US Fed Chief Janet Yellen’s Irrational Exuberance Warnings 2015 Edition

In July 2014, in reporting to both houses of the US Congress, US Federal Reserve chairwoman Ms. Janet Yellen mimicked Alan Greenspan’s "irrational exuberance" warning in 1996, with an admonition that some segments of the equity markets have been “substantially overstretched”.

Given that stocks have reached record upon record highs after this appearance, this only means the markets has been ignoring or fighting the FED. 

Another way to see this is that the FED has “lost control” over the asset bubbles.

Yet in the same appearance before the US congress, yesterday, Ms. Yellen reiterates her irrational exuberance warning for 2015.

From Ms. Yellen’s Monetary Policy Report to the US Congress dated February 24

From page 22 (bold and italics mine)

Over the second half of 2014 and early 2015, broad measures of U.S. equity prices increased further, on balance, but stock prices for the energy sector declined substantially, reflecting the sharp drops in oil prices (figure 32). Although increased concerns about the foreign economic outlook seemed to weigh on risk sentiment, the generally positive tone of U.S. economic data releases as well as declining longer-term interest rates appeared to provide support for equity prices. Overall equity valuations by some conventional measures are somewhat higher than their historical average levels, and valuation metrics in some sectors continue to appear stretched relative to historical norms. Implied volatility for the S&P 500 index, as calculated from options prices, increased moderately, on net, from low levels over the summer.

From page 24

The financial vulnerabilities in the U.S. financial system overall have remained moderate since the previous Monetary Policy Report. In the past few years, capital and liquidity positions in the banking sector have continued to improve, net wholesale shortterm funding in the financial sector has decreased substantially, and aggregate leverage of the private nonfinancial sector has not picked up. However, valuation pressures are notable in some asset markets, although they have eased a little on balance. Leverage at lower-rated nonfinancial firms has become more pronounced. Recent developments in Greece have rekindled concerns about the country defaulting and exiting the euro system. 

With regard to asset valuations, price-to-earnings and price-to-sales ratios are somewhat elevated, suggesting some valuation pressures. However, estimates of the equity premium remain relatively wide, as the long-run expected return on equity exceeds the low real Treasury yield by a notable margin, suggesting that investors still expect somewhat higher-than-average compensation relative to historical standards for bearing the additional risk associated with holding equities. Risk spreads for corporate bonds have widened over recent months, especially for speculative-grade firms, in part because of concerns about the credit quality of energy-related firms, though yields remain near historical lows, reflecting low term premiums. Residential real estate valuations appear within historical norms, with recent data pointing to some cooling of house price gains in regions that recently experienced rapid price appreciation. However, valuation pressures in the commercial real estate market may have increased in recent quarters as prices have risen relative to rents, and underwriting standards in securitizations have weakened somewhat, though debt growth remains moderate

The private nonfinancial sector credit-to-GDP ratio has declined to roughly its level in the mid-2000s. At lower-rated and unrated nonfinancial businesses, however, leverage has continued to increase with the rapid growth in high-yield bond issuance and leveraged loans in recent years. The underwriting quality of leveraged loans arranged or held by banking institutions in 2014:Q4 appears to have improved slightly, perhaps in response to the stepped up enforcement of the leveraged lending guidance. However, new deals continue to show signs of weak underwriting terms and heightened leverage that are close to levels preceding the financial crisis.

As a result of steady improvements in capital and liquidity positions since the financial crisis, U.S. banking firms, in aggregate, appear to be better positioned to absorb potential shocks—such as those related to litigation, falling oil prices, and financial contagion originating abroad—and to meet strengthening credit demand. The sharp decline in oil prices, if sustained, may lead to credit strains for some banks with concentrated exposures to the energy sector, but at banks that are more diversified, potential losses are likely to be offset by the positive effects of lower oil prices on the broader economy. Thirty-one large bank holding companies (BHCs) are currently undergoing their annual stress tests, the results of which are scheduled to be released in March.

Leverage in the nonbank financial sector appears, on balance, to be at moderate levels. New securitizations, which contribute to financial sector leverage, have been boosted by issuance of commercial mortgage-backed securities (CMBS) and collateralized loan obligations (CLOs), which remained robust amid continued reports of relatively accommodative underwriting standards for the underlying assets. That said, the risk retention rules finalized in October, which require issuers to retain at least 5 percent of any securitizations issued, have the potential to affect market activity, especially in the private-label residential mortgage-backed securities, non-agency CMBS, and CLO sectors.

Reliance on wholesale short-term funding by nonbank financial institutions has declined significantly in recent years and is low by historical standards. However, prime money market funds with a fixed net asset value remain vulnerable to investor runs if there is a fall in the market value of their assets. Furthermore, the growth of bond mutual funds and exchange-traded funds (ETFs) in recent years means that these funds now hold a much higher fraction of the available stock of relatively less liquid assets—such as high yield corporate debt, bank loans, and international debt—than they did before the financial crisis. As mutual funds and ETFs may appear to offer greater liquidity than the markets in which they transact, their growth heightens the potential for a forced sale in the underlying markets if some event were to trigger large volumes of redemptions.

Again we see authorities dishing out warnings after warnings on asset bubbles albeit on a sanitized basis—there is a growth in the risk environment but the economy is strong yada yada yada…

And for me, current imbalances have been so apparent that it can't be ignored anymore. And these warnings seem more about escape outlets, so that when the real thing occurs, authorities will jump in defense: I saw and warned about it...so it is not my fault—a veneer.

And speaking of former Fed chief Alan Greenspan. At one of the latest investment conference, Alan Greenspan had a dire outlook for the markets.

Here is Mac Slavo on Alan Greenspan’s gloomy predictions (bold and italics original)

Greenspan recently joined veteran resource analyst Brien Lundin at the New Orleans Investment Conference to share some of his thoughts. According to Lundin, the former Fed chairman made it clear that the central bank is facing a serious problem and one that will have significant ramifications in the future.

We asked him where he thought the gold price will be in five years and he said “measurably higher.”

In private conversation I asked him about the outstanding debts… and that the debt load in the U.S. had gotten so great that there has to be some monetary depreciation. Specially he said that the era of quantitative easing and zero-interest rate policies by the Fed… we really cannot exit this without some significant market event… By that I interpret it being either a stock market crash or a prolonged recession, which would then engender another round of monetary reflation by the Fed.

He thinks something big is going to happen that we can’t get out of this era of money printing without some repercussions – and pretty severe ones – that gold will benefit from. 

Record stocks in the face of record imbalances and record warnings from authorities

Alan Greenspan: Gold is a Premier Currency. No Fiat Money including the Dollar can Match it

Once again here is former Fed Chair Alan Greenspan, now as an outsider, advocating the supremacy of gold.

From Zero Hedge (bold, italics and underline original)

For some reason, the Council of Foreign Relations, where ex-Fed-Chief Alan Greenspan spoke last week, decided the following discussion should be left out of the official transcript. We can perhaps understand why... as Gillian Tett concludes, "comments like that will be turning you into a rock star amongst the gold bug community."

Greenspan (Uncut):

TETT: Do you think that gold is currently a good investment? 

GREENSPAN: Yes... Remember what we're looking at. Gold is a currency. It is still, by all evidence, a premier currency. No fiat currency, including the dollar, can match it. 

Which is missing from the official CFR transcript... 

GREENSPAN: ...remember, we had that first tapering discussion, we got a very strong market response. And then we reassured everybody to have no -- remember, tapering is still (audio gap) of an agreement that the central banks have made -- European central banks, I believe -- about allocating their gold sales which occurred when gold prices were falling down (audio gap) has been renewed this year with a statement that gold serves a very important place in monetary reserves. 

And the question is, why do central banks put money into an asset which has no rate of return, but cost of storage and insurance and everything else like that, why are they doing that? If you look at the data with a very few exceptions, all of the developed countries have gold reserves. Why? 

TETT: I imagine right now, it's because of a question mark hanging over the value of fiat currency, the credibility going forward.

GREENSPAN: Well, that's what I'm getting at. Every time you get some really serious questions, the 50 percent of the gold price determination begins to move.

TETT: Right.

GREENSPAN: And I think it is fascinating and -- I don't know, is Benn Steil in the audience?

TETT: Yes.

GREENSPAN: There he is, OK. Before you read my book, go read Benn's book. The reason is, you'll find it fascinating on exactly this issue, because here you have the ultimate test at the Mount Washington Hotel in 1944 of the real intellectual debate between the -- those who wanted to an international fiat currency which was embodied in John Maynard Keynes' construct of a banker, and he was there in 1944, holding forth with all of his prestige, but couldn't counter the fact that the United States dollar was convertible into gold and that was the major draw. Everyone wanted America's gold. And I think that Benn really described that in extraordinarily useful terms, as far as I can see. Anyway, thank you.

TETT: Right. Well, I'm sure with comments like that, that will be turning you into a rock star amongst the gold bug community.

Alan Greenspan: QE Failed the Real Economy, Unwinding will Unleash Market Volatility, Recommends Gold

As the US Federal Reserve officially “concluded” its QE 3.0 program this month, former Fed chief Alan Greenspan has been quoted by the Wall Street Journal as giving his assessment and predictions from such actions. (hat tip Zero Hedge)

Mr. Greenspan on the QE’s efficacy: (bold mine)

He said the bond-buying program was ultimately a mixed bag. He said that the purchases of Treasury and mortgage-backed securities did help lift asset prices and lower borrowing costs. But it didn’t do much for the real economy.

“Effective demand is dead in the water” and the effort to boost it via bond buying “has not worked,” said Mr. Greenspan. Boosting asset prices, however, has been “a terrific success.”

Mr. Greenspan fails to include the massive debt build up as part of the asset based 'success story'.

Yet it’s one thing to be an insider and it’s another thing to be outside the corridors of power; personal views radically changes. In the case of Mr. Greenspan he goes from defending incumbent policies (as insider) to critiquing them (as outsider). 

Ironically, Mr. Greenspan initiated today's de facto easy money “aggregate demand” policy-standard, which his successor Mr. Bernanke improvised.

On QE withdrawal:

He also said, “I don’t think it’s possible” for the Fed to end its easy-money policies in a trouble-free manner.

“We’ve never had any experience with anything like this, so I’m not going to sit here and tell you exactly how it’s going to come out,” Mr. Greenspan said. But he noted that markets often react to changes in central bank policy unpredictably and not entirely rationally. Recent episodes in which Fed officials hinted at a shift toward higher interest rates have unleashed significant volatility in markets, so there is no reason to suspect that the actual process of boosting rates would be any different, Mr. Greenspan said.

He said the Fed may not even have that much power over the timing of interest-rate increases. The problem as he sees it is an interest rate the Fed pays on the money banks park at the central bank, called reserves. Fed officials plan to use this tool as their primary lever for raising interest rates when the time comes. If bankers decide to put this money to work, creating inflation risks, the Fed may be forced to raise rates, even if the economy isn't ready for it, he warned.

“I think that real pressure is going to occur not by the initiation by the Federal Reserve, but by the markets themselves,” Mr. Greenspan he said.

chart from zero hedge

With world debt levels going bonkers, the path to a relatively tighter money policy would naturally cause 'adjustment strains' which may be characterized as “significant volatility in markets”. 

Of course this won’t be limited to just the financial asset markets.

Finally. Mr. Greenspan seems to have reverted to his pristine position as 'gold bug'.

Mr. Greenspan said gold is a good place to put money these days given its value as a currency outside of the policies conducted by governments.

In 1966, the pre-Fed chair Mr. Greenspan penned this classic Gold and Economic Freedom article on the gold standard, here is an excerpt...

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.

This just illustrates how power changes people. 

But I agree with the Maestro here, in today's massive manipulation of money and markets, gold is an insurance.

Phisix: The Implication of the US Boom Bust Cycle

We are big fans of fear, and in investing, it is clearly better to be scared than sorry. -Seth Klarman

Stock markets of the US and select developed countries continue with its melt-UP record smashing breakout streak.

This week, the Dow Industrials (not in chart) climbed 1.1% approaching a record while her peers at historic highs also posted gains, particularly, S&P 500 +.88% and the Nasdaq +.74%. The Russell 2000 small cap closed nearly unchanged +.003%.

Outperforming US stocks, this week, relative to emerging markets and against many other developed peers imply that the share of US stocks in terms of market capitalization to the world should be expanding.

However, the flagging US dollar has essentially offset nominal currency gains made by US equities.

Net foreign selling in US equities during the 2^nd quarter, which I cited two weeks back[1], represents the second largest in record since the 1990s.

Political bickering theatrics over government shutdown, debit ceiling and Obamacare reportedly prompted for net foreign selling of US assets in August. Net sales of U.S. equities by official holders abroad were a record $3.1 billion, according to a report from Bloomberg[2].

Rising stock markets amidst severe currency strains hardly represents signs of economic strength. Instead such dynamics are manifestations of an escalation of monetary ailment.

A good example of such extremes can be seen in the unfolding real time currency crisis in Venezuela. The Caracas Index or Venezuela’s stock market benchmark has been in a phenomenal vertiginous parabolic climb—up 347.5% (!!!) year-to-date, this adds to the 2012 gains at 302.81% for a total of 650.31% in one year and ten months (!!!)—as the collapse of the Venezuelan Bolivar[3] as shown via its black market rates steepen.

Ironically, in the face of massive goods shortages or an economic standstill, the increasingly desperate Venezuelan government decrees a Vice Ministry of Supreme Social Happiness[4]. Individual “happiness” will now be substituted for collective “happiness” as perceived and implemented by the political leaders[5].

I know the US is not Venezuela. Japan is not Venezuela too. But all three has exercised the same currency debasement programs, resulting to the same outcomes at varying degrees.

Venezuela which is at the advance stage of a currency crisis, serves as example of what may happen to the US or Japan if political leaders insist proceeding towards such trajectory.

And since the world still depends on the US dollar as main currency for foreign currency bank reserves and as the principal medium for payment and settlements for international financial transactions, despite actions by some nations to wean themselves from the US dollar via currency swaps, bilateral currency trade deals and barter[6], the fate of the US dollar will have significant influence on the direction of the global financial markets.

I would also add that aside from the US dollar, developments in the US financial markets—the largest in the world, for instance, the US stock markets, despite the fall of US market cap relative to the world, remains at 34.6% (as of October 13, 2013) according to Bespoke Invest[7]—will also have big sway on global markets. The meltdown from the perceived tapering by the Fed last May which intensified the actions of the bond vigilantes should be a noteworthy example.

In today’s globalization expect connectivity not just in the web, or telecoms but also in financial markets and economies.

Manipulating Earnings Guidance to Boost Share Prices

When market participants frenziedly bid up stock prices to astronomical levels, the unsustainability of such actions can be established by simple observations.

Again as I pointed out last week, zooming stocks has led to astonishing valuations. The small cap Russell[8] 2000’s PE ratio[9] has been valued at a fantastic 84.51 as of Friday’s close.

Given that the Forward PE has been estimated at 22.5, this means that earnings for the coming year have been expected to explode by a stunning 276%!

However if one were to weigh on the sentiment of small businesses to assess such potentials, a recent survey by small business (conservative lobbying[10]) organization the National Federation of Independent Business (NFIB)[11] seems barely sanguine to justify such valuations (bold mine)

Small-business owner optimism did not “crash “ in September, but it did fall, dropping 0.20 from August’s (corrected) reading of 94.1 and landing at 93.9. The largest contributing factor to the dip was the significant increase in pessimism about future business conditions, although this was somewhat offset by a notable increase in number of small-business owners expecting higher sales

So we have basically a neutral condition unsupportive of wild earnings growth expectations. 

The same hold true with Dow Utility. With a trailing PE at 30.89 and forward PE at 16.15 this means that priced at Friday’s close, the drop in forward PE will mean that earnings must jump by 92%!

Aside from bond based share buybacks discussed last week, publicly listed companies “beat earnings estimates” by resorting to lowering guidance[12] has been a major pillar in driving up US stocks.

As one would note, 62.6% of corporations recently beat earnings estimates. Although the positive surprise trend has been on a decline since 2006.

On the other hand, the spread or the variance between positive and negative guidance by companies has been in a deficit since the 3^rd quarter of 2011.

In other words, listed firms set easier profit goals which they eventually outperform via “beat estimates”. The positive surprise then spurs higher prices.

In my view this looks like accounting prestidigitation.

Yet negative guidance according to the Factset has been at record levels[13]

For Q3 2013, 89 companies have issued negative EPS guidance while 19 companies have issued positive EPS guidance. If 89 is the final number of companies issuing negative EPS guidance for the quarter, it will mark the highest number of companies issuing negative EPS guidance since FactSet began tracking guidance data in 2006.

Managing earnings expectations in order to “beat the estimates” has usually been a bear market technique used by the management.

According to Investopedia.com[14] “It is one of the analyst's jobs to evaluate management expectations and determine if these expectations are too optimistic or too low, which may be an attempt at setting an easier target. Unfortunately, this is something that many analysts forgot to do during the dotcom bubble.”

The Factset graph also shows that Utilities and Telecoms have had 100% negative guidance changes. In short, these two industries expect materially LOWER profits thus the widespread downscaling of their estimates.

So how on earth will Utility earnings jump by 92%?!

Except for the energy sector, positive guidance has been a scarcity.

Since corporate profits represent a component of the income side of the National Income and Product Account (NIPA) [15], the lowering of profit guidance hardly reflects on a robust economy. This hardly justifies a sustainable upside run of stock market prices.

But again over the interim, rational irrationality may rule.

The other way to look at these: Management of many publicly listed corporations may have purposely been guiding “earnings” expectations down in order to generate “surprises”. Such positive surprise should extrapolate to an increase in (earnings performance based) compensation.

Rewarding executives based on earnings performance has been loaded with agency (conflict of interest) problems

According to an academic paper written by Lan Sun of UNE Business School, Faculty of the Professions[16] (bold mine)

In theory, a link between a CEO's compensation and a firm performance will promote better incentive alignment and higher firm values (Jensen & Meckling, 1976). However, executive compensation contract is an incentive where opportunistic earnings management behaviour is likely to be detected since CEOs are expected to have incentives to manipulate earnings if executive compensation is strongly linked to performance. A substantial literature has emerged to test the relationship between executive compensation and earnings management and has documented that compensation contracts create strong incentives for earnings management…When earnings management is driven by opportunistic management incentives, firms will ultimately pay a price and its negative impact on shareholders is economically significant.

So far, total corporate profits based on y-o-y changes inclusive of Inventory Valuations Adjustments (IVA) and Capital Consumption Adjustment (CCAdj)[17] have chimed with the trend of lowering of profit expectations.

Yet curiously bad news (negative trends), which represents the underlying largely overlooked or ignored real factor of declining trend of profitability or eps growth rate and net income as shown last week, has been seen as good news (by mainly focusing on beat estimates or nominal growth figures or Fed easing)

It’s all about selective perception or picking of information to fit one’s biases or beliefs.

Let’s Keep Dancing: The Intensifying Credit Orgy

In a manic phase of the boom-bust cycle, zooming stocks equals ballooning credit.

Back to the future with exploding leveraged loans and covenant lite bonds, from the Financial Times[18] (bold mine)

Neiman Marcus, the upscale US department store chain, is no stranger to fashion trends. But in the autumn of 2005 the luxury retailer started a very different kind of fad – this time for an unusual new bond structure known as a “payment-in-kind toggle”.

Pik-toggle notes, as they became known, gave Neiman Marcus the option to pay its lenders with more bonds instead of cash if the retailer ever ran into financial difficulty. For a company that was at the time being bought by private equity giants TPG and Warburg Pincus, in a leveraged buyout involving about $4.3bn worth of debt, that additional financial flexibility was considered a savvy move….

The average amount of debt used to finance LBOs has jumped from a low of 3.69 times earnings in 2009 to an average 5.37 so far this year, according to data from S&P Capital IQ. At the height of the LBO boom, average leverage was 6.05.

The $6bn sale of Neiman Marcus to Ares and a Canadian pension fund is expected to leave the retailer with a debt of about seven times earnings.

At the same time, more than $200bn of “cov-lite” loans have been sold so far this year, eclipsing the $100bn issued in 2007. That means 56 per cent of new leveraged loans now come with fewer protections for lenders than normal loans.

Regulators have sounded the alarm bells on covenant light loans but the industry group has pushed back saying that loan warnings will hurt the “neediest borrowers”[19]. Such characterizes the rationalization of the mania phase. Echoing the infamous words of ex-Citibank chair Charles Prince during the height of the US housing boom, “For as long as the music is playing, you’ve got to get up and dance. We’re still dancing[20].” 

Let’s keep dancing

And when it comes to yield chasing via increased leveraging, the absence of a stamp of approval by credit rating agencies has hardly become a factor to Wall Street’s peddling of Commercial Mortgage Bonds (CMBS). [note credit rating enthusiasts, credit rating warnings ignored by markets]

From the Bloomberg[21]: (bold mine)

Wall Street banks that package commercial mortgages into bonds are forgoing a ranking from Moody’s Investors Service on the riskier portions of the deals, a sign the credit grader isn’t willing to stamp the debt investment-grade amid deteriorating underwriting standards.

Moody’s didn’t grade the lower-ranking debt in 9 of the 14 commercial-mortgage bond transactions it’s rated since mid-July, according to Jefferies Group LLC. Deutsche Bank AG (DBK), Cantor Fitzgerald LP and UBS AG (UBSN) are selling a $1 billion transaction this week that doesn’t carry a Moody’s designation for a $64.3 million portion that Fitch Ratings and Kroll Bond Rating Agency ranked the lowest level of investment grade, said two people with knowledge of the deal.

Moody’s absence from the riskier securities in commercial-mortgage deals suggests the New York-based firm is taking a harsher view of the quality of some new loans as issuance surges in the $550 billion market, Jefferies analysts led by Lisa Pendergast said in a report last week. Credit Suisse Group AG’s forecast for $70 billion of offerings this year would be the most since issuance peaked at $232 billion in 2007.

Credit bacchanalia has gone global. Booming issuance of high yield (junk) bonds linked to M&A has reached 2007 highs. 

From the Financial Times[22]:

A burst of investor “animal spirits” has boosted the value of mergers and acquisitions-related bonds to the highest raised since the financial crisis.

Global acquisition-related bond issuance from non-investment grade, or high yield, companies has risen by 15 per cent to $62.9bn for the year to date compared with the same period in 2012.

This is the highest amount since 2007, according to Dealogic, the data provider.

The surge has been driven by purchases outside the US as non-US acquisition bond issuance nearly tripled to $14.1bn compared with last year, including deals such as Liberty Global ’s $2.7bn issue

High grade corporates likewise reveals of a debt issuance bonanza.

From the Wall Street Journal[23], (bold mine)

According to data provider Dealogic, the $884.3 billion of highly rated corporate bonds sold in the U.S. this year through Wednesday has been the most of any year at that point since 1995, when it began keeping records.

October’s rush of supply has helped put 2013 back on track to exceed the record $1.01 trillion issuance seen in 2012.

The accounts above validate my view on the transition process of companies from hedge financing to Ponzi financing.

As I wrote last week[24], (bold original)

So while most publicly listed US companies have yet to immerse themselves into Ponzi financing, sustained easy money policies have been motivating them towards such direction.

The greater the dependence on debt, the more Ponzi like dynamics will take shape.

The Fallacy of Little Screwy People

Record or near record issuance of high yield bonds, commercial-mortgage bonds, covenant lite bonds leverage buyout loans and investment grade bonds constitute signs of liquidity trap? To the contrary it would seem like a tidal wave of money.

Yet most central bankers and the consensus see the former (as if the world exists in some vacuum) to justify direct intervention via QE.

And thus far all these credit easing has failed to accomplish its end.

And we don’t need to heed on the former Fed chief Alan Greenspan’s view[25] about forecasting.

We really can't forecast all that well. We pretend that we can but we can't. And markets do really weird things sometimes because they react to the way people behave, and sometimes people are a little screwy.

And if officials can’t forecast on the consequences of their policies using their econometric models, then why experiment?

Yet it is hardly about people being a “little screwy” but more about people responding to daft experiments imposed on societies as economic policies (US and their multiplier effects worldwide) by ivory tower bureaucrats who hardly knows about real economic relationships except to see them as mechanistic mathematical models, and at the same time, have the impudence to undertake grand trials because they barely have skin on the game. 

Moreover policies which punish savings and simultaneously “nudge” the public to wantonly indulge in reckless risk activities leads people to become “screwy”. Bad ideas have bad consequences.

So the cost of their policies will be borne by the average citizenry via restrictions of economic opportunities, financial losses, assuming a bigger burden of financing pet projects of politicians and their bureaucracy, diminished purchasing power and many other non-pecuniary social costs (e.g. erosion of moral fiber, curtailment of civil liberties, social upheaval and etc...)

And these booming credit markets have largely undergirded the financing of the housing or the stock markets bubbles rather than channelled to the real economy for productive activities. The opportunity cost for monetary policy-induced speculation has been the productive sectors, thus the real economy’s growth remains muted or sluggish relative to asset markets.

Monetary inflation has essentially been absorbed by the asset markets. Monetary inflation has spurred massive risk taking, speculative splurge, blatant momentum yield chasing, having been financed by exponential credit growth that has resulted to severe misallocation of resources, blatant mispricing of assets and maladjusted economies.

And such asset bubbles have become international. Thus risks from any unhinging of the bubbles from the US or from any developed economies or even from big emerging markets may likely have a domino effect.

We don’t really need to forecast. All we need is to understand the real economic relationships applied to instituted policies to appreciate the risks.

As the great dean of Austrian economics Murray Rothbard explained[26]: (bold mine)

Economics provides us with true laws, of the type if A, then B, then C, etc. Some of these laws are true all the time, i.e., A always holds (the law of diminishing marginal utility, time preference, etc.). Others require A to be established as true before the consequents can be affirmed in practice. The person who identifies economic laws in practice and uses them to explain complex economic fact is, then, acting as an economic historian rather than as an economic theorist. He is an historian when he seeks the casual explanation of past facts; he is a forecaster when he attempts to predict future facts. In either case, he uses absolutely true laws, but must determine when any particular law applies to a given situation. Furthermore, the laws are necessarily qualitative rather than quantitative, and hence, when the forecaster attempts to make quantitative predictions, he is going beyond the knowledge provided by economic science

---

[1] See Phisix: Rising Systemic Debt Erodes the Margin of Safety October 14, 2013

[2] Bloomberg.com Foreigners Sold U.S. Assets as China Reduces Treasuries October 22, 2013

[3] Steve Hanke Venezuela The Troubled Currencies Project Cato Institute

[4] Telegraph Venezuela creates Social Happiness ministry October 26, 2013

[5] Happiness See Amidst Hyperinflation, Venezuelan Government Decrees a ‘Happiness’ Ministry, October 27, 2013

[6] See Has the Fed’s Taper Talk induced foreign selling, swap and bilateral currency deals? October 23, 2013

[7] Bespoke Invest US Loses Share to Rest of World October 14, 2013

[8] Russell Investments Russell 2000® Index The Russell 2000 is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

[9] Wall Street Journal P/Es & Yields on Major Indexes Market Data Center

[10] Wikipedia.org National Federation of Independent Business

[11] National Federation of Independent Business October Report Small Business Economic Trends

[12] Bespoke Invest Guidance Remains Weak October 24, 2013

[13] Factset Guidance S&P 500 September 30,2013

[14] Investopedia.com Earnings Guidance: Can It Accurately Predict The Future?

[15] Bureau of Economic Analysis Corporate Profits: Profits Before Tax, Profits Tax Liability, and Dividends

[16] Lan Sun EXECUTIVE COMPENSATION AND CONTRACT-DRIVEN EARNINGS MANAGEMENT ASIAN ACADEMY of MANAGEMENT JOURNAL of ACCOUNTING and FINANCE 2012

[17] Yardeni.com US Economic Indicators: Corporate Profits in GDP, October 26, 2013

[18] Tracy Alloway and Vivianne Rodrigues Boom-era credit deals raise fears of overheating Financial Times October 22, 2013

[19] Bloomberg.com Fed Loan Warning May Hurt Riskiest Borrowers, Trade Group Says October 26, 2013

[20] Deal Book Citi Chief on Buyouts: ‘We’re Still Dancing’ July 10, 2007

[21] Bloomberg.com Wall Street Skips Moody’s as CMBS Standards Slip: Credit Markets October 25, 2013

[22] Financial Times M&A bonds surge to highest in six years October 21, 2013

[23] Wall Street Journal Latest Headlines Low Rates Bring Bond Bonanza October 25, 2012

[24] see Phisix: US Debt Ceiling Deal and UNTaper Spurs a Global Melt UP October 21, 2013

[25] BusinessInsider.com 'YOU JUST LEARNED THIS?!?' — Jon Stewart Struggles To Understand How Former Fed Head Greenspan Missed Wall Street 'Screwiness' October 22, 2013

[26] Murray N. Rothbard, 1. Economics: Its Nature and Its Uses CONCLUSION: ECONOMICS AND PUBLIC POLICY Man, Economy & State

On University of Chicago’s Raghuram Rajan as India’s Central Bank Governor

Austrian economist Peter Klein cheers the appointment of University of Chicago’s finance and banking professor as the Governor of the central bank of India, noting of Mr. Rajan’s familiarity of the Austrian Business Cycle.

Writes Professor Klein at the Mises Blog

Raghu Rajan is a very good neoclassical economist who has made important contributions to banking, finance, the theory of the firm, corporate governance, economic development, and other fields. He is also taking over as head of India’s central bank. Rajan is no Austrian, but he has a quasi-Austrian take on the financial crisis, and far greater appreciation for free markets in general than any of the key US or European policymakers. As I tweeted this morning, Rajan is about 1,000,000 times better than either Summers or Yellen. I’d gladly trade him for any US central banker.

Consider, for example, Rajan’s take on the financial crisis:

The key then to understanding the recent crisis is to see why markets offered inordinate rewards for poor and risky decisions. Irrational exuberance played a part, but perhaps more important were the political forces distorting the markets. The tsunami of money directed by a US Congress, worried about growing income inequality, towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans. And the willingness of the Fed to stay on hold until jobs came back, and indeed to infuse plentiful liquidity if ever the system got into trouble, eliminated any perceived cost to having an illiquid balance sheet.

As I wrote before, I’d reverse the order of emphasis — credit expansion first, housing policy second — but Rajan is right that government intervention gets the blame all around.

Rajan also wrote an interesting theoretical paper with Peter Diamond that echoes the Austrian theory of the business cycle: “[W]hen household needs for funds are high, interest rates will rise sharply, debtors will have to shut down illiquid projects, and in extremis, will face more damaging [bank] runs. Authorities may want to push down interest rates to maintain economic activity in the face of such illiquidity, but intervention may not always be feasible, and when feasible, could encourage banks to increase leverage or fund even more illiquid projects up front. This could make all parties worse off.”

Read the rest here

Having a free market proponent in the belly of the beast can both be a blessing or a curse. Although like Mr. Klein, one side of me wishes Mr. Rajan all the luck, another side of me tells me not to expect anything substantial.

While it may be true that Mr. Rajan has a magnificent track record of understanding central banks and the entwined interests of the banking system coming from the free market perspective, in my view, it is one thing to operate as an ‘outsider’, and another thing to operate as a political ‘insider’ in command of power.

Mr. Rajan will be dealing, not only conflicting interests of deeply entrenched political groups, but any potential radical free market reforms are likely to run in deep contradiction with the existing statutes or legal framework from which promotes the interests of the former.

Moreover, other political agencies, whose interests has been to promote the status quo, may run roughshod with Mr. Rajan perspective of reforms.

It would be interesting to see how Mr. Rajan will deal with  the present repressive “war on gold” policies by the Prime Minister’s Economic Advisory Council (PMEAC) whose interventionists actions has expanded to cover not only gold imports, but on gold transactions at every distribution level of the Indian economy.

In short, assuming the central bank governorship won’t just be about monetary, or banking policies but about the politics of bureaucracy, the welfare state and crony capitalism. 

Mr. Rajan will also have to deal with the huge resistance-to-change attitude from these groups.

In addition, in assuming the role of the proverbial hammer, where everything would look like a nail, the allure of the possession of the extraordinary power of political control over society risks overwhelming Mr. Rajan’s principles.

A great precedent would be former Fed Chair Alan Greenspan. Dr, Greenspan used to be an ardent Ayn Rand fan and a Ms. Rand influenced objectivist who embraced free market principles. Mr. Greenspan even authored the splendid, Gold and Economic Freedom in 1966. 

However upon assuming the Fed Chairmanship, Mr. Greenspan eventually abandoned free market principles to become a rabid inflationist or a serial bubble blower. Yet today’s lingering problems have, in effect, been a legacy of Greenspan-Bernanke actions.

True Mr. Rajan may not be Dr. Greenspan. But with the manifold challenging tasks ahead coming from different fronts, Mr. Rajan may want to take heed of Yoda’s advice to Anakin Skywalker: The fear of loss is a path to the dark side.

Video: Greenspan Says Stock Markets causes Economic Growth

In the face of US fiscal problems, former Fed chief Alan Greenspan says in the following video interview that only the stock market is truly important.

Quotable:

[3:40] data shows that not only are stock markets a leading indicator of economic activity, they are a major cause of it – the statistics indicate that 6% of the change in GDP results from changes in market values of stocks and homes.

This is just an example of experts who resort to statistics to misleadingly associate asset inflation with economic growth: a post hoc fallacy. This has been anchored on the so-called Wealth Effect myth which sees consumption as drivers of the economy.

As I previously explained real economic growth is about the acquisition of real savings or capital accumulation from production.

And that the real concealed reason for the promotion of the wealth effect has been to justify government intervention.

But of course the principal reason behind the populist consumption economy narrative has been to justify myriad government interventions via ‘demand management’ measures applied against the supposed insufficient “aggregate demand” from so-called “market failures”.

Moreover, the consumption story aims to buttress mostly indiscriminate debt acquisition as a means of attaining statistical rather than real growth based on value creation.

The central banks' serial blowing of asset bubbles is really an illusion that eventually will implode, thus the bubble cycles. 

Also a major reason for such undertaking has been to subsidize the crony banking system, who serves as agents for central banks and as financiers of the political class at the expense of the economy.

Nonetheless, inflating asset bubbles has become the de facto central banking standard adapted by the world monetary authorities, that has been articulated by Mr. Greenspan’s successor, the incumbent Ben Bernanke, as a “smart way” of protecting the economy.