It all started with Alan Greenspan. Before Greenspan, Central Bankers were at best boring stuffy old men, and at worst, job destroying kill joys that worried too much about inflation and all the other things that might go wrong if they allowed monetary policy to run too loose. But Alan changed all that. During Greenspan’s tenure, the world experienced a unique set of twin disinflationary forces. The fall of the Berlin Wall combined with the rise of the Chinese manufacturing powerhouse, ushered in a new era where inflation was sent cowering into a corner. As these disinflationary forces were unleashed on America, Greenspan was faced with a choice. He could conduct monetary policy using the traditional guidelines. Or he could experiment with allowing monetary policy to run looser than normal due to the large global disinflationary forces that were holding down inflation. Of course Greenspan chose the latter, and in the process, made himself a hero, but also more ominously set off a series of bubbles followed by busts, followed by even larger bubbles, followed be even greater busts. But in the late 1990s most pundits didn’t realize this. To them Greenspan was one of the main architects of the new found American prosperity.
As our society has become more dependant on these financial asset bubbles, the mystique of Central Bankers has only increased. I doubt if 50 years ago most Americans would even recognize the name of the Central Bank chairman. Today the Chairman is giving 60 minutes’ interviews, or his (or her) face is being plastered on the cover of the mainstream news magazines. It has been made even worse by the fact that the partisan bickering within the Federal government has handcuffed any fiscal response. Central Banks have become the only game in town.
The power of the Central Bank allows them to appear to fix almost everything they set their mind to. Throw enough liquidity at any problem and it eventually goes away. At least for a while…
Their power to influence the short to medium term has created an air of omnipotence. The markets are rightfully scared of the Central Banks and Wall Street wisdom of “don’t fight the Fed” has become standard fare.
This reputation of omnipotence has been even greater by the fact that, those critics that have been worried about the Fed’s reckless behaviour, have been shamed with the recent deflationary wave. Their dire predictions about runaway inflation have proven to be nothing more than Chicken Little scare tactics.
Central Bankers seem to have won the battle. They are able to reflate only financial assets, without that reflation spreading into general prices. The large amount of faith that the Central Bankers commandeer seems to be well placed.
Are they really so smart?
But what if they aren’t quite on top of things as the market believes? What if they are simply flying by the seat of their pants – putting out fire after fire, with the same solution of more and more liquidity?
Last year one of my favourite hedge fund managers, David Einhorn of Greenlight Capital, had a private dinner with the recently retired Ben Bernanke. Einhorn was scared by the lack of any real plan.
“I got to ask [Bernanke] all these questions that had been on my mind for a very long period of time, right? And then on the other side, it was like sort of frightening because the answers weren’t any better than I thought that they might be. I asked several things. He started out by explaining that he was 100 percent sure that there’s not going to be hyperinflation. And not that I think that there’s going to be hyperinflation, but it’s like how do you get to 100 percent certainty of anything? Like why can’t you be 99 percent certain and like how do you manage that risk in the last 1 percent? And he says, well, hyperinflations generally occur after wars and that’s not here. And there’s no sign of inflation now and Japan’s done a lot more quantitative easing than we’ve done, and they don’t have it. So if there is a big inflation, the Fed will know what to do. That was kind of the answer.
Einhorn is no “guns and ammo” type gold bug. He is one of the smartest well thought out hedge fund managers out there. But he is scared by the Fed’s lack of any real plan.
However the market is ignoring Einhorn’s worries. The market is convinced that the Central Bankers know what they are doing. After all, they have shown time and time again how much they are on top of everything. Right?
Is Draghi really the second Maestro?
How about Europe’s Alan Greenspan equivalent? Until recently, Draghi was viewed as the next great Central Bank Maestro. This reputation was cemented during the European sovereign debt crisis. The now famous “we will do whatever it takes” comments stopped the panic in its tracks. Draghi seemed to be able to commandeer the markets with only his sheer force of will.
But was Draghi really in control of things as much as the market gives him credit? Recently the FT published some candid Timothy Geithner recollections of that moment. The truth of the matter is that Draghi was no cool customer that knew exactly how to calm markets. No, he was simply throwing stuff at the wall and seeing what would stick.
Geithner: [T]hings deteriorated again dramatically in the summer which ultimately led to him saying in August, these things I would never write, but he off-the-cuff – he was in London at a meeting with a bunch of hedge funds and bankers. He was troubled by how direct they were in Europe, because at that point all the hedge fund community thought that Europe was coming to an end. I remember him telling me [about] this afterwards, he was just, he was alarmed by that and decided to add to his remarks, and off-the-cuff basically made a bunch of statements like ‘we’ll do whatever it takes’. Ridiculous.
Interviewer: This was just impromptu?
Geithner: Totally impromptu…. I went to see Draghi and Draghi at that point, he had no plan. He had made this sort of naked statement of this stuff. But they stumbled into it.
This illusion that the Central Bankers are in control has been perpetuated and developed over time. But it is just that – an illusion.
The market is way too complacent that the Central Banks will be able to control this massive monetary expansion experiment. Maybe the inflationistas were too smug in their prediction that it would end in hyperinflation. Maybe we needed this deflationary dip to shake everyone off the trade. Maybe it won’t ever create inflation in real goods, but merely continue to exacerbate a massive financial asset boom bust cycle.
I don’t know the answer. But I do know that the market is much too convinced that the monetary authorities know what they are doing.
These Central Bankers don’t have some master plan. They are merely rushing from one crisis to the next. There will be long term costs that the market is not counting on.
My suspicion is that they will eventually lose control of the bond market, but I don’t know for sure. I don’t share in Bernanke’s 100% confidence level in anything.
I do know that when everyone is sure of something, it is time to look for the opposite to happen.
Right now everyone is sure that Central Banks can inflate financial assets only, with no spill over into general prices. I sure don’t hold that same degree of confidence.
I think we are at the height of maximum Central Bank confidence. The recent moves by the Bank of Japan have seemingly come without a cost, and thus confirmed that Central Banks are able to fix any problem they set their mind to.
When we look back at this point in history, I think we will be amazed at how much faith we had in these Central Bankers. These omnipotent heroes will be good for nothing bums before you know it.