Helicopter Ben

November 3, 2005

From an investing point of view, the second most important person in government is the Chairman of the Board of Governors of the United States Federal Reserve - or head of the Fed.

Ronald Reagan appointed current Fed Chairman, Alan Greenspan, in 1987 and reappointed him every four years. While no one person runs the Fed - there are twelve presidents of the regional Federal Reserve operating banks and a board of governors for the Fed - the Chairman role is the most important.

This is why the President's October 24th announcement of a replacement for a retiring Greenspan is worthy of observation - ongoing observation.

Ben Bernanke is not an old Bush chum or just semi-qualified for the job. The stock market did not react badly to the news. Bernanke seems more than deserving of the top job in the entire world of economics. But as I dug a little deeper, I uncovered some details that are a little scary.

A few days ago I was reading an old textbook from a money and banking course when I noticed Bernanke's name as a reference. The textbook itself is 15 years old. The Bernanke paper referred to in the text was written in 1983. This caught my attention because Ben isn't that old (a point brought up in the media, as he may be our Fed Chairman for several decades). As it turns out, Bernanke was 29 when he wrote the paper - pretty impressive, as is the entire Bernanke story.

Some say Ben Bernanke was just 10 points away from a perfect score on his SAT. He was no fortunate son either. Have you ever driven down I-95 to Florida? Are you familiar with South of the Border (Pedro feex later…), the ersatz Mexican theme stop on the border of North and South Carolina? Bernanke worked there as a waiter in the summer to pay for college. Ben eventually graduated summa cum laude from Harvard and received a Ph.D. from M.I.T.

It's a Horatio Alger story that warms the heart, one of a hardworking, smart kid who appears on the verge of reaching the very pinnacle of success, intellectually at the very least.

There was some criticism. James Grant, respected publisher of "the Interest Rate Observer", just wrote an editorial in the New York Times pointing out the danger to the world's finical markets with Bernanke at the helm. Grant was convincing until he stepped off the deep end and his real reason for hating Bernanke and the government became apparent: he's a gold bug who thinks this country is going to hell in a hand basket because we got off the gold standard. 

Grant thinks that so-called "fiat" money like the U.S. dollar (and every major currency in the world) is a sham, and real money is "specie" money backed by glorious gold. His well written, chilling forecasts for the stock market and the economy would be more frightening had he not made them so often before the stock bubble.

Bill Gross, manager of the world's largest bond portfolio (and portfolio holdings of ours), is positive on Bernanke in his latest monthly commentary. Gross likes Bernanke's preference for explicit targets for inflation as apposed to Greenspan's mysterious goals known only to him. This is no surprise as many foreign governments follow such targeting, setting visible goals like 2% for inflation, and Gross has owned foreign bonds in recent years.

Still, this solid endorsement by Gross didn't squelch the nagging feeling that something just wasn't right.

After skimming several of Bernankes scholarly papers (the kind that "prove" economic theories with complex formulas) and transcripts of speeches he gave during his recent tenure as a member of the Board of Governors of the Federal Reserve, some of his philosophies appeared with regularity.

Ben Bernanke went through life much smarter than everyone else around him - even as he climbed to circles of smarter and smarter people. This can have negative consequences, particularly in economics, which unlike physics or geometry isn't made up of provable truths. Economics is as much religion or philosophy as it is science. Much of it is theoretical and not provable until economists get a chance to prove it - namely the economists that leave the ivory tower and join, say, the Fed. 

When brilliant people put plans into action, sometimes they don't work out as well as planned. Long Term Capital Management was a hedge fund that almost single-handedly brought down the world's capital markets (so much so that the Fed had to corral banks together to shore up the failing fund's bets). Some of the smartest people in finance worked with LTCM, notably one of the most famous bond traders, and not one, but two Nobel Prize winners.

The trouble is, well-earned confidence in your own ability can prove hazardous because markets cannot be modeled 100% like gravity can. Unpredictable things happen in markets that have never happened before. 

Bernanke's confidence in monetary policy - using Federal Reserve powers over money to manage price levels, consumer demand, and employment levels - to solve all the worlds problems (and our past problems) runs high. Too high.

Bernanke is an expert on the Great Depression. He is quite sure the blame lies squarely on the feeble-minded bureaucrats who were running the Federal Reserve at the time. He argues that the Great Depression could have been largely avoided (and possibly the great crash and ensuing bear market) with a good dose of monetary stimulus to fight deflation.

Ben has similar scorn for Japanese central bankers. The country had largely been in a decade-plus recession after 1990, with massive declines in stock and real estate prices to boot. Again, according to Bernanke, a good dose of monetary stimulus could have averted the years of misery and deflation in Japan.

The underlying message is, if Bernanke was the central banks puppet master at the time, there would have been no U.S. Great Depression and market crash or Japanese mega recession and bear market. 

Aggressively fighting deflation is Bernanke's prescription for financial catastrophe. Most Federal Reserve chiefs worry about inflation - broadly rising prices year after year. Ben worries about deflation - price level collapses that generally only happen during major financial fallouts. 

If you recall, a few years ago our own Fed was talking about deflation risk during our mild recession. The Fed lowered rates to multi-generational lows as if we were in the worst recession in history. You have to wonder now if Bernanke was behind these strange initiatives. 

Such artificially low interest rates juiced speculative behavior - behavior that was falling since the tech bubble was pricked (and Enron, among others, collapsed). Suddenly, money flowed back to junk bonds, emerging markets, small-cap stocks, etc. We've benefited in our newsletter from such investor behavior, but are worried about the after effects of the cheap money. 

Low interest rates and easy money had the most pronounced effects on the housing market. The housing boom, which has added as much paper winnings to the public's net worth as the stock bubble of the late 1990s, was almost completely the result of ultra low rates used to fight a mythological, deflationary spiral.

Worse, Bernanke doesn't believe in pricking bubbles, unlike the old guard at the Fed in the late 90s, who openly discussed dot com IPOs trading at 7 billion dollar market caps (the text of which is only now being released to the public) with questionable financials (if any), and what the Fed could do to stop the insanity. The Fed eventually raised rates and tightened credit, possibly causing the 2001 mini recession.

Some are calling Bernanke "Helicopter Ben" because at the height of the deflationary scares in 2002, he explained all the ways the fed could fight deflation, even if interest rates got near zero (as rates did in Japan), which would appear to cut off the ammo of the Fed to continue the good fight (you can't lower rates below 0%). Ben eluded to something famed economist Milton Friedman once described as a heavy-handed way to increase the money supply: go up in a big helicopter and drop bags of money from the sky. This sort of talk rattles bond investors, who fear inflation more than anything since they would be paid back in progressively more worthless paper, err, fiat money.

Ben's favorite economist seems to be Irving Fisher, whom he refers to in his own papers. This is an unusual choice. Professor Fisher was a well-respected and brilliant Yale economist, whose fame peaked in 1929 when a few weeks before the great stock market crash he uttered the infamous words, "Stock prices have reached what looks like a permanently high plateau". Fisher went on, largely discredited, in the 1930s and wrote about how the Depression didn't have to happen if monetary blunders weren't made - the part that appeals to Ben. 

We think the people running the show in the 1920s and 30s (or Japan in the 1990s) deserve more credit than Bernanke gives them. Geniuses like Ben Bernanke, and the portfolio managers at LTCM, are smart enough to understand everything that has ever happened before. Unfortunately, they are not smart enough to understand something that has yet to happen. And they lack the humility that those of lesser intellect carry with them through life - a keen awareness of one's own shortcomings.

Bernanke may be handicapped by his own brilliance.