11 Silver Things You Need To Know About Silver Right NOW

The Wealth Effect Shifts Into Reverse

Stripped of all the acronyms and economist-speak, government policy of the past few years has been simple: lower interest rates to push people out of cash (which yields nothing) and into stocks and houses. And then, when those assets go up enough to make their owners feel rich, hope that this paper wealth translates into a willingness to max out credit cards and take out car loans.

This propensity to borrow and spend more when your investments are rising is called the wealth effect, and by early 2013 it seemed to many that America’s “normal” debt-driven consumer society was reviving and that we might, after all, be able to maintain our military empire, welfare state, big houses, SUVs, massive banker year-end bonuses, easy incumbent reelections, etc, etc, without any prioritization or hard choices.

Nope. It turns out that the laws of economics can be bent but not broken. You can’t have a vibrant, growing economy AND interest rates near zero AND a stable currency at the same time. One of these has to give. And in the past month interest rates have started moving back towards historically normal levels.

Rising interest rates are incompatible with housing and equity bubbles, and the air is now leaking from both. As this is written, global stock markets are down big. And US housing, which in some markets was approaching 2007-esque levels of speculation, has hit a wall, at least based on mortgage applications:

Mortgage applications tumble as rates rise further: MBA

(Reuters) – Interest rates on home mortgages rose last week to hit their highest level in over a year, sapping demand from potential homeowners, data from an industry group showed on Wednesday.

Rates climbed 2 basis points to average 4.17 in the week ended June 14, according to the Mortgage Bankers Association. It was the highest level since March of last year.

After hovering around record lows, rates have surged for six weeks in a row, pushed higher by worries that the Federal Reserve could slow its stimulus program sooner than had been expected. Rates have accelerated by 58 basis points since the start of May.

The Fed’s bond purchases have kept borrowing rates, including mortgages, low. Though mortgage rates remain low by historical standards, the ultra-cheap mortgages have helped lure buyers back into the market and worries have crept in that higher rates could disrupt the still-young housing recovery.

The rise in rates appeared to hold back homebuyers as MBA’s seasonally adjusted index of loan requests for home purchases – a leading indicator of home sales – fell 3 percent. The gauge of refinancing applications slipped 3.4 percent, though the refinance share of total mortgage activity held steady at 69 percent of applications. The overall index of mortgage application activity, which includes both refinancing and home purchase demand, declined 3.3 percent.

And so the wealth effect shifts into reverse. Fewer people can afford mortgages, so home prices stop rising, making homeowners feel less rich. Stock prices stop rising (or, like today, start going down) and the record number of people who have been buying on margin see their exciting gains melt away. They feel both less rich and suddenly very stupid. Most of them will spend less, and the recovery will stop in its tracks.

Which means it’s time to think about the next big government plan to save us. Will it be a massive public works program? Expanded  QE? Maybe a major war? Whatever, it will have to be commensurate with the size of the now-global crisis. So, just a guess, but this time around it won’t be surprising to see a coordinated attack on deflation from Europe, the US and China. In other words, global Abenomics.

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End Of QE?

A A new meme is spreading in financial markets: The Fed is about to turn off the monetary spigot. US Printmaster General Ben Bernanke announced that he might start reducing the monthly debt monetization program, called ‘quantitative easing’ (QE), as early as the autumn of 2013, and maybe stop it entirely by the middle of next year. He reassured markets that the Fed would keep the key policy rate (the Fed Funds rate) at near zero all the way into 2015. Still, the end of QE is seen as the beginning of the end of super-easy policy and potentially the first towards normalization, as if anybody still had any idea of what ‘normal’ was.

Fearing that the flow of nourishing mother milk from the Fed could dry up, a resolutely unweaned Wall Street threw a hissy fit and the dummy out of the pram.

So far, so good. There is only one problem: it won’t happen.

Now I am the first to declare that the Fed SHOULD abolish QE, and not only in the autumn of this year or the summer of next, but right now. Pronto. Why? –Because a policy of QE and zero interest rates is complete madness. It distorts markets, sabotages the liquidation of imbalances, prohibits the correct pricing of risk, and encourages renewed debt accumulation. It numbs the market’s healing powers – by enabling more ‘pretend and extend’ in the financial industry – and it adds new imbalances to the old ones that it also helps to maintain.

This policy may have prevented – for now – debt deflation but maybe debt deflation is what is needed.

QE is nothing but heavy-handed market intervention. It is destructive. It doesn’t solve the underlying problems. It creates new ones.

Larry Summer’s getaway car

However, none of these objections even register at the Fed. The Fed has a completely different perspective: This policy was a roaring success and as it has worked so well it can now be faded out. Soon there will be no need for it. Larry Summer’s dreadful phrase captures that thinking probably best: The economy will soon have achieved ‘escape velocity’.

Most analogies are somewhat poor but this one is particularly inept. Ironically, though, the reference to mechanics captures beautifully the logic of Keynesians and other interventionists: the economy is like a physical object moving through space and is occasionally in need of a little push to get moving again at an appropriate speed. Policy provides the push.


Bernanke doesn’t use these terms but his thinking is similar. He explained QE to the American public in 2010 by announcing that his job was to occasionally manipulate interest rates and asset prices to encourage lending, borrowing, spending, shopping, and other healthy economic activities, and that once his machinations had stimulated enough of those activities, the economy would again enter a virtuous cycle (his words) of self-sustained growth. Escape velocity has been restored.

I think this is nonsense – however appealing it may sound to many laypersons. The economy is not an object that needs a push, or a machine that needs to be jump-started, or a lazy mule that needs a gentle slap on its behind to get going again (of course, you should never hurt an animal!). The economy is a complex process of coordination, an elaborate tool that allows an extensive and diverse group of actors with different and frequently conflicting goals and interests to co-operate with one another peacefully toward the best possible realization of their own material aims. A crisis is a failure of that coordination process. It is a cluster of errors. The only explanation for the occurrence of such a cluster of errors is a systematic distortion of the market’s coordinating properties, such as occurs when monetary expansion distorts interest rates and other relative prices, and leads to imbalances that unhinge the economy.

The economy went into recession because of massive financial deformations. Easy money had led to excessive indebtedness, a housing bubble and dangerous levels of leverage. The problems were such distortions, not lack of momentum. The real question is not whether the GDP statistics exhibit the right velocity but if the underlying dislocations – which, to the chagrin of the econometricians, cannot be easily ascertained from the macro-data – have now dissolved.

No Escape

The Fed believes it has healed an economy that was sick from easy money with more easy money. The patient is feeling better and can soon be released from intensive care. In my view, the patient is still sick and now suffers from a dangerous addiction to boot. The ‘feeling-better’ bit maybe, just maybe, a lingering drug high from Dr. Bernanke’s generous medication. Withdrawal symptoms may surface soon. If they do, Dr. Bernanke will simply open the medicine cupboard again. Don’t forget, only a few weeks ago the man appeared on TV and tried to talk up the Russell 3000 stock index.


I do not doubt that, if measured by overall GDP, the US economy is presently doing better. I would be foolish to take on the Fed on this point. The Fed has a staff of 200-plus economists, most of them, I assume, from America’s finest universities, which doesn’t mean they are good economists but at any rate probably good statisticians. If they say there are signs of life in the economy, that’s good enough for me.


Where I disagree is on the narrative. The deformations are largely still there. How can they not, given the enormous policy effort to suppress the very market forces that would – in a free market – have exposed and liquidated these deformations? They are still visible, among other indicators, in high degrees of indebtedness. And they matter. That is why I am mistrustful of the Fed’s projections. Their theories compel them to believe in virtuous cycles and ‘escape velocity’ and to disregard imbalances and distortions. Any sustained removal of super-easy money will allow these deformations to resurface and immediately cloud the near term cyclical outlook. According to my worldview, this should be allowed to happen as it is part of the essential healing process. But it runs counter to the Fed’s worldview and the Fed’s view of its own mission.The one institution that lacks ‘escape velocity’ is the Fed. It will remain hostage to the financial monsters it created and the dangerous misconception of its own grandeur.

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