Like a Mastodon in a Tar Pit

Recently
by Peter Schiff: Cyprus
Lifts the Curtain



For years we
have been warned by Keynesian economists to fear the so-called “liquidity
trap,” an economic cul-de-sac that can suck down an economy like
a tar pit swallowing a mastodon. They argue that economies grow
because banks lend and consumers spend. But a “liquidity trap,”
they argue, convinces consumers not to consume and businesses not
to borrow. The resulting combination of slack demand and falling
prices creates a pernicious cycle that cannot be overcome by the
ordinary forces that create growth, like savings or investment.
They say that a liquidity trap can even resist the extraordinary
force of monetary stimulus by rendering cash injections into useless
“string pushing.” Some of these economists suggest that its power
can only be countered by a world war or other fortunately timed
event that leads to otherwise politically unattainable levels of
government spending.

Putting aside
the dubious proposition that the human desire to strive and succeed
can be permanently short-circuited by an economic contraction, and
that modest expected price declines can quell our desire to consume,
the Keynesians have overlooked a much more dangerous and demonstrable
pitfall of their own creation: something that I call “The Stimulus
Trap.” This condition occurs when an economy becomes addicted to
the monetary stimulus provided by a central bank, and as a result
fails to restructure itself in a manner that will allow for robust,
and sustainable, growth. The trap redirects capital into non-productive
sectors and starves those areas of the economy that could lead an
economic rebirth. The condition is characterized by anemic growth
and deteriorating underlying economic fundamentals which is often
masked by inflation or asset price bubbles (I
look at how stimulus has impacted the U.S. stock market in the March
edition of my newsletter
).

Japan has been
caught in such a stimulus trap for more than a decade. Following
a stock and housing market boom of unsustainable proportions in
the 1980s, the Japanese economy spectacularly imploded in 1991.
The crash initiated a “lost decade” of de-leveraging and contraction.
But beginning in 2001, the Bank of Japan unveiled a series of unconventional
policies that it describes as “quantitative easing,” which involved
pushing interest rates to zero, flooding commercial banks with excess
liquidity, and buying unprecedented quantities of government bonds,
asset-backed securities, and corporate debt. Although Japan has
been technically in recovery ever since, its performance is but
a shadow of the roaring growth that typified the 40 years prior
to 1991. Recently, conditions in Japan have deteriorated further
and the underlying imbalances have gotten progressively worse. Yet
despite this, the new government is set to double down on the failed
policies of the last decade.

I believe that
the United States is now following Japan into the mire. After the
crash of 2008, we implemented nearly the same set of policies as
did Japan in 2001. In the past two years, despite the surging stock
market and apparently declining unemployment rate, the size and
scope of these efforts have increased. But as is the case in Japan,
we can clearly witness how the stimulus has perpetuated stagnation.
(See
my analysis of the new plans of the Japanese government
).

In 2008, one
of the country’s biggest problems was that we had over-leveraged
too many non-productive sectors of the economy. For instance, we
irresponsibly lent far too much money to people to buy over-priced
real estate. Since then, the problem has gotten worse. Currently
the process of writing, securitizing, and buying home mortgages
has been essentially nationalized. Fannie Mae and Freddie Mac (which
are now officially government agencies) write and package the vast
majority of new home mortgages, which are then guaranteed (almost
exclusively) through the Federal Housing Administration, and then
sold to the Federal Reserve. According to a tally by ProPublica,
these government entities bought or insured more than nine out of
10 home mortgages originated last year, a $1.3 trillion business.
Compare this to 2006, when the government share was only three in
10. As a result of this, our lending is far more irresponsible than
it has ever been.

In the fourth
quarter of 2012, 44% of all FHA borrowers either had no credit score
or a score of 679 or lower. In addition, the overwhelming majority
of FHA guaranteed loans are being made at 95% or greater loan-to-value.
This means down payments are an afterthought. Under the FHA’s Home
Affordable Refinance Program (HARP), loans are now even extended
to underwater borrowers whose mortgages may be worth far more than
their homes. As a result, the FHA could be exposed to enormous losses
in the event of future housing market downturns. Such an outcome
would be likely if mortgage interest rates were ever to rise even
modestly from their current low levels.

In fact, losses
on low-quality mortgages have already left the FHA with $16 billion
in losses. To close the gap, it has had to raise the insurance premiums
it charges to borrowers. With those premiums expected to rise again
next month, many fear that marginal borrowers could be priced out
of the market. But rather than learning from its mistakes, the government
just announced that Fannie Mae would pick up the slack, lowering
its lending standards to match the ones that had led to losses at
the FHA. In other words, we haven’t solved the problem of bad lending
– we have simply made it bigger and nationalized it.

The overall
financial sector is equally addicted to cheap money. Banks have
seen strong earnings and rising share prices in recent years. But
their businesses have largely focused on the simple process of capturing
the spread between the zero percent cost of Fed capital and the
3% yield of long term Treasury debt and government insured mortgage
backed securities. As a result, banks are not making productive
private sector loans to businesses. Instead, the capital is being
used to pump up the already bloated housing and government sectors.

Corporate profits
are indeed high at the moment, but much of that success comes from
the extremely low borrowing costs and extremely high leverage. Investors
chasing any kind of yield they can find are pouring money into companies
with dubious prospects. This January, yields on junk rated debt
fell below 6% for the first time. Currently they are approaching
5.5%. Consumers are using cheap money to buy on credit. Savings
rates are now hitting post-recession lows.

Lastly (but
certainly not least), the Federal government is now totally dependent
on the Fed’s largess. Without the Fed buying the bulk of Treasury
debt, interest rates would likely rise, thereby increasing the cost
of servicing the massive national debt. While Congress and the media
have focused on the $85 billion in annual cuts earmarked in the
“Sequester,” an increase of Treasury yields to 5% (3% higher than
current levels) on the $16 trillion in outstanding government debt
would translate to $480 billion per year of increased interest payments.
Such an increase would force a tough choice between raising taxes,
cutting domestic spending or reducing interest payments sent abroad
for debt service. If foreign creditors begin to doubt that America
has the resolve to make the hard choices, they may refuse to roll-over
maturing obligations, forcing the government to actually repay principal.
With trillions maturing each year, actual repayment is mathematically
impossible.

But for now
most people feel that the transition is underway to a healthy economy.
The prevailing debate is when and how the Fed will let the economy
fly on its own. Many of the top market analysts have great faith
that Ben Bernanke can pull the monetary tablecloth off the table
without disturbing the dishes. Those who hold this view fail to
understand that the United States is caught in a stimulus trap from
which there is no easy exit. How can the Fed wean the economy from
stimulus when stimulus IS the economy? In truth, the trick Bernanke
must actually perform is to pull the table out from beneath the
cloth, leaving both the cloth and the dishes suspended in air. (Read
how Iceland confronted its own crisis while avoiding the stimulus
trap
).

What would
happen to the Treasury market if the Federal Reserve, by far the
biggest buyer and largest holder of Treasury bonds, became a net
seller? Who will be there to keep the sell off from becoming an
interest rate spiking rout? It may sound absurd to those of us who
remember the economy before the crash, but our new economy can’t
tolerate “sky high” rates of four or five percent. What would happen
to the housing market and the stock market if interest rates were
to return to those traditional levels? The red ink would flow in
rivers. With yields rising and asset prices falling, how long would
it take before the Fed reverses course and serves up another round
of stimulus? Not long at all.

That means
any talk of an exit strategy is just that, talk. Not only can the
Fed not exit, but it will have to delve further into the stimulus
abyss. While doing so, the Fed will continuously insist that the
exit lies just behind an ever moving horizon. It will repeat this
mantra until a currency crisis finally forces a painful exit.

Unfortunately,
the longer the Fed waits to exit, the more painful the exit will
be. But trading long-term pain for short-term gain is the Fed’s
specialty. In the meantime, Wall Street watches in uncomprehending
stupor as the economy settles deeper and deeper into the stimulus
trap.

March
27, 2013

Peter
Schiff is president of Euro Pacific Capital and author of
The
Little Book of Bull Moves in Bear Markets
and Crash
Proof: How to Profit from the Coming Economic Collapse
. His
latest book is
The
Real Crash: America’s Coming Bankruptcy, How to Save Yourself and
Your Country
.

Copyright
© 2012 Euro Pacific Capital

The
Best of Peter Schiff