Federal Reserve should embrace more pain for good of the economy (by David J. Campbell)

Despite the stock market being up, unemployment being down, and inflation remaining low, significant risks of a financial meltdown remain. When Jerome Powell takes over the chairmanship of the Federal Reserve next February, he should make three moves to ward off future financial collapses like the one consumers and investors suffered in 2008.

He should push the Fed to:

 Be more discerning before interfering in the economy, and, when doing so, limit the dosage and duration;

Sell off quickly the bond investments it already has made to stimulate the economy; and

Let bankruptcy be a normal byproduct of the business cycle.

He needs to do this swiftly as the financial system has entered its own “opioid crisis” as the economy and investors have become addicted to the Fed’s extraordinary pain-relieving measures.

At first glance, it looks like Powell is inheriting a fairly sunny economic outlook. But along with stock prices, investor complacency has soared. Risk has not been allowed to play its proper role in helping the economy and asset markets to function normally.

For example, when the technology stock bubble burst in 2001, triggering a recession, the Fed moved aggressively by reducing the rate at which banks can lend to each other to just 1 percent. The recession turned out to be brief and mild, but the policy’s aftermath was dramatic and long-lasting. Investors and consumers went on a buying binge. Stock and real estate prices ballooned.

Similarly in 2008, as financial liquidity dried up and assets collapsed during the financial crisis, the Fed again purchased bonds to prop up both asset prices and the economy, driving interest rates to an unprecedented zero percent. In fact, its balance sheet more than quintupled to $4.5 trillion in the past decade. As a result, stock and real estate prices have soared once again.

Who pays the price for all of this intervention? You do.

Savers earn near to zero percent on bank deposits. Insurance companies have been squeezed as the Fed drove down interest rates. Pension plans are being chronically underfunded and the pension deficit is increasing: according to a Willis Towers Watson report, 410 of the Fortune 1,000 companies held an average of just $80 for every $100 of promised benefits.

The stabilization of the economy made people confident that regulatory actions could bring better control over the markets, prevent bad outcomes and smooth out normal economic cycles. It’s this abiding faith that has led to the bailout of banks that made bad loans and the bailout of a failing auto industry.

It also has produced a dangerous level of hubris on the part of public officials and those in the private sector who now feel insulated from any bad investment decisions. Removing the real risk of bankruptcy creates investor complacency and the willingness to buy at any price.

This isn’t to knock intervention altogether. When it’s well-applied, measures to protect citizens from systemic risks are vital to a well-functioning economy and society. The Fed was absolutely correct to step in strongly in 2008 but as far back as four years ago, it was clear that the economy was strong enough to function satisfactorily without the persistent application of the Fed’s medicine. Yet the Fed kept on prescribing it and is only now considering reducing the dosage.

David J. Campbell is a principal of the San Francisco wealth management firm BOS, which has about $4.3 billion in assets under management as of Oct. 31.

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About John Vashon

I own a family business that invests in and manages our own portfolio of mobile home parks.
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2 Responses to Federal Reserve should embrace more pain for good of the economy (by David J. Campbell)

  1. tshort says:

    Nice post, John. Reading what you said about complacency got me thinking about other triggers for that. Do you think ETFs have also contributed to individual/retail investor complacency? Seems like conventional wisdom has been updated from the speculator days of Fidelity Magellan funds, and “know what you own and why you own it.” Now it’s just easier, and problably safer, to just “buy the market” by investing in index tracker funds that aren’t trying to beat the market – just match it.

    I’ve often wondered what would happen if literally everyone just bought index funds ??? Would there be any return at all in the market? Who would be taking the risks that drive the differences that drive appreciation?

    Definitely *not* my baliwick – but would love to hear from your or others on that.

    • John Vashon says:

      Thanks for your reply! I’m quite certain when the Fed induced stock bubble bursts it’s going to wipe out the retirement of millions of aging baby boomers. SELL, SELL, SELL!

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