Comstock Partners, Inc.February 17, 2011
No Easy Way Out Of The Dilemma
It seems incredible that the Fed is creating the third bubble within 11 years, but that is what is underway. In the late 1990s the Fed kept the pedal on the gas and helped engender the dot-com bubble that collapsed with a 75% decline in the Nasdaq and 50% in the S&P 500. To prevent the economy from correcting the imbalances created in that era, the Fed kept the funds rate at 1% for an extraordinarily long time, thereby fostering the backdrop for the historic housing boom that also collapsed and came dangerously close to bringing down the global economic and financial system.
The initial gargantuan efforts by the Fed and the Administration and Congress to keep the economy from collapsing were necessary and effective. Since then, however, further stimulative programs have resulted in only a tepid economic recovery along with the addition of dangerous amounts of new debt and a soaring stock market that seems doomed to disappointment once again as in 2000-to-2002 and 2008-2009.
The Fed jump-started the stock market with two rounds of massive easing commonly known as QE1 and QE2. Not coincidentally, the market bottomed in March 2009 just as QE1 got underway. When that program, consisting of the Fed's purchase of $1.5 trillion of Treasury Bonds and mortgages, ended in April 2010, stocks dropped 17% in a few months. When stocks declined and the economy faltered Chairman Bernanke, at a late August meeting in Jackson Hole, announced the Fed's intentions to institute QE2, a program to buy $600 billion of 2-to10-year Treasury notes by June 30, 2011. Since that time the market began rising and hasn't stopped since. Notably the program, which actually began in October is pumping about $3.4 billion into the economy and assets every workday of the week.
The stated purpose of QE2, as outlined in a Washington Post op-ed column by Bernanke, is to pump up asset values with the hope that it would feed into the economy and to lower mortgage rates in an effort to aid the housing market. QE2 did goose the stock market, but appears to be failing miserably on a number of other fronts. It has not helped housing, which is still in the doldrums, and has only marginally helped employment. Furthermore the policy has created a lot more commodity inflation with higher prices for energy, food, cotton and a wide number of other items. It has led to inflation in emerging nations that have begun tightening money to slow down their economies. It has also caused a rise in long-term bond and mortgage rates, contrary to initial expectations. In addition let's not overlook the contribution of food price inflation to the unrest in Tunisia, Egypt and the rest of the Mid-East.
Underlying all of these problems is the massive debt, both government and household, built up over the past few decades, particularly in the most recent one. Household debt has averaged about 55% of GDP over the last 60 years, but recently peaked at 98%, and is now down to 91%. As a percent of disposable personal income, household debt has averaged 75%, with a recent top of 130% and is currently at 117%. Similarly, government debt has averaged 66% of GDP and is now at a peak 108%, as government debt has recently risen more than private debt has dropped.
The problem, as everyone belatedly realizes, is that, as a nation we have far too much debt, both public and private. But debt is the fuel that enables economic growth. Without an increasing amount of debt the economy cannot grow and, in fact, shrinks. The hope is that by substituting government debt for household debt we can get the economy back on a normal growth path while also getting consumer balance sheets back into shape.
In our view the chances for success are dim. After all is said and done, debt is debt whether it's the government debt or private debt. And as Greece has shown, even governments cannot keep increasing their debts without severe consequences down the road. It seems the only way out is to reduce total national debt, both public and private. That would have dire consequences for the economy in the short run. On the other hand, continuing to increase debt as we have been doing may work in the very short run but in the end, is unsustainable. And note that QE2 ends in June. After that, any further stimulus is probably politically impossible anyway, given the climate in Washington and the various state governments. This will all become obvious to the market soon enough, and once again they will say nobody saw it coming.