Coronavirus and the Federal Reserve's Political Policy

It's when times are tough that you see what's really going on.  Last week, the stock market fell 11% because of fears over the economic impact of the coronavirus epidemic, dropping into a correction in a matter of days.  President Trump called loudly for a Fed interest rate cut.  Always ready for another government handout, Wall Streeters also chimed in for a rate cut.  Yesterday, rumors that the Fed and other central banks would act together pushed the Dow Jones Industrial Average up over 1200 points.

Early this morning, the Fed indicated it was considering accommodative action, but signaled that nothing was imminent.  https://www.cnn.com/2020/03/03/economy/federal-reserve-rate-cut/index.html.  However, a few hours later, the Fed announced a surprise 0.5% cut in short term interest rates.  The Dow, instead of responding positively, promptly fell almost 800 points.

What gives?  It's hard not to think the Fed gave in to political pressure.  A rate cut won't cure coronavirus.  Nor will it vaccinate humans against the disease.  It won't quarantine the virus or establish barriers to its spread.  People who are avoiding traveling, large gatherings, restaurants, concerts, sporting events, and other potential infection venues won't start spending and exposing themselves to the illness just because of a rate cut.  Even if stocks had risen, people wouldn't have started to engage in risky behavior.  Of course, things were only made worse because the market fell after the rate cut.  The market wanted a bigger welfare check.  The President, perhaps too lazy to do the work needed for a fiscal stimulus, promptly called for another immediate Fed rate cut.

But another immediate cut would only tell us that the epidemic is far worse than we thought, and that we'd best hunker down and isolate ourselves for a long time.  No travel, no restaurant meals, no public gatherings, no socializing, no contact with anyone we don't know and trust.  Romance would halt abruptly, as who'd want to meet new people in a time of epidemic?  Dating websites would collapse and singles bars would shutter. The President would be much better off committing billions of federal dollars to emergency medical research.  But he seems to have a problem with science, like he doesn't believe in it because it sometimes contradicts his political views.  So maybe the Fed will be bullied into another rate cut that will only instill even more alarm and panic.

There are powerful reasons for the historic independence of the Federal Reserve.  Most important among them is that an independent Fed can serve the public interest, not the short term scheming of politicians.  This means, among other things, that the long term vigor of the stock market is served by a rigorously independent Fed (see the story of Paul Volcker's career for further information).  Today's surprise rate cut gave the market and us discouraging news:  that the coronavirus crisis is much worse than we thought, that the Fed is becoming the sous chef of monetary policy, and that instead of focusing on medicine, the White House is focused on the political aspects of the coronavirus epidemic.  Now that the Fed is politicized, expect more poor policy and national distress.

How Donald Trump Could Create a Stock Market Crash

Stock market crashes, such as in 2008, emanate from inflated asset prices.  While economic recessions and other events, such as war, can trigger market downturns, large, sharp market drops (a/k/a crashes) are the result of artificially high asset prices that often have started bubbling.  In 2008, the asset bubbles resulted from overly generous prices being paid for real estate, the resulting mortgages, stocks that seemed like good bets in light of all the real estate activity, and stocks generally because market averages kept rising.  It didn't help that the U.S. government guaranteed almost all mortgages on a de facto or de jure basis.  The easiest way to get people to pay too much for an asset is to make it seem like a sure bet.  Con men know this and profit from it because, despite all the evidence that there is no such thing as a sure bet except taxes and death, people remain suckers for sure bets. 

Donald Trump bet the image of his Presidency on the rising stock market.  Stocks rose briskly right after Election Day in 2016 and maintained their upward momentum for over a year.  Trump noisily celebrated the huzzahs he thought he heard from the financial markets and wore out the fabric of his suit jackets patting himself on the back.

But Trump, despite decades as a New York businessman, hasn't absorbed a simple lesson that he should have learned about stocks a long time ago:   that stocks go up and stocks go down.  There is no such thing in the stock markets as continuing upward momentum.  There is no endless applause.

So, when the stock markets got tummy trouble in 2018, and began to burp, belch and make other inelegant noises, Trump became discombobulated.  He berated the Federal Reserve Board for raising interest rates, manipulated oil prices down by persuading the Saudis to keep pumping large volumes, and condemned American businesses that closed down domestic operations.  Sometimes, on down days in the market, he made statements about trade talks that turned out to be optimistic or premature.  He seemed indifferent to widening federal deficits, instead suggesting a further tax cut for the middle class.  All of these actions seem linked to a desire to support stock prices.  But stocks have remained gloomy.  So we can expect that Trump will keep searching for some way to boost the metric that he thought made him look so good.

Persistent efforts by governments to support and boost asset prices have tended to end badly.  There is no free lunch, and governmental distortion of asset prices inevitably leads to misallocation of capital and other resources.  Pushed far enough, this mispricing eventually becomes too much for investors to stomach, and they back away from the asset. Then, bad things happen to the asset's price. That happened with real estate and mortgages in 2008 and it may be happening with stocks now.  If Trump pushes too hard on maintaining and increasing stock prices, he could foster a bubble in the stock markets, and nothing good for him will result from that.  If you're an investor, don't bet on governmental action to make stocks great again.  Remember:  in the final analysis, stocks go up and stocks go down.

How Much Damage Will the Bitcoin Bubble Do?

Bitcoin is a bubble.  There's no doubt about that.  Its value has risen 1,000% this year, and indeed by $1,000  (or about 10%) on each of the past two trading days.  This morning, it popped over $11,000 before dropping about 18% (i.e., over $2,000), all in one trading day.  That's volatile.  That's a bubble if ever there was one.  We once again have graphic evidence that there are a lot of stupid idiots in the financial markets.  History teaches that market stupidity can have major, and indeed systemic, consequences.  Those of us careful enough to avoid Bitcoin may nevertheless be adversely affected by the idiots.  The question at this point is how much damage will this bubble do.

The investors who trade Bitcoin can be found all over the world.  Their personal losses, although potentially large in the aggregate, may be spread out and therefore appear to have a  relatively diffuse impact.  A person who risked and lost most of their net worth on Bitcoin can now look forward to uncomfortable (to say the least) discussions with their spouse and children.  But that personal loss won't affect the rest of us.

The potentially widespread and even systemic impact of Bitcoin losses could come from where and how Bitcoin was traded.  Bitcoin is traded on exchanges and through brokerage firms.  If investors were trading on margin (i.e., with borrowed money) and can't repay the loans, the brokerage firms will take the loss.  If the customers were able to transact directly with a Bitcoin exchange, the exchange takes the loss.  Or, if transactions went through a brokerage firm that sent them to an exchange and the firm can't pay the exchange what it owes for trades, the exchange takes the loss.  There is no organized settlement and clearance process for Bitcoin.  Unlike stocks and bonds, there is no clearing firm, with substantial amounts of capital, to protect against large scale defaults in payments.  If a Bitcoin exchange collapses, the firms and individuals to whom it owes money may be S.O.L.

If a brokerage or proprietary trading firm takes Bitcoin losses, it still needs to pay its obligations.  In order to do so, it may begin liquidating other assets it holds--stocks, bonds, commodities and currencies.  If the firm's losses are big enough, its selling may affect the price of those other assets.  If those other assets begin to sag, other investors (who may not be involved with Bitcoin at all) may begin to sell in order to limit their losses.  This increases the downward pressure on those assets, which may lead in turn to yet more selling.  The potential for a more widespread market crash may develop.

In order to reduce the potential for market contagion, financial regulators need to identify the firms and exchanges where the impact of Bitcoin losses may be concentrated and take steps to limit the damage.  That would be pretty hard, since Bitcoin trading is, by and large, unregulated and there is no organized way to find out where the losses and risks may lurk.  In other words, we may not find out how bad things are until the losses have landed in our laps.

When Bitcoin was trading for a few hundred dollars (in those ancient times as far back as a year ago), the potential for major or systemic loss was almost nonexistent.  But when Bitcoin rises by 10% a day and drops 18% in a day, while trading around $10,000 or more, the losses may be much, much larger and the potential for major or systemic losses increases commensurately with the increases in transaction amounts.  Even though they could have shrugged a year ago, regulators and creditors of Bitcoin exchanges and traders need to start paying serious attention.  The volatility in Bitcoin could easily get worse before it gets better.  Bitcoin may soon trade for $25,000, $50,000 or even more.  The losses, when they inevitably come, could involve mucho dinero--and we mean mucho.  Failure to give Bitcoin their full attention could be very costly and painful, not only for players in the Bitcoin markets but also for we innocent bystanders.  The time for vigilance has arrived.