Weekly Market Comment
by John P. Hussman, Ph.D
March 21, 2016

Extinction Burst

In behavioral psychology, a “reinforcer” is anything that increases the likelihood of a given behavior. Reducing an undesirable behavior usually involves two steps: a) “extinction,” where the reinforcement for the existing behavior is removed, and; b) “substitution,” where another behavior is introduced that hopefully satisfies the underlying need in a more desirable and effective way.

Now, when a given behavior stops being reinforced, one might expect the behavior to be abandoned. Instead, and particularly when no substitute behavior is available, you’ll actually see an initial “extinction burst” - a nearly frantic increase in the frequency and the intensity of the behavior.

Consider central bankers. For the past several years, global central banks have pursued increasingly deranged monetary policies, creating massive distortions in financial markets. It’s easy to point to these effects on the financial markets, as Bernanke, Kuroda, Draghi and other central bankers have emphasized, as evidence that central bank policy is “working.”

Unfortunately, that’s not how one measures the impact of monetary policy on the real economy. The correct approach is to compare how the economy has actually done versus how it would have been expected to do with and without those interventions. Specifically, you estimate the trajectory of output, employment, and other variables using past values of a) only non-monetary variables like output and employment, and b) both non-monetary variables and monetary ones (typically using a statistical method known as "vector autoregression" or VAR). What we, and others, have found, is that all of this deranged monetary policy has raised the level of GDP, industrial production, and employment by barely 1% from what would have been expected in the absence of these interventions.

On January 29, a week after insisting that a move to negative rates was not under consideration, Bank of Japan Governor Harohiko Kuroda announced a rate cut to -0.1%. On February 18 he reiterated that the BOJ was prepared to ease further. He wavered on that stance at the end of February, but shifted again last week, saying that a move to even deeper negative rates was possible. Meanwhile, facing economic erosion in Europe, Mario Draghi came out on February 15 saying “we will not hesitate to act.” He followed on March 10 with his “bazooka” including a rate cut to -0.4%, an increase in the pace of QE, and a broadening of ECB purchases to include investment-grade, non-bank corporate bonds. On Wednesday, Janet Yellen announced that the expected pace of Fed rate hikes this year was likely to be slower than expected, as a result of weak global economic conditions and widening credit spreads.

Aside from a one or two-day knee-jerk response, these moves have had very little sustained impact on the equity markets. Japan’s Nikkei index is down about 5% since the day after Kuroda’s rate-cut announcement. The Dow Jones EuroStoxx Index is also down since the day after Draghi’s bazooka. One suspects that the response of the S&P 500 to Yellen’s dovishness will be similarly short-lived, though we need not rely on that. Given the continued sequence of erosion in economic measures, central bankers continue to point to the financial markets as evidence that their policies are “working.” Now even those effects have become unreliable.

The press conferences following central bank moves increasingly sound like real people have been replaced with “bots,” mechanically retrieving phrases to make a historically extreme monetary stance sound prudent and to simultaneously encourage speculation. Every phrase has to be weighed individually, so one observes a halting, almost rambling quality to the remarks. Consider this response by Janet Yellen to the first question in the press conference following the Fed’s dovish monetary policy statement on Wednesday:

“So, you have seen a shift, uh, this time, in most participants assessments of the appropriate path for policy, and as I tried to indicate, I think that largely reflects a somewhat slower projected path for global growth, for growth in the global economy outside the United States, um, and for some tightening in credit conditions in the form of an increase in spreads, and, um, those changes in financial conditions and in, uh, the path of the global economy have, uh, induced, uh changes in the assessment of individual participants in what path is appropriate to achieve our objectives, so that’s what you, uh, see, that’s what you see. Now I guess you asked me also, what would we need to see, um, to continue raising rates, and I think it’s worth pointing out here that, um, the committee, most participants do continue to um, envision that if economic developments unfold as they expect, that further increases in the federal funds rate will prove appropriate over time, um, most participants anticipate that uh, and, uh, that the pace will be gradual.”

- Janet Yellen, March 16, 2016 press conference following FOMC meeting

This sudden escalation of dovish pronouncements by central bankers isn’t sound monetary policy, being conducted based on demonstrated cause-and-effect relationships between policy tools and the real economy. No, this is an extinction burst. Central bankers are behaving like lab rats frantically pressing a bar in hope that more food pellets will come out of the chute. They ain’t comin’.

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The problem with punishing saving in order to encourage more consumption is that it’s ineffective, and also leaves the economy with nothing to show for it. The wealth of a nation consists of its stock of real private investment (e.g. housing, capital goods, factories), real public investment (e.g. infrastructure), intangible intellectual capital (e.g. education, inventions, organizational knowledge and systems), and its endowment of basic resources such as land, energy, water, and the environment. In an open economy, one would include the net claims on foreigners. Everything else cancels out, because every security is an asset of the holder, but a liability of the issuer. If we want greater prosperity, it will come from expanding our productive capacity and defending our natural resources.

Monetary authorities have now become little more than lab rats on a frantic extinction burst. If there are no adults in the room among our policy-makers who are willing to pursue the appropriate substitute behavior - expanding productive investment through fiscal means - we’re going to have a deeper and more concerted global economic downturn than is already likely. I remain convinced that monetary authorities have already ensured a financial collapse in the coming years that is baked-in-the-cake as a result of obscene valuations. That outcome will unfold nearly regardless of economic prospects.

By encouraging acute financial distortions, enabling massive issuance of speculative-grade securities and stock buybacks at near-record valuations, and repeatedly diverting national savings toward speculative malinvestment, the concerted behavior of central banks is increasingly pushing the global economy toward financial crisis and depressed long-term growth. There is no hope for long-term economic prosperity if we place our faith in the monetary policies of deranged bankers and ivory tower college professors. All they can do is to buy interest-earning bonds and replace them with zero-interest paper. How ignorant must we be to believe that financial bubbles will carry us to prosperity without consequences, and how many collapses must we endure before we focus on strengthening our own legs?

The irony of economics is that when we pursue policies that encourage speculative malinvestment and make productive investment scarce, the pie gets smaller but a larger share of it goes to the owners of existing capital. The “rents” are always highest for those resources that are most scarce. If we really want more jobs, higher labor productivity, stronger growth, better real wages, a balanced income distribution, and a return to long-term economic prosperity, only an expansion of real productive investment - at every level of the economy - will do the job. Ever more deranged monetary policy will not.

The economy is unlikely to reach "escape velocity" due to the influence of Federal Reserve and other central banks' policies, billionaire investor Stanley Druckenmiller said Wednesday.

"We have pulled so much demand forward and borrowed so much from our future, so much financial engineering has gone on," the former Duquesne Capital Management chairman and president told CNBC's "Squawk Box."

Druckenmiller said he can't see the U.S. economy breaking free of sluggish growth any time soon.

"This idea that we're going to have escape velocity in the economy, I just don't see it," he said. "At best we're going to muddle through," he said.

The U.S. economy grew by 1 percent in the fourth quarter of 2015, according to the second of three readings released last week by the Bureau of Economic Analysis.

Druckenmiller said the market was overvalued heading into last year, following "huge" liquidity support for a number of years. But that support is now dissipating as China and Saudi Arabia scale back purchases of Western assets, he said.

"The Fed stopped injecting, so I think it's just the natural outgrowth — the markets themselves — the natural outgrowth of this cessation of liquidity," he said.

The Fed held interest rates near near zero from December 2008 until a meeting of its policymaking committee in December, when they raised interest rates by 25 basis points. With bonds yielding little return, investors have flocked to stocks, raising concerns about misallocation of capital and bubbles.