Hussman - The Beauty of Truth and the Beast of Dogma

Weekly Market Comments
September 14, 2015
by John P. Hussman, Ph.D.

The beauty of truth, and the beast of dogma

Other “relationships” that are used to justify activist monetary policy have similarly weak support when one actually takes the effort to examine the data. You’ll find a similar shotgun scatter of uncorrelated points if you plot unemployment versus general price inflation, for example. It’s unfortunate that the Federal Reserve is actually allowed and even encouraged to impose massive distortions on the U.S. economy based on relationships that are indistinguishable from someone sneezing on a sheet of graph paper.

We do know one thing very clearly, and we should have learned it during the housing bubble – suppressed interest rates encourage yield-seeking speculation, enable low-quality creditors access to the capital markets, direct scarce savings toward unproductive malinvestment, subsidize leveraged carry-trades, and unleash a whole host of “structured” products “engineered” by financial institutions to directly or indirectly piggyback on the good faith and credit of Uncle Sam.

When you examine historical data and estimate actual correlations and effect sizes, the dogmatic belief that the Fed can “fine tune” anything in the economy is utter hogwash. At the same time, the demonstrated ability of the Fed to provoke yield-seeking speculation and malinvestment is as clear as day. An activist Federal Reserve is an engine of disaster and little more. Even with the best intentions, a dogmatic Fed, unrestrained by reasonable rules and constraints, is a reckless and deceptive beast, constantly offering to heal the nation with precisely the same actions that inflicted the wounds in the first place.

Truth, on the other hand, is beautiful. Economic relationships that are supported in real-world data are a sight to behold. You want to see some relationships you can count on? The chart below shows the relationship between the 3-month Treasury bill and the ratio of the monetary base (currency and bank reserves) to nominal GDP, in data since 1929. Notice something. Without paying banks interest to hold excess reserves idle in the banking system, the Fed could reduce its balance sheet by more than one-third (over $1.4 trillion) without pushing short-term interest rates above zero. That excess base money does nothing to support the real economy.

Nobody’s desired level of saving, consumption, or real investment changes just because the Fed has chosen to force the economy to hold more base money and fewer Treasury bonds. But somebody has to hold that cash at every point in time – and nobody wants to hold it. So it simply acts as a hot potato, encouraging yield-seeking speculation in the financial markets. In my view, the most urgent action the Federal Reserve should take is to cease reinvestment of principal as the holdings on its balance sheet mature, in order to reduce this massive pool of idle base money, which does nothing but to promote speculation. No increase in interest rates would need to result from that action.