Friday, March 11, 2011
- Pain To Our Left, Oblivion To Our Right
Yesterday I was reminded of the Hitchhikers Guide to the Galaxy. Not the whole thing, just those glasses that Zaphod wore all the time that were sensitive to peril. Any time they detected immanent danger they would turn utterly opaque preventing the wearer from seeing whatever it was that might alarm them. I think a rising stock market is like that in some respects. We see our 401K balances rising and start complaining about all manner of otherwise minor things because we can no longer see how close we are to utter oblivion.
All this was brought on by an email discussion that I had yesterday with a good friend of mine who runs the fixed income trading unit of a major Japanese bank. He’s a profoundly smart guy with years of experience, and a profit making history that I can only envy. He’s one of my ‘go to’ guys for information on the fixed income market, and there are few people whose opinion I respect more – none in his area of the markets. But I think he’s still got a pair of the Zaphod Beeblebrox glasses in his drawer somewhere.
“More QE would be a bad idea” he said “inflation is beginning to creep up and the rates are low – it makes no sense.” “I agree” I replied, “but we’re going to get it anyway. It’s just a question of whether we get a little bit of it this year in order to keep things from tipping over, or we get a ton of it next year after things have already gone pear shaped and we're into a new recession.”
We went on like that for a few hours. He explaining to me over and over all the reasons that more QE would be the wrong thing to do in this environment, and me explaining to him that I didn’t think it would matter – and that we would be getting more anyway.
In fairness, we were talking past each other. He was talking about what was 'right' and I was talking about what was likely. In truth we didn't really disagree. In fact, for the record, I think he was absolutely correct in everything he said. But it doesn’t change my mind. My friend was focused on the ‘battle inflation’ half of the Fed’s charter. And although that’s desperately important, I don’t believe it’s what Ben Bernanke is thinking about.
I think Bernanke, like everyone in government, is thinking about ‘control’. What’s most important for policy makers is that whatever policy they pursue, they want to make sure it leaves them in control of as much future decision making as possible. Rule one for horseback riding is ‘stay on the horse’. And similarly, policy makers never want to pursue a policy that leaves them powerless in the future - whether it’s right, wrong, or other. This sounds horribly cynical, but in Bernanke’s case that isn’t really so. Another way to think about it is that he’s hoping to live to another day so he can continue to fight the fight.
You see, Bernanke knows precisely how to eliminate inflation. It’s no secret. It’s been done in the past, and it will absolutely be done again in the future. There will be a day when he will raise interest rates dramatically and inflation will melt away. But that day isn’t today. Today, he’s worried about deflation. And for deflation, there is no magic bullet like there is for inflation. On the contrary, he watched the Japanese flail about for nearly 2 decades now trying unsuccessfully to figure a way to tame it. Worse, in his mind it was deflation that caused the great depression. And as a long time student of the depression he probably wakes every morning saying to himself ‘today is not the day that America slips into darkness’.
The problem with that thinking right now though is that there is considerable debate about what ‘inflation’ actually is. Typically people look at the ‘Consumer Price Index’ to determine the inflation rate. But 43% of the CPI is based on housing, whose prices have cratered. So when you try to fill the hole made by deflation in housing with inflation in things like food and energy, you end up with a contradiction. People’s living standard falls due to rising prices of consumables while the traditional measure of CPI doesn’t indicate any inflation at all.
In the meantime, Bernanke is kept awake at night with visions of soup lines, and cardboard box cities. And measured against nightmares like those, I’m sure a CPI inflation number of 5% or so seems like it’s completely manageable. But that number will involve a bit of suspended disbelief. The degree to which people’s living standard will fall as a result of rising prices will be much more severe than those numbers will indicate.
But in the end I don’t think that will matter. There will be much talk and rumination. There will be screaming debates between Steve Liesman and Rick Santelli, and Ron Paul will go on TV and blame Ben Bernanke for everything from the violence in the Middle East to his lost dry cleaning. And none of it will change anything because Ben Bernanke DOES NOT have a pair of those peril sensitive glasses. He knows we’re still dangerously close to the edge, and as bad as more QE may seem to those of us blinded by rising markets, to him I think it seems like small potatoes.
So the question isn’t whether more QE is a good idea or a bad one. The question is whether it’s better to be in an economic environment where the policy makers know all the demons and all the threats and have a ready set of tools to handle them, or whether we should wander off into the dark unknown where our best tools are all useless, and the demons are fierce. It’s still a choice between Japanese deflation where the policymaker is powerless, or Argentinean inflation where he knows how to end it as soon as the economy will justify it. It’s not a choice between right and wrong, it’s a choice between known evil with known solutions and unknown evil where the solutions are a mystery.
As much as the politics of the day will allow, Ben Bernanke will choose the devil he knows. And what’s more, I think he’s absolutely right to do so.