Kenneth D. Gartrell

By: Kenneth D. Gartrell

Does the Federal Reserve Board birddog for the Congress? Does it help create big problems for the esteemed members of Congress to solve in pursuit of their passion to garner name recognition and political capital? What are the unintended consequences of these actions and what are the implications for the future.

Since at least 1996, the US Federal Reserve Board has performed the role as the Chief Bubble Buster in Charge of the US Economy. The culmination of all the bubble chasing has created a highly unstable domestic economic situation. In this climate, the Fed needs more than ever to be truly independent and stop (even inadvertently) acting as a political agent for central planning by a “jawboning Congress”. In allowing itself to be politicized so severely the Federal Reserve Board does a great injustice to economic science and limits its effectiveness and usefulness as competent guide for political/legal and economic progress.

Perhaps it is time to end altogether the Congressional oversight of the Federal Reserve. We have to be, as we stand today, concerned that such things as the serial appointment of Alan Greenspan during the 1990s and into 2004 compromised the independence of the Fed. Long-term reappointments for “going along to get along” can satisfy the needs of someone like Greenspan who palpably lusted for the label “smartest man in Washington.” Now, again the current Board and the Chairman seem even more inclined to do the bidding of Congress and at the same times lacks Greenspan’s great knack for obscuring and obfuscating even the most elementary aspects of economic thinking.

The Fed at times in the past has relished applying economic constraints under political pressures in Washington. Paul Volker, for example, led the assault on credit card rates in the Carter administration. This move did no cognizable near-term good for the economy, but it surely modified the political landscape by raising the misery index” to soaring and unheard of heights. It also did not do anything but harm for Jimmy Carter in the 1980 election cycle by fueling the Reagan Revolution.

Despite the checkered history of Federal Reserve activity as a participant in central planning, it appears we have to come to a newer, higher and more destabilizing period of consistent political activity at the Federal Reserve Board. We can guess, but only wonder what the political and electoral implication of all the Fed bubble chasing will be for 2008 and 2012 election cycles. But, first let’s get a little grounding in where we are today and how we got here.

The tech bubble: Fed actions and un-intended consequence

The current round of bubble busting started at the Fed with the assault on the NASDAQ in 1996. Led by none other than the increasingly fallible Alan Greenspan of today, the Fed began raising short-term interest rates in 1996 to control the “excessive” (price to earnings) P/E multiples of the NASDAQ. The move ultimately worked to achieve the intended consequences when by late 2000 the Fed Funds Rate reached 6%.

The Fed was obsessed with the level of the P/E in the NASDAQ when it reached 176 to 1 at the 5,000-market peak in early 2000. In its zeal, the Fed overlooked or failed to tell the Congress and the public three important facts about the “tech bubble” and the limited powers of the Fed. The result has been a remarkably counter-productive accumulation of unintended consequences setting the economic clock of the United States back about 10 years and perhaps more by the time 20012 rolls around.

Fact number one: there was no “tech bubble” of “irrational exuberance.”

The Fed consistently failed to explain the NASDAQ market was not only high in expectations, but it was also volatile – meaning very simply that the players in the NASDAQ stocks in the 1990s and early 2000s understood or should have understood well the risks in the market at the time. The market was not a product of “irrational exuberance”. As the chart below shows, it was an observable fact that the risks were known and rationally factored into prices because of the significant and mounting volatility in prices.

The collapse of the NASDAQ was a clear function of short-term rates with a modest lag in time. The failure of the NASDAQ to return to former levels after the relaxation of interest rates has been a surprise and a disappointment. So far, no one has provided a rational explanation of the reasons for the failure to rebound. This has allowed the myth of the “tech bubble” to persist and it has added legitimacy to Fed action and concerted political and regulatory activism ever since.The markets did not need the Fed rate hikes precisely because the risk to return relationship was in tact and working. Rates, nevertheless, are not the reason the markets have never returned. There are now a host of bigger and longer-term problems owing to the spate of regulatory and statutory moves in the wake of the “collapse” of the NASDAQ. The Congress rushed into the vacuum after the collapse, but before the natural rebound, tying the most innovate and productive segment of our economy to the ground. In efforts to curb “corporate greed” governments at all levels (but especially by the Federal Government and the State of New York) imposed costly new and ill-considered regulations; imposed undue criminalization on otherwise civil conduct and stepped-up enforcement of existing statures already known to be of dubious character.

Fact number two: Markets responded to Fed action based on the Law of the Conservation of value

During all the time since the aggressive move on the NASDAQ, the Fed never acknowledged the economic law of the conservation of value. But, it was and remains operational. It was first manifest in the fact that the cash chased out of the NASDAQ went into the pockets of the mature, but less productive major corporations, in turn to the credit markets, hedge funds, private equity funds and ultimately into real assets (laying the seeds of the flight to real assets we have today or a.k.a. the “housing bubble”). It was a direct forcible transfer of capital otherwise intended for long-term growth into an extreme emphasis on short-term liquidity.

The direct shift in liquidly was the reason for the fall in the NASDAQ. Investors had to adjust their portfolios depending on the return to risk ratios of their investments. All the interest rate increases accomplished was to create a context for investors to earn more returns in cash or real assets per unit of risk than markets required in order to sustain the then ongoing pace of technology implementation, productivity enhancement and related economic growth.

Investors generally got out the NASDAQ markets progressively and with plenty of capital intact. As for those who took profits on the way down, the impact was not severe and they moved their capital to other less risky assets or to risky assets in other capital market segments. The big losers were those who bet the market would come back and bought on the way down. What those investors did not know is that they were placing a bet in favor of rapid follow up innovation, fiscal stimulation and/or a bet against undue regulatory incursion that would limit the return of the stocks beaten down by monetary incentives.

Another important consideration for the shape of markets today follows the method of wealth shifting constrained the capital markets. The method encouraged innovations such as the securitization of short-term loan instruments to overcome the liquidity constraint on the shifted capital. The overall funds needed to remain more or less frontally liquid to meet the requirements for marketable securities on major corporate balance sheets.

Fact number three: monetary policy is only good for slowing economic activity.

Short-term interest rate reductions have far less impact on the downside of a market than short-term rate increases have on the upside. The best analogy is to distinguish between the brakes of a car (monetary policy) and the accelerator of a car (private economic innovation and /or fiscal policy). Today, the cumulative burdens of compliance with bad-for-growth laws such as the Sarbanes-Oxley Act (SARBOX) keep innovative firms flat on their backs. The NASDAQ languishes 3000 points below year 2000 peak levels – even though the Dow and the S&P indexes have returned to and exceeded the former high levels.

The reason the NASDAQ crumbled as cash piled up at already cash-rich corporations is simple. As rates increased, the treasury functions in these firms quickly recognized the ability to make easy money through concentration banking and investments in overnight repos. When the Fed pushed rates above their true market levels, it created a substantial cash and/or real property arbitrage opportunity for anyone with cash. Treasury executives at the Fortune 500s have no difficulty explaining to other executives and their boards of directors that leaving money in the bank overnight is profit maximizing. If, after all, you can drop a 2% to 4% incremental return on cash to the bottom line – all with zero incremental risk — then it is clearly a time to reallocate assets from technology and capital spending to short-term investments.Why work to squeak out a 1% productivity gain on new technology? Besides, waiting for a while might even cause an increase in productivity for new systems adopted later. This possibility also caries with it the accounting benefit of stabilizing and “smoothing” earnings over time.

All you have to know is that 176 to 1 in P/E ratios implied growth rates were so high for the emerging sector in 1999 that a one budget cycle delay in technology spending and a five year 50% per year reduction in NASDAQ revenue “growth” explains the entire drop in the NASDAQ from 5000 to 1500 that in 2001.

In its avarice to please Robert Schiller and other trendy left-leaning economists looking for any opportunity to criticize the Efficient Markets Hypothesis, the Fed ran down a great stag of American innovation, and leaving it exhausted on the ground, made it possible for the “do good” Congress to drive the less than well honed dagger of (Sabannes-Oxly Act) SARBOX into its throat.Tendency persists

The Fed should have been exposed for these disasters by now, but it persists in chasing the same bubbles it created. Today the bubble has shifted to the housing market and the rise in private equity capital flows. The liquidity that once fueled the NASDAQ has since expanded growth in the housing sector; growth in merger and acquisition activity; growth in going private activity and a return of widespread corporate conglomeration.

All the high mindedness and lack of clarity about “irrational exuberance, “corporate greed” and “consumer greed “ obviously have enough people persuaded that it makes good politics to continue to bully the markets and adopt fruitless regulations. The resulting political landscape is clearly affected by all this and the ripple effects are apparent in 2008 election rhetoric. The decline in growth has been at the root of increasingly divided political perspectives.

Beyond the realm of Wall Street, the reverberations show up in many kinds of regional and political differences. Consider, for example, the obvious links to the now rampant Xenophobia, fear of trade, border walls, mistrust of innovation, mistrust of markets and on and on. The Left of American politics chastises the Right for mongering “national security” while itself arousing fears over the “domestic” economy. In the meantime, the Right promotes “national defense” and preaches the virtues of lower taxes and less regulation.

Future political and electoral implications

In fast forward to the present we can see that very many if not most of the political issues now being brought to the top by the debate agenda for the 2008 election cycle are rooted in the shocks to the economy caused by the actions of the Federal Reserve in its attack on the NASDAQ. In retrospect is was not an attack on “irrational exuberance but rather and attack of the growth in the US Economy. The diminished growth has been institutionalized by regulation and criminal litigation. The regional and demographic disparities in all of this can only now be addressed by the 2008 election and the consequences that will certainly ripple into the off-year 2010 campaign and the 2012.

Americans are obviously confused by all the complexities. Yet they will have to make important decisions that will set the policy agenda for the foreseeable future. A left leaning result will almost certainly shift the politics of the next few years in the direction of central planning and greater governmental-decision rights into formerly private matters. A right leaning result is not so clearly defined. On the one hand, the right promises less regulation etc. But, it is not clear from the last eight years that the right leaning coalition favors a broad liberalization of the economy or whether it serves the agenda of the slower growth path that is most comfortable to the established order among the Fortune 500.

Taking the entire picture at face value, it is hard to see anything but a long period of groping to recover that same level of growth and innovation that existed in the 1990s. The most likely scenario is a move to the left as in 1976 and a chance for the next, but new and improved, Reagan revolution to occur in the following election cycles leading up to 2012.

Additional Reading with pros and cons

Bubble Man: Alan Greenspan and the Missing 7 Trillion Dollars

Greenspan’s Fraud: How Two Decades of His Policies Have Undermined the Global Economy

Alan Shrugged: Alan Greenspan, the World’s Most Powerful Banker

Paul Volcker: The Making of a Financial Legend

Inflation Targeting: Lessons from the International Experience

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