Published May 09, 2012
| Wall St. Cheat Sheet
Only in America can you find monetary policy metaphors involving jelly donuts and the Simpsons. In a rare column, hedge fund manager David Einhorn recently penned a colorful critique of the Federal Reserve and how it affects financial markets.
The Greenlight Capital founder, which is well-known for raising red flags on Lehman Brothers and Green Mountain, uses jelly donuts to relate the Fed’s ongoing stimulus to the economy. He writes, “A jelly donut is a yummy mid-afternoon energy boost. Two jelly donuts are an indulgent breakfast. Three jelly donuts may induce a tummy ache. Six jelly donuts, that’s an eating disorder. Twelve jelly donuts is fraternity pledge hazing.” Einhorn is referring to the Fed’s zero interest rate policy and Bernanke’s pledge to keep rates at record lows until at least late 2014.
Einhorn explains, “My point is that you can have too much of a good thing and overdoses are destructive. Chairman Bernanke is presently force-feeding us what seems like the 36th jelly donut of easy money and wondering why it isn’t giving us energy or making us feel better. Instead of a robust recovery, the economy continues to be sluggish. Last year, when asked why his measures weren’t working, he suggested it was bad luck.” However, Einhorn believes it has nothing to do with luck and everything to do with human nature.
Due to unforgettable market events such as the dotcom bubble, housing collapse and flash crash, savers such as Homer and Marge are hesitant to invest in the volatile stock market. Instead, they place retirement funds into CDs and money market accounts. Lower interest rates affect the returns on these investments, but the lower rates also help other people such as Lisa get a cheap mortgage. The trouble comes from rates staying too low for too long. Einhorn writes, “Everyone agrees that low interest rates are a good way to stimulate a stalled economy. The Fed takes this logic a step further. It believes that if low interest rates are good, then zero-interest rates must be even better. At the peak of the crisis, it made sense. But that was four long years and many jelly donuts ago. In the 2012 economy, a zero rate policy not only adds no benefit, it’s actually harmful.”
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While Bernanke is trying to create a wealth effect by forcing investors into equities and pushing stock prices higher, many investors are still wary of the financial markets and seek safety in bonds, which appear to have downside protection with the Fed supporting prices. Einhorn says, “Let’s think about it from an investor’s perspective: For about 30 years, bonds have mostly risen in value. By directly intervening in the bond market and by promising zero percent short-term interest rates through 2014, the Fed has all but guaranteed that it will do what it takes to keep bond prices from falling. Right now, Homer and Marge own bonds that yield 2 percent, practically risk-free.” Other individuals nearing retirement are forced to reduce spending or stay in the work force longer. A recent survey by the Employee Benefit Research Institute says at least 20 percent of U.S. workers have postponed their planned retirement age at least once during the last year.
Although deflation is generally viewed as a good thing in scientific breakthroughs such as the Apple iPhone, just the fear of asset price deflation is enough to make Bernanke reach for the box of jelly donuts. Instead, Einhorn would like to see a small increase of interest rates to provide more income to families. However, the Fed is unlikely to raise rates, because according to presidential candidate Ron Paul, “Our central bankers are intellectually bankrupt.”
In a column posted on the Financial Times, Dr. Paul also criticizes the Fed for believing it knows best when it comes to interest rates. He says, “The Fed’s response to the crisis suggests that it believes the current crisis is a problem of liquidity. In fact it is a problem of poorly allocated investments caused by improper pricing of money and credit, pricing which is distorted by the Fed’s inflationary actions.” The markets have become so dependent on cheap money that speculation for more quantitative easing appears to be the only variable that matters. “We live in a world that seems to have abandoned the concept of savings and investment as the source of real wealth and economic growth. Financial markets clamour for more cheap money creation on the part of central banks. Hopes of further quantitative easing from the Fed, the Bank of England, or the Bank of Japan – or further longer-term refinancing operations from the ECB – buoy markets, while decisions not to intervene can cause stocks to plummet,” Dr. Paul explains.
From the Great Depression to the Great Recession, financial panics and the Fed’s inability to prevent them are nothing new. As a result, Dr. Paul continues to advocate a changing of the guard. On Tuesday, he hosted a Congressional hearing on monetary policy and the Federal Reserve. The hearing was titled “The Federal Reserve System: Mend It Or End It?” and involved testimony from several economists and lawmakers. “More and more people are beginning to understand just how destructive the Federal Reserve’s monetary policy has been,” Paul said in a press release. “I hope that this hearing will kick start a serious discussion on the need to rein in the Fed.”
While few are expecting immediate action to be taken against the Fed, the columns by Einhorn and Dr. Paul raise public awareness and just might inspire individuals to consider ways to protect themselves against the damaging monetary policies implemented by the Fed. Einhorn and Dr. Paul both view gold and gold miners as one way to seek protection.
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Disclosure: Long EXK, AG, HL, PHYS