SOMETHING REMAINS TERRIBLY WRONG

John Hussman captures the disillusion of the average American with the recovery for the .1% and a continued recession for the 99.9%. When 77 million people have a debt in collection and most American families couldn’t raise $400 in cash without borrowing or selling something, there is something terribly wrong with our system. The culprits are the Federal Reserve and their Wall Street owners.

When the majority of Americans examine the world around them, they see a stock market at record highs and modest apparent improvement in the economy, but they also have the sense that something remains terribly wrong, and they can’t quite put their finger on it. According to a recent survey by the Federal Reserve, 40% of American families report that they are “just getting by,” and 60% of families do not have sufficient savings to cover even 3 months of expenses. Even Fed Chair Janet Yellen seemed puzzled last week by the contrast between a gradually improving unemployment rate and persistently sluggish real wage growth.

We would suggest that much of this perplexity reflects the application of incorrect models of the world.

Before the 15th century, people gazed at the sky, and believed that other planets would move around the Earth, stop, move backwards for a bit, and then move forward again. Their model of the world – that the Earth was the center of the universe – was the source of this confusion.

Similarly, one of the reasons that the economy seems so confusing at present is that our policy makers are dogmatically following models that have very mixed evidence in reality. Worse, when extraordinary measures don’t produce the desired results, the only response is to double the effort without carefully asking whether there is a reliable, measurable cause-and-effect relationship in the first place. When there are broken links in the chain of cause-and-effect, “A causes B” may be true, and “C causes D” may be true, but if B doesn’t cause C, then all the A in the world won’t give you D.

Federal Reserve policies since Greenspan have been devised to protect and enrich their Wall Street benefactors. The people have been left with stagnant wages and persistent inflation in the prices of things they need to live. Doubling down on a flawed solution will just lead to further misery for the middle class and another crash.

The always observant Charles Hugh Smith puts it this way: “Diversity and adaptability go together; each is a feature of the other. The Federal Reserve has created an unstable monoculture of an economy. What should have triggered a ‘die off’ of one predatory species – the ‘too big to fail’ mortgage/commercial banks and the Wall Street investment banks – was redistributed to all other participants. In insulating participants from risk, fact-finding, and volatility, you make price discovery and thus stability impossible.”

Rather than breeding a resilient economy by allowing the undistorted allocation of capital, rather than taking any lesson from a global financial crisis whose growing risks Yellen dismissed with “No, No, and No,” the Fed has created a food web that channels resources to the top predators, and ensures that scarce capital is diverted to the use of financial engineers and speculators. For someone who wants to help the middle class, the jobless, and ordinary Americans, Janet Yellen – as well meaning as we honestly believe she is – may inadvertently make matters quite a bit worse if her benign view of growing financial risk continues.

Yellen and her band of merry bankers have set in motion another train wreck. It may happen next week or it may happen next year, but it will happen. And when the economy is in flames after the third Federal Reserve created disaster in the last 15 years, the response will again be to save the banks and the .1%. Hopefully, the other 99.9% won’t fall for this crap again. Civil chaos and societal disarray will be the likely outcome.

The Federal Reserve’s prevailing view of the world seems to be that a) QE lowers interest rates, b) lower interest rates stimulate jobs and economic activity, c) the only risk from QE will be at the point when unemployment is low enough to trigger inflation, and d) the Fed can safely encourage years of yield-seeking speculation – of the same sort that produced the worst economic collapse since the Depression – on the belief that this time is different. From the foregoing discussion, it should be clear that this chain of cause and effect is a very mixed bag of fact and fiction.

So the greatest risk of QE is not the inflation risk that may or may not emerge, but the financial distortion, overvaluation, and speculation that is already baked in the cake and is progressively worsening, in a manner quite similar to the 2000 and 2007 extremes, though less evident because the cyclical elevation of profit margins makes prices seem tolerable relative to current earnings. As I’ve frequently noted, based on equity valuation measures that are most reliably correlated with actual subsequent stock market returns, stocks are now more than double their pre-bubble historical norms, and presently suggest that the S&P 500 will be no higher a decade from now than it is today. We expect the current QE bubble to unwind no more kindly than the prior bubbles in 2000 and 2007. As in those instances, my view remains that speculators who successfully exit this bubble will do so through the eye of a needle, and that the exit signal most envision will be far noisier and less timely than they imagine. See Ockham’s Razor and the Market Cycle and Yes, This is An Equity Bubble for additional background on these concerns.

As for the U.S. economy, QE-induced speculation misallocates resources that might otherwise contribute to long-run growth, and while conditions could certainly be worse, the benefits of this economic recovery have been highly uneven. Again, 40% of families report that they are “just getting by,” with the majority essentially living paycheck to paycheck without enough savings to cover even a few months of expenses. We could be, and should be doing better, except that this complex adaptive system of ours responds to good incentives as well as bad ones, and has been repeatedly crippled by policies that have produced waves of malinvestment, bubble, and collapse. The economy is starting to take on features of a winner-take-all monoculture that encourages and subsidizes too-big-to-fail banks and large-scale financial speculation at the expense of productive real investment and small-to-medium size enterprises. These are outcomes that our policy makers at the Fed have single-handedly chosen for us in the well-meaning belief that the economy is helped by extraordinary financial distortions. The Federal Reserve is right to wind down quantitative easing, and would best terminate reinvestment of maturing holdings, ideally beginning in October or quickly thereafter. The issue is not whether the U.S. economy does or does not need “life support.” The issue is that QE is not life support in the first place.

Read John Hussman’s Weekly Letter