Wednesday, July 21, 2010

Stocks Fall After Bernanke Testimony

“Bernanke calls the outlook 'unusually uncertain" and notes the central bank is prepared to take additional action if needed. His economic outlook sees lower than expected inflation and at best a slow pace of falling unemployment levels. He notes financial conditions are hindering growth and expects interest rates to stay low for ‘extended period.’ At the same time, he says the Fed is continuing to think of ways to shrink its portfolio, and any asset sales will come gradually. Bernanke's comments to Congress are largely as expected, but some may be a bit taken aback by his comments on shrinking the balance sheet, which doesn't suggest much central bank appetite to provide additional stimulus to a troubled economy. Stocks are taking it on the chin while the two-year Treasury yield is hitting yet another record low. The dollar is holding pretty steady.” As reported by the on-line Wall Street Journal.

The markets are looking for someone to pull off some magic. Maybe we can get Nicholas Cage from “The Sorcerer’s Apprentice” to come do something special. Or, maybe the cry is for an alchemist, someone who can change the real world into something it isn’t.

One of the fundamental principles of economics, a principle of the real world, is that economic variables that are nominal in value cannot change economic variables that are real in value. Throwing more money (a nominal variable) into the economy will not reduce unemployment (a real variable). But, maybe an alchemist could do this.

Furthermore, there are some real structural problems that exist in the economy, the result of the past fifty years of inflationary monetary and fiscal policies. These problems are not going to be chased away by “Helicopter” Ben.

The first of these problems has to do with the labor markets and the current structural dislocations that labor is now facing. I wrote about this yesterday. See

The second has to do with the banking industry and the credit problems that still exist for many, many commercial banks. See

Third, the private sector of the economy is still heavily in debt. Credit card debt remains excessively high and the housing market continues to drag along the bottom. Foreclosures for the year are expected to reach 1.0 million and personal bankruptcies are still at near-term highs. Small- and medium-sized businesses continue to face financial difficulties due to having too much leverage on their balance sheet and commercial real estate is expected to remain a problem well into next year.

Commercial banks have over $1.0 trillion in excess reserves. Is their behavior going to change if excess reserves in the banking system rose to $2.0 billion?

One criticism that has been leveled at economists is that they have built their “science” to resemble classical physics with too much emphasis upon concepts like “equilibrium”. Over the past fifty years or so, one could argue that economists believed that they could use the models they developed to change the world from what it is to what they would like it to be. They assumed that they were alchemists.

In some situations there is only so much humans can do. They cannot “wave their wands” and create something that isn’t there. Reinhold Niebuhr is quoted as saying: “God grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference. “

I am not, by nature a pessimist, nor am I a defeatist. There are things we can do. However, continued aggressive monetary and fiscal policies may not be appropriate at this time. In fact, I have argued that the continued use of aggressive monetary and fiscal policies over the past fifty years has actually created the problems we are now facing. (See Maybe the government needs to try other means of relieving pain and helping people to transition to a new world.

The advancement of human knowledge requires us to learn what we can change and what we cannot change. It was an advancement in human knowledge when people learned that you cannot change a common substance into gold. Then people began to find out what they could really do within the real world when they worked with nature and didn’t work against the way things are.

Maybe Bernanke and the central banks realize that there is only so far they can go. The financial crisis of 2008-2009 was minimized by the Fed’s “throw everything you can against the wall and sees what sticks” policy. Here the Fed was doing something it could do.

Now there is some form of “liquidity trap” that prevents the actions of the Fed from working through the banking system. We are in a “pushing on a string” environment. Maybe the Fed realizes that additional efforts at this time would just be trying to make gold out of a common substance.

Maybe the financial markets should realize that the Fed is not going to come up with some magic wand that will sweep away the current economic and financial problems.

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