Paul...I do agree that the stress test using multivariate regression models which by definition are using historical data to model potential future scenarios is tricky because as you say another credit dislocation similar to 2008-2009 can wreak havoc on market psychology because it strikes at the heart of what makes a modern economy tick and that is the credit markets and apart from the great depression we do not have historical periods that could provide appropriate models of what could happen. And yes the Fed has experimented with QE1-3 to unprecedented levels. Where I differ with you and the utter disdain you have for what the Fed has done is that my take is they had no other options available to them when they launched TARP and engaged in QE1. Believe me as a frontline participant in the equity markets when markets were imploding, I can tell you that we came very close to the precipice and something had to be done to backstop the financial system. Where I do agree with you (but I place the blame elsewhere) is that we should not have followed up QE1 with 2.0 and 3.0, ballooning the Fed's b/s to the level it has reached now. However, had we had a functioning political system with adults in Washington DC and a Republican and Democratic parties that could take on the follow up responses needed to spur economic growth by adopting fiscal policies that were pro-growth, then the Fed could have stopped after QE1. We could have had a much better recovery in GDP and jobs growth and much sooner than we did had their been a functioning body politic in Washington. Instead we had partisan politics that resulted in policies that did everything to retard economic growth. We could have been off the zero bound on Fed Funds rate 2-3 years ago with a much smaller Fed b/s and a more manageable debt profile had we had some adult supervision in DC. Instead we have had nonsensical partisan bickering with zero fiscal support for the economy (and by the way, I mean both traditional fiscal investment policies as well as pro-growth fiscal tax policies which is a combination of both traditional Democratic and Republican fiscal levers), and with that backdrop and a mandate to spur economic growth and stable inflation, the Fed did what they could only do given the policy tools available to them, and that is QE2 and QE3. I see your frustration with the Fed but I place the blame on our politicians in DC for forcing the Fed's hand to over rely on QE in trying to spur a recovery from the extreme fall out of the financial crisis.
I suspect we will look at the same stats and have different interpretations of why things have played out the way they have and how good/bad things are economically. I wholeheartedly agree with you that the amount of leverage in the US and globally is alarming and should be of concern and using the "printing press" (although it's not quite printing money in the traditional sense) to spur on economies has resulted in a race to the bottom in terms of interest rates and hence currencies. But I think if the US can achieve escape velocity (which it is on the verge of doing) then in 12-18 months, Europe will follow, allowing the ECB to exit its easing cycle and with 60%+ of global GDP in growth mode, we will be ok because growing economies naturally delever and bring those debt levels back into more normal historical and sustainable levels.
We are currently experiencing a little hiccup with China's deceleration and that is causing some agita in the markets and placing some question marks as to whether this will depress growth in the US, however, I think those worries are overblown given our limited export exposure to China (Europe is a much bigger trading partner and again Europe is starting to rebound). Anyway, that's neither here nor there. I appreciate your valid concerns but I don't think we are at the precipice of some great financial calamity (I do think you are right in pointing out that we have capped out future growth due to our over leverage situation) and I also don't place the blame on the Fed. I place 100% on the dysfunction in DC and the lack of fiscal support to take over/supplement the unprecedented monetary easing we have gone through in the past 6 years.
Good response. I agree with a lot more now. We have a few issues here and I want to respond clearly. I see them as follows: 1) how the fed behaved in 2008 Crisis; 2) what we think of the current banking capital positions and the validity of stress test; 3) what we think about post 2008 Crisis global central bank behavior and the future. (I apologize if I missed something.)
1) I do not completely lament what the Fed did in 2008 given the urgency of the situation. I wish there had been higher moral hazard; if you do not allow markets to penalize bad behavior, such behavior is destined to return. I believe I understand the condition of the markets at the time, but I simply believe a systemic melt down could have been managed with a lot less tax payer money left on the table. Hank was a savvy banker in his day and during the crisis he was like a fox in the hen house, but came off looking like a rooster. But hey, Hanks a pro and thats what he does.
2) My views are covered in posts 27 and 39. It seems we pretty much agree the Fed has given it "the old college try" but I believe they drastically over state their case regarding the results. Between Dodd Frank which has precipitated even more systemic reliance on the "to big to fail players" and the continued modest level of competence of the average Fed Official, I see little change in the system to ensure confidence.
3) Here is where things get very interesting. I don't disagree with QE1 or even 2 or 3; it was important to flood the system with liquidity at the time of a crisis. But beyond this point is where I think great scrutiny is required. What we face this time around relative to climbing out of a recession is different than anything else the modern economy has ever faced and the old techniques will not work. We are seeing this ever day.
In a traditional recession printing money reduces the cost of capital which creates an incentive to borrow capital to make investments which spurs the economy. In all past recessions the debt capacity existed on the demand side to react to these technique. Additional cheap money was borrowed, capital investments were made and the economy responded. This time it is not happening because it can not happen. (Look at the leverage curves above.) Debt capacity is no longer available.
In addition, the system built global capacity to meet demand from current income plus the income from the next 30 years. This level of capacity is too high because the ratio of Debt-to-GDP is reaching its finite limit. Printing money has only had the effect of reducing velocity and precipitating financial transactions. M&A is sky rocketing because capital is cheap and deals are getting done to consolidate capacity but no capacity is being created and hence no real growth is occurring.
So here is where it gets scary. Since global capacity can't increase, countries have gone to war against each other trying to grab the biggest piece of a fixed pie. They have done this through their currencies. As I have said before, for the USA to have dramatically increased its money supply in relation to GDP and still have its currency strengthen is absolutely stunning. This can only happen when everyone else is printing even more money than the US!
In a nut shell, if global capacity is too high because we spent future income today and debt capacity is exhausted, printing money doesn't spur growth it can only weaken currencies. Growth can only occur after a purging of the excess capacity which will only occur when deflation drives the least efficient capacity out of the system (i.e., recession). By printing money in the mean time to steel from your neighbor all we are doing is creating the possibility that the inevitable recession will be coincident with currency collapse which is a profound consequence.
This is all visible in the system in the form of historically low money velocities, hyperactive M&A, borderline deflation, modest growth, and highly irrational currency markets. What is not present is the market pricing in the impact of the events discussed above which is not uncommon. The lists are long of markets staying stable in the face of insanity and then collapsing with a fury. Did people really think real estate in Japan made sense in the 1980's, tech stock prices in the late 1990s, gardeners getting mortgages for $700,000 houses in the 2000's?
If the central banks don't knock it off, this thing could get very ugly.
