Listening to the Canary
By Terry Coxon, Senior Economist
The unfolding economic landscape has significant implications for investors and the general public alike. By examining historical events and current trends, we can gain insights into the potential risks that lie ahead.
During World War II, the British Royal Air Force (RAF) initiated a plan of deception to enable a squadron of bombers to approach a highly protected target undetected. This target was so fortified that executing a successful attack required an extraordinary level of surprise.
Although the RAF had the capacity to disrupt the electronic detection systems along the path to the target—using a rudimentary version of radar at the time—they feared their interference might alert the German defenses. Thus, they devised a strategy to mislead the German operators into believing a false narrative. The British had a distinct advantage, as the German personnel were using unfamiliar equipment, which led to misinterpretations of the signals they received without any direct visual confirmation.
On the first day, at sunrise, the RAF transmitted a jamming signal for just a fraction of a minute. By the second day, the signal extended to slightly over a minute and continued to lengthen each day, always initiating just before sunrise.
This training lasted nearly three months, during which the German radar operators came to the erroneous conclusion that their systems struggled under the atmospheric conditions present at sunrise, a belief that compounded as the season advanced. This misunderstanding allowed an RAF squadron to penetrate deep into Europe and ultimately destroy the target.
Over time, people can become accustomed to nearly any situation. This acclimatization occurs swiftly, especially in cases where individuals lack a thorough understanding or direct experience. While terms like Quantitative Easing (QE), money printing, and government deficits may circulate widely, the public often doesn’t witness these actions first-hand, much like observing a car crash or burnt toast that would evoke a more immediate emotional response.
Fleeing the Ghost of the Dot-Com Bubble
QE has now become merely a narrative, dragging on for so long that it has lost its capacity to instill fear. Consequently, far fewer investors recognize how peculiar the current state of the U.S. economy and global investment markets truly is—strange, and possibly perilous—but we’ve all grown accustomed to it.
Consider the four major oddities at play:
- The Federal Reserve is still grappling with the aftermath of the dot-com bubble. Concerned that the collapse of this bubble, which began in March 2000, would harm the economy, the Fed aggressively increased the monetary supply, causing the growth rate of the M1 money supply to surge from nearly 0% to almost 10%. This maneuver briefly shielded the economy from a recession that commenced the following year.
- While this immediate response had benefits, it also initiated a bubble within the housing market. Beginning in 2003, the Fed gradually reduced the money supply growth rate to mitigate soaring housing prices. This, too, was successful, as housing prices started to decline in 2006.
However, the subsequent consequences led to the financial crisis of 2008. In reaction, the Federal Reserve drastically increased the monetary supply, witnessing year-over-year growth rates of 21%, which remain at a rapid annual growth of 9% today.
- The continuous increase in the money supply since 2008 has maintained interest rates on money market accounts near zero. While rates on longer-term debt aren’t at absolute zero, they remain remarkably low; for instance, the yield on a ten-year Treasury bond is currently at 2.7%, a rise from a previous low of 1.7%.
The influx of new money permeates all financial markets. In the United States, stock and bond markets fluctuate with every indication of the Fed tightening monetary policy. The impact isn’t confined to the U.S.—when credit is inexpensive in America, considerable borrowing occurs for investments globally, inflating asset prices almost everywhere.
- The management of U.S. federal debt is precarious. The deficit for 2013 was $600 billion—an improvement from prior trillion-dollar deficits—but this reduction was only attainable due to exceptionally low interest rates that ease the burden of servicing government debt. Should interest rates rise, what now seems less alarming will revert to a troubling scenario.
Few envision this situation preserving itself indefinitely. However, many investors harbor an expectation—perhaps just a hope—that a return to a “normal” state is achievable, confident that those at the helm, particularly Federal Reserve governors, possess the wisdom and knowledge to navigate these challenges. The belief is that the brightest minds are on the case.
Listening to the Canary
Were the best minds tasked with crafting a bridge, I would anticipate its reliable performance, even during storms. And if those same experts designed an airplane, I’d expect it to fly effectively. Yet, if they were to oversee a field as nebulous as economics—where the guiding principles remain uncertain—I would brace myself for potential failures, albeit ones adorned with impressive academic accolades.
Despite the complex mathematics often associated with it, economics cannot be considered a mature science. It remains a nascent discipline, burdened by cherished beliefs and untested doctrines, much like medicine in the 17th century, when the academic elite debated whether blood circulated or merely pooled in veins. Presently, economists wrestle with whether newly minted currency will circulate within the economy or simply remain stagnant in the hands of recipients.
Let us analyze the conundrum before the esteemed economists today.
If the Federal Reserve were to persist with the money printing initiated in 2008, the economy might continue its gradual recovery, reducing unemployment further. However, this surge in the money supply would inevitably trigger a rise in price inflation. Only a significant slowdown in monetary growth could curtail this inflation, yet doing so would likely lead to much higher interest rates, pushing the federal deficit back above the trillion-dollar threshold and possibly plunging the economy back into recession.
To address this, the Fed has embarked on a “tapering” strategy, attempting to gradually slow the money supply’s growth. Their objective is to orchestrate this process with precision and care, thereby avoiding catastrophic inflation while preserving the recovery. What are the chances of their success?
Regrettably, my assessment is grim—“very low.” The reason is that they are not grappling with a linear system. Managing the money supply resembles disarming a bomb; a simple miscalculation can lead to disastrous outcomes, unlike adjusting the flavors in iced tea where a minor oversight won’t ruin the drink.
Modifying the money supply incites multiple reactions, some of which can backfire. Suppose the taper is executed so delicately that the U.S. economy remains stable. That, however, is not the end of the narrative. Stock and bond markets worldwide have thrived on the Fed’s expansionary policies. A gentle touch that sustains U.S. markets might inadvertently destabilize other markets, leading to consequences that reverberate back into the U.S. through investment losses, loan defaults, and harm in export demand. With this interconnectedness, even the lightest touch could potentially prove destabilizing.
In conclusion, the current economic climate demands close attention and careful consideration. As the Federal Reserve attempts to navigate these complexities, the outcome remains uncertain, and vigilance will be essential in the times ahead.
Sincerely,
Terry Coxon
for Economic Prism
[Editor’s Note: To understand the consequences of economic mismanagement and how subtly disaster can approach, watch the 30-minute documentary, Meltdown America. Experience the compelling narratives of three ordinary individuals who endured a crisis, highlighting the warning signs of potential turmoil in the U.S. Click here to watch it now. This article, Listening to the Canary, was originally published at caseyresearch.com.]
