There are a handful of themes out there on recent market action that are either totally wrong or otherwise highly misleading. For instance, regarding the recent calamity in the capital markets, one especially apparent dichotomy has presented itself as offering two choices as to what, exactly, is causing the painful turbulence.
There are some who, in a complete echo of the news headlines, are quick to point the finger at both oil and China. And yet there are others who point the finger at the Fed for “raising rates too early.” Along with the second is the observation that “inflation is totally MIA” and therefore it was ludicrous that the Fed felt the need to “raise interest rates.” Both of these tend to express anguish over the “strong dollar.”
Both of these miss the entire point, and the cause of the current trouble. For one thing, it is ridiculous to blame oil for the falling markets when the falling oil is the very thing that needs to be explained. It is wholly unsatisfactory to explain something by describing it. It works well for headlines, and for shifting the blame away from where it really belongs, but one must learn to look deeper. One cannot expect to impress anyone by explaining that the plane is crashing to the ground because it is no longer flying. What is the cause of oil’s magnificent plummet toward the bottom? That is the true question.
Lee Ainslie's Maverick Capital had a difficult third quarter, although many hedge funds did. The quarter ended with the S&P 500's worst month since the beginning of the COVID pandemic. Q3 2021 hedge fund letters, conferences and more Maverick fund returns Maverick USA was down 11.6% for the third quarter, bringing its year-to-date return to Read More
Moreover, the problem with the “China thesis” is that it doesn’t explain anything either. It merely observes a correlation in the markets and therefore makes it highly convenient to put the blame on “the other guys.” Let me not be misunderstood here: the Chinese and US economies are certainly influenced by each other, especially in our age of fluctuating fiat currencies. But ultimately, both China and the US — indeed the entire world — are being dragged down by past actions of their respective central banks and more specifically the illusion of prosperity via monetary and credit expansion.
Which leads to the second theme: putting the blame on the Fed for “raising rates” too early. That is, there are a good many who argue that if the Fed had never announced in December that it was going to seek minuscule increases in the Federal Funds rate, none of the recent market drops would have happened. They will say things like “inflation was never a threat, so the Fed was irresponsible to raise rates.”
Money-Supply Inflation vs. Price “Inflation”
This is confused. First, it must be constantly emphasized that the meaning of inflation, contrary to the mainstream’s application of it, is more appropriately defined an increase in the money supply, not “rising prices.” The reason why the Fed and proponents of central banking prefer the “rising prices” definition is because it obscures the chief source of our present economic condition. It rips the blame away from the Fed and toward all kinds of other “market forces” and therefore encourages the central bank to swoop in to the rescue rather than be the object of severe suspicion. Indeed, as Mises observed (page 420 of Human Action):
What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates. This innovation is by no means harmless. It plays an important role in fomenting the popular tendencies toward inflationism.
First of all there is no longer any term available to signify what inflation used to signify. It is impossible to fight a policy which you cannot name. …
The second mischief is that those engaged in futile and hopeless attempts to fight the inevitable consequences of inflation — the rise in prices — are disguising their endeavors as a fight against inflation. While merely fighting symptoms, they pretend to fight the root causes of the evil. Because they do not comprehend the causal relation between the increase in the quantity of money on the one hand and the rise in prices on the other, they practicalIy make things worse.
Rising prices can be a result of inflation, but it is not itself inflation. So then, inflation was actually very high in the last decade due to the Fed’s QE and other monetary policy schemes. Second, it should never be ignored that “rising prices” can easily be found in the capital markets themselves. It doesn’t take an investment guru to observe the staggering levels to which the various market indexes have reached. Digging only a little bit farther into the surface reveals the absurd prices for the so-called highest valued stock such as Facebook, Amazon, Apple, and so on.
Where All That Money Went
More importantly, however, is the fact that much of the newly created money has not even come close to creating “widespread [consumer price] inflation” due to the actual structure of the current, post-crises banking regime. In fact, Jeffrey Snider, among others, have argued that it is literally impossible for “price inflation” to take place as a direct result of QE due to the way that money currently enters the system as reserves. “Price inflation” would need to come from the actions of individual banks themselves who are at present cautious about their consumer lending practices. Therefore the Fed is not creating “price inflation,” but something far worse: capital misallocation.
The point here is simply that those who want the interest rates to be continually suppressed so that economic activity will be encouraged, don’t even realize that this is literally the cause of bubble creations, not productive economic activity.
It used to be, under the pre-crises fractional-reserve model, that there would be loads of malinvestment as a result of banks creating new loans (new economic activity would take place, and then collapse back down). But now, money is created, not by commercial banks, but mostly by the Fed itself. Which means that, in the phraseology of David Stockman, the new money is simply sloshing around the canyons of Wall Street and pushing up equity and bond prices, rather than reaching the “real economy.”
The Bubble Only Prolongs the Problem
Thus, contrary to those blaming the Fed for causing stocks to fall by “raising rates” (which Joe Salerno reflects on here) we want to stress the fact that, in raising rates, the most that the Fed could do is unravel previously made mistakes. In other words, there is nothing praiseworthy in the first place about artificially propped up stock market levels. We have no interest in lauding the longevity of the bubble, because the bubble is the enemy of the healthy economy. The collapsing equity markets reveal where bubbles were formed and that our alleged prosperity is an illusion. And this is precisely what former Dallas Fed Chairman Richard Fisher stated in a conversation on CNBC last week when he confessed: “We frontloaded a tremendous market rally to create a wealth effect.”
And thus, the money expansion must inevitably cycle back down. Fisher himself admits: “… and an uncomfortable digestive period is likely now.” What was inflated up to the top, must deflate down to the floor. That is the only way for an economy to recover: bad credit needs to be liquidated. Unfortunately, it is painful indeed.
That is the true cause of the recent calamity. The dollar is “strengthening” by virtue of our credit system cracking at the seams. In other words, the so-called “strong dollar,” is merely one side of the pendulum swing of a volatile collapsing banking system. It shouldn’t be assumed that the dollar is becoming more sound; it is not. But if we might ever again have a sound currency, we first have to face the music.
And thus oil too, after years of being elevated up toward the heavens via the Fed’s monetary shenanigans, is experiencing its own inevitable bust. The illusion is being exposed.
Unfortunately, the Fed is a wild card, so we stay tuned to whether it will let the markets recover, or continue the perpetual cycle of money creation. My own advice for the Fed is neither to “raise rates” nor to lower them. But rather, to let go and let the market correct itself. For we have a lot of correction ahead of us.