The Price Of Destroying Key Prices

man in black suit jacket and black pants figurine

What is the sound of one hand clapping? It is when you are sitting around in a quiet house at night, and you realize the motor of the refrigerator just turned on.

This piece may be a little discursive, so please bear with me. When did US economic policy begin going badly wrong? There were two major errors, and both happened in the (drumroll) Reagan administration.

Error 1 was ceasing to run balanced budgets. Error 2 was appointing Alan Greenspan as Fed Chairman. The second error was the bigger one. (Dishonorable mention goes to the Greenspan commission on Social Security, which made our future problems there worse.) Greenspan did not let recessions do their work, eliminating malinvestment. He cut recessions short, and as malinvestment increased, GDP grew slower than it otherwise would have. The resultant trajectory of interest rates went down creating the problem that as they got lower monetary policy got closer to the zero bound, where changing interest rate became less and less effective.

What was worse, was that the Fed began imbibing the idea that they needed to protect all of the securities markets. After Black Friday in 1987, rather than saying that the Fed would provide liquidity as needed, he should have said that the stock market, aside from setting margin limits, is not within the purview of the Fed.

The same would apply to the pseudo-bailout of the banks that came from the 3% Fed funds rate in 1992-1993, and the ultra-steep yield curve that came as a result. That created pressures in the mortgage markets, such that when the Fed started tightening, a self-reinforcing cycle arose that made long rates rise dramatically as bond investors found they needed to sell long bonds as mortgage-backed securities lengthened.

The Fed post-Volcker has been a sorcerer’s apprentice, ever and always. They appear so confident, make huge mistakes, and deflect blame. (They remind me of a certain President. Now who could that be?)

Meddling with Long Term Capital Management, providing huge amounts of liquidity during the dot-com bubble, including the debacle during Y2K, which gave the market a blow-off top. Then, not learning from their error from keeping rates too low in the early 90s, they made the same mistake 2003-2004 keeping monetary policy weak far longer than necessary (Fed funds near 1%), leading to another panic in the mortgage markets when they started tightening policy.

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Disclaimer: David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on ...

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