Time to Stop the Bubble Machine?

Debt and deficits are not inventions of ideology. They are facts of arithmetic.

~Paul Martin, Canada’s finance minister at the start of the country’s “Redemptive Decade”

Federal Reserve Bubbles

Usually our Friday Food for Thought posts highlight a single article. Today, I’m going to highlight and compare 3 great pieces, so this article is a little longer than usual. I think you’ll find, however, that these articles will provide you with a lot of food for thought that’s well worth your time.

On Monday I laid out some of the reasons why most of our capital is in cash. I then went on to look at What Would Make Me Invest in the Stock Market again. I said that the current economic system is a Ponzi scheme, made more so by further quantitative easing. Markets oscillate violently according to what various Fed officials leak to the press and the resulting effects on the U.S. dollar. Good companies rise a little more when the tide is up and fall a little less when it goes down. That is as close as we seem to get to a real free market.

The Ponzi Bubble Machine & Our Collective Sammy Scheme

Once upon a time it would have been considered blasphemous to compare our mighty capitalist economy to a Ponzi scheme. These days, it seems to have become rather fashionable. Bill Gross of Pimco had this to say in his November Investment Outlook:

“Check writing in the trillions is not a bondholder’s friend; it is in fact inflationary, and, if truth be told, somewhat of a Ponzi scheme. Public debt, actually, has always had a Ponzi-like characteristic. . . . I ask you: Has there ever been a Ponzi scheme so brazen? There has not. This one is so unique that it requires a new name. I call it a Sammy scheme, in honor of Uncle Sam and the politicians (as well as its citizens) who have brought us to this critical moment in time.”

Gross, while basically endorsing the Fed’s approach with the assumption that there’s nothing else they can do, addresses the probability that their QE policy will indeed cause asset price dislocations and create more bubbles. A couple of months ago, I wrote extensively about bubbles, identifying 5 Financial Bubbles and 5 Socioeconomic Bubbles that may be ready to pop. I defined bubbles as “structurally tenuous entities with nothing of substance at their core.” I guess you could probably say the same for both Ponzi schemes and Sammy schemes.

Mr. Gross also laments the sad state of American political affairs and suggests abolishing the two party system. He further suggests that the U.S. electorate is just as responsible for the sorry state of affairs in the country, since they have elected those who are in office. In fact, the letter begins like this: “They say a country gets the politicians it deserves or perhaps it deserves the politicians it gets.” (Note that Gross also postulates that the 30 year old bond bull market is on its last legs with a really great turkey analogy.)

How Do We Make It Better?

On Monday, I mentioned that better fiscal and monetary policy might entice me to buy the markets again: “The U.S. needs to signal that it’s ready with a concrete plan to tackle its fiscal mess. There are policies that don’t involve monetary alchemy that can be used to right the ship in less time than you might think.” I promised to talk about a few of those ideas today. Incidentally, these aren’t my ideas; they’re just suggestions I’ve read about and found interesting. I hope you will too.

There are two main arguments that I’d like to highlight for you. I don’t have room to go into a great deal of detail, so I invite you to read both articles in their entirety. One approach is a no-holds-barred dare aimed at Ben Bernanke’s manhood and dripping with American arrogance pride. The other is a more measured suggestion that perhaps it’s time for Americans to swallow their pride and borrow a solution from a country that did it right. Nice juxtaposition, eh?

Suggestion #1: Raise Rates

You read that right. Josh Brown over at The Reformed Broker sent this message to the Fed: Raise Rates, Cowards. If you set aside the testosterone-laced Homer Simpsonesque (“U.S.A.! U.S.A.!”) rhetoric of the piece, there are some really compelling arguments here for why the Fed should do a U-turn and immediately raise the Fed funds rate to 1%:

  • China shocked the market by tightening policy out of nowhere and the market flinched briefly, but then went about its business.
  • It would send a signal to the markets and the world that things aren’t so bad.
  • It would act like a shot of Raid to the gold bugs and extinguish smoldering currency war fears.
  • It would kick those waiting to buy a house off the sidelines as they will want to lock in lower rates, and clear out some of the huge foreclosure inventory.

Please don’t mistake my good natured chiding for disagreement or disrespect. Josh writes beautifully, and he tells it like it is. Here’s my favourite section, where he describes how a rise in rates would affect the banks:

The free money game for the banks has been a holocaust for savers and the elderly.  It’s also been the most despicable corporate giveaway in American History.  Allowing the banks these risk-free, automatic profits is treason.  Stop it now.  Force these banks to do their job and serve their function in society – the financing of business activity.  No more borrow-from-and-lend-to the government.

If the Fed raised rates to 1% on Monday morning, the markets would likely throw a tantrum and tank. But I have to tell you that if they did, I would be selling the rest of my inverse ETF position and fine-tuning my shopping list.

Suggestion #2: Go Canadian

Another one of my favourite writers is John Mauldin. Each Monday, he puts out an article written by someone else who thinks Outside the Box. This week’s article was written by David Hay, Chief Investment Officer of Evergreen Capital Management. Today’s main quote from former Prime Minister Paul Martin came from this essay.

The article is basically a review of a book called The Canadian Century: Moving Out of America’s Shadow by Brian Lee Crowley, Jason Clemens and Niels Veldhuis. The book reminds us that Canada faced a horrific fiscal crisis in the 1990s and was able to turn things around within a few years.

Here are a few of the policy initiatives the Canadian government undertook under the direction of then-Finance Minister Paul Martin:

  • Martin unveiled a budget in early 1995 that shocked all the cynics accustomed to smoke-and-mirrors accounting. It reduced program spending by 8.8% over two years (and our politicos quiver over a mere hint of spending freezes).
  • As part of this radical spending rationalization, federal government employment was reduced by 14%.
  • Federal grants to the provinces were reduced by 14% as well, but the trade-off was that they were allowed to control how the money was spent. Provincial governments also needed to provide half of all funding (i.e., put skin in the game).
  • While some taxes were raised (and, according to the authors, these worked against the recovery), spending cuts were 4 ½ times tax hikes.
  • Canada’s welfare system was dramatically modified. Rather than just providing a blank check to the provinces (which administered the welfare programs), Ottawa incentivized them to put the funds to better use. Benefits were cut for single, employable individuals and aggressive efforts were made to get them back in the work force.
  • Despite accusations from the far left that the poor would suffer due to these changes, the percentage of welfare recipients fell in just a few short years from 10.7% of the population to 6.8% by 2000. From 1997 to 2007, the percentage of Canadians classified as low-income plunged by over 30%.
  • As a result of these actions, and many others I’ve left out, the federal budget was balanced within three years.

These are quoted more or less directly from the article, but there are many more interesting points, so go I would encourage you to read the essay in full. Interestingly, just as I was finishing up today’s article, The Financial Post reported that a couple of economists from Wells Fargo said that Canada-style deficit reduction, ’90s-style, won’t work in the US. They point out that Canada depended a lot on exports and interest rate cuts to orchestrate their turnaround. Neither are viable options for the U.S. at the moment.

While the Wells Fargo guys make some good points, maybe there are other aspects of the great Canadian renaissance that our friends to the south might be able to use. Americans tend to be fiercely independent and that has often moved them to the head of the global class. But this just might be one of those times where it would do them some good to copy another classmate’s work, for if they fail this test, they’re going to take the whole class with them. Note to U.S. policymakers: Go ahead. Look at our paper – please.

What do you think of these potential solutions? Will they help or hurt? Are they better than the QE alternative?

Written by Kim Petch

11 Responses to Time to Stop the Bubble Machine?

  1. I still do not understand why the USA is not taking their debt/deficit seriously. What are they counting on? devaluation? The first cut that comes to mind is the military budget that is almost 700billion dollars for 2010. Why not shift 200 billion into major transportation development, high speed trains or renewable energy projects, this sure beats playing policeman in how many bases again?

    • Yeah. You know, I thought a lot of those stimulus dollars were supposed to go toward infrastructure. We hear all the time about how the power, water, highway, bridge, and transportation infrastructure in North America desperately needs to be updated. It seems like a no-brainer to me to spend resources on this stuff rather than trying to create an economy based on fairy dust and monopoly money.

      I’m afraid, however, that because the debt is getting too large, it might be too late to provide this type of employment/economic boost.

      Thanks for your thoughts today Mich!

  2. I love the quote that opens the article. It’s all about bubbles and the way to stop bubbles is to start paying attention to arithmetic.

    I’m not too crazy about the idea of focusing on the Fed. The Fed certainly shares in the blame. But it is disempowering to turn to politicians (that’s what Fed members are) to save us. We can save ourselves. We can take a look at the man or woman in the mirror.

    Bubbles start with us. If we refuse to invest in overpriced stocks from this point forward, there will never again be a bubble. The Fed will be perfectly happy with that. Each citizen who cares about the future of the free market should be speaking out in clear and firm terms in opposition to the continued promotion of Buy-and-Hold (bubble-creating) investing strategies. The politicians will follow our lead when we make clear that we are serious.


    • It sounds like Bill Gross agrees with you. We elected these folks and we cheered the markets higher with little thought for the fact that they were rising based on monetary policy initiatives rather than real economic activity.

  3. You’re talking about the reincarnation of the ol’Soviet bureaucrats who got into the ego boosting practice of controlling prices to control the economy. The Greenspan/Bernanke Fed caused a massive shift of resources into housing by controlling the price of short term money and brought us to the brink of collapse and now seek to bring us out ex Greenspan by jerking the car hard right. When it flips they’ll all be shocked but quite adept at putting the blame elsewhere.
    In the meantime those who are seeking a decent rate on low risk investments are out of luck.
    Now they seek to control price of longer term money via “quantitative easing”.

    • Amen. Market manipulation has become standard operating policy even as stock cheerleaders attribute the recent rally to the wonders of free market capitalism. The market may be rising, but it certainly has nothing to do with a functioning free market.

      In the meantime, pension funds, retirees, and conservative investors are left to make due with paltry fixed income returns. It’s remarkable that they keep lowering rates across the curve on one hand while touting the great economic recovery on the other. If the economy is doing well, why do we need more QE? Maybe it has something to do with ginormous black holes on bank balance sheets due to the trillions of dollars in faulty mortgages they underwrote a few years ago. 😉

      Thanks for stopping by and for contributing to the conversation!

  4. The Fed should raise rates and we should also implement the “Canadian Solution”. Because the Market Always Wins the Fed will eventually be forced to raise rates anyway. Cuts in government services will also happen once the cost of borrowing is prohibitive. It would be best to take action now while we have some control over our destiny.

    • It’s always a good idea to get your finances under control, but that seems more true today than ever. Thanks for stopping by!

  5. This is a great post. This subject is so important and yet it gets very little attention.

    I definitely think this much quantative easing is bad for our economy and I agree the Fed should raise interest rates immediately. Japan tried near zero interest rates and their economy has languished for decades. Right now, traders are “borrowing” Yen with no interest and investing the money in other currencies.

    The Fed and our so-called leaders need to realize they have pulled the QE lever past the point where it is effective and now they need to implement real solutions. These real solutions should include lowering the deficit and auditing the Fed. The banks and Wall Streeters need to be told the free ride is over. Having negative rates of return on iBonds is a national embarassment.

    As for the political situation in our country, it is very obvious that money is buying too much influence. Unless we get some real campaign finance reform, that isn’t going to change. Americans are so fed up with our government, they are going to vote a lot of poeple out of office next week. Unfortunately, the new people who get elected will soon become corrupted by the same influencers. I think Bill Gross is right about the two-party system being rigged. But, I can’t blame voters, because they usually don’t get a choice of good candidates. That’s why I’m glad to see the TEA Party movement, even though I’m not a member.

    • Thanks Bret. While we are responsible for the politicians elected to the extent that we actually take the effort to educate ourselves about the issues and exercise our right to vote, your point about the shortage of decent candidates is well-taken. We seem to have the same problem here in Canada.

      Maybe part of the problem is that most of the people who are smart enough to run a country don’t want anything to do with the current political morass. Maybe people with integrity just don’t want to be part of a corrupt system.

      Hey, have you ever considered running for office? 😉

      • There are way too many skeletons in my closet. 🙂

        Seriously, my Mom is retired and has become very active as a political volunteer. She worked really hard to get a good honest businessman elected to office. But, it’s virtually impossible to get elected in either party, unless you sell your soul to the special interests and blindly follow the party line.

        The TEA Party has come from out of nowhere to get more independent candidates elected in Massachusetts, Alaska and other states. If they can keep it up, we may be able to break the two-party duopoly and obtain fair representation for voters.

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