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Posted: October 21, 2010

Bernanke and Econ 101

The theory makes sense, but what about reality?

Arthur Polner

"In theory there is no difference between theory and practice. In practice there is."
Yogi Berra

One of the basic principles of economics is that if a price is lowered, demand will increase. Chairman of the Federal Reserve Bank, Ben Bernanke, was an economics professor at Princeton prior to joining the Fed. By utilizing quantitative easing, creating money to purchase treasury bonds, Chairman Bernanke is pursuing classic Econ 101 theory hoping to lower interest rates, thereby increasing demand for money.

Well, in theory it makes sense, but in practice I see two issues. The first is what if cost isn't the only factor in demand. In my estimation, it's possible that because of fear of future economic and political events, corporations might not borrow at lower rates. It is also possible that individuals will continue to increase their saving rate and won't releverage their personal balance sheets no matter how low interest rates go. If corporations don't utilize the cheap cash, in all likelihood, they will not hire new workers nor expand existing capacity. If individuals don't borrow more, there won't be a pop in consumer demand with its anticipated economic results. If cheap money just lies fallow, the economy will not benefit from the Fed's actions.

If this proves to be correct, I would expect equities to decline, bond yields to get and stay very low, and an outperformance in frumpy (a favorite word of mine) dividend paying stocks as an income alternative to bonds.

The second issue is what if the cheap money is borrowed as theoretically anticipated but utilized in a manner not anticipated. Let's posit that rather than being utilized to increase gross domestic product, lowering unemployment and causing housing prices to rise, the borrowed money chases higher rates of return in emerging markets or speculates in commodities.

If this occurs, I would expect an outperformance of emerging market equities and commodities. I believe this scenario could lead to an increase to manufacturing costs and could be a negative for the economy, since costs would rise, theoretically causing demand to decline. This result would be consistent with economic principles but would be an unintentional consequence of quantitative easing.

It has been my experience that many times Yogi is correct; not always but enough for me to keep an eye open for unintended consequences.

As I have stated before, in my estimation, the Fed would not be utilizing quantitative easing if the economy was strong. The recent release of the Fed Open Market Committee minutes indicates a disposition to quantitatively ease. The equity market has been signaling that it believes the Fed will quantitatively ease, and this will strengthen the economy and equities are rising in anticipation. In theory, the markets are responding in a conventional manner. Should either or both of my points prove correct, this new round of quantitative easing may, in my opinion, show a disconnect between theory and practice.

I'll end with another sports quote, "It ain't over till the fat lady sings."


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Arthur T. Polner, Certified Investment Manager Analyst (CIMA�), is a Senior Vice President, Senior Portfolio Manager and Financial Advisor with Morgan Stanley Smith Barney. He and his team believe in an ongoing relationship with families and individuals in order to help manage their wealth for their benefit. Arthur provides guidance that his clients need in discerning the trustworthiness of financial information and its relevance to them. Arthur can be reached at (303) 545-1817 or arthur.t.polner@morganstanleysmithbarney.com. For more information, visit http://fa.smithbarney.com/polner.

 

 

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