A Fool's Market Rally Authored By a Very Foolish Fed
"An increase in the quantity of money can no more increase the welfare of the members of a community, than a diminution of it can decrease their welfare." - Ludwig von Mises, The Theory of Money and Credit, p. 102
Global stock markets rallied last week on news that central banks - led by our own hapless Bernanke Fed - would provide cheap, emergency dollar loans to banks in Europe and elsewhere short on cash. Much as markets were buoyed in 2008 following central bank action - only to suffer a much worse hangover later - the same is occurring three years hence.
Ultimately markets are smart, and the ability of central banks to do much of anything to lift their spirits (short of getting out of the way) will wither away. That's the case because interventions like the one from last week only serve to create much bigger problems down the line.
If this is doubted, readers need only ask why central banks are intervening to begin with. They are because banks have committed egregious errors, and with banks clients of the central banks wrongly charged with protecting them, they would only need help like that offered last week if they'd erred so grandly that private sources of capital deemed them unfit to transact with.
With the above hopefully having cleared up any misconceptions as to the why of central bank rescue activities, we need now to look ahead to the certain harm being foisted on the global economy by the banks' protectors in the form of arrogant central banks. The harm is very real.
To reduce the problems of the global banking system to the basics, bolstered by regulations that value government debt held on banks' books at par, banks loaded up on the bonds of overextended governments that have subsequently run into trouble staying current on what is owed. So while ever behind-the-times regulators view government securities as gold-plated, market actors have a different view.
And because they do, they've grown less and less willing to exchange cash for the dodgy assets held by banks. Central banks, blinded by the false view that banks are the only source of credit in the global economy, have stepped in to provide the cash in return for weak assets that private players will not touch.
The economic harm here is obvious. For one, the banks that put themselves in the position to be supplicants of central banks should be allowed to fail if their balance sheets don't allow them to conduct normal, profitable banking operations. If so, the banking sector in total would be strengthened for bad practices being cleansed from the system in concert with new owners stepping in with an eagerness to manage poorly run banks better. Instead, central banks will prop up errors made, thus perpetuating faulty banking practices. Put simply, if banks are so important to the global economy, central banks should underscore their importance by letting them fail with an eye on strengthening the sector altogether.
Secondly, what the central banks fear is that in their desperation to attain liquidity, their client banks will sell the limping government debt on their books at a discount, and in doing so weaken the system even more for the value of government debt falling to more realistic levels. This too would have a cleansing effect on the banking system, but even better, would be grand for the global economy for falling prices of government securities signaling to investors that they should avoid supporting more government destruction of capital. But since the central banks won't allow market forces to discipline banks or discredit investment in profligate governments, the global economy will suffer for central banks subsidizing the failed practices that led governments and banks into trouble to begin with.
Notably, last week's action wasn't just meant to aid banks heavily exposed to European debt. Some financial institutions at the moment are experiencing cash shortfalls due to their ownership of credibility-challenged U.S. mortgage securities. So while the U.S. economy would certainly benefit from capital migration away from anything that has to do with housing, central bank interventions are blunting what would be a very healthy (for the overall economy) decline in mortgage securities that would unlock capital wasting away in the failed ideas of the past, and ensure that more good money won't chase all the bad that's already been sent in the direction of the housing sector.
But with central banks never lacking self-assurance despite market evidence regularly revealing their actions as the source of myriad global problems, their constant interventions which prop up the losers at the expense of the winners will continue, thus making global recovery a distant object. A fool's rally indeed.
After that, we can't discount the negative impact on the dollar and the euro of these interventions. With private market actors no longer trusting of bank collateral, central banks have as mentioned stepped in to monetize their errors. This has necessarily weighed on the credibility of both the euro and the dollar, with the price of gold having risen quite a bit in recent weeks.
This column is a broken record about the importance of currency credibility, but if the dollar is the most important price in the world, the euro is arguably the second most important price. And when investors consider committing capital to business concepts actually meant to stimulate real growth, they're buying future dollar and euro income streams. Of course with central bank policy working in favor of dollar/euro devaluation, investors have no incentive to provide capital to the productive, thus exposing to an even higher degree the long-term horrors that will result from last week's central bank actions.
At present, global central bankers are the world's sham doctors, constantly seeking to trick the global economy into feeling flush with interventions that will do nothing to stimulate the lone thing that will actually author recovery: production. It's time for the world's central banks to do what good doctors do, which is to allow the overmedicated patient to heal free of more cures. If not, as in if they continue to doctor the wilting patient, soon enough they won't even be able to fool the fools.