Correction: A previous version of this article incorrectly described the timing of Nazi Germany’s World War II occupation of France and the “phony war,” the lull in Allied activity that immediately preceded it. Germany invaded France in spring 1940, not in 1941, and the “phony war” began with Poland’s fall to the Nazis in autumn 1939. This version has been corrected.
Toward the end of her Nov. 14 confirmation hearing to be the next chair of the Federal Reserve, Janet Yellen faced a question from Sen. Mike Johanns (R-Neb.) about the effect of years of easy-money policies at the Fed:
“Here’s what I’m saying. . . . I think the economy has gotten used to the sugar you’ve put out there. And I just worry you’re on a sugar high.”
Yellen, who has been vice chair of the central bank since 2010, was not given time to address the charge, but her prominent role in supporting such policies gives us a strong sense of her answer.
The nomination of Yellen and the transition at the Fed highlights the fundamental financial questions of our day: Are we in a period of financial stability, perhaps marked by anemic growth in affluent nations such as the United States and the euro zone but, nonetheless, in no real danger of collapse? Or are we simply in the midst of another set of value-destroying bubbles that have punctuated the economic world with increasingly regularity? And is the cause of either reality the policies of central banks, whether as stewards of the financial system or as addled wizards casting their easy-money spells and critically wounding free markets and economic equilibrium to the detriment of us all?
Many investors, however, clearly believe that we are in a precarious situation thanks to misguided central bankers. Like Johanns, they see a world of burgeoning bubbles, a plethora of inflated assets absorbing the trillions of dollars of Fed bond buying, of zero interest rates throughout the developed world, of aggressive central banks — not just in the United States but also in Japan and Europe — flooding the planet with lucre in an attempt to prop up a global banking system whose failures were exposed in the 2008-09 crisis and have yet to be fixed.
This view is close to conventional wisdom, not just across swaths of the Republican Party but on the Democratic side of the aisle as well. On Wall Street and among investors, the view essentially is that we are living through the financial-system equivalent of the 1939 “phony war,” that lull between the fall of Poland to Germany and the collapse and occupation of France in 1940. All seemed calm, but that calm only presaged far greater turmoil just around the bend.
Investors routinely use words such as “turbocharged” and “punch bowl” to describe the impressive strength of stocks over the past few years. The multibillion-dollar initial public offering of Twitter this month was immediately greeted as a sign that Wall Street was ready to party like it’s 1999, replete with technology stocks soaring well beyond their earnings. A Barron’s cover story screamed last week: “Bubble Trouble?” While the article did not call the end just yet, it warned that the moment might be fast approaching.
The role of the Fed is never far from the surface. It is undoubtedly true that the bank’s policies of quantitative easing have been aggressive and unprecedented. The decision to buy $85 billion of bonds a month to ease lending conditions and improve access to mortgages has led to the Fed’s accumulation of close to $4 trillion on its balance sheet.
The results have been decidedly mixed, at least so far. Economic growth is chugging along at about 2 percent, but that much-less-than-robust expansion is spread unevenly across the country. There has been some easing of the mortgage market, especially considering the stringent lending standards that prevailed in the immediate aftermath of 2009. Borrowers no longer need a credit score in the mid-700s and a 20 percent down payment to qualify for a loan. But that is not to say the credit spigots are gushing, and residential mortgage debt is still down more than 13 percent from its 2008 peak. The unemployment rate — another target of the Fed’s policies — has gradually declined to its current level of 7.3 percent, but far less quickly than had been intended.
But it is also true that the Fed’s policy of easing has gone hand in hand with a significant rally in equities and housing prices. It is tempting to say that the rally has been caused by such policies. We know what the Fed has done. We know that assets and markets have rallied. We don’t know whether those policies are the key reason. Correlation is not causation.
The program of quantitative easing actually began in late 2008, and it accelerated with the third round of such easing in 2012, which accounts for about half of the $2 trillion in bonds the Fed has bought. Over the past two years, the Standard & Poor’s 500-stock index has gained about 40 percent, while housing prices have gained more than 10 percent, according to the Federal Housing Finance Agency (though they are still below their 2007 peak). Riskier assets such as lower-credit bonds have also climbed in price. Along with high-profile, attention-grabbing stories such as Twitter’s IPO, these trends have stoked the bubble narrative.
In June, when it appeared the Fed might soon begin to taper its sizable monthly purchases, financial markets reacted. The most violent response came from the bond markets, especially for more speculative bonds tied to emerging-market growth. But equities sold off as well. Though the Fed, led by Chairman Ben S. Bernanke and Yellen as vice chair, decided not to curtail the program this fall in the midst of the government shutdown, the market reaction was taken as a sign that the primary reason for financial market strength and stability was indeed the atypical — and likely unwise — policies of recent years.
This interpretation has been repeated so often that it passes for truth. Bubble mania made a frequent appearance during Yellen’s confirmation hearings, and it is a mantra in financial circles. None of that, however, makes it true.
Seemingly lost in the conversation are equally potent alternative explanations for economic stability and financial market strength. Stability, let’s be clear, does not mean that national economies are thriving, only that they are not imploding and not gyrating wildly. Lost in the fray as well is a disturbing tendency to see the Fed, financial markets and economies in general entirely through the lens of the past decade in the United States. Save for a brief housing bubble, that decade plus has not been a kind one for Americans.
Even with recent stock market strength, equities are barely back to where they were at the turn of the millennium; many homes are worth less than their mortgages; incomes for the vast and sundry have barely budged; and with interest rates and inflation so low, what used to be safe investments in bonds yield perhaps 3 percent when once generated 6 percent or more.
But on a global scale, two other forces are at play. More people have emerged out of poverty into a middle class and urban life more quickly than ever before in human history; and more than ever, larger companies are benefiting from that growth, while even smaller companies involved in the world of technology, information and production have never had it so good.
For proof of just how much global growth has benefited companies, look no further than the S&P 500. Though exact calculations are tricky, as much as 50 percent of the earnings of these large and purportedly American companies comes from outside the United States. Even with the head winds facing some of the markets thought of as “emerging,” the locus of growth in past years has undoubtedly been outside the United States.
Much of that has been fueled by the rise of China, not just as a manufacturer of lower-cost goods but also as a vast consumer of grain, commodities and high-end industrial and retail products. The story, however, is by no means limited to China; it extends across swaths of Latin America, sub-Saharan Africa, Eastern Europe, India, Indonesia and other parts of Asia.
That fundamental story, however, gets shouted down by the noise that markets and economies around the world are being propped up by the spigotlike policies of the Fed and guardians such as Yellen. Between Washington dysfunction and Wall Street cynicism, the notion that markets may be doing well for fundamental reasons remains inherently alien. The idea that companies are doing well because there is actually decent demand from global customers also does not fit the widespread perception of economic crisis.
In a country of 320 million people and a planet in excess of 7 billion, is it not possible that multiple realities exist simultaneously? In fact, it’s almost certain. Large companies are thriving because they have many of the advantages of the expansion of the global middle class and few of the liabilities. They contribute comparatively little of the tax base to support roads, infrastructure, education and collective welfare. Markets might not be exhibiting the lofty levels of expansion that some investors and commentators unrealistically expect, but many companies are routinely generating double-digit growth even while others are treading water or contracting. For every Apple, there is a BlackBerry.
Our ability to grapple constructively with challenges is hobbled by this entrenched suspicion that the ill-advised policies of the Fed are all that stands in the way between us and the bare truth — and painful consequences — of a failed financial system. Yes, the expansion of the Fed’s balance sheet in excess of $4 trillion is an experiment that may go awry and might have already. It may also have succeeded in preventing unnecessary deterioration in the financial system. We will never know for sure, not even when the program ends. We do know, or at least should, that the Fed is not the only game on the globe, any more than the U.S. government is. Life may be lived at the margins, but the forward motion of billions of people is not.
The 21st-century middle-class revolution cannot be explained by bubbles, and it will take more than price inefficiencies in markets here and there to halt or reverse that. The chair of the Fed matters, but our fear that its policies are at the core of the economic world is just that — fear. That is never a sound basis for addressing the problems of the day. Fear, as Franklin Roosevelt so eloquently reminded us 80 years ago, paralyzes us and impedes our ability to act. Washington and Wall Street today pulse with that fear, and yet the world moves along, in stops and starts, but still it moves.
And if you stop the proverbial man on the street in Sao Paolo or Shanghai or Mumbai, and the proverbial woman in Nairobi or Kuala Lumpur or Toronto, they will have little to say about quantitative easing or the Fed and easy money and everything to say about carving out their lives and their ambitions, and they will know that never have more people been able to achieve so much.
Karabell is head of global strategy for Envestnet. His next book, “The Leading Indicators,” will be published by Simon and Schuster in 2014.