Tuesday, January 26, 2010

Ben Bernanke and Moral Hazard

At the end of last week, when it looked like Ben Bernanke might not be confirmed for re-appointment as Chairman of the Fed, the stock market was in a tizzy, with the Dow dropping over 200 points on Friday alone. Now, after repeated insistent pronouncements by high level administration and Congressional figures that Bernanke will be approved for a second term, the markets have stabilized and even moved slightly upwards. If you're invested in stocks, that's good. But only for now. In the long run, you, we and all have a problem.

It's no secret the stock markets are complex. With the Internet's informational horn of plenty and thousands of pages of SEC filings per year per company, the data flow is overwhelming. But the crucial information of what a company is truly about and where it's going is very difficult to discern. Add to this the fact that there are thousands of public companies, and anyone who tries to rationally analyze the totality of the markets is destined for discombobulation. Some investors seek out talismanic signs--those would be the now tarnished credit rating agencies' little letter and number grades. Others follow gurus--whichever analyst du jour has the best discernible track record from whatever point of view one considers meaningful. But, more than anything, today's markets rely on big medicine--the big medicine of big government.

Not long ago, the most esteemed medicine man was Alan Greenspan. In an age of asset volatility, beginning with the 1987 stock market crash, Greenspan seemed to have magical powers. He could calm roiling waters. While the Japanese stock and real estate markets boomed and busted, leaving Japan in seemingly perpetual stagnation, Greenspan wielded the monetary wand first to expunge any signs of inflation, and then transport American assets--equities and real estate--to Lake Wobegon, where they all performed above average. Nary a cloud was to be seen in ever brighter blue skies. Seldom was heard a discouraging word. The buffalo roamed. The deer and the antelope played. Chairman Greenspan was practically deified and the markets rose ever higher while he presided over the Fed.

But Chairman Greenspan's big medicine offended the gods of supply and demand. He, a professional economist, had the hubris to think that he could magically stop prices from falling, and the economy from contracting. The gods simmered, then fumed, and then raged. Finally, they cast fearsome bolts of lightning that set the financial world ablaze and burned down numerous houses of cards. The nation was tossed out of Lake Webegon. Justice, untempered by mercy, was administered by the laws of supply and demand.

Alan Greenspan's luck continued to hold. By the time the ship hit the iceberg, he had departed the Fed and taken up a new role as eminence grise to the financially powerful. In his place was a new Chairman, Ben Bernanke, whose medicine was untested.

It's conceivable that the stock market crash of 2007-08 was severe as it was because the Fed was then chaired by a rookie. Because Bernanke wasn't predictable at that time, asset prices couldn't be easily established, and demand fell away.

We know what happened next. The Fed opened up all of its doors, even the emergency exits in the cafeteria, and invited every imaginable financial institution to come in for loans. It organized the first ever money printers' SWAT team to work 'round the clock rescuing beleaguered financial firms. Short term interest rates magically disappeared, and they've been gone for so long many teenagers and children don't believe they ever really existed.

But the stock market revived, and the real estate market may soon be moved from the ICU. Ben Bernanke was complimented, then toasted, and most recently, deified as Man of the Year. The markets now believe in his magic. As long as Bernanke serves as their totem, they will know that no bullet can kill them. Appetite for risk has made a comeback. The bulls strut in the range.

The financial markets' reliance on Great Men is a bad sign. Trading and investing have become bets on the direction of government policy. It's easier to rely on the perceived avuncular omniscience of a senior federal official than deal with the markets in all their mindnumbing complexity. Enormous political pressure is placed on the Chairman of the Fed to pump out soothing liquidity forever. Enormous political pressure is placed on the administration and Congress to keep the seemingly gifted Medicine Man in the Fed Chairmanship forever.

As long as the Big Medicine Man stays in office, no risk will be deemed too great, no speculation foolish. All assets will be good buys, because if supply ever threatens to exceed demand, Uncle Ben will pump out more liquidity to absorb the evil excess.

It was this way with Uncle Alan that we got the Great Bursting Bubble of 2007-08. Now, with the financial markets clinging to Ben Bernanke like lint, the cycle appears poised to renew itself. The financial markets have become increasingly addicted to government policy--and in particular, government handouts. This isn't a story that will have a happy ending in the long run. Lasting prosperity won't come from Big Medicine Men. It will come from the individual efforts of people producing things that other people want to buy, and from the financial markets financing the efforts of these productive people. But the near term profits and bonuses of Wall Street are harder to harvest from the pedestrian activities of the production process. Massive cash flows provided by the Fed are much more lucrative. Plus ca change, plus c'est la meme chose. And that's too bad.

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