Former Federal Reserve Chairman Alan Greenspan opened his mouth last Friday to caution on the perils of quantitative easing and artificially suppressed interest rates. Greenspan also cogitated upon how to put the worms back into the already opened can.
What follows is a sampling of his utterances…
“The sooner we come to grips with this excessive level of assets on the balance sheet of the Federal Reserve – that everybody agrees is excessive – the better. There is a general presumption that we can wait indefinitely and make judgments on when we’re going to move. I’m not sure the market will allow us to do that.
“I think the issue is not only a question of when we taper down, but when do we turn. The markets may not give us all the leeway we might like to do that.”
The difference between tapering and turning is similar to the difference between slowing down the rate new debt is added and actually paying debt back. Currently, as you know, the Federal Reserve creates $85 billion a month – from nothing – to prop up the credit market. Tapering, as Greenspan calls it, would be to cut back to a monthly Fed balance sheet expansion of something less than $85 billion. Turning, would involve drawing down the Fed’s balance sheet, which, as of June 5, towered at $3.357 trillion.
At some point, as Greenspan notes, the Fed will have to taper and turn. Naturally, this will produce a shock through the financial system.
Perhaps, the yield on the 10-Year Treasury Note is foreshadowing what may be just around the corner. Last month, for instance, yields spiked 30 percent, from 1.63 to 2.13 percent. Yesterday they settled at 2.21 percent. This may be a subtle message from the market to the Fed that their time is running out.
“Bond prices have got to fall,” added Greenspan. “Long-term rates have got to rise. The problem, which is going to confront us, is we haven’t a clue as to how rapidly that’s going to happen.
“We’re still well below the [rate] level we normally ought to be at this stage. The consequence of that is that when the bond market begins to move we may not be able to control it as well as we’d like to. And that has a lot of ramifications with respect to all sorts of markets.”
Certainly, rapidly rising rates could crash the bond market, stock market, and dollar all at once. Thus, the Federal Reserve may want to get out in front of the market…and begin tapering back its asset purchases. The problem, however, is that the Federal Reserve, through its policies, has engendered an economy that’s fully reliant upon massive issuances of cheap credit. Just taping back could be enough to crater the market.
In other words, the Federal Reserve has printed itself into a corner. They have a conundrum on their hands that’s of their own making. They must keep expanding the money base or the economy will most surely crack. Yet if they keep pumping in more and more money, credit markets will ultimately drive yields up…which will also crack the economy.
Here’s another way to look at it…
Salting the Earth with Money
Dropping down the backside of the grapevine from the Tejon Pass, along Interstate 5 between Los Angeles and San Francisco, one is greeted by an endless sea of agricultural fields. However, the farms of California’s San Joaquin Valley are not 160-acre family homestead farms rooted in the 19th century nor are they in the yeoman farmer tradition envisioned by Thomas Jefferson. They are large-scale, highly productive, corporate farms.
While these massive agricultural operations are quite a sight, what’s more incredible is that they even exist at all. Given the natural resources of the area, the possibility for anything – aside from cactus and scrub – to grow here is a miracle.
“The southern part of the valley was a barren desert waste with scattered saltbush when first viewed by Don Pedro Fages in 1772 coming from the south over Tejon Pass,” wrote University of California Berkeley Professor Emeritus, James Parson. “Less than five inches of rain annually falls in southwestern Kern County, maybe ten inches at Fresno. Pan evaporation in a summer month on the west side pushes 20 inches.”
Still, a barren desert waste and parched conditions didn’t stand in the way of what was to come. For with a little imagination, subsidized water, and cheap migrant field workers, mankind was able to create what “has been called ‘The world’s richest agricultural valley,’ a technological miracle of productivity.”
Unfortunately, endlessly dumping chemical fertilizers, pesticides and herbicides, and imported water, is not without consequences. What has stimulated the productive miracle of the San Joaquin Valley over the last century is the same blend of factors that has propped up American financial markets, and government debt, over the last decade…
Namely, cheap credit and excess liquidity.
For example, in the San Joaquin Valley, vast irrigation networks convey water thousands of miles to make the desert bloom. But as surface water is conveyed along the open California aqueduct it becomes saltier. And as it’s applied for irrigation, the residual salts collect in the soil.
After decades of this, the salt in the soil has built up so that it strangles the roots of the plants. To combat this, over-watering is required because the irrigation water – while salty – is fresher than the salt encrusted soil. By applying excess irrigation water, the soils around the plants are temporarily freshened up so that crops can grow. Yet, at the same time, this over-watering accelerates the mass quantity of salt being applied to the soil.
In this grand paradox, the freshness of the excess water that’s keeping the farmland alive is the source of the salt that’s killing it.
So, too, goes the U.S. economy. After five years of rapidly expanding their balance sheet and pumping cheap credit and excess liquidity into financial markets the Federal Reserve has surfaced a similar paradox.
They must keep expanding the money base to keep the economy afloat…but in doing so they’ll ultimately kill it. Our guess is the Fed won’t get serious about turning until the market forces them too. By then they’ll have lost any remaining control they still hold.
for Economic Prism