Why one economist isn’t running with the bulls: Dow 5,000 remains closer than you think
But don’t get accustomed to that, warns Chapman University professor Terry Burnham. The former Harvard economics professor, author of “Mean Genes” and “Mean Markets and Lizard Brains,” Burnham argued on this page last summer that we would see Dow 5,000 before Dow 20,000. Ten months later, and a lot closer to an eventual end to the Federal Reserve’s stimulus program, the Dow has crept closer to 20,000. But Burnham’s sticking by his prediction, suggesting that U.S. macroeconomic policy is about to look a lot less fair to people who failed to recognize it as foul.
Our “lizard brains,” Burnham has often argued, blind us to the reality behind booming stock prices. Paul Solman interviewed Burnham about his lizard brain theory in 2005.
Burnham has been a long-time critic of the Federal Reserve and compared America’s dependence on printing money to the Stockholm Syndrome last year. Now he updates his Dow prediction in light of the market’s recent highs, and identifies three macroeconomic hurdles to reaching 20,000.
— Simone Pathe, Making Sen$e Editor
On July 11, when the Dow Jones Industrial Average stood at 15,460, I predicted that the Dow would hit 5,000 before it hit 20,000. On May 13, the Dow closed at an all-time high of 16,715, and the index has risen by 5.9 percent since I made my gloomy prediction.
Beyond the stock market rally, there is good economic news. For example, the U.S. unemployment rate has declined from 10 percent in 2009 to 6.3 percent as of April 2014, not far above its long-run average of 6.0 percent.
Is it time for me to surrender and join the bullish herd? No.
In this piece, I revisit the Dow 5,000 prediction and the economics of it, and I identify three macroeconomic hurdles to reaching Dow 20,000. The first of these hurdles is the U.S. Federal Reserve’s plan to end its loose money policy of quantitative easing by October of 2014.
The Prediction: Dow 5,000 before Dow 20,000
Harry Truman said he wanted a one-handed economist because he was tired of waffling economic advisers who made predictions qualified by saying, “but, on the other hand.”
Most economic arguments remain unsettled because the antagonists use obscure and movable metrics. For example, this year’s economic Nobel Prize winners include University of Chicago professor Eugene Fama, who believes financial markets are efficient, and Yale professor Robert Shiller, who believes markets are irrational.
Commenting on their diametrically opposite opinions, Fama stated, “we agree on the facts.” So it goes with many economic arguments; the two sides can maintain contrary views for centuries with no clear winner.
I use the Dow Jones Industrial Average as a public scorecard. If the Dow hits 20,000 first, I will be wrong, and I will make no excuses. Conversely, if the Dow hits 5,000 first, I will claim victory, and I will not listen to ex poste rationalizations from my opponents.
Former NFL coach Bill Parcells said, “You are what your record says you are.” The Dow stands at 16,374, significantly closer to 20,000 than on the day of my prediction. In the spirit of Parcells, I acknowledge the current score, but concede nothing so early in the game.
The logic of the prediction
“Fair is foul, and foul is fair.” So say the witches in Macbeth.
I believe that U.S. macroeconomic policy is foul but has been labeled as fair by many.
The fiscal response to the housing crises has been to overspend by running very large U.S. government deficits. Similarly, the Federal Reserve has flooded the world with money in the form of “quantitative easing” and low interest rates.
What is the impact of large, persistent government deficits and loose monetary policy? Here are some of the countries that have followed this economic prescription: Weimar Germany, Japan in recent decades, Greece and Zimbabwe. What happened to these countries?
Weimar Germany experienced hyperinflation, societal instability and the rise of Nazism.
In the 1980s, Japan’s economy was the best in the world. More recently, Japan has suffered a quarter-century of stagnation. Because of years of government overspending, Japan now has the highest sovereign debt levels among the large, industrialized countries.
Greece has both created and endured pain. It has created pain by defaulting on its debt and taking repeated bailouts. It citizens have suffered a severe economic contraction, and face a depression-level unemployment rate of over 25 percent. Greece still has unmanageably high government debt levels.
Zimbabwe experienced hyperinflation that caused its economy to collapse. Once a fertile country producing surplus grains and meat, many of its people are now hungry. Loose money in Zimbabwe created inflation and economic pain; it destroyed wealth.
Dow 5,000 is founded on a view that the U.S. is pursuing foul economic policies, which will one day be recognized as foul. Macbeth’s final statement is “I will not yield … And damn’d be him that first cries, ‘Hold, enough!’” Despite his resolve, Macbeth was destroyed. I expect a similar unpleasant end to U.S. macroeconomic policies.
Three macroeconomic hurdles before Dow 20,000
If U.S. macroeconomic policy is currently foul, but perceived as fair, what will cause the situation to change? One possibility is the coming unwinding of some of these policies. Beginning in 2008 the U.S. has pursued three very aggressive and unusual macroeconomic policies:
Quantitative easing is scheduled to end this year, and ZIRP may end next year. Federal government deficits are on course to be large indefinitely, however, the market may intervene and force a reduction in federal debt growth at some future time.
Reversing any one of these unusual macroeconomic policies is likely to be a significant hurdle to the economy. The next sections reveal the extreme nature of current policy.
Hurdle #1: End quantitative easing
The Federal Reserve has pursued years of quantitative easing where it buys Treasury and mortgage bonds from private investors. Those investors then have cash on their hands, which they can use to buy stocks, houses and other assets. Thus, quantitative easing creates higher house and stock prices.
Former Federal Reserve Chair Ben Bernanke stated that pumping up the stock market is an explicit goal of quantitative easing: “Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
If quantitative easing is designed, in part, to cause stock prices to rise, what will happen when quantitative easing ends?
This effect of the end of quantitative easing is all the more important because the program’s scale has been increasing in recent years. We can measure the size of quantitative easing by looking at the Fed’s balance sheet.
As of April 23, the Fed’s balance sheet stood at $4,296,339,000,000.00, up almost exactly one trillion dollars in the prior 12 months (see graph).
The Federal Reserve is planning to end quantitative easing in October, just five months from now. The Federal Reserve’s “taper” plan is to go from expanding the balance sheet at the fastest rate in history to zero new bond buys by October.
What will happen when the Federal Reserve ends quantitative easing? The amazing reality is that no one knows.
Economics is a lost field where leading scholars do not agree even on the direction of the impact of the most important policies. Does quantitative easing create jobs and support the economy? Federal Reserve Chair Janet Yellen says yes; Stanford professor John Taylor, and others, say no.
The end of quantitative easing will be a fascinating test of the Federal Reserve’s policies. Because quantitative easing has never been done before in the U.S., no one knows what will happen when it ends. This incredible, novel macroeconomic experiment is about to start.
Pop the popcorn, take a seat, and prepare to witness something historic.
Hurdle #2: End Zero Interest Rate Policy
The Federal Reserve sets short-term interest rates. Since 2009, the Federal Reserve has followed a zero interest rate policy (ZIRP) by keeping rates at almost exactly zero (see chart).
ZIRP is an extreme change from normal interest rate policy. The Federal Reserve controls short-term interest rates through what is called the Fed funds rate. Over the last 60 years, the Fed funds rate has averaged 5.2 percent; today it sits at 0.09 percent. The Fed funds rate is used by banks, and yields on Treasury bills and savings accounts are closely tied to its level. When the Fed funds rate is 0.09 percent, savers earn 0 percent on their bank balances.
The Federal Reserve argues that ZIRP is good for the economy because it lowers the cost of borrowing. The idea is that businesses will build more factories and buy more goods if they can borrow money at low cost.
Does ZIRP actually encourage companies to hire and invest? Perhaps.
However, ZIRP also encourages companies to perform financial engineering where they use low-cost debt to increase stock prices without creating jobs or increasing investment.
Consider the drug company Pfizer. On May 5, Pfizer reported a dismal performance where profits dropped by 15 percent and sales dropped by 9 percent.
Pfizer has a $100+ billion plan to combat its crumbling business. As part of that plan, Pfizer is going to borrow tens of billions of dollars by issuing debt. This debt will cost Pfizer very little: Even a 4 percent yield on a risky Pfizer bond looks good to some people in a world where the Federal Reserve pays nothing.
How many jobs is Pfizer going to create with its $100 billion plan? Zero. In fact, Pfizer will fire thousands of people. The Wall Street Journal writes, “In Drug Mergers, There’s One Sure Bet: The Layoffs.”
Pfizer plans to use its ZIRP-fueled funding, not to create new drugs, but to buy British drug maker, AstraZeneca. This corporate acquisition will allow the two companies to reduce investments and fire thousands of people. Additionally, because of arcane legal rules, Pfizer will avoid paying billions of dollars in U.S. taxes.
In the case of Pfizer, ZIRP creates billions for Wall Street in fees, millions for drug company executives, a larger U.S. federal government deficit, decreased investment, fewer life-saving drugs, and thousands of unemployed people. To paraphrase Austin Powers, yea ZIRP!
While the Federal Reserve believes that ZIRP is good, ZIRP has two main costs beyond Pfizer-like financial engineering.
First, ZIRP punishes savers. Consider the example of my 86-year-old father. While he was working, he paid his taxes, paid his mortgage and saved for retirement. Unfortunately, the income from his pension and Social Security is too low to cover his assisted-living expenses.
Because the Federal Reserve has set interest rates to zero, retirees must choose one of two unpleasant alternatives: one, buy risky assets and hope they rise in value, or two, draw down savings to pay current bills.
My father has chosen the second alternative; he has a low-risk investment strategy, which produces a modest income. My father is unlikely to lose his invested money, but, because his living expenses exceed his income, he gets poorer every month.
Watching one’s savings shrink is stressful. My dad asks me on almost every phone call, “Will I be okay financially?” To which, I am tempted to reply, “as long as you die soon, everything will be fine.”
ZIRP hurts seniors and other savers every day.
Second, ZIRP distorts economic decisions. For example, because safe investments pay 0.09 percent, anyone who wants a higher return has to buy stocks, real estate, commodities, risky bonds, or other risky investments. The distortion is that many people who cannot afford financial losses have been pushed by ZIRP to buy risky assets.
Warren Buffett said, “You only find out who is swimming naked when the tide goes out.”
When the financial tide turns, risky assets will decline in price. Who is responsible for the future losses that will occur on risky assets? In one sense, individuals are responsible for their own investment decisions.
While individuals retain responsibility, the government officials who create financial dangers are also culpable. We would be outraged if the military placed landmines on city streets. We can also be unhappy with macroeconomic policies that create financial landmines that will blow up our retirement accounts.
“Neither a borrower nor a lender be.” So says Polonius to his son Laertes in Hamlet. This may sound like good advice, but Shakespeare’s intent was to portray Polonius as spewing paternal platitudes.
Polonius’s hackneyed advice might prove wise in ZIRP-times. Borrowers face bankruptcy if they cannot repay their debts. Investors lose when borrowers such as Greece and Detroit default, and there will be many more defaults in coming years.
Yellen said ZIRP is likely to end “around six months” after the end of quantitative easing. In contrast, on May 4, Dallas Federal Reserve President Richard Fisher said, “Sometime in the next 100 years, interest rates will go up.” So who knows.
The end of ZIRP will be an enormous change to the economy. After years of ZIRP, any rise in interest rates is likely to cause some risky assets to plummet in value. Investors who own these risky assets will suffer. Borrowers, on the other hand, will have to re-learn how to live with debt costs that are no longer artificially low. Maybe Pfizer will have to create a new drug to boost its stock price.
Hurdle #3: End Federal Government overspending
The U.S. federal government has been spending more than it takes in almost every year since its inception. Since 2008, the pace of that debt increase has been historically large. How big?
Part of government spending has been used to produce a web page that reports the public debt to the penny on a daily basis.
On April 30, the total U.S. federal debt was $17.474 trillion, up from $16.738 trillion at the end of the prior fiscal year (September 30, 2013). In the last seven months, the U.S. government has added over $100 billion dollars a month in debt (see chart).
How do we make sense of the size of recent federal government deficits?
First, recent deficits are the largest in history outside of World War II. The largest increase in debt occurred between 1936 and 1945, when total U.S. debt grew by 80 percent of GDP. Between 2004 and 2013, total U.S. debt grew by 40 percent of GDP.
Between 1936 and 1945 the U.S. defeated Nazism and ended the Great Depression. Readers can decide for themselves what has been purchased for the deficits over the last decade.
Second, consider the current fiscal situation as compared with another one of the most extreme in history — the Civil War era. The country ravaged itself and killed more than 2 percent of the overall population. There were more military deaths in the U.S. during the Civil War than there are active duty soldiers in the U.S. Army today (even though the population is now more than three times as large).
At the end of the Civil War, total federal debt was about 30 percent of GDP. Currently, federal debt is 100 percent of GDP, and the increase in debt in the last seven years, relative to GDP, exceeds the entire federal debt at the end of the Civil War. We have borrowed more money, relative to the size of the economy, in recent years, than all the combined borrowings for the Revolutionary War, the War of 1812 and the Civil War.
In short, drunken sailors wish they could overspend like the U.S. government; they can’t because no one will lend them so much money.
While Yellen predicts that the Federal Reserve will end quantitative easing and ZIRP soon, the federal government is making no such promises. The Congressional Budget Office projects large federal government deficits forever.
How long can the U.S. go on spending more than it earns? No one knows. Japan’s debt-to-GDP ratio is more than twice that of the U.S., so our debt can continue to climb for decades. However, it is also possible that the market will refuse to lend to the U.S. at some point. Such events are unforeseeable in timing, but when they occur they tend to be very rapid.
At some point, the U.S. government will stop overspending. The date of this change is unknowable yet inevitable.
Summary Dow 5,000 thoughts as of May 2014
I have been a relentless critic of the Federal Reserve, arguing on this page in January:
When the Federal Reserve intervenes in markets, it has two effects — both negative. First, it decreases overall wealth by distorting markets and causing bad investment decisions. Second, the members of the Federal Reserve become reverse Robin Hoods as they take from the poor (and unsophisticated) investors and give to the rich (and politically connected).
We are entering an incredibly important and interesting time for economics. The end of unusual monetary and fiscal policy will reveal if the U.S. economy can prosper without these interventions.
My prediction remains unchanged: Dow 5,000 before Dow 20,000.