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October
18
2017

Kevin Warsh to Lead the Fed in a New Direction
Jim Stone

The threat of nuclear crisis with North Korea. Two destructive hurricanes. Puerto Rico devastated and about out of money. The start of a major comprehensive tax reform effort, along with general political mayhem in Washington. The worst mass shooting in U.S. history. In the midst of it all, the President is apparently about to make a potentially momentous decision: A Fed chair will be appointed with a new four-year term.

As has become the norm, markets are happy-go-lucky (at almost daily record highs). How could anything possibly rock the boat? Outside of the financial media, a change of the guard at the Fed is hardly newsworthy.

It's an interesting narrative leading up to the President's decision. Of course, there's the typical "hawk" vs. "dove" framework. The Wall Street Journal had an insightful op-ed: "Donald Trump's Fed Choice: Continuity or Disruption." And there was Friday's Krugman piece in the New York Times: "Will Trump Trumpify the Fed?" - that I will return to.

I am working to prepare myself for the President's decision. When it comes to the Fed, I have been consistently disappointed over the years. At every turn. Trumpeting the risk of deflation, the Greenspan Fed in the early-nineties took to interest-rate and yield curve manipulation as primary reflationary policy measures. Greenspan recognized how the clever exploitation of contemporary market-based finance yielded the Federal Reserve history's most potent monetary policy transfer mechanism.

Monkeying with the markets is always a slippery slope. And generations ago it was appreciated that the greatest risk associated with discretionary policymaking was that one mistake invariably leads to another (and another and...).

What began in 1987 with post-crash assurances of ample liquidity for the stock market - and then a few years later a surreptitious bank bailout (after late-eighties "decade of greed" excess) - evolved into a cycle of historic booms and busts. Ever more experimental reflationary measures were the inevitable responses.

It has been said that it took a "cold war hawk" like Ronald Reagan to break the ice in relations with the Soviet Union. In that vein, it was the subterfuge of the free-market disciple Alan Greenspan that got the inflationism ball rolling. Back in March 2000 I titled a CBB "John Law and Alan Greenspan - The Great Inflationists."

Another burst ("tech") Bubble and only more histrionic deflation fears. It was a bogey man, powerfully conjuring images of the Great Depression. The establishment brought in Dr. Ben Bernanke in 2002, replete with an inflationist doctrine that in most backdrops would have been designated the fringe of lunatic fringe. When it came time to replace Alan Greenspan, I argued "Anyone but Bernanke!" It was astonishing how the establishment - and conventional thinking more generally - had so readily adopted inflationist doctrine.

Sure, it was all seductive; but not even token pushback? The New Age Wall Street "money" machine - backstopped by the Fed, the GSEs and the Treasury - had transfixed the rich, the powerful and the levers of power in Washington. The seeds to our nation's drift toward socialism - and the counterrevolution that brought Donald Trump to the Whitehouse - were neglectfully scattered by Greenspan and then aggressively fertilized by "helicopter Ben."

Quality contemporaneous analysis is valuable for providing a historical account to be called upon in the future to counter historical revisionism. Especially in these days of record prices for most assets around the world (securities, real estate and otherwise), it's important to appreciate the unmitigated disaster that inflationism turned out to be. Bernanke was the lead instigator of "mortgage finance Bubble" reflation that culminated in the "greatest financial crisis since the Great Depression." No Credit is given for reflating Bubbles.

A top Wall Street executive was lauding the Fed's "brilliance" Friday morning on Bloomberg Television. Yet the Fed has done nothing close to brilliant for a long time now. The Bernanke Fed doubled-down on experimental inflationist monetary management. While there have been numerous zealous bouts of inflationism throughout history, I know of none that emerged from the test of time as esteemed policymaking. The proponents of contemporary central banking disregard a crucial fact: Now approaching a decade since the start of the crisis period, the world is more addicted than ever to ultra-low rates and massive QE. Inflationism is always a trap.

I was naïve. The degree to which the establishment would embrace inflationism caught me by surprise. Have they finally seen enough? Fed governor Jerome Powell has become the favorite candidate for those preferring to stay the course.

I would much prefer former Fed governor (2006-2011) Kevin Warsh at the helm of the Federal Reserve. He is viewed as the reformer candidate - somewhat of a disrupter that might shake things up a bit. From my perspective, he is more the outcast traditionalist in an age of monetary radicalism. Fed governor Warsh was the most outspoken member of the Fed's inner circle arguing against Bernanke's radical monetary doctrine.

Importantly, Warsh is not an inflationist - and for this he is on the receiving end of criticism from the left as well as the right. Willing to stand tall against the powerful consensus view, Warsh recognizes the great risks that come with monetary inflation. He was against QE and - despite the chorus of pundits convinced otherwise - Warsh was right.

Mr. Warsh is generally opposed to the Fed meddling in the markets. As Larry Kudlow suggested, the former Fed governor wants "the Fed out of the day trading business." Of course, overheated Bubble markets simply cannot contemplate a world where the Fed's number one priority is anything other than bolstering the markets - with routine assurances, low rates and QE on demand.

If things weren't already ludicrous enough, the Fed went off the deep end with Bernanke's 2013 assurances that the Fed would "push back against a tightening of financial conditions." With booming equities, corporate Credit and derivatives markets having come to dominate system financial conditions, the Fed at that point was basically pre-committing to zero tolerance for market disruptions, corrections, recessions and bear markets. This was a gross assault on free-market Capitalism - a twist of the knife - administered without protest.

The Fed needs to reverse course and return to traditional monetary management. It is imperative to rein in its discretionary power to manipulate markets and whimsically print "money." It is fundamental that the Fed ends its doctrine of the securities markets as "Too Big to Fail."

It is taken as fact that the U.S. (and the world more generally) is better off today because of the extreme crisis-era measures taken by the Fed and global central bankers. I vehemently disagree. Today's faux prosperity is built on a fragile foundation of electronic debits and Credits - contemporary (speculative) finance too often divorced from real economic wealth creation. Central banks have inflated the greatest Bubble in history, a Bubble that created only greater excesses and global imbalances. Already deep structural maladjustment worsened, and vital financial and economic reforms were forestalled.

I could only chuckle at the headline: "Paul Krugman: Trump Is About to Take a Wrecking Ball to the Last Competent Government Institution Left."

From Krugman's Friday New York Times piece:

"What all this means is that if congressional Republicans play a large role in selecting the next Fed chair, they'll insist that it be someone who has been wrong about everything for the past decade. Kevin Warsh... certainly fits the bill. He warned about inflation in the midst of global economic collapse; he argued vigorously against doing anything, monetary or other, to fight 10% unemployment; he warned that the United States was about to turn into Greece, Greece I tell you. And he has shown no hint of being chastened by the failure of events to play out the way he expected. Now, I don't know who Trump will actually pick to head the Federal Reserve. It might actually end up being someone smart, knowledgeable and honest. Hey, there's a first time for everything. But surely it's possible, even probable, that the Federal Reserve, like other government agencies, is about to get Trumpified, that one of American policy's last remaining havens of competence and expertise will soon share in the general degradation. And won't that be fun when the next crisis hits?"

Regrettably, the Fed is anything but a "haven of competence." Their progressive policy radicalization has been fundamental to the repeated inflation of ever more destabilizing asset Bubbles - the great culprit when it comes to social strife and divisiveness. As candidate Trump stated unequivocally throughout the campaign, the Fed is in desperate need of new leadership and a new direction. Maybe it was all BS - or perhaps the administration has tied its agenda to equities and (seemingly like everyone else) became a serf to the markets. Yet I'm holding out hope that there is a behind the scenes groundswell of support for rescuing monetary policy from the quagmire of experimental inflationism.

This is not about "hawk" or "dove" - low rates or even actual normalization. And, in the grand scheme of things, I don't get all that worked up about modest financial deregulation. Responding to Krugman, the next crisis will be no fun whatsoever. A 1929-like systemic crisis of confidence event would not be a surprise.

I have argued that the Fed's balance sheet is likely on its way to $10 TN. This is a rough guesstimate - expecting that the unwind of unprecedented speculative leverage during the next serious market dislocation would see the Fed again doubling the size of its balance sheet (as it did even after formulating its so-called "exit strategy" in 2011). Such a scenario risks a full-fledged calamity. The fanciful notion of open-ended QE forever must be invalidated. A straight-shooter appealing to my analytical heart, Mr. Warsh authored a provocative 2016 paper titled, "Challenging the Groupthink of the [economics] Guild."

Adhering to the inflationist mindset, Yellen or Power would surely be willing to double-down on desperate "money" printing operations. Why not "helicopter money" - just toss it about to needy governments, businesses, consumers and securities markets alike? I hold out hope that a Chairman Warsh - along with some fresh faces on the committee - would be willing to hold back the printing presses. Such an incredibly important feat will require a rare combination of competence, communication skills and courage. In my eyes, Kevin Warsh is one of the few individuals associated with the Federal Reserve that has demonstrated much in the way of attributes that will be so vitally important come the next crisis.

Below are excerpts from two articles that help illuminate how Kevin Warsh has distinguished himself from other leading Fed chief contenders:

"The Federal Reserve Needs New Thinking - Its Models are Unreliable, its Policies Erratic and its Guidance Confusing. It is also Politically Vulnerable," Kevin Warsh, Wall Street Journal, August 24, 2016.

"The conduct of monetary policy in recent years has been deeply flawed... A robust reform agenda requires more rigorous review of recent policy choices and significant changes in the Fed's tools, strategies, communications and governance. Two major obstacles must be overcome: groupthink within the academic economics guild, and the reluctance of central bankers to cede their new power.

First, the economics guild pushed ill-considered new dogmas into the mainstream of monetary policy. The Fed's mantra of data-dependence causes erratic policy lurches in response to noisy data. Its medium-term policy objectives are at odds with its compulsion to keep asset prices elevated. Its inflation objectives are far more precise than the residual measurement error. Its output-gap economic models are troublingly unreliable.

The Fed seeks to fix interest rates and control foreign-exchange rates simultaneously—an impossible task with the free flow of capital. Its "forward guidance," promising low interest rates well into the future, offers ambiguity in the name of clarity. It licenses a cacophony of communications in the name of transparency. And it expresses grave concern about income inequality while refusing to acknowledge that its policies unfairly increased asset inequality.

The Fed often treats financial markets as a beast to be tamed, a cub to be coddled, or a market to be manipulated. It appears in thrall to financial markets, and financial markets are in thrall to the Fed, but only one will get the last word. A simple, troubling fact: From the beginning of 2008 to the present, more than half of the increase in the value of the S&P 500 occurred on the day of Federal Open Market Committee decisions.

The groupthink gathers adherents even as its successes become harder to find. The guild tightens its grip when it should open its mind to new data sources, new analytics, new economic models, new communication strategies, and a new paradigm for policy.

The second obstacle to real reform is no less challenging. Real reform should reverse the trend that makes the Fed a general purpose agency of government. Many guild members believe that central bankers—nonpartisan, high-minded experts—are particularly well-suited to expand their policy remit. They fail to recognize that central bank power is permissible in a democracy only when its scope is limited, its track record strong, and its accountability assured."

"The Fed Has Hurt Business Investment - QE is Partly to Blame for Record Share Buybacks and Meager Capital Spending," Michael Spence And Kevin Warsh, Wall Street Journal, October 26, 2015.

"We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose 'shareholder friendly' share buybacks over investment in a new factory. But public policy shouldn't bias investments to paper assets over investments in the real economy.

How has monetary policy created such a divergence between real and financial assets?

First, corporate decision-makers can't be certain about the consequences of QE's unwinding on the real economy. The resulting risk-aversion translates into a corporate preference for shorter-term commitments—that is, for financial assets.

Second, financial assets are considerably more liquid than real assets. Trade among financial assets like stocks is far easier than buying and selling real assets like capital equipment. The financial crisis taught an important lesson to investors of all sorts: Illiquidity can be fatal. Financial assets have large liquidity benefits over real assets...

Third, QE reduces volatility in the financial markets, not the real economy. By purchasing long-term securities, the Fed removes significant market volatility from stocks and bonds. Any resulting reduction in macroeconomic volatility—affecting real asset prices—is far more speculative. In fact, much like 2007, actual macroeconomic risk may be highest when market measures of volatility are lowest. Central banks have been quite successful in stoking risk-taking by investors in financial markets... Clearly, market participants believe central bankers use QE, among other reasons, to put a floor under financial asset prices."

 

I just wrapped up 25 years (persevering) as a "professional bear." My lucky break came in late-1989, when I was hired by Gordon Ringoen to be the trader for his short-biased hedge fund in San Francisco. Working as a short-side trader, analyst and portfolio manager during the great nineties bull market - for one of the most brilliant individuals I've met - was an exciting, demanding and, in the end, a grueling and absolutely invaluable learning experience. Later in the nineties, I had stints at Fleckenstein Capital and East Shore Partners. In January 1999, I began my 16 year run with PrudentBear, working as strategist and portfolio manager with David Tice in Dallas until the bear funds were sold in December 2008.

www.safehaven.com