by Eric Janszen

August 31, 2006

By giving my last Quick Comment the title The Fed: Dishonest or Incompetent? I left forum members to choose between corruption and stupidity to explain the Fed’s behavior over the past ten years or so, more or less forcing a lively debate. We got that in spades.

I’d say that to the question, "Is the Fed dishonest or incompetent?" the consensus answer among the iTulip community so far is a resounding: "Yes!"

This thread has also generated more conspiracy theory discussion than we usually get here at iTulip. That’s not surprising. After all, if the Fed is behaving in a way that appears dishonest and incompetent, it’s fair to wonder why. Nefarious motives inevitably come up.

As long time readers of the site know, I’m not a fan of conspiracy theories, and for the usual reasons. Conspiracies are impractical; they require many players to achieve broad goals and fool the crowd over a long period of time and that’s hard to pull off. Sooner rather than later someone in the "cabal" gets out of line and blows the whole game, thwarted factions break off to work against the group, and so on. Conspiracies require secrecy, covert operational brilliance, hidden central organization. In these days of Internet transparency especially, these are harder than ever to acheive.

Generally, where many see a conspiracy, I see a system, and where others might see a random event, I see a step in a process.

I view asset bubbles as systems, and their rise and collapse as more or less predictable processes. I was perhaps the first to identify the Internet Bubble as an asset bubble system, and compare it to the tulip mania in Holland in the 1600s.

I watched that particular bubble in action close up, and it continues to this day in the form of an echo bubble in Web 2.0 companies like MySpace.

The tech stock bubble was not a conspiracy. A bunch of VCs did not gather weekly in a room, drinking port and smoking cigars, scheming about how to rig things to sell worthless stock to suckers in the public markets. The bubble got started when someone made some money in an unexpected way. The IPO of Netscape is often cited as the firing gun. Then others imitated them by forming similar companies and tried to replicate what they did. Several succeeded. VCs started throwing money at new similar companies, and variants emerged, and they too got funded. The SEC let many of these companies go public, but should not have. The Fed allowed speculators to buy these stocks on margin, but should not have. An awestruck press covered the incredible money deals, fueling greater investor interest, but should have been more critical. I can assure you that at no time did a group of VCs gather with the SEC and some investment bankers in a dark room to figure out how to run this racket. But, I will tell you that some did sit together, quietly in the corner of a bar in Palo Alto or Boston or New York City, and after a couple of glasses of wine, say, "I can’t believe we’re getting away with this."

As the system of financing, investing, promotion, public offerings, and the re-investing of money thus generated went on, more VCs, investors, press and so on, piled in, and the bigger it got. Soon you had a self reinforcing system generating its own money, no fuel from the Fed required. Even those VCs that were skeptical of the longevity of this bubble system were forced to participate as their limited partners (investors) pounded on the table demanding, "Where’s my Netscape? How come we don’t have one of those!" One might reply, "It’s a bubble, Sir. Maybe we can make you lots of money or maybe it’ll pop and we’ll loose your money." That, while true, was the wrong answer. Any partner of a VC firm who conveyed this truth was simply not with the program, and had limited career opportunities with the firm and probably the industry at the time.

So it goes today with so-called hedge funds, what I call USIPs (Unregulated Speculative Investment Pools, because true hedge funds of old were hedged, long one thing and short a correlated other, whereas many so-called hedge funds today are merely long and are hedged only insofar as they have taken out some insurance in the form of some kind of derivative that is supposed to protect their bets from catastrophic losses).

SEC officials nod their heads in agreement with representatives of the hedge fund industry, acquiessing to the idea that regulation isn’t required because it will be "bad for investors" or "bad for the industry" or "bad for the world" and "there are enough laws on the books already" and "it’s all so complicated… we don’t know how." And, blah, blah, blah. Even as they cheer the SEC’s wisdom to abdicate their responsibility as regulators, I can see a hedge fund manager eating dinner in the back yard of his Norwalk, Connecticut estate this weekend, and after a couple of glasses of wine, leaning forward to get closer to one of his guests who is an investor in his fund, and whispering, "I can’t believe we’re getting away with this."

No conspiracy but certainly a system, and a process. At this point, the hedge fund bubble system is going through a several stage process of collapse. So is the housing bubble, although the two are not directly related. One is the rich man’s bubble, the other the every-man’s bubble.

Brings us back to the question of motive. Why allow these systems to develop? Why did the SEC allow all those dot coms to go public? Why is 27 year old Zachary R. George of Pirate Capital allowed to bully the 55 year old CEO of Cornell Companies? Is that really good for the country? Why is it fair to use public funds to bail out LTCM when the payees had no opportunity to reap any of the benefits?

Sometimes the most simple answer is the right one. It will surprise you, and I’ve come to this conclusion after meeting literally hundreds of these guys, and I do mean guys. Precious few women inhabit The System.

It comes down to culture.

Read more….

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Maybe there’s a New Economy after all

by Eric Janszen


Let’s put to rest the myth that the Fed is blind to asset bubbles and never intentionally acts to prick them. The truth can be obtained by anyone with an internet browser and a few hours on their hands to read the voluminous Fed Open Market Committee (FOMC) meeting minutes. In the FOMC meeting minutes from March 22, 1994 (pdf), Greenspan says (my emphasis in italics):

    "When we moved on February 4th, I think our expectation was that we would prick the bubble in the equity markets. What in fact occurred is that, as evidence of the dramatic shift in the economic outlook began to emerge after we moved and long-term rates began to move up, we were also clearly getting a major upward increase in expectations of corporate earnings. While the stock market went down after our actions on February 4th, it has gone down really quite marginally on net over this period. So what has occurred is that while this capital gains bubble in all financial assets had to come down, instead of the decline being concentrated in the stock area, it shifted over into the bond area. But the effects are the same. These are major capital losses, which have required very dramatic changes in the actions and activities on the part of individuals and institutions."

    "So the question is, having very consciously and purposely tried to break the bubble and upset the markets in order to sort of break the cocoon of capital gains speculation, we are now in a position—having done that and in a sense succeeded perhaps more than we had intended—to try to restore some degree of confidence in the System."

To try to restore some degree of confidence in "the System," as Greenspan calls it, the Fed injected liquidity in 1994 that restored function to a dysfunctional banking system and rescued the bond market. But what cures one bubble sows the seeds of new ones. As Martin Mayer said in his book The Fed: "The truth is that liquidity, the only significant weapon remaining in the central bank’s arsenal as decision making moves to the markets, will not necessarily go where you want it to go when you need it to go there."

The 1994 liquidity injection kicked off the largest and longest period of real estate appreciation in US history and launched the late 1990s stock market bubble in the bargain. Five years later, in June 1999, the Fed appears to have moved to prick the new stock market bubble in the same purposeful manner as in 1994, except you won’t find the same explicit discussion about pricking bubbles in the minutes of the June 30 FOMC meeting notes. The only reference to asset bubbles comes from the President of the Federal Reserve Banks of Boston, Cathy E. Minehan, during the previous month’s meeting (emphasis added):

"We recently held a meeting of the Bank’s Academic Advisory Council which, as you all know, includes two or three Nobel Prize winners and people from Harvard, MIT, Yale, and so forth. The discussion focused on issues related to productivity growth, labor market tightness, and asset market bubbles. The group was lively, to say the least. But some consensus was reached on the need for action that might take the wind out of asset markets, even in the absence of tighter monetary policy, perhaps through increased margin requirements or increased supervisory oversight on credit extended, particularly in the day trading operations."




She also commented on "excesses and imbalances" in the "stock markets, real estate markets, corporate and personal debt." If there was concern around the FOMC in 1999 about real estate excesses, you have to wonder what the FOMC thinks today. The median home price in California is up 123 percent since then. That’s close to the median home price increase for the US in the previous 20 years, from 1980 to 1999.

We won’t know for a while what committee members think because the full minutes of FOMC meetings are released after a five-year lag, but two things appear to have changed since 1994. First, there has been an apparent shift in the policy of talking about bubbles openly in committee meetings. Second, the Fed now appears to wait until the latest bubble has become considerably more egregious than the previous one. But otherwise the responses and results are the same.

Nine months after the Fed began to withdraw liquidity from the markets (starting in June 1999), the bubble popped in March 2000. The Fed then beat the previous post-bubble Fed rate cut record of 4% in 14 months, from 6% to 2%, that followed the 1929 crash. Between January 2001 and June 2003, the Fed flushed the System with liquidity once again as the Fed Funds Rate target was cut from 6.5% to 1%.

After more than four years of post stock market bubble collapse reflation, with short term interest rates kept below the rate of inflation, it appears that liquidity once again did "not necessarily go where you want it to go," resulting in the creation of bubbles in several asset classes. Unique to this bubble period, several asset classes that have historically been counter-cyclical, such as bonds and equities, are all rising in tandem. Now we have:

A Housing Bubble

A Bond Bubble

A Private Equity Bubble

A Hedge Fund Bubble

A Commodities Bubble

An Art Bubble

All asset classes can’t rise together forever. These bubbles too will eventually collapse. Then it’s reflation time again.

Ever since markets overran the Fed in the creation of money and credit in the late 1970s, the Fed has overseen a series of bubble booms and bubble busts. Market professionals, especially hedge fund managers, have learned how to position themselves to profit from these boom and bust cycles. Speculators are now well-trained and will be standing by; ready, willing, and able to turn the next post-bust liquidity flow of money their way.

Read More….ITulip

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