How the Federal Reserve Destabilizes the Markets and Influences Politics

The Fed is being hoisted on its own petard.  Since 2008, it has suppressed interest rates, keeping them exceptionally low and forcing investors to put savings into risk assets such as stocks and high-yield bonds.  While there were good reasons for taking extraordinary action in 2008 and 2009, the Fed left rates so low for so long that investors, corporate America and borrowers have come to expect that really easy money is the norm, the default.  This dependency has made it virtually impossible for the Fed to normalize interest rates.  If the Fed raises rates, risk assets fall in value (as they did in recent months when faced with the specter of short term rates reaching a ghastly 1% to 1.25% by the end of this year).  The markets simply won't stand for interest rate increases, and the Fed sees itself as having no choice but to do the markets' bidding.  However, as the Fed continues to suppress interest rates, it only increases the markets' dependency, making future rate increases even more difficult. 

The Fed claims its interest rate policy is data dependent, and that it will raise rates as warranted by the data.  The U.S. economy is now at full employment and growing moderately.  Although last month's inflation data show stable prices, the recent rise in oil and gasoline prices will push up inflation numbers for March.  Yet, when it comes to the decision whether or not to increase rates, there is only one data point that matters.  That is the willingness of the financial markets to accept an increase.  With the markets' long term addiction to low rates deeply embedded, and their turbulent hissy fits every time the Fed hints at rate normalization, there is no foreseeable time when interest rates will return to historical norms. 

The Fed is undermining deeply rooted foundations of our society.  Highly rated long term bonds are essential to the stable retirements for which Americans and many other peoples hope.  Shorter term interest rates provide important supplemental income to savers, and promote financial stability and responsibility that mitigate the impact of economic cycles.  When people face lousy retirements (see http://blogger.uncleleosden.com/2015/04/is-federal-reserve-wrecking-retirement.html), and can't count on much of any return on savings (especially after netting out inflation), you can get the political unrest that we see today. 

The Fed is missing an important part of the picture.  People don't just want cheap credit.  They want stable long term prospects.  During the 1950's, 60's and 70's, the World War II generation endured many layoffs and cutbacks, due to recessions, factory retoolings, labor strikes and so on.  But their fundamental faith in the future was unshaken, because they knew they had pensions and Social Security to take care of them in their golden years (which in fact were golden for many of them).  This kind of long term stability isn't evident today.  Instead, havoc permeates today's politics.  Angry voters in America and Europe are upending established political orders because they fear the future.

Personal consumption and wealth have suffered greatly from low interest rates.  From 2008 to 2013, savers lost about $750 billion due to low interest rates (see http://www.cbsnews.com/news/report-low-interest-rates-have-cost-consumers-750-billion/).  Adding in likely losses for 2014 through today, the amount now is probably around $1 trillion.  That's real money.  Take that much out of people's hands, and they feel less secure, less inclined to spend, less inclined to borrow (you borrow less if you have less income), and more angry about the status quo.

What's more, the Fed's insistence on favoring risk assets has exacerbated the increasing inequality of income and wealth.  Rich people have the capital to invest in risk assets, and they become increasingly wealthy when cheap money pumps up the value of those assets.  Those getting the short end of the stick are now turning toward political extremism, because they feel they have no other choice.

The last thing the Fed wants to do is get entangled in politics.  It is supposed to be an independent agency that dispassionately dispenses policy in the public interest.  But the Fed's inability to act independently of the financial markets' short term tantrums is having significant impact on social stability and political trends.  Things will only get worse.  As the fall election approaches, the Fed will find itself in the horns of a dilemma largely of its own making.  If it raises rates because inflation is flaring (which is possible given the recent sharp increases in oil and gasoline prices), it will be accused of tilting the political picture one way.  If it does not raise rates despite an upswing in inflation, the markets will hum along on their cheap credit high, and the Fed will be accused of tilting the political landscape another way. 

The Fed is largely staffed and run by economists.  The economists there have failed to appreciate the diminishing returns of continuing the cheap money IV for the markets.  They have also failed to appreciate the costs of their cheap money policy.  If all they acknowledge is the upside (the return to full employment and moderate growth), and fail to acknowledge the pain they inflict on savers and workers who want to retire, then of course they will continue to inject cheap credit into the markets because they only see the benefits and not the costs.  Economists who don't acknowledge diminishing returns and see only benefits but not costs are bound to get policy wrong. 

The Fed measures its performance by short term metrics--current GDP growth, current unemployment, current inflation.  It doesn't appear to pay much attention, if any, to long term factors.  Long term factors are harder to measure.  But that doesn't mean they aren't important.  By focusing on the short term, and ignoring the long term, the Fed inevitably creates problems.  And we all have to live with the consequences of those problems.

Bernie Sanders is the Most Electable Candidate for President

The latest CNN/ORC poll shows that Bernie Sanders is the most electable candidate for President.  He would beat Trump (55% to 43%), Cruz (57% to 40%) and Rubio (53% to 45%).  By contrast, Hillary Clinton would beat Trump (52% to 44%), but would trail Cruz (48% to 49%) and Rubio (47% to 50%).  In other words, Sanders is the candidate most likely to win the Presidency in the general election, should he become the Democratic nominee.  Clinton's well-known negatives continue to dog her.

Clinton is supposed to be more electable than Sanders, but the latest poll negates that notion.  While Clinton has numerous advantages that give her the lead in the primaries for the Democratic nomination, she appears more likely to lead the party to defeat in the fall.  Sanders faces a difficult, uphill path in the primaries.  But if he succeeds in getting the nomination, he may well be the next President of the United States.

So if you're voting Democratic, and want to increase the chances for a Democratic President for the next four years, choose Bernie Sanders.  You can find the new CNN/ORC poll here: http://www.cnn.com/2016/03/01/politics/donald-trump-hillary-clinton-bernie-sanders-poll/index.html.

Hillary's Obama Gambit

Hillary Clinton has embraced Barack Obama's policies and legacy, and has promised to continue them if she is elected President.  This has helped her draw the support of African-American voters, who she desperately needs to counteract Bernie Sanders' appeal to the young and the independent.  It's helping her now, in South Carolina and other Southern states.  But she will pay a price if she becomes the Democratic nominee.

The key to the general election will be the ability to attract the support of independents.  The Republican and Democratic nominees, whoever they may be this year, will have the support of the conservative right and liberal left, respectively.  The winning candidate will be the one to whom independents flock.  Independents, to be sure, aren't always the same as moderates or middle of the road voters.  They are often beyond classification, very conservative on some issues while simultaneously very liberal on others.  But if you try to paint them as libertarians, they will turn out to be staunch supporters of big government safety net programs like Social Security and Medicare.  These are the disaffected drawn to Donald Trump and Bernie Sanders.  They often don't like Barack Obama or Hillary Clinton.  And they are likely to dislike Clinton even more for embracing Obama's legacy.  By positioning herself as Barack Obama's ideological successor, Clinton makes herself less attractive as a candidate to a large group of voters who are likely to be crucial to victory. 

Barack Obama had an almost unique ability to draw the support of traditional Democratic constituencies and independents.  Hillary Clinton doesn't have that ability.  By promising to take up Obama's mantle, she has made herself into a target which, in the general election, the vast right wing conspiracy will bombard with Super PAC funded ads highlighting her sworn fealty Obama.  Many of the Obama haters will turn against her, and vote for the other candidate.  Traditional Democratic constituencies may not be enough to elect her.  She's gained a short term advantage, but a long term problem.

Afraid of Another Financial Crisis? Watch the Banks

Financial crises like we had in 2008 before the Great Recession, and earlier in the 1930's before the Great Depression, are the triggers for big, long lasting economic downturns that require painfully long times from which to recover.  They differ from ordinary economic recessions (i.e., two quarters of negative economic growth), which generally don't last more than a couple of years and are usually followed by good levels of growth.  Financial crises are caused by liquidity shortages in the financial system.  When major banks and other financial institutions cannot obtain ready access to loans, especially short term loans, the financial system can teeter, and in worst case scenarios, collapse. 

Recent news articles report that European banks are under stress because of the decline in oil prices (http://www.cnbc.com/2016/02/08/european-banks-face-major-cash-crunch.html), and because of low interest rates and legal costs, as well as oil prices (http://money.cnn.com/2016/02/05/investing/bank-stocks-worse-than-oil/index.html?iid=EL).  Things got so shaky today that Deutsche Bank, Germany's largest, felt compelled to put out a statement reassuring shareholders about its financial condition.  http://www.reuters.com/article/us-deutsche-bank-stocks-idUSKCN0VI1WI.  If Europe's major banks begin to encounter liquidity shortfalls, we could have a problem.  If not addressed properly, it could be a big problem.

Europe's big banks are in general not as well capitalized as America's big banks, so it's not surprising that the Europeans might encounter turbulence sooner.  But if Europe's big banks teeter, America's big banks will, because of the interconnections between all major banks worldwide, at least feel pretty nauseated.  Of course, in such a scenario, the European Central Bank and U.S. Federal Reserve will mount up and ride to the rescue.  But not even the Brobdingnagian bailouts of 2008 prevented the Great Recession.

If the financial system stays sound, the slowdown in China and the other BRICS may cause a recession, but probably not a catastrophe.  But if the financial system dives into the septic tank, as it did in 2008, then we can expect a stinky mess.  So watch the banks.

How to Manipulate the Stock Market

The recent unusually close correlation between the price of oil and the prices of stocks offers an opportunity to manipulate the stock market.  A trader could purchase a large holding of stock index futures that would increase in value if the stock market rises, and then purchase oil futures contracts in rapid sequence in order to push up the price of oil.  The price jump in oil would, presumably, pump up stocks.  The stock index futures would rise in value and the trader could sell them for a quick profit.  An individual person couldn't do this, except one who is exceptionally wealthy.  But large hedge funds and other financial entities might have enough funding to pull this off.  It could be done in the U.S. markets, and some foreign markets (since the oil-stocks correlation isn't limited just to the U.S. markets).

Doing something like this could be seriously illegal.  Kids, don't try this at home, not unless you want to be a long term guest of the U.S. government at a facility not of your choosing.  But, as hardly needs to be said, not all participants in the financial markets observe the highest degree of fidelity to legal requirements.  Mega bucks could be made this way, and for some, money talks even if getting it involves stepping off the curb.  Hopefully, financial regulators worldwide are tuned into this possibility.  The recent exceptional volatility in the oil markets, and consequential sympathetic gyrations in stock prices, could raise the specter of shenanigans.  Some financial markets players are big thinkers, and will do very aggressive things to make big money.  Regulators need to think as big in order to keep up with them.

Bernie Sanders' Appeal

Bernie Sanders is now running neck and neck with Hillary Clinton in the first two primary states, Iowa and New Hampshire.  How is it possible that a first term senator, an avowed Socialist, from one of the smallest states, a virtual unknown a year ago, could challenged the mighty Clinton political machine?

In a word, because he cares.  Bernie Sanders is a throwback to the 1960s, a let's-change-the-world type who, after fifty-five years, seems still to be responding to John F. Kennedy's challenge:  "ask what you can do for your country."  His campaign is about helping others and improving their lives.  His rumpled sartorial disarray is vivid evidence that he doesn't obsess over himself.

By contrast, Hillary Clinton continues to run a perfectly coiffed, highly calculated, endlessly scripted campaign focused on burnishing her image, protecting her from attack, and saying what the pollsters tell her voters want to hear.  It's hard to avoid the feeling that she's in it for herself, that this is all about Hillary. 

Voters respond favorably to candidates who care about them.  That's Politics 101, but not every politician seems to get it.  Bernie Sanders does.  Even though he still faces a very steep climb to get the Democratic nomination, his chances are growing.  Eight years ago, a first time senator from Illinois convinced voters that he cared about them, and beat Hillary Clinton for the Democratic nomination.  It could happen again.

The Challenge For China

The Chinese stock market fell some 12% this first week of 2016.  The downturn triggered corresponding drops in other stock markets around the world, including a loss of over 6% for the week in the U.S.  The financial press is probably secretly delighted, since such volatility captures the attention of a lot of people and brings a surge of traffic onto their websites.  But most people are unhappy.

The Chinese stock market fell for a simple reason--it's overvalued.  It's been overvalued for a while, at least since early 2015.  As we in America know, overvalued stocks fall sooner or later.  It happened in 2000 and 2008.  It's happening now in China, and elsewhere. 

Chinese financial regulators complicated matters by halting trading after a circuit breaker was triggered by a 7% fall two days in a row.  Circuit breakers can be useful in ameliorating short term panics.  But significant overvaluation, as one sees in China, is a long term problem, and circuit breakers may actually increase selling pressure by sharply limiting the time available for trading.  When trading hours are circumscribed, sellers want to move quickly to sell, but buyers want time to evaluate whether or not prices are leveling out.  The result is that there are many more sellers than buyers in a limited amount of time and prices plummet.  Chinese regulators had to suspend the circuit breakers, which was followed by a modest rise in Chinese stocks at the end of the week.

But the regulatory miscues aren't the long term story.  Stocks in China were pumped up by a number of government policies that directly or indirectly encouraged investment in equities.  The bubble peaked and burst this past summer, and the Chinese government has since been trying to prop up the market with restrictions on selling and government-induced purchasing.  These measures to balance supply and demand don't address the basic underlying problem--Chinese stocks aren't worth their nominal market prices--and consequently can't really calm things down. 

At this point, losses inhere in Chinese stocks.  These losses have not been fully recognized in market prices.  With the Chinese economy slowing and capital flowing out of China, there isn't much realistic prospect of the losses reversing.  They will have to be realized sooner or later.  The Chinese government probably understands this, but will endeavor to smooth out the process of realization of the losses to reduce the pain perceived by investors.  The U.S. Federal Reserve and European Central Bank used similar smoothing strategies to deal with the fallout from the Great Recession and the European sovereign debt crisis.  Smoothing carries a major risk of kicking the can down the road, with losses emerging like new heads of the Hydra if underlying economic growth hasn't been revived.  The challenge for China will be to accelerate its economic growth.  But the prospects for a near-term rebound of the Chinese economy are poor.  Low-cost manufacturing is gradually shifting out of China, where wages are rising, and hasn't yet been fully replaced by anything else.  China's economy seems to be meandering.  We can expect more market volatility.

Another Obama Foreign Policy Miss

The ongoing dustup between Iran and Saudi Arabia over the Saudi execution of a Shiite cleric (Nimr al-Nimr) and three other Shiites reflects another foreign policy foul up by the Obama administration.  Instead of tamping down sectarian tensions in the Middle East, the Obama administration (and its predecessor, the George W. Bush administration) made it easier for conflict to flare up.  A "democratically elected" government was established in Baghdad which, not surprisingly was Shiite dominated because Iraq is majority Shiite.  But adequate protection for the interests of Iraqi Sunnis, Kurds and other ethnic or religious groups wasn't ensured.  So Iraq degenerated into sectarian warfare, with the Sunni-dominated ISIS readily able to seize vast amounts of Sunni Iraq without facing much of a fight.  For the same reasons, it's been impossible to organize a military force in Iraq that can dislodge ISIS, except at the margins.

The Obama administration stood by the sidelines as Syria descended into civil warfare, without having a discernible, let alone coherent, policy.  The only line in the sand drawn by President Obama was to warn Bashar Assad against using poisonous gas, and when Assad did just that, Obama flinched.  His flinch paved the way for Vladimir Putin to start mucking around in Syria, a role that Putin has now expanded to a much larger military commitment to Assad.  Iran has been supporting Assad, because he is a member of the Alawites, a religious group affiliated with the Shiites.  So we have Russia and Iran working against the Saudis and their allies, who have been supporting Sunni interests in Syria.  The war in Syria is now firmly sectarian.  The ideals of the Arab Spring died a hard death there.

In Yemen, Shiite rebels have booted the Sunni ruler, and Iran is supporting the Shiite side of a civil war against the Saudi-supported Sunni side.  The U.S. used to have a Special Forces presence in Yemen, but those troops reportedly have left the country.  So we have in Yemen a second proxy war between Iran and Saudi Arabia.

The Obama administration has been trying to sell the nuclear accord with Iran as a great diplomatic achievement.  But the Saudis are nervous about the agreement, apparently believing that it doesn't truly restrain Iranian nuclear ambitions.  So, even while Obama thinks he's getting somewhere with Iran, he's losing influence over the Saudis.  It shouldn't be a surprise that the Saudis are getting feistier.  They evidently don't believe they can count on the U.S.  One would think that the U.S. might have restrained the Saudis from executing Nimr al-Nimr.  But either the administration didn't know the execution was scheduled (which would seem an intelligence failure) or it didn't understand the importance of the execution to the Iranians (which would seem an intelligence analysis failure). 

At the same time, the nuclear accord appears to have emboldened the Iranians.  They fired missiles from a ship that was hardly a mile away from an American aircraft carrier in the Persian Gulf.  They've announced they'll increase their ballistic missile capabilities, apparently in violation of a UN resolution.  But neither action generated a response from the U.S. other than commentary by official spokespersons along the lines of "naughty, naughty." 

The President reportedly is holding back on sanctions against Iran because he wants to implement the nuclear accord and strengthen the hand of Irans moderates.  The problem is we don't really know who is in control of Iran (another intelligence failure).  Implementing the accord means rolling back sanctions and allowing Iran to sell more oil internationally and otherwise engage in more international trade.  This will increase Iran's financial strength.  Who really controls that strength--Iranian moderates, Iranian radicals or Iranian terrorists?  No wonder the Saudis think they may have to go their own way.  If Obama is, in effect, going to strengthen Iran, the Saudis have to find ways to push back.

President Obama is dead set on avoiding conflict.  That much is clear to everyone.  Assad steps across his line in the sand and he does nothing.  Iran engages in provocative behavior after the nuclear accord, and he does nothing.  Putin has Russian jets bomb American-supported moderate rebels in Syria and Obama does nothing.  While almost no one in America wants our ground troops back in the Middle East, it's clear that the administration's policies are heightening sectarian tensions in the Middle East.   Just as the Obama administration was unduly focused on al-Qaeda until ISIS literally blasted its way into the administration's consciousness, it's now too obsessed with combating ISIS and not focused enough on the root problem of reducing sectarian tension.

The Middle East could degenerate into regionwide sectarian warfare in a flash--indeed, it's already partly there.  ISIS has been able to hold large amounts of territory only because sectarian tensions have been allowed to flare up.  It's important now to try to get the Iranians and Saudis to stand down.  The more Obama appeases Iran, the more provocative Iran becomes.  The recent Iranian Persian Gulf missile firing and ballistic missile program boost should be met with sanctions and a delay in the implementation of the nuclear accord.  The Iranians need to be firmly told that if they want to be re-admitted to international society, they have to be good citizens.  At the same time, the U.S. should quietly reassure the Saudis that it stands with them, and that they need to cool their jets.  Saudi arms should be twisted if necessary.  In other words, Obama has to stop appeasing and get tough with the toughs in the Middle East.

If the U.S. can lower sectarian animosity in the Middle East, it may be able to put together a working alliance to defeat and eventually destroy ISIS.  But if sectarian tensions keep increasing, there will be no workable solution for dealing with ISIS, and more conflict will likely erupt, further eroding American interests and influence.  ISIS could survive and perhaps even prosper.  It seems unlikely, however, that Obama, now firmly ensconced in his Ivy League populated bubble, will somehow connect with the realities of foreign relations.  That's a shame, because it means that he, like George W. Bush before him, will leave a foreign policy mess for his successor.

The Case For Regulating Drug Prices

Perhaps the most important reason for rising health insurance costs is continued large, and sometimes astronomical, increases in the price of pharmaceutical products.  These increases don't apply to aspirin or antacids.  They tend to appear in the price of lifesaving drugs.  Or they are imposed on drugs for serious medical conditions that require treatment if the patient is to have a decent quality of life. 

Also alarming is the fact that the people behind the rising prices are sometimes speculators, who purchase the rights to the drug and then ratchet up the cost.  While some major pharmaceutical companies may be able to point to substantial research and development costs as a reason for the expensive prices of new drugs, a speculator who buys the rights to established drugs and takes advantage of seriously ill patients is doing something that, as Berkshire Hathaway Vice Chairman Charlie Munger put it, is "deeply immoral."

In addition, those drug companies that can legitimately claim to have significant research and development costs aren't necessarily playing fair.  Many, and perhaps most, other countries around the world already regulate pharmaceutical prices.  Frequently, the prices they permit are so low that pharmaceutical companies may not recoup much, if any, of their R & D expenses.  So the drug manufacturers often seek to recover most or all of the R& D expenses from American consumers.  Americans are paying through the nose so people in other countries can enjoy low health care costs.

How can drug prices shoot up like a geyser when the economy is sluggish, incomes stagnant and general inflation almost nonexistent?  In a word, health insurance.  Health insurance programs allow drug companies to spread the cost of expensive drugs across large numbers of insured people, most of whom don't need the expensive drugs.  Even though health insurers are taking many steps to control drug price increases on many pedestrian pharmaceutical products, the price levitators have concentrated their immorality on drugs that people badly need.  It's hard for insurers to combat these price increases, since many patients may suffer dire consequences without the expensive drugs. 

While price controls are generally undesirable, as they can produce misallocation of resources, we are seeing a failure of market forces with expensive pharmaceutical products.  The prices American consumers pay aren't the result of the free interplay of competitive markets.  They are the product of exploitation of very ill people through speculative excess and the misallocation of outsized amounts of R & D expenses to Americans.  People with major medical problems have what economists call inelastic demand, a desire or need for a product that is unaffected by its price.  If you're dying, you'll pay any price for a medication that will let you live.  Price isn't a consideration if you otherwise have to live with terrible suffering.  Other countries around the world (including major industrial nations) don't allow drug companies to exploit this inelasticity of demand of their seriously ill citizens.  Why should Americans be hammered over the head?

There's no need for price regulation of most pharmaceutical products.  Go into any drug store and you'll see lots of price competition for lots of products.  These can be left alone.  The drugs that need regulation are the ones for which there aren't competitive and effective substitutes, especially if they are used for serious or life threatening ailments or conditions.  Lobbyists for the pharmaceutical companies and their running dog economists will endeavor to over-complicate the issues, asking how can a bureaucrat come up with a more rational pricing scheme than market forces.  However, let us note that market forces aren't working rationally in the drug market and most of the rest of the world doesn't get into a tizzy over the self-serving palaver of the drug industry. 

It may be difficult to construct a model for price regulation that the economics profession as a whole would consider elegant.  But how can it be elegant or fair for Americans to bear pharmaceutical R& D costs for most of the rest of the world?  How about allocating some of that cost to persons in Europe and Asia, many of whom live in wealthy, industrialized nations?  How can it be socially beneficial for speculators to exploit the inelastic demand of seriously ill people?  Perhaps price regulation models couldn't be certain of offering more than rough justice to the drug companies.  But rough justice to them is better than gross injustice to the seriously or desperately ill and to the Americans who pay already high and ever rising health insurance premiums.

Fed Raises Rates, Civilization Ends

Today, the Federal Reserve raised short term interest rates a quarter point.  Stock up on food, water, blankets, toilet paper and ammo.  Barricade your doors and windows.  Civilization is ending.  Massive hordes wielding pitchforks will rage through the streets.  Entropy will increase.  Chaos will reign.

Okay.

Actually,

in all likelihood, not much will happen in the near future.  A quarter point really isn't a lot.  If the typically usurious credit card interest rate were increased a quarter point, you'd barely notice it, unless you're so deep in debt that bankruptcy is a more realistic option than minimum monthly payments.  If a quarter point increase on your mortgage rate knocks you out as a buyer of your dream home, you were probably about to pay too much for that house.  Money market funds and bank money market accounts have been paying almost nothing in interest.  If they now start paying a quarter point, you won't see a stampede from stocks to money markets.  The only thing that will happen is that savers will start thinking they can add one four-dollar cup of coffee per year to their budgets.

Will the rate increase exacerbate the fallout in the junk bond market?  Maybe by a bit.  Mathematically speaking, higher interest rates imply lower bond prices.  But, again, a quarter point won't greatly change bond prices.  The junk bond losses are, to a large degree, a result of the oversupply in the energy markets (oil and natural gas).  That's not the result of Fed policy.  It's because the energy markets were overstimulated by rapid growth in some parts of the world (especially China) which has now abated. 

The key question is how fast the Fed will raise rates over the one, two and three years.  Rapid increases will, indeed, significantly change the relative values of assets.  But Fed Chair Janet Yellen is signaling that the Fed will be kinder and gentler with rate increases than it has been in the past. 

Could the Fed be making a mistake?  As one former vice presidential candidate would have put it, you betcha.  The Fed has made many mistakes in the past and some of them were egregious.  Stay alert for trouble--the junk bond market, the manufacturing slowdown, China's slowdown, falling commodities prices and who knows what else could signal the next economic dislocation.  But the market was expecting a quarter point increase today, and if the Fed hadn't raised rates, it would have probably created more market turmoil than raising rates causes.