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"Storage Wars" & The Fed - The Legacy of Quantitative Easing

Wednesday, October 29, 2014

Barry drives a fancy car - a different one each time - to the auction.

The auctioneer cuts the bolt on the shed, rolls up the door, and the bidders all look inside.  They're not allowed to examine the contents other than just looking - and then the auctioneer starts his riff.

As the bids come in Barry starts bidding up the unit.  It's almost like he bids on more of a whim than any sense of what he might get for the shed's contents.

It almost seems like he can print money.

So the price of the unit goes up, up and then up some more.  The other bidders start by shaking their heads.  They follow on by rolling their eyes.  Then they throw up their hands - they're out.  The riff ends with 'SOLD - to the man with the fancy car who can print money!'

As ridiculous as it might sound, A&Es "Storage Wars" is a great pivot on the end of the Federal Reserve's Quantitative Easing (QE).  This is their Orwellian term for 'printing money', only in today's computer age there is no need for paper and ink.  All the Fed does is add to its 'balance sheet' with keystrokes at the keyboard, and then tells the banks what it will pay for U.S. Treasury bonds (i.e. government debt) and home mortgage bonds.

In this world of 'bonds' (think of a mortgage, just with different payment terms), the interest rate goes down as the price goes up.  The federal government - 17+ trillion dollars in debt - cannot refinance bonds which are coming due unless the interest rate on the new bond is lower.  (No one refinances a mortgage at a higher rate.)  So the longer this goes on, the more important it becomes to suppress those interest rates - or to keep the price of bonds artificially high.

Enter Uncle Ben and Aunt Janet.

But at some point they must take away the punch bowl, as they say.  Today the Federal Reserve announced that its program of QE is ending.  Tomorrow will be an interesting day on the stock market.  In the coming weeks and months the markets will judge the results of QE.  Some commentators are already arguing that it was a success.  After all, inflation is low and the stock market has soared, right?  I'll show below that those two observations are self-contradictory.

Let's start with the stock market.  One of the most common barometers of the market is what is called the 'Price to Earnings Ratio', or P/E.  To keep it simple, divide the price of a share of stock in a company with the earnings of that company over a year.  In his book "Irrational Exuberance" Robert Shiller shows an approach to this ratio which accounts for economic cycles and relative profit margins.  His methodology produces a chart (below) which shows that the historic mean for P/E is 16.6.  If the market is at any one point significantly higher than this, it reflects an 'inflation' of stock values.

When we look at Shiller's data we can see an extreme inflation during what we remember as the 'Dot Com Bubble' which burst in 2000 when the P/E was 43.77.  We can also see that the easy money of the Greenspan years was an effort to re-inflate that bubble.  That easy money went primarily into the sub-prime mortgage world and we see that bubble burst at 27.21.  At the bottom of the last financial crisis the number is 15.17, slightly below the mean.

This the context in which we must judge Uncle Ben and Aunt Janet and their program of QE.  It has been an effort to re-inflate the bubble and has brought us to a P/E today of 25.96 - a hairbreadth away from where we were before the last crisis.

So the commentators are right in one sense: Yellen and Bernanke have brought us back to where we were before the crisis.  Whether or not that is a good thing, though, is an entirely different question.

Land and Stock as an 'Inflation-Sink'

But before we judge the merits, just take note of the deflation/inflation cycle - if we think of those things as measures of price.  The Fed is fond of telling us that inflation is low - at less than 2% lower even than they would like it.  But if we look at when the Dot Com bubble burst (22.9 in January 2003) and then right before the sub-prime bubble burst (27.21 in January 2007) we see an increase in the P/E ratio of 20.79%.  Then when we look at the bottom of the Great Recession (15.17 in January 2009) and today (25.96) the rate of increase is 71.12%.

We can see a very similar dynamic in the housing market (using the Case/Shiller Home Price Index):

In this chart we see what happens when the easy money is directed to the housing market.  From the bottom (125.36) to the top (217.86) of the sub-prime bubble we see an increase of 73.79%  There are only so many objectively qualified borrowers in the market for homes.  So after they have been financed and there is still a lot of money sitting around the result is inevitable - a lowering of lending standards.  We all know how this ended.

What this shows us is that land and stock have become an 'inflation-sink'.  By 'sink' I don't mean the kitchen sink.  I mean something more along the lines of a 'heat-sink' - surfaces designed to absorb and dissipate heat.  Land and stock have become the 'sink' that absorbs the inflation of the money supply - and dissipates it among the already wealthy.

The Deception of the "Consumer Price Index"

Not long ago, President Obama tweeted a pose for his concern for the poor and middle class.  This was an appeal to increase the minimum wage.  In his tweets, Obama points out that since 2009 the price of eggs has gone up by 23% and the price of milk by 17% - with the minimum wage remaining the same.

As an example of the ridiculousness of this as rhetoric, Mitt Romney tried the same nonsense in one of the presidential debates, noting how the price of gas has soared.  Conveniently, of course, Romney was starting at the bottom of the financial crisis in 2009 - just as Obama is here.  And Obama rightly laughed at Romney in the debate - just as we should be laughing at Obama today for trying to pull the same trick.

Eggs are sold (usually) by the dozen.  Milk is sold mainly by the gallon.  You cannot take some eggs away, keep the price the same, and still call it a 'dozen'.  You cannot lower the amount of milk in the carton, keep the price the same and call it a 'gallon'.  And it is for this reason that things like milk and eggs are perfect indicators of the truth about inflation.  They are also - along with things like energy - excluded from the Consumer Price Index.

The reason, they will say, is because these prices are more volatile.  Which means, of course, they are more susceptible to the inflation of the money supply when the money supply has been hijacked to prop up government borrowing.  (Hang in there... I'll get back to 'Storage Wars' shortly.)

Purchasing Power and Income Inequality

Let's go back really quick to the idea of a heat-sink.  These are used, for example, on computer chips because the chips themselves can run quite hot.  The heat-sink absorbs that heat and dissipates it.  With land and stock as 'inflation-sinks' the inflation of the money supply is absorbed principally by the increase in prices for land and stock. Who is it that owns land and stock?  Among whom, to ask this another way, is the inflation of the money supply dissipated?

Here is where we see how the Fed's easy money has fed income inequality.  In order to suppress government borrowing, all interest rates have to be kept artificially low.  This makes credit - which is part of the money supply - more available.  This causes lending standards to decline and the prices of things like land and stock to increase.

The rich get richer, and...

The 'lower middle class' - these are those among the middle class who do not own their own home - and the poor do not have land and stock in any significant measure.  All they have are the dollars in their purse/wallet or in their 'savings' account.  And those dollars buy 17% less milk and 23% less eggs than before, as an example.  As prices for energy and food go up, the purchasing power of the dollar in terms of these necessities goes down.

...the middle class and poor watch their standard of living slip away.

The Legacy of Quantitative Easing

Regardless of the usual liberal protests about good intentions, this is the legacy of Quantitative Easing, regardless of what happens next.  But since Uncle Ben and Aunt Janet aren't coming to the auction anymore, the demand supported by the biggest former buyer of government debt is no longer there.  It is like 'Barry' has bailed on the buyers on Storage Wars.  If he and his money tree are no longer bidding on the sheds, the price of the sheds has to come down.

When the price of bonds drop (the 10 year Treasury Bond in particular), the interest rate on all loans will rise.  As these rates rise, it becomes profitable for banks to deploy their now massive reserves - why lend now at 2% when you can lend later at higher rates?  Where will that money go?  It will not go to hiring and production as long as you can make higher margins on land, real estate and speculation in commodities like oil.

The rich will get richer... land, stock, energy and food will increase in price... and the middle class and poor will watch as their standard of living slips even further away.

And when 2% Treasury bonds mature and they cannot be replaced by new bonds at a lower rate?  Well, at the point, things will get really interesting.

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