. Once this path is trod and the FED is the bartender rather than the designated driver, the question arises about when the system is healthy enough to sustain increased growth without a continued monetary infusion.

In an effort to weigh the PORTFOLIO BALANCE CHANNELS’ success the FED has proven to be hesitant when the stock and bond markets react negatively to the removal of stimulus. The announcement of a possible tapering in May 2013 and the fall in the equity markets, global bonds and emerging market currencies is such an event. The FED has been unable to break Wall Street’s addiction to easy money as the cure-all for a balance sheet recession. Even though the current tapering has not negatively affected recent equity market strength, it is significant to point out that reducing the purchase of BONDS is not a shrinking of the FED‘s balance sheet. As the Fed constantly reminds us, tapering is not tightening.

Why do financial and bond markets need to rely on the “kindness” of the FOMC? The blame is to be placed on Alan Greenspan’s shoulders for his rush to judgment to bail out LONG TERM CAPITAL MANAGEMENT (LTCM). Greenspan’s efforts to prevent the systemic collapse of the world’s large banks sent a signal to all systemic significant institutions that the FED would be there to support the financial system and prevent its failure. The simple fact is that LTCM was a mere pimple on the global financial system. Yet in an effort to save the system Greenspan panicked and set the entire global system on a course to be dependent on the rise or fall of the equity markets for direction on monetary policy. It is not the economy stupid its the value of stocks. When the post-Greenspan Fed was confronted with a genuine systemic event it went into overdrive in an effort to prevent a liquidation of the world’s financial system.

Bernanke was certainly right to flush the system with liquidity at the time of the negative echos from the Lehman collapse, but at what point do selloffs in the equity markets signal a correction in asset prices and not a financial panic? Greenspan has left global central banks with the major conundrum of all. When is enough QE enough? The irony is that the continued adherence to the Greenspan PUT creates the greatest systemic risk of all. Global bond markets certainly reflect the mispricing of risk as Jeremy Stein has warned. The FED and others have to stop being ultra sensitive to the machinations of the world’s equity markets. Oh well, WHATEVER IT TAKES.

***In tomorrow’s Financial Times there is a short piece by Robin Harding titled, “The Fed’s Riposte on Short v. Long-Term Unemployment.” I bring this to your attention because it is important to note the incipient battle over the idea of structural unemployment from the work of Professor Alan Kruger. Using the Kruger research, the Harding article conjectures that the “… long-term unemployed are to disconnected from the labor market to hold down wage inflation.” It boils down to maybe the OUTPUT GAP GENERATED BY HIGH UNEMPLOYMENT does not pose a deflationary threat as many models have supposed. It is an argument that maintains that it is short-term unemployment that is the reservoir of worker slack and the loss of skills from the long-term unemployed keeps them from being employed.

It seems that Chair Yellen is not readily accepting the Kruger research for that would necessitate the FED being quicker to raise rates as the pool of the short-term unemployed diminishes. This may be why the Yellen Fed has dropped the quantitative thresholds of forward guidance and suggested a more qualitative approach in reacting to its dual mandate. This is the next big battleground in the halls of the FED and academic institutions. If Kruger’s argument is correct, it seems to me that a diminishing pool of workers with the needed skills should be upward pressure on wages and work weeks as employers have to pay more to sustain their present work force. This is why the average hourly earnings and average hours worked become so important.

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2 Responses to “Notes From Underground: The Tail That Wags the Dog”

  1. Shocked to Find Gambling Says:

    Yra- great post.

    To me, the tragedy of the Greenspan and Bernanke moves to save the TBTF banks, is that those banks are now much bigger than in 2008 and risk is more concentrated.

    I guess it takes a PhD from Princeton (or maybe DeVry) to figure out that the way you correct the threat to the world economy of concentrated risk, is to concentrate it further.

  2. Notes From Underground: Has the Fed Potentially Created a Trap For Itself??? (Maybe) | Notes From Underground Says:

    […] week I wrote about the “Tail That Wags The Dog” (and I will repost the reference to the Robin Harding FT […]

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