Butterflies, Blowback & Unintended Consequences
The Law Of Unintended Consequences, often cited but rarely defined, is that actions of people – and especially of government – always have effects that are unanticipated or unintended. Economists and other social scientists have heeded its power for centuries; for just as long, politicians and popular opinion have largely ignored it.
Rob Norton, The Concise Encyclopedia of Economics
There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen.
Frederic Bastiat, What Is Seen And What Is Not Seen
The curious task of economics is to demonstrate to men how little they really know about what they imagine the can design.
Unintended consequences are what happen when you design a monetary policy without considering the effects outside the US. The Fed has taken great pains to warn the world of the impending end of Quantitative Easing and provided ample forward guidance on the course of interest rates. And yet, just as happened last spring when the tapering trial balloon was first launched, the market doesn’t seem to be getting the message. Currencies in vulnerable countries – primarily those running current account deficits – were under pressure again last week and even US stocks decided to sit up and listen. The Fed may believe that tapering isn’t tightening but the market begs to differ and the shift in the tide of capital flows is causing a bit of unexpected turbulence.
With an FOMC meeting next week at which QE is expected to be tapered again, emerging market troubles hit the headlines again last week. Argentina and Venezuela devalued their already debased currencies, Turkey intervened in currency markets in a vain attempt to stem the fall of the Lira, China injected funds into its money market to fight off a cash crunch, the Brazilian Real fell to a 5 month low and even the new darling of emerging market investors, Mexico, saw its peso decline to an 18 month low. Of course, it isn’t necessarily the anticipation of more tapering that pushed down those currencies last week; they’ve all got other problems with which to deal. Anyone with a pulse knows that Argentina and Venezuela are economic and political basket cases and the further devaluation of their currencies should have surprised no one. China is trying to rein in a shadow banking system that has become the tail wagging the dog of their monetary policy and losses are starting to emerge from a system that binged on credit the last few years. China’s PMI also fell below 50, a potential warning for future growth. Turkey has a political scandal on its hands and Brazil is, well, Brazil.
But not all the troubles were in the emerging backwaters of the world. Some economies that have been hailed as paragons of virtue in the recent past joined in the fallout. The Australian and Canadian dollars both have fallen versus their US counterpart with Aussie down over 10% since November and the Canadian down almost as much and nearly 5% just last week. Obviously, these countries are quite sensitive to the health of the Chinese economy and commodity demand so news of a slowdown in the Middle Kingdom certainly affected these markets last week but if easy Fed policy played a role in blowing the Chinese bubble then certainly the beginning of the end of that policy is having an effect too.
One can’t help but wonder if the Fed thought about all this before implementing a policy with such global implications. It certainly isn’t the first time that actions in the US have caused problems in other countries, especially emerging markets. The Asian crisis of the late 90s emerged after a period of US dollar strength – a reversal of capital flows to those countries – as did previous episodes in the early 90s and early 80s. The blowback from those crises was mitigated by further Fed interventions but one can’t help but wonder what ammo the Fed has left to deal with the consequences of their latest self inflicted wounds. Bastiat would likely be unimpressed by the economists who dominate the Fed today.
It is ironic, to say the least, that Ben Bernanke’s pledge to Milton Friedman that the modern Fed would avoid deflation and the fate of its earlier incarnation in the 30s, lies at the root of these current, emerging difficulties. Bernanke and most other modern economists have an ingrained aversion to falling prices and associate it exclusively with Depression though history shows that deflation has co-existed with growth many more times than depression. In fact, it is the opposite – inflation – that is most often associated with poor growth or economic contraction and with the Fed and Treasury working so hard to devalue the dollar over the last 12 years, it should not be a surprise that growth continues to be a primary concern. It was Bernanke’s determination to avoid deflation after the dot com bust along with the weak dollar policies of the Bush administration that blew not only a housing bubble but also the commodity bubble that was the impetus for the boom in emerging markets.
As the US Dollar fell from 2002 to 2008, capital flowed into emerging markets feeding a credit boom that is just now starting to deflate. Low interest rates from the Fed further inflated the bubble by pushing up US real estate prices and allowing consumption well beyond what would have occurred in the absence of easy credit. The Chinese boom of the early part of this century was born in the easy money policies of the FOMC, both before and after the Great Crisis of 2008. The build up of dollar reserves in China and the rest of Asia – a result of Fed policy and their desire to limit the rise in their currencies – in the early part of the century allowed them to feed a domestic credit boom after the crisis that they are now trying to reverse. The blowback is felt from Sydney to Ankara to Rio to the provinces of western Canada, all a result of the fatal conceit of Federal Reserve officials who thought they could rescue the US economy from the excesses created by the Fed itself.
The beneficiary of the reversal of emerging market capital flows was not the US Dollar but rather the Japanese Yen and the Euro, both of which rallied last week. That probably has to do with the preference of those currencies as funding sources for leveraged trades around the world, particularly in emerging markets and possibly US stocks. Treasuries did seem to find a bid despite the specter of future Fed tapering with the yield on the 10 Year Note falling to 2.74% last week. Proving once again that markets tend to act in ways that frustrate the maximum number of participants, Treasuries are outperforming stocks by a rather wide margin since the beginning of the new year.
With floating currencies and free flowing capital, Fed policies impact not just the US economy but the entire world. Global imbalances, created by hyperactive Fed policy and successive administrations enthralled by the siren song of a weak dollar, can only go so far before markets act to correct them. This might – and I stress might because I have no idea how the Fed and other central banks will react – be the beginning of that long needed and awaited correction. Certainly, capital is no longer flowing into most emerging markets and as it reverses – to Japan, Europe and the US – it is impossible to know what problems might emerge. Warren Buffet has said that we only find out who is swimming naked when the tide goes out. Well the tide is ebbing in the emerging world and we may find out soon how many banks, hedge funds and others have been skinny dipping.
The Fed’s serial interventions that created what was dubbed the Great Moderation in US economic growth in the 90s and accelerated after 2008, are not and cannot be cost free. I have no doubt about the good intentions of the Fed. I’m sure Greenspan and Bernanke believed what they were doing was right. Unfortunately, I think they may have fallen victim to what Robert Merton called the “imperious immediacy of interest” where the intended effect – economic growth in this case – is so wanted that the unintended effects are purposefully ignored. But there is no such thing as a free lunch in economics. The Fed thought it had created a system that ensured continuous economic growth for the US. In the process, they enabled the creation of a pile of debt, world wide, that makes the likelihood of Bernanke’s dreaded deflation more likely. His efforts to ward off falling prices seemed to work until the implosion in 2008. And they seem to have worked in the aftermath but the blowback now that QE is coming to an end is something for which they apparently didn’t plan. When the butterfly of US monetary policy flaps its wings, financial hurricanes appear in far away countries – and sometimes closer to home. I sure hope the Fed has a disaster recovery plan.
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