Market View - November 2012

The law of unintended consequences says that “the actions of people and especially government or policy makers always have effects that are unanticipated or unintended”

The Concise Encyclopaedia of Economics’ website explains that the law of unintended consequences illuminates the perverse unanticipated effects of legislation and regulation”, and quotes an early example of this when in 1692 the English philosopher John Locke, a forerunner of modern economists urged the defeat of a parliamentary bill designed to cut the maximum permissible rate of interest from 6% to 4%. Locke argued that instead of benefiting borrowers, as intended, it would hurt them since people would find ways to circumvent the law, with the costs of circumvention borne by the borrowers. To the extent the law was obeyed, Locke concluded, the chief results would be less available credit and a redistribution of income away from widows, orphans and all those who have their estates in money!

Following the banking credit crisis fallout that began in 2008, the role and influence of policymakers such as The Federal Reserve System (Fed) in the US and other central banks in most other Western democracies have been inexorably expanding, while trying to anticipate the unintended consequences of these actions becomes increasingly more difficult. For example the Fed is now committed to expanding its balance sheet which already stands at around $1.5 trillion by approximately another $500 billion a year for the foreseeable future through a combination of quantitative easing (QE3 or QEI as some are calling it) and an extension of operation twist!

The Fed’s unprecedented stimulus program is supposedly an attempt to bring down the US unemployment level from the current 8.5% (although most commentators are sceptical that the Bureau of Labor Statistics’ numbers are correct and suspect the real figure is at least 12% when all the people excluded by the BLS are factored back in), but it remains questionable whether this action will be successful in achieving the Fed’s dual mandate of maintaining price stability while promoting full employment. The unintended consequences thus far of all the quantitative easing undertaken (not just in the US but in most other Western economies as well), together with the zero interest rate policy (ZIRP) enacted shortly after the Lehman Bank failure have seen asset bubbles in US Treasuries and other developed economy government debt markets, as well as many commodities. This has contributed towards soaring energy and food inflation while middle and working class people throughout the West have seen the yield on cash deposits and government bonds almost disappear, forcing more and more savers to resort to risk assets to try and make up the shortfall!

Narayana Kocherlakota, The President of the Federal Reserve Bank of Minneapolis was recently quoted as saying that “as long as the FOMC (Federal Open Markets Committee) is continuing to satisfy its price stability mandate, it should keep the fed funds rate extremely low until the employment rate has fallen below 5.5%”. At the pathetically slow current rate of decline in US unemployment numbers, that could mean ZIRP being with us for between another five and ten years!

While the ZIRP and QE policies unquestionably cause pain and distress to a lot of middle and working class people, and most especially the elderly on fixed incomes, it might be reasonable to surmise that small businesses would surely benefit and potentially boost the economy by expanding and or starting new businesses. However the reality is not that simplistic as confirmed by research from Sylvain Leduc and Zheng Liu at the Federal Reserve Bank of San Francisco who concluded “Heightened uncertainty lowers economic activity and inflation, and thus operates like a fall in aggregate demand. During the Great Recession and recovery, we estimate that higher uncertainty has boosted the unemployment rate by at least one percentage point. Policymakers typically try to mitigate uncertainty’s adverse economic effects by lowering nominal interest rates. However, in the recession and recovery, nominal interest rates have been near zero and couldn’t be lowered further. As a consequence, high uncertainty has been a greater drag on economic activity in the Great Recession and recovery than in previous recessions.”

Renowned Wall Street commentator Jim Grant when appearing on CNBC recently said that “we are living in a world where only PhDs know what is best for us all, while the monetary mandarins have interjected themselves between us and the public price mechanism as the Fed’s influence has grown exponentially since its inception. We need to return to capitalism and markets are finally allowed to clear”

Witnessing the furore of nature in the guise of Hurricane Sandy wreaking havoc on the American Eastern seaboard at the end of October reminded many of us on this side of the Atlantic of another great storm that wrought havoc here in Southern England twenty five years ago in 1987 just before the Black Monday stock market crash. A recent article in The Economist newspaper looked at the implications of that crash (when the Dow Jones Industrial Average fell almost 23% on the 19th October) and suggests that the banking credit crisis that began in 2007 was a direct result of the wrong lessons being taken from the events of twenty five years ago.

Most importantly the wrong precedent on monetary policy was put in place with the now infamous Greenspan put resulting in asymmetrical risk when it came to market bubbles, but additionally the protected parts of finance were mistakenly expanded and also investors did not seem to learn the lesson of there’s no such thing as a perfect hedge, since if everyone else is selling, there will be no buyers at almost any price!

The Economist concludes “With trading then, investors (and their regulators) simply failed to learn anything and made the same mistake again. Perhaps the biggest conclusion of all is that any extended period of rapidly rising prices is an indication of a bubble – and that sadly there is no painless way to clean up the mess after the bubble pops.

During October global equities as measured by the MSCI World index in US$ terms fell 0.76% but are still up more than 10% since January 1st 2012, while the JP Morgan Global Bond Index has risen 2.5% since the start of the year. Regional equity indices gave mixed performances during October with the S&P 500 down almost 2% (up 12.29% year to date), but the FTSE 100 bucked the trend rising 0.71% ( and is up 3.78% YTD), as did the FTSE Eurotop up 0.61% (up 7.26% YTD), the Nikkei 225 in Japan climbed 0.66% (up 5.59% YTD), the Hang Seng in Hong Kong climbed 3.85 % (up 17.40 YTD), while MSCI India fell 1.96% (but is still up more than 20% YTD), and the Shanghai Composite in China fell another 0.81% (and is down almost 6% YTD)!

And so finally to return to the US where this month the electorate decides who will control the White House and Congress before peering over the so called fiscal cliff which will occur at year end when automatic tax hikes and public spending cuts will combine to tighten US fiscal policy by some 4% of GDP unless Congress passes new legislation to prevent it! Anatole Kaletsky writing for Reuters is not unduly concerned as regardless of who wins the election, “politics, economics and markets in Europe and America interact in very different ways.”

In effect Anatole is arguing the Federal Reserve’s decision to extend its Zero Interest Rate Policy (ZIRP) to 2015 gives the US government licence to run its deficit at almost no cost,  which has made the threats from the bond vigilantes (whom have wreaked havoc in some European debt markets) redundant. Suggesting that the likely political outcome of the imminent US elections is a continued stalemate (most likely via an Obama and Republican Congress combination), and therefore continued procrastination in 2013, Anatole believes the fiscal cliff will continue to be postponed indefinitely.

Anatole concludes “After the election, both parties will face the inevitable prospect of living together for four more years and they will be held responsible by voters and business funders. Neither side will dare to start this long period of unavoidable cohabitation by pushing the economy over a fiscal cliff.”

Let us hope there are no additional unintended consequences of those actions!