Former Federal Reserve Chairman Alan Greenspan recently shared his views on the risks associated with quantitative easing and the artificially lowered interest rates. He also pondered on the challenge of addressing these issues after they’ve already begun.
Below is a selection of his key statements…
“The sooner we confront the excessive level of assets on the Federal Reserve’s balance sheet – which everyone acknowledges is indeed excessive – the better. There’s a widespread belief that we can wait indefinitely before making decisions about when to take action. I’m not convinced the market will grant us that patience.
“The real question isn’t simply when we slow down our asset purchases, but when we start to reduce them. The markets may not provide us the flexibility we might prefer.”
The distinction between tapering and turning is akin to differentiating between reducing the rate at which new debt accumulates and actually repaying existing debt. Currently, the Federal Reserve is generating $85 billion monthly—out of thin air—to support the credit market. Tapering, as Greenspan describes it, would mean scaling back the expansion of the Fed’s balance sheet to an amount less than $85 billion a month. Turning would involve actually shrinking the Fed’s balance sheet, which stood at a staggering $3.357 trillion as of June 5.
Eventually, as Greenspan notes, the Fed will be forced to taper and turn. This will naturally induce a shock throughout the financial system.
No Insight
The yield on the 10-Year Treasury Note may be hinting at what lies ahead. For instance, last month, yields surged by 30 percent, rising from 1.63 to 2.13 percent. They settled at 2.21 percent yesterday. This could serve as a subtle alert to the Fed that their time is running short.
“Bond prices must decline,” Greenspan stated. “Long-term interest rates are bound to rise. The challenge we face is that we have no understanding of how quickly that will unfold.
“We remain significantly below the interest rate levels we should be at this point. This means that when the bond market begins to shift, we might not have the control we desire. The implications of this extend to a multitude of markets.”
Indeed, a rapid increase in rates could simultaneously collapse the bond market, stock market, and dollar. Thus, the Federal Reserve may need to act quickly to taper its asset acquisitions. However, the issue is that the Federal Reserve has crafted an economy that heavily relies on the continual issuance of inexpensive credit. A simple tapering might be enough to destabilize the market.
In essence, the Federal Reserve has boxed itself into a corner. They face a dilemma of their own making: they must continue to expand the money supply to keep the economy intact, but doing so risks leading to its downfall. Conversely, if they persist in injecting more money into the system, rising credit market yields will eventually spell trouble for the economy.
Salting the Earth with Money
Traveling down the grapevine from Tejon Pass along Interstate 5, between Los Angeles and San Francisco, one is greeted by an expansive panorama of agricultural fields. Yet, the farms in California’s San Joaquin Valley are not quaint 160-acre family homesteads reminiscent of the 19th century, nor do they embody the ideals of the yeoman farmer envisioned by Thomas Jefferson. They are instead vast, highly productive corporate farms.
While these enormous agricultural enterprises are impressive, what’s even more astonishing is their very existence. Given the region’s natural resources, the ability for any crops to flourish—aside from cacti and scrub—seems miraculous.
“The southern region of the valley was a desolate wasteland with scattered saltbush when first encountered by Don Pedro Fages in 1772,” noted University of California Berkeley Professor Emeritus, James Parson. “Annually, less than five inches of rain falls in southwestern Kern County, maybe ten inches in Fresno. During summer months, pan evaporation on the west side can reach 20 inches.”
However, a barren desert didn’t deter human ingenuity. With a touch of creativity, subsidized water, and an abundance of cheap migrant labor, we transformed it into what is often hailed as “The world’s richest agricultural valley,” a technological achievement of remarkable productivity.
Nonetheless, the unrestrained use of chemical fertilizers, pesticides, herbicides, and imported water comes with serious consequences. The very ingredients that have fueled the San Joaquin Valley’s productivity over the last century mirror the elements that have supported American financial markets and government debt over the past decade…
Specifically, cheap credit and excess liquidity.
For instance, in the San Joaquin Valley, extensive irrigation systems transport water miles to make the barren land fertile. But as this surface water travels through the open California aqueduct, it becomes increasingly salty. When it’s applied for irrigation, the residual salts accumulate in the soil.
After years of this practice, the salt levels in the soil have risen to a point where they impair plant roots. To counteract this, excessive watering is necessary because the irrigation water—while salty—is still fresher than the salt-laden soil. By over-watering, the areas around the plants are temporarily revitalized, allowing crops to grow. Yet this excess irrigation simultaneously accelerates the inflow of salt into the soil.
In this complex paradox, the very excess water that sustains farmland also serves as the source of salt that jeopardizes it.
A similar story unfolds within the U.S. economy. After five years of aggressively expanding their balance sheet and injecting cheap credit and surplus liquidity into financial markets, the Federal Reserve finds itself grappling with a comparable paradox.
They must continue to increase the money base to support the economy, but this very act may ultimately lead to its demise. Our expectation is that the Fed won’t truly commit to a reversal until market forces compel them to do so. By that time, they may have lost any remaining control over the situation.
Sincerely,
MN Gordon
for Economic Prism
