The Greatest Cost:
An astute analyst posed the following question yesterday: "The current debate is centered on whether the Fed can take back the liquidity in time in order to prevent inflation. Suppose it can. Suppose they execute this perfectly. But if the Fed is able to flood the system with the liquidity (thus reducing the severity of the downturn) and take it back before it causes inflation, it seems there is a free lunch. We get something for nothing. So, assuming a perfectly executed game plan by the Fed, is there a cost? Do they keep rates low for a time, only to raise them a lot a year down the road – is that the cost? Or is there another cost?"
I’m short on time today, so I’ll attempt a brief response.
First of all, while it often appears otherwise, finance provides no free lunch. The mispricing of Credit and misperceptions of risk in the marketplace have deleterious effects, although their true impact may remain unexposed for years. Indeed, the more immediate (and always seductive) consequences of loosened financial conditions tend to be reduced risk premiums, higher asset prices, and a boost to economic "output". Conventional analysis of monetary policymaking still focuses on "inflation" and "deflation" risks. I would strongly argue that our contemporary world has already validated the analysis that acute financial and economic fragility are major costs associated with market pricing distortions…..
Admittedly, the massive extension of government Credit and obligations works wonders in stabilizing a devastatingly impaired system. Inflationism is always seductive; Trillions worth is absurdly seductive. Yet this extra layer of debt does little to affect change to the underlying economic structure. Actually, a strong case can be made that it only delays and sidetracks the necessary adjustment process. And, importantly, this enormous additional layer of system debt exacerbates system vulnerability.
At the end of the day, a system is made or lost on the soundness of its underlying economic structure. I posit that a sound economic structure is reliant upon only moderate Credit growth and risk intermediation. Our system requires massive Credit expansion and intensive risk intermediation. I would also posit that there are no benefits – only escalating costs – to throwing massive Credit inflation upon an unhealthy economic structure. And, returning to Ponzi Dynamics, one of the major costs to such inflationism is a massive expansion of non-productive Credit – obligations that are created without a corresponding increase in real economic wealth producing capacity. The debt can only be serviced by the creation of more debt obligations.
The danger is that markets too easily and for too long accommodate massive Credit expansion during the boom. Federal Reserve policies are fundamental to this dynamic. But at some point and out of the Fed’s control, as Wall Street learned, greed inevitably turns to fear and a reversal of speculative flows marks the onset of the bust. And it’s the massive inflation of non-productive Credit that ensures the unavoidable crisis of confidence. Can the underlying economic structure service the mounting debt load or, instead, is it the massively inflating debt load that is sustaining a vulnerable economy? And it is in this vein that I fear the Government Finance Bubble is on track to destroy the Creditworthiness of the entire economy. And this Ponzi Dynamic is The Greatest Cost to what I fear is a continuation of unsound policymaking.
Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.