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A break for patience

Divorces are wonderful. So are heavy due loan payments. They make emergencies. They force asset sales. If you’re there — at the right time and place — you can pick up a cheap house, a cheap business or a cheap piece of a private equity fund. A friend just bought a piece. It was valued at $85,000 (that was its NAV — net asset value). He bought it for $35,000. The deal was less the money, it was the delivery. “Can you FedEx a bank check for $35,000 tonight?”

Gold still shines. Gold gained 24% in 2009. It gained 5% in 2008. It’s come back from its 2009 high. So it’s a good time to buy a little of the metal and its miners. I like GLD, FSAGX, AEM, GG,  GOLD, AUY and GSS. And for a speculation, BRCO.

The bubbles continue.  Remember the quote from How Markets Fail? During the past forty years, there have been 124 systemic banking crises around the world. These were credit-driven boom and bust cycles. There were three of them in the U.S. from 2000 to 2010.  Boom and bust cycles are  absolutely destined to continue, which means, for us investors:

1.  Cut way back on our borrowing.

2. Focus on the worst evntuality.

3. Stick with reasonably liquid assets.

4. Play with the bank’s money.

We are on the way to another bubble. I can smell, feel it. It’s coming. By maintaining, ultra-low interest rates, the Fed is encouraging another bubble.  I was thinking about the next bubble as I read this piece.

Fed Missed This Bubble. Will It See a New One?

By DAVID LEONHARDT. New York Times, January 6, 2010

If only we’d had more power, we could have kept the financial crisis from getting so bad.

That has been the position of Ben Bernanke, the Federal Reserve chairman, and other regulators. It explains why Mr. Bernanke and the Obama administration are pushing Congress to give the Fed more authority over financial firms.

So let’s consider what an empowered Fed might have done during the housing bubble, based on the words of the people who were running it.

In 2004, Alan Greenspan, then the chairman, said the rise in home values was “not enough in our judgment to raise major concerns.” In 2005, Mr. Bernanke – then a Bush administration official – said a housing bubble was “a pretty unlikely possibility.” As late as May 2007, he said that Fed officials “do not expect significant spillovers from the subprime market to the rest of the economy.”

The fact that Mr. Bernanke and other regulators still have not explained why they failed to recognize the last bubble is the weakest link in the Fed’s push for more power. It raises the question: Why should Congress, or anyone else, have faith that future Fed officials will recognize the next bubble?

Just this week, Mr. Bernanke went to the annual meeting of academic economists in Atlanta to offer his own history of Fed policy during the bubble. Most of his speech, though, was a spirited defense of the Fed’s interest rate policy, complete with slides and formulas, like (pt – pt*) > 0. Only in the last few minutes did he discuss lax regulation. The solution, he said, was “better and smarter” regulation. He never acknowledged that the Fed simply missed the bubble.

This lack of self-criticism is feeding Congressional hostility toward the Fed. Mr. Bernanke is still likely to win confirmation for a second term, based on his aggressive and creative policies once the crisis began. But Congress hasn’t decided whether to expand his regulatory authority and is considering reining in the Fed’s other main mission – setting interest rates.

A once-marginal proposal – from Representative Ron Paul, the Texas Republican – that would give Congress the power to review interest rate decisions recently passed the House and will soon be considered by the Senate.

Economists are generally horrified by this idea. If Congress could force Fed officials to answer questions about every interest rate move, the process could easily become politicized. A politicized central bank is a first step toward runaway inflation.

But politicizing monetary policy isn’t the only mistake Congress could make. It also could end up going in the other direction and handing Fed officials more power without asking them to grapple with their failures.

When Mr. Bernanke is challenged about the Fed’s performance, he often points out that recognizing a bubble is hard. “It is extraordinarily difficult,” he said during his Senate confirmation hearing last month, “to know in real time if an asset price is appropriate or not.”

Most of the time, that’s true. Do you know if stocks will keep going up? Is gold now in the midst of a bubble? What will happen to your house’s value? Questions like these are usually an invitation to hubris.

But the recent housing bubble was an exception. By any serious measure, houses in much of this country had become overvalued. From the late 1960s to 2000, the ratio of the median national house price to median income hovered from 2.9 to 3.2. By 2005, it had shot up to 4.5. In some places, buyers were spending twice as much on their monthly mortgage payment as they would have spent renting a similar house, without even considering the down payment.

More than a few people – economists, journalists, even some Fed officials – noticed this phenomenon. It wasn’t that hard, if you were willing to look at economic fundamentals. You couldn’t know exactly when or how far prices would fall, but it seemed clear they were out of control. Indeed, making that call was similar to what the Fed does when it sets interest rates: using concrete data to decide whether some part of the economy is too hot (or too cold).

And Fed officials could have had a real impact if they had decided to attack the bubble. Imagine if Mr. Greenspan, then considered an oracle, announced he was cracking down on wishful-thinking mortgages, as he had the authority to do.

So why did Mr. Greenspan and Mr. Bernanke get it wrong?

The answer seems to be more psychological than economic. They got trapped in an echo chamber of conventional wisdom. Real estate agents, home builders, Wall Street executives, many economists and millions of homeowners were all saying that home prices would not drop, and the typically sober-minded officials at the Fed persuaded themselves that it was true. “We’ve never had a decline in house prices on a nationwide basis,” Mr. Bernanke said on CNBC in 2005.

He and his colleagues fell victim to the same weakness that bedeviled the engineers of the Challenger space shuttle, the planners of the Vietnam and Iraq Wars,
and the airline pilots who have made tragic cockpit errors. They didn’t adequately question their own assumptions. It’s an entirely human mistake.

Which is why it is likely to happen again.

What’s missing from the debate over financial re-regulation is a serious discussion of how to reduce the odds that the Fed – however much authority it has – will listen to the echo chamber when the next bubble comes along. A simple first step would be for Mr. Bernanke to discuss the Fed’s recent failures, in detail. If he doesn’t volunteer such an accounting, Congress could request one.

In the future, a review process like this could become a standard response to a financial crisis. Andrew Lo, an M.I.T. economist, has proposed a financial version of the National Transportation Safety Board – an independent body to issue a fact-finding report after a crash or a bust. If such a board had existed after the savings and loan crisis, notes Paul Romer, the Stanford economist and expert on economic growth, it might have done some good.

Whether we like it or not, the Fed really does seem to be the best agency to regulate financial firms. (It now has authority over only some firms.) As the lender of last resort, it already has a vested interest in the health of those firms. The Fed’s prestige also tends to give it its pick of people who want to work on economic policy.

“The Federal Reserve has unparalleled expertise,” Mr. Bernanke told Congress last month. “We have a great group of economists, financial market experts and others who are unique in Washington in their ability to address these issues.”

Fair enough. At some point, though, it sure would be nice to hear those experts explain how they missed the biggest bubble of our time.

Harry Newton

Let me have your comments on gold and the next bubble. No one should listen to me exclusively on this emotional (not logical)  stuff.

12 Comments

  1. SY says:

    Hi love the column…but how do I print it??S

    • harrynewton says:

      Ctrl P works with most browsers to print.
      Otherwise hlightlight the bit you want, Ctrl C and then open Word and Ctrl V into Word and print from Word.

  2. Linnaea says:

    At the risk of sounding as ignorant as I am, how do you simultaneously cut way back on your borrowing and play with the bank's money?

    • harrynewton says:

      “the bank's money” means your profits, as against your original investment which you cash out and hold in cash or a safe bond.

  3. Rami says:

    Harry- why is your blog now soo squeezed and narrow. AND why must I be solicited for ETF trading, Fischer Investments, Tradeof the week.com, and Midas Investments???? Looks like a sell-out to me. How does it work…you get paid everytime someone clicks over to their website??

  4. Noland says:

    Harry,
    The next bubble forming might be bonds? Money flows have been into bond funds and out of money markets for quite some time now, yet interest rates are abnormally low. If this trend continues, and the Fed would initiate a series of interest rate hikes, bonds would move toward a more accurate valuation and the bond market could collapse.

    • harrynewton says:

      Absolutely correct. When interest rates rise, bond prices drop. And vice versa. That's why people are buying short-term bonds. Or holding their longer ones to maturity.

  5. RobertChastain says:

    Harry,

    take a look at NG for a gold play……… they are a decent company that most people don't hear about……… let me know what you think about it……. but I do own it from down below…….

    Rob

  6. playj says:

    Harry: BRCO looks very interesting. A 25% stake in 34 million ounces of gold? What's the downside and what's the upside potential for this stock?